Ready for Rising Rates?

FFIEC warns depository institutions to monitor interest-rate risk.

July 29, 2010

Get ready for rising market interest rates. That’s the message from the Federal Financial Institutions Examination Council (FFIEC).

FFIEC comprises federal bank, thrift, and credit union regulators. The group’s January interest-rate risk advisory stresses the “importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the interest-rate risk exposures of depository institutions.”

(Visit and enter “2010 interest-rate risk” in the search box.)

The advisory isn’t a big surprise. Financial institutions are exposed to interest-rate risk—the likelihood that income (or economic value) will change when market interest rates change. And that exposure has increased recently.

The Federal Reserve has repeatedly expressed its intention to keep rates low for an extended period of time. But those days are numbered, as are the days of massive Fed security purchases that have helped keep longer-term interest rates low.

Some reasons for recent interest-rate risk increases:

  • The combination of low home prices, low mortgage interest rates, and continuing government home purchase incentives have increased originations of fixed-rate, long-term mortgages. During the past three years, credit union fixed-rate mortgages with terms greater than 15 years increased from 29% to 37% of total first mortgages outstanding.
  •  Savings growth has outpaced loan growth by a fairly wide margin. Credit union savings deposits increased approximately 10% while loan balances grew only 4% in the 12 months ended September 2009. Investment balances increased dramatically. Some “fought” the resulting downward pressure on asset yields by placing more investments in higher-yielding, longer-term investments.
  • Low rates and marketplace uncertainty mean members want to stay liquid. So a substantial portion of the big increases in savings balances might be hot money—headed out the door (or into higher-yielding accounts) when rates increase. Core deposits (share drafts and regular shares) have declined significantly from 47% of total savings at the end of 2005 to only 37% of total deposits at the end of September 2009.

While interest-rate risk exposure has increased, the risk is limited when viewed more broadly. Fixed-rate mortgages with terms greater than 15 years now represent 37% of total mortgages, but they represent only 9% of total credit union assets. And while longer-term investments represent nearly 18% of total investments, they equal only 5% of total assets.

On the other hand, although only 800 credit unions (10% of all credit unions), report more than 40% of their assets are in longer-term assets, these institutions hold 33% of total credit union assets.

The FFIEC guidance reminds decision makers that effective risk management isn’t limited to risk identification and measurement. It also must address appropriate actions to control risk. If an institution determines its core earnings and capital are insufficient to support its interest-rate risk level, it should take steps to mitigate exposure, increase capital, or both.

Financial institutions are in the business of assuming risk. But FFIEC expects them to employ sound risk-management practices to measure, monitor, and control interest-rate risk exposures.

The council also expects each financial institution to use risk-management processes and systems “commensurate with its complexity, business model, risk profile, and scope of operations.” That means gap analysis is only appropriate for the least complex, generally small, plain-vanilla institutions. And financial institutions should supplement simulation models—whether static (assuming no balance sheet changes as rates change) or dynamic—with more rigorous economic value analysis.

Credit unions have a long track record of effectively measuring, monitoring, and controlling risk. But now isn’t the time to rest on laurels. Interest-rate risk exposure will be a point of emphasis in the exam process.

Directors ultimately are responsible for risks undertaken by their credit unions. Understanding this risk through regular updates is now more important than ever.

MIKE SCHENK is vice president, economics and statistics, for the Credit Union National Association. Contact him at 608-231-4228 or at