Types of Interest Rate Risk

Types of IRR include:

• Repricing Risk

• Basis Risk

• Yield Curve Risk

• Option Risk

• Price Risk

Repricing Risk

Repricing risk arises from the possibility that a credit union’s assets and liabilities will reprice at different times or amounts and potentially negatively affect the credit union’s earnings, net worth, and financial position. Repricing differences create a mismatch between sources and uses of funds. For example, a portfolio of long-term, fixed-rate loans or securities (such as credit union assets) funded with short-term deposits (such as credit union liabilities) could significantly decrease in value when rates increase, because the loan rates are fixed, while funding costs increase. Nevertheless, maintaining some degree of repricing mismatch is fundamental to the credit union business. Repricing gaps can occur from either borrowing short-term to fund longer-term assets or borrowing long-term to fund shorter-term assets. Such mismatches expose a credit union to adverse changes in both the overall level of interest rates (that is, parallel shifts in the yield curve) and the relative level of rates across the yield curve (that is, nonparallel shifts in the yield curve).

Basis Risk

Basis risk arises from a change in the relationship of rates in different financial markets. Basis risk occurs when market rates, or the indices used to price assets and liabilities, change at different times or by different amounts. The relationship between different market indices can change over time: in other words, if sources of funds are priced in relation to one market index while uses of funds are priced on a different index, the spread between the two indices can change. For example, a credit union may use funds from 6-month certificates to purchase 6-month Treasury bills. The market interest rate for the 6-month Treasury bill might remain constant while local market interest rates for certificates increase due to competitive pressures. Thus, changes in the spreads of instruments that are being repriced from different market indices will affect a credit union’s net interest margin, and potentially reduce earnings.

Yield Curve Risk

Yield curve risk reflects exposure to various changes in the shape or slope of the yield curve. It occurs when assets and funding sources are linked to similar indices with different maturities. The most typical exposure for depositories is to “borrow short” (typically demand deposits) and “lend long.” Changes in the relationship between short- and long-term rates changes will impact earnings. The relationship changes when the shape of the yield curve for a given market flattens, steepens, or becomes inverted or negatively sloped during an interest rate change.

• In a parallel yield curve, all maturities on the yield curve move by an equal amount. In a parallel shift, a credit union would see a yield increase or decrease in all maturities by the same amount.

• In a steepening yield curve, long-term rates increase faster than short-term rates or short-term rates decrease faster than long-term rates. For example, long-term rates may change by 100 basis points, while short-term rates may change by only 50 basis points.

• In a flattening yield curve, the difference between long-term rates and short-term rates narrows as either long-term rates or short-term rates move closer to the other.

• In an inverted yield curve, long-term rates are below short-term rates. This historically has been a short-term phenomenon when the market is anticipating a recessionary period where rates are expected to fall. For example, the yield on a long-term asset drops to 200 basis points, while the yield on a short-term asset remains constant at 250 basis points.

Changes in the shape of the yield curve can change the IRR of a credit union’s position by magnifying the effect of maturity mismatches.

Option Risk

Option risk is the risk that a financial instrument’s cash flows (timing or amount) will change at the exercise of the option holder (such as a depositor, borrower, or other transaction counterpart), who may be motivated to exercise an option by changes in market interest rates. The exercise of options can adversely affect a credit union’s earnings by reducing asset yields or increasing funding costs. Balance sheet accounts that present option risk include, but are not limited to, the following.

• Non-maturity shares (deposits), such as regular shares, share drafts, and money market accounts, present option risk because they have no contractual maturities. While balances in these accounts can be withdrawn on demand, typically these accounts fluctuate as customers deposit or withdraw funds. Therefore, while these shares can be a long-term funding source, the uncertain timing of inflows and outflows can make the appropriate treatment of NMS challenging. It is not possible to predict with any degree of certainty what the future balances in non-maturity accounts will be, how long they will need to remain open, or what future rates will be paid to members on these accounts.

• Loans that give borrowers the option to refinance or make prepayments present option risk. For example, a mortgage holder may elect to refinance a mortgage in a falling interest rate environment to take advantage of a lower interest rate. This will reduce the credit union’s yield on assets. Similarly, if a borrower makes prepayments on a loan, credit union income will potentially be reduced.

• Investments, such as callable bonds, present option risk because they can be redeemed by the issuer before reaching maturity. For example, assume that a credit union purchased a five-year callable bond at a market yield of two percent. If market rates decline to 0.5 percent, the bond’s issuer will be motivated to call the bond and issue new debt at the lower market rate. At the call date, the issuer effectively repurchases the bond from the credit union. As a result, the credit union will not receive the originally expected yield. Instead, the credit union may re-invest the principal at the new, lower market rate. On the other hand, in a rising rate environment, the issuer will likely not call the bond and the credit union will have a below market-yielding investment.

  See NCUA IRPS 98-2, Investment Securities and End-User Derivatives Activities. This examiner guidance covers a broad range of instruments, including all securities in held-to-maturity and AFS accounts―as defined in the Statement of Financial Accounting Standards No. 115 and the more recent guidance on Financial Instruments—Credit Losses (Topic 326) ― certificates of deposit held for investment purposes, and end-user derivative contracts not held in trading accounts.

Price Risk

Price risk is the risk that the fair value of a financial instrument will change due to market factors. Generally, long-term assets have more price risk than short-term assets because, as cash flows become more distant, the present value or price of the investment declines. When market interest rates rise, the market value of a credit union’s assets will typically decrease; when market interest rates decline, the market value of the credit union’s assets will typically increase.

However, this does not hold true for all types of assets. For example, changes in market interest rates have the opposite impact on mortgage servicing rights. Anything that increases the amount of unscheduled principal payments (such as refinances and prepayments) will lower the expected earnings stream from mortgage servicing rights and cause their value to decline. When interest rates decrease, the value of a credit union’s mortgage servicing rights generally decrease because the total servicing fees fall as consumers refinance. Because servicing assets are measured at fair value, or carried at amortized cost and tested for impairment, the fair value adjustment or any impairment is reflected in current earnings.

Last updated on December 06, 2024