Just over 6 years ago, the National Credit Union Administration (NCUA) announced key changes to interest rate risk supervision during its June 16, 2016 board meeting, which included the rollout of the Net Economic Value (NEV) Supervisory Test. Developed to help identify potential instances of unsafe and unsound risk exposure within the industry, the test has become a mainstay of the regulatory interest rate risk measurement process, and we run hundreds of these tests each quarter at ALM First to help credit union clients monitor the assessment’s results and prepare for examinations.

For ALM practitioners familiar with the design of the test, the recent trend of test results comes as no surprise. The first quarter of 2022 saw a significant rise in the level of risk indicated by this test, as evident in our historical results (Figure 1), which shows the frequency of the four risk category results. While the test results have been trending worse for some time, they have worsened substantially from Q4 2021 to Q1 2022 as interest rates increased substantially (between 50 and 150 basis points depending on curve tenor). According to our data as of Q1 2022, the High and Extreme categories represent nearly 50% of all test results.

For those less familiar with the mechanics of the assessment tool, let’s define the NCUA’s NEV Supervisory Test in greater detail. The NCUA NEV Supervisory Test is an NEV sensitivity measurement using standardized values for non-maturity deposits (NMDs) in lieu of the credit union’s applied fair values; the fair values for all other accounts are left unchanged (e.g., loans, investments, term deposits). The resulting balance sheet sensitivity is categorized as shown in Figure 2 using the shocked NEV Percent Change and NEV Ratio in the +300 basis point scenario.

As outlined in this NCUA fact sheet, the test was developed in response to the significant degree of uncertainty surrounding the valuation of NMDs and the desire to create a cross-comparable standardized treatment. The treatment uses a 99.00 price in the base scenario (1% benefit to economic value) and a 95.04 price in the +300 basis point scenario (a 4 percent decline from base) for NMD valuations.

The test was initially calibrated using deposit-study data from hundreds of credit unions. The 1 percent base value indicates a deposit franchise premium benefit, which was observed from the dataset. The mean and median values were used to initially calibrate the base price but were not indexed to adjust for changes in market conditions.

The non-indexed NMD values (set to 99.00 in each quarterly test) represent an important factor in the increasing frequency of High/Extreme risk results. Consider a hypothetical example to illustrate this concept: a perfectly balanced asset-liability (AL) profile, meaning the economic value (EV) of equity is immunized to changes in interest rates, as shown in Figure 3. Note as EV of equity remains stable, the NEV Ratio increases due to falling asset values from higher discounting rates.

This balance sheet’s NEV Supervisory Test result would be in the Low category: 8.26% post-shock NEV ratio and -28.61% NEV Percent Change. Now, if we assume a +100 basis point scenario happens and use the +100 scenario values as the base to rerun the Supervisory Test, as seen in Figure 4, the result becomes Moderate: 6.47% post-shock NEV ratio and -33.35% NEV Percent Change. As shown, the interest rate risk of the hypothetical entity was actually improved by higher rates, but the increased test risk result stems from the lower asset value in the base (from higher discount rates).

Of course, the impact of higher rates is dependent on the asset duration, defined as sensitivity of fair value to changes in interest rates. We used 2.50% in this example. Institutions with lower asset duration are much more resilient to a deteriorating test result from higher interest rates, as seen in Figure 5. Using a 1% asset duration and a 10% capital ratio, the test results in Low in even a +300 basis point rate shock. On the other hand, a 4% asset duration, while having a Moderate result in the base, becomes Extreme in just the +100 scenario.

With High/Extreme results now occurring nearly 50% if the time, the question of whether recalibration is warranted has become very timely. In the NCUA’s initial fact sheet, the administration mentioned that it expected to review the NEV Supervisory Test “over time to address changes in market conditions and potential shifts in credit union risk profiles,” and “assess the risk classifications for low, moderate, high, and extreme interest rate risk to ensure appropriate measurement values.”

It remains to be seen how the NCUA responds and what supervisory actions are taken during examinations. While a document of resolution (DOR) would still be expected for an Extreme result at this time, the required response and actions taken could be passive in nature, giving reference to the current market rate environment and organic growth plans through retained earnings. It will be important to recognize the extent to which an Extreme or High result is caused by external factors versus risk management and governance. In other words, the “appropriate de-risking actions” should be in the context of overall balance sheet risk. This is an important nuance.

Credit unions that find themselves in the Extreme category and between examination cycles are encouraged to reach out to their federal or state regulator to discuss reasons for the increased risk position and action plans to address risk exposure. A proactive approach could mitigate supervisory concerns and potential supervisory findings from an examination.

Overall, several important factors have contributed to a substantial increase in High and Extreme results. Along with rapidly increasing interest rates, these include a decade-low net worth ratio level for the credit union industry and similar highs in NMD portion of total funding. However, the focus on sensible risk management must be maintained, which would include adherence to internal risk limits and independent evaluation of financial performance.

Want to input your own NEV parameters to explore the impacts of a rate shock? Contact us about the Excel tool that we’ve created for your reference.

About Authors:
Alec Hollis joined ALM First Financial Advisors in 2012.  As a Managing Director for the ALM Strategy Group, Alec is responsible for product management, including planning and execution of ALM First products and services, particularly related to asset/liability management, hedging and asset management strategy. He also assists in client service, in implementing client balance strategy and hedging programs.

Alec has shared his areas of expertise on various topics at ALM First educational events, along with ongoing research for use in ALM First’s industry commentary. He has also written numerous articles on these topics that have been published in publications such as CU Business and Western Banker Directors Digest.

Alec holds a bachelor’s degree in finance from the University of Notre Dame, as well as the Chartered Financial Analyst (CFA) designation.

Robert Perry is a Principal at ALM First Financial Advisors, joining the firm in 2010. Robert leads ALM First’s ALM and Investment Strategy Groups and is responsible for the development of asset liability and investment portfolio themes for the firm. He also provides strategic focus for financial institution client portfolios that are primarily invested in the high credit quality sectors, and is instrumental in balance sheet hedging strategy development.

Robert has more than 30 years of experience in the banking and bank-consulting businesses. Over his career, he has spoken at many conferences, written on various topics and has been published in publications such as WIB CFO Digest, WIB Directors Digest, Credit Union Business, and many more. He has performed board of directors educational events and consulted with many financial institutions in the areas of ALM and investment strategy.  Robert’s in-depth knowledge and financial management background have also made him a popular speaker on bank profitability and portfolio strategies, as well as hedging and derivatives use.

Before joining ALM First, Robert previously served as Managing Director of the ALM and Investment Strategy division of DataTech Management in Los Angeles, and Chief Investment Officer for First Coastal Bank in Manhattan Beach. Previously, Robert was a Principal and Product Portfolio Manager at Smith Breeden Associates, Inc., where he managed Smith Breeden’s Enhanced Cash and Enhanced Equity Strategies. He also managed Smith Breeden’s bank consulting group, which included the non-discretionary asset management and risk-reporting businesses. Prior to joining Smith Breeden in 1991, he worked as an analyst in the risk management area of Centura Bank in North Carolina.

Robert graduated from North Carolina State University with a bachelor of arts degree in business management.

Brent Lytle joined ALM First Financial Advisors in 2021. As a Director for the firm, Brent partners with clients to develop successful balance sheet strategies that maximize performance. Supported by our experienced team, he interprets full balance sheet risk analytics and risk positioning to determine the best opportunities for each client to achieve their financial goals, providing advice and insights on loan pricing, loan transactions, investment portfolio management, funding strategies, hedging and more. Brent also coordinates internal collaboration to deliver analytics and timely reporting to assist clients throughout the entire process from strategy development through implementation and post-execution analysis.

Prior to joining ALM First, Brent spent nearly a decade with the Federal Reserve Bank of Kansas City. He initially served as a Bank Examiner before becoming a Capital Markets Specialist and being promoted to Manager, Surveillance & Risk Analytics (SRA). As SRA Manager, Brent was responsible for overseeing a team of experienced risk specialists and routinely collaborated with the Bank’s senior management, key stakeholders at the Board of Governors, and across the Federal Reserve system in support of risk and surveillance supervisory activities.

Brent received a bachelor’s degree in business administration from the University of Missouri – Kansas City. He is also a Chartered Financial Analyst.

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