How Interest Rate Risk Impacts a Credit Union’s Financial Position
Changes in interest rates impact a credit union’s net worth, earnings, and liquidity position by altering its NII and other interest-sensitive income and expenses. Nearly all credit unions maintain a maturity mismatch between their assets and liabilities as their business requires them to intermediate funds between members who are savers and those who are borrowers. The fact that the risk associated with their source of funds (liabilities) is different than the risk associated with their use of funds (assets) makes IRR a factor when rates move.
If rates rise significantly, credit unions experience a rising cost of funds and an extension in the average life of their assets. If rates fall significantly, they experience a falling cost of funds but also experience maturity calls and principal prepayments on investments and loans, which creates reinvestment risk. This incidental mismatch is both a source of income and a source of risk.
Changes in interest rates also impact the underlying economic value of the credit union’s assets and liabilities. These changes occur because the present value of future cash flows, and in many cases the cash flows themselves, change when interest rates change, which alters future earnings and the credit union’s underlying economic value.
IRR is related to the following aspects of a credit union's financial position:
Net Worth and Economic Value
Net worth represents the credit union’s equity, provides the credit union protection from unexpected losses, and serves as a foundation for future strategic initiatives/growth. As market interest rates change, the economic value (base valuation at current interest rates) of a credit union’s assets and liabilities will change, which impacts a credit union’s level of net worth.
The sensitivity of a credit union’s economic value to changes in interest rates is an important concept when assessing its net worth adequacy. A credit union with higher IRR may experience a significant decline in net worth levels over time, in response to adverse changes in interest rates.
Per NCUA regulations § 741.3(b)(5) and part 741, Appendix A, Guidance for an Interest Rate Risk Policy and an Effective Program, credit unions with higher IRR exposure must hold additional net worth to provide a larger margin for potential reductions in economic value and earnings.
Earnings
Earnings represent a credit union’s overall net income. The largest source of earnings typically comes from NII, which is highly sensitive to interest rate changes. As credit unions adjust their rates on loan and share products in response to market interest rate changes, the impact of those changes varies by product. For example, the impact may occur overnight for regular shares, while for longer-term mortgage loans, the impact will occur incrementally, which can strain NII.
High earnings can be the result of successfully executed strategic plans. However, it is also possible for a credit union to record high earnings in the short term by assuming an unacceptable degree of IRR, which could negatively impact future earnings, given adverse changes in interest rates.
Liquidity
Liquidity represents a credit union’s ability to meet share withdrawals and other operational demands (expenses and liability payments) and to fund assets (originate loans and purchase investments). Credit unions should maintain adequate liquidity to manage both expected and unexpected cash flows from changes in interest rates without adversely affecting either short-term liquidity needs or the financial condition of the credit union.
A credit union’s primary source of funds is member shares. For many credit unions, evaluating how shares will behave under changing interest rates is a very important component of analyzing IRR.
Another liquidity source, investments, is impacted by changes in market interest rates. In the event of an adverse change in interest rates, the value of these assets will be lower than their book value. If a credit union needed to sell investments to generate liquidity, it may incur a loss, reducing net income.
Last updated on December 06, 2024
