On Compliance: Revised interest rate risk framework adopts a more qualitative approach

NCUA should next consider revising its tests to mathematically consider risk mitigation strategies.

In September the National Credit Union Administration issued new guidance on its updated interest rate risk supervisory framework. Interest rate risk is the risk to a financial institution that its interest-earning assets, such as loans or bonds, will decrease in value as interest rates and funding costs increase. NCUA’s updated approach to interest rate risk modifies what had previously been a strictly quantitative supervisory approach to add qualitative elements that should allow credit unions more flexibility to manage their interest-rate-risk exposures.

While this more principles-based approach is a step in the right direction, NCUA should next consider revising its quantitative interest-rate-risk tests to incorporate better credit unions’ risk mitigation strategies on a mathematical basis.

A History of Interest Rate Risk

Interest rate risk is a significant safety and soundness concern that has historically caused the failures of numerous depository institutions. The savings and loan crisis, for example, began when interest rates increased significantly in the early 1980s. Savings and loan associations, savings banks and other thrifts at that time were heavily invested in fixed-rate mortgages and faced increased funding costs as interest rates rose, resulting in net-interest-margin compression and retained earnings erosion. More than 1,000 institutions failed.

 

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