Sensitivity to Market Risk
Sensitivity to market risk is a measure of the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a credit union’s earnings or capital. Most credit unions will experience market risk through exposure to changing interest rates. Therefore, this section focuses on assessing IRR. However, examiners may apply these same guidelines when evaluating foreign exchange, commodity, or equity price risks.
IRR refers to the current and prospective risk to a credit union’s capital and earnings arising from movements in interest rates. Because of this, IRR is evaluated relative to the current earnings and capital position of a credit union. When interest rates shift, the present value and timing of future cash flows may shift. This, in turn, changes the underlying value of a credit union’s assets, liabilities, and off-balance-sheet items and thus its overall NEV.
NEV acts as a present value calculation for all future cashflows on the balance sheet as of the examination date.
IRR is inherent to lending activity in all credit unions. Credit union lending activity is typically on a fixed rate basis, but interest rates can vary significantly over time. This creates risk exposure to maturity mismatch (for example, long-maturity assets funded by short-maturity liabilities) or rate mismatch (such as fixed-rate loans funded by variable-rate shares/deposits). In addition, there are embedded options in typical credit union balance sheet items (such as NMS, term deposits, mortgage loans, and investments) that could be triggered with changes in interest rates.
Shifts in interest rates also affect a credit union’s earnings by altering interest rate-sensitive income and expenses, which affects its NII. Excessive IRR can present a significant threat to a credit union’s current capital and projected earnings if not managed appropriately. Further, IRR is deeply intertwined with liquidity. As IRR increases, the ability to acquire share deposits at reasonable prices becomes a larger challenge. These interconnected reasons are why IRR is so important to understand, and why it can be an excellent leading indicator of market sensitivity.
ALM is the process of evaluating, monitoring, and controlling changes in a credit union’s market and balance sheet risk. These risks, if not managed prudently, can adversely affect earnings and capital adequacy. Examiners’ evaluation of a credit union’s IRR is reflected in the “S” component of the CAMELS rating. For more information, refer to Letter to Credit Unions 22-CU-05, CAMELS Rating System.
This chapter covers the following topics:
Last updated on December 06, 2024
