Interest rate risk strategies can be confusing, given the diversity in credit unions and their investment holdings.
Alan Lloyd, general manager of the financial institutions unit at Teraverde Management Advisors, Lancaster, Pa., noted that most CUs contract out their IRR models to third-party advisors.
"It does not represent a significant [or] additional regulatory/compliance burden, as this should already be part of an institution's effective financial management strategy," he said.
Jim Deitch, CEO of Teraverde, explained that the most important aspect of an IRR model has to do with how it would respond to a "shock" event — such as an unexpectedly large rate hike by the Fed, or some geo-political event (like terror attack, sudden change in government of an economically powerful nation, natural disaster, etc.) that might negatively impact the U.S. economy and markets.
To be sure, such a catastrophic event cannot be predicted ahead of time, but a credit union's internal model for dealing with such risks must be addressed in anticipation for such an event. "Such an IRR model should have such unforeseen events built into its system as part of its assumptions of a future risk scenario," he said.
Douglas M. Winn, president of Wilary Winn Risk Management LLC, a Saint Paul, Minn., consulting firm, noted that his firm runs multiple interest rate scenarios for its clients to cover as many possible alternatives.
"We also run a scenario in which rates remain flat and a 'bear flattener' in which we twist the yield curve by pushing up short-term rates and increasing long-term rates," Winn said.
Noting that the effects of an increase in interest rates depends on the magnitude of the increases and also the interest rate risk profile of the credit union, Winn said that most of his clients would benefit in the medium-term from moderate increases in interest rates given their loan and investment profiles as they would be able to re-price the cash flows arising from amortization, prepayment and termination at a higher interest rate.
But Winn warned that — though unlikely — "a rapid and large" increase in interest rates could have a negative effect on the industry as a whole.
"The worries in this scenario are that the increases are sufficient to significantly curb new loan demand and extend the duration of existing long-term loans as the incentive to refinance disappears," he said. "In addition, a rapid large rate increase could lead to disintermediation as funds flow from credit unions back into the bond markets. This could force credit unions to incur higher borrowing costs or sales of investments — presumably at a loss — to provide the necessary liquidity to fund the outflows."
