Sensitivity Analysis

Sensitivity analysis should be conducted to help determine which assumptions have the most influence on the model results. Through sensitivity analysis, management can identify, document, monitor, and test those assumptions. Sensitivity testing can also be used to identify less material assumptions and weaknesses in the measurement system. It is important for credit unions to document the sensitivity of their NEV and EAR measures that result from changes to key assumptions. This helps risk management staff isolate the factors, if any, that pose a key threat or vulnerability to net worth, the earnings stream, and informs decision making about how best to mitigate IRR if necessary. Credit unions should generate pre- and post-modeling results when changing assumptions and review the comparison. Sensitivity analysis is an increasingly important aspect of IRR management, as it is the primary identification method for key drivers of risk and potential model error risks.

Sensitivity testing should only be applied to one assumption at a time. Credit unions should test the effects of small, large, and, in some cases, extreme changes to significant assumptions, and assess their impact on the overall measure of IRR.

For example, to test the sensitivity of non-maturity share decay rates, a credit union could alter its non-maturity share RSF assumptions incrementally (up and down) in multiple scenarios (for example, test a 10, 25, and 50 percent increase/decrease from the base-case assumption). The revised results could then be compared to the base-case scenario. If a change in the assumption disproportionately impacts the results, management should implement more robust assumption documentation, monitoring, and testing.

Credit unions should consider assessing risks using sensitivity analysis annually. Management should document the results of sensitivity testing and present the results to the board of directors and/or ALCO. By conducting sensitivity analysis over time, management can gain a more in-depth understanding of the assumptions that contribute the most volatility to output results. This will reinforce management’s understanding of IRR in the credit union’s balance sheet and the rate conditions that may affect the level of earnings and capital.

An absence of sensitivity testing indicates a weakness in the risk management program. Some credit unions generate results only for “compliance” purposes. Credit unions with strong risk management disciplines use their sensitivity analyses to challenge their thinking and influence actions they take to manage IRR.

Last updated on December 06, 2024