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Interest-Rate Risk: What Goes Down Must Come Up?

July 23, 2010
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What’s your risk exposure?

A strong asset/liability management (ALM) program can help credit unions position the previous question relevant to two others: How much risk does a credit union have to rising rates? And what’s the credit union’s strategy when interest rates do change?

It’s important to quantify how much risk a credit union has to changes in interest rates. But understanding how and why credit union-specific risk exposures are embedded in the balance sheet is just as important.

Without knowledge of these key issues, how can a credit union devise a sound strategy to address risk exposure and avoid undue pressure on earnings and capital? The answer: It can’t!

Most credit unions have seen their mortgage portfolios increase extensively over the past few years, and to a large extent they’ve funded this growth with relatively short-term funds (less than two years). The resulting long-term risk exposures have trended higher and higher. But why?

The answer becomes clear by evaluating the ALM reports or even the resulting weighted average lives (WAL) of assets versus funds. Growth in long-term assets (such as mortgages) that are funded with short-term deposits (such as one-year certificates) is causing a widening of the mismatch between the WAL of assets and liabilities.

As the mismatch increases, risk increases. The heightened risk exposures shown in a credit union’s net economic value analysis suggest long-term earnings and capital risk to rising interest rates.

When interest rates begin to rise, maturing deposits may need to be replaced at what will be higher prevailing interest rates, while long-maturity mortgages remain on the balance sheet at the older, lower interest rates. This mismatch creates pressure on earnings and capital: funding costs rise faster than asset yields, reducing gross spread, return on assets, and projected capital contributions.

By employing a sound risk management process, a credit union can monitor risk exposures and then enact a balance sheet strategy to ensure that interest rate risk doesn’t become overly burdensome and threaten earnings stability and capital adequacy.

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