Policies and Processes

NCUA regulation part 741, Appendix A, Guidance for an Interest Rate Risk Policy and an Effective Program, requires all federally insured credit unions with assets greater than $50 million to incorporate the following six elements into their IRR program:

  • A board-approved IRR policy

  • Oversight by the board of directors and implementation by management

  • Risk measurement systems assessing the IRR sensitivity of earnings and/or asset and liability values

  • Internal controls to monitor adherence to IRR limits

  • Risk limits

  • Decision making that is informed and guided by IRR measures

This topic addresses:

IRR Policy

NCUA regulation § 741.3(b)(5) requires all federally insured credit unions with assets greater than $50 million to develop and implement a written IRR policy and an effective IRR management program as part of ALM. NCUA regulation part 741, Appendix A, Guidance for an Interest Rate Risk Policy and an Effective Program, provides guidance on how to develop an IRR policy and an effective IRR program.

Note: part 741, Appendix A is guidance for all federally insured credit unions with assets equal to or greater than $50 million but can be referenced by any credit union seeking to build a robust approach to managing IRR.

An effective IRR policy will establish risk limits, as well as responsibilities and procedures for identifying, measuring, monitoring, controlling, and reporting IRR. Specifically, IRR policies and procedures should:

  • Set IRR limits to maintain risk exposures within prudent levels for the size and complexity of the credit union

  • Identify committees, persons, or other parties responsible for reviewing the credit union's IRR exposure

  • Direct management to identify, measure, monitor, and control IRR exposures

  • Establish a reporting frequency for measurement results to enable the board to review information that is timely (such as current and at least quarterly) and provides sufficient detail to assess the credit union’s IRR profile

  • Set risk limits for IRR exposures based on selected measures (such as limits for changes in repricing or duration gaps, income simulation, asset valuation, or NEV)

  • Identify tests, such as interest rate shocks, that the credit union will perform using the selected measures

  • Establish a schedule for periodic review of material changes in IRR exposures and compliance with board approved policy and risk limits

  • Mandate a pre-implementation assessment of the IRR impact of any new business activities (such as evaluating the IRR profile of introducing a new product or service)

  • Provide for at least an annual evaluation of policy to determine whether it is still commensurate with the size, complexity, and risk profile of the credit union

Risk Limits

IRR limits should be consistent with the credit union’s overall approach to measuring and monitoring IRR and should address the potential impact of changes in market interest rates on earnings and NEV. The limits for monitoring a credit union’s income and NEV should be appropriate for the size and complexity of its underlying positions.

The goal of IRR management is to maintain a credit union’s IRR exposure within board- and management-approved parameters over a range of possible changes in interest rates. Policies defining IRR limits and setting guidelines for risk-taking support a credit union’s achievement of that goal.

Policies defining IRR limits should set the expectation that any violation of a credit union’s chosen IRR limits will receive prompt management action. The policy that defines aggregate IRR limits, clearly articulating the amount of IRR acceptable to the credit union, should be approved by the board of directors and reevaluated periodically.

Typically, a credit union will use a combination of limits to monitor its IRR exposures. These include primary limits on the level of reported EAR and economic value at risk (the amount by which NII and NEV may change for a given interest rate scenario) as well as secondary limits.

For earnings-based limits, the approach should be consistent with the methodologies used to monitor the exposure of economic value. IRR limits on earnings volatility primarily address the short-term effects of changing interest rates on the credit union’s financial condition. EAR limits are designed to monitor and control the risk of a credit union’s projected earnings using various rate scenarios and assumptions. A limit is usually expressed as a change in projected earnings (in dollars or percent) over a specified time horizon and rate scenario.

IRR limits on NEV are used to monitor the effect of changes in interest rates on the present value of all transactional earnings and cash flows from the credit union’s current balance sheet. A credit union’s NEV limits should reflect the size and complexity of its underlying positions. Ultimately, NEV policy limits are the prerogative of a credit union’s senior management and board of directors, and these limits should serve to place meaningful constraints upon the level of exposure consistent with a pre-determined risk tolerance threshold. Thus, a credit union that states it has a low tolerance for IRR exposure would not be expected to permit aggressive (high-risk) limits on their activities or operate with high IRR exposures for an extended period.

If a credit union professes to have a high tolerance for IRR and intentionally adopts high-risk policy limitations to match, the supervisory expectations surrounding their IRR risk management program will rise significantly, and the examiner's surveillance will need to increase in both frequency and depth.

Credit unions can vary significantly with respect to their tolerance for different business risks, and IRR is no exception. The NCUA does not have a preferred level of IRR exposure, but rather an expectation that risk management will be scaled to match the risk level that is adopted.

The NCUA’s current risk tolerance thresholds for NEV measures are tied to the level of economic capital, so risk exposures are automatically viewed in the context of capital adequacy. Whatever risk tolerance level a credit union adopts in its IRR limits, those limits must be reasonable and supportable from the standpoint of the management, systems, and processes being used to manage the actual exposure. For additional information, refer to NCUA regulations § 741.3(b)(5) and part 741, Appendix A, Guidance for an Interest Rate Risk Policy and an Effective Program.

Generally, when credit unions set internal policy limits on both post-shock NEV and NEV sensitivity measures, they will consider the NCUA’s supervisory guidance to understand how the agency characterizes (and rates) IRR exposure. The NCUA has maintained long-held guidance on what constitutes low, moderate, and high levels of IRR expressed for both NEV and EAR, dating back to the early 2000s.

Gap (maturity or repricing) limits are designed to reduce the potential exposure to a credit union’s earnings or capital from changes in interest rates. Gap limits control the volume or amount of repricing mismatch in a defined period. These limits often are expressed by the ratio of rate-sensitive assets to rate-sensitive liabilities in a defined period. A ratio greater than one suggests that the credit union is asset-sensitive and has more assets than liabilities subject to repricing. All other factors being constant, the earnings of such a credit union generally will be reduced by falling interest rates.

An RSA/RSL ratio of less than one means that the credit union is liability-sensitive and that its earnings may be reduced by rising interest rates. Gap ratios may be a useful way to monitor a credit union’s repricing exposures but may not be an adequate or effective method of managing and reporting IRR risk.

Last updated on December 06, 2024