Note: This policy should only be used as a starting point.
INTEREST RATE RISK
ASSET AND LIABILITY MANAGEMENT
POLICY AND PROCEDURES
The purpose of our IRR and asset/liability policy and procedures is to establish a prudent and
comprehensive interest rate risk management plan for the credit union. There are four main
elements in good interest rate risk management:
1. A policy adopted by the board
2. Measurement of the level of risk
3. Limits on the amount of risk the credit union can take
4. Regular reports to management and the board to monitor the current level of risk
Some of the items to be addressed in this plan are the Asset/Liability Committee (ALCO), profit
planning and liquidity guidelines. The end result of this plan should be for the credit union to
maintain consistent earnings independent of fluctuating interest rates.
The purpose of the ALCO Committee is to establish, communicate, coordinate and
control asset/liability management. The Committee will establish and monitor volume
and mix of assets and funding sources. The objectives is to manage assets and funding
sources to produce results that are consistent with liquidity, capital adequacy, growth, risk
and profitability goals.
B. COMMITTEE MEMBERS
C. RESPONSIBILITIES AND AUTHORITY
Each division and department will make available to the ALCO Committee any
information necessary to support the committee’s activities. At each meeting the
Committee will recommend appropriate strategy changes based on a review of the
1. Local and national business and economic conditions
2. Forecasts for changes in interest rates
3. Anticipated changes in the volume and mix of the loan and investment portfolios
4. Anticipated changes in the volume and mix of the sources of funds (overnight
funds, large CD’s, demand deposits, member savings and time deposits, etc.)
5. A comparison of key performance ratios between this and other similarly
6. Mismatches between anticipated levels of interest-sensitive assets and interest
7. The liquidity and capital positions
8. The maturity distribution of assets and liabilities
9. Cash and due from balances
10. Current loan strategies, investment strategies, and funding strategies
11. The repricing frequency and percentage change in rate of various loan and share
rates (ECR’s) as interest rates move
12. Any amendments that need to be made to this policy
MEASUREMENT OF THE LEVEL OF INTEREST RATE RISK
The goal of asset/liability management is to maximize and stabilize the net interest margin while
maintaining credit quality, reasonable interest rate risk, adequate capital and liquidity. It is
among the duties of the ALCO Committee to manage the mismatch between rate-sensitive
assets and rate-sensitive liabilities to reduce interest rate risk to an acceptable level. Rate
sensitive is defined as anything maturing or repricing within the next twelve months. Twelve
months is considered an appropriate time frame for several reasons. Forecasting is required in
order to ascertain the volume and mix of rate-sensitive assets and liabilities for the twelve month
period. Forecasting involves making assumptions about multiple variables in the future –
interest rates, loan demand, share mix, credit union growth, regulatory changes, etc. As most of
these variables are outside of the control of credit union management, forecasting beyond
twelve months would sacrifice accuracy and reliability and will therefore not be done.
Additionally, we feel that an analysis of twelve months gives us adequate time to recognize and
adjust to any relevant trends.
Traditionally, a zero gap was thought to provide zero interest rate risk. In other words, if rate-
sensitive assets equaled rate-sensitive liabilities, then the institution had a zero gap; and
traditional wisdom said that changes in rates would not effect earnings. Recent studies have
shown, however, that most institutions with zero gaps still have earnings changes when rates
change. This problem is caused by differences in how asset yields and liability costs adjust to
For example, National Prime moves by 100 basis points, statistical studies show the following
changes in national markets.
Prime Rate 100
Fed Funds 100
Non-Jumbo CDs (liability) 104
Jumbo CDs (liability) 104
3-Month T-Bill 94
6-Month T-Bill 101
1-Year Treasury 99
2-Year Treasury 96
5-Year Treasury 83
10-Year Treasury 72
Muni Index 72
Discount Rate 100
3-Month LIBOR 100
11th District COFI 50
Conventional Mortgages 43
Once weighed, yields on assets will change more than costs on liabilities. To create an “income
statement gap,” the balance sheet gap is adjusted by weighing each line item based on its
anticipated rate sensitivity.
The primary tool of measurement for qualifying our interest rate exposure is our Earnings
Change Ratio (ECR) analysis. The ECR analysis provides a display of the balance sheet gap,
weighed by the appropriate rate sensitivity factor, to define the impact on the income statement
from 100 basis-point changes in National Prime. The analysis assumes an immediate and
parallel change in all rates, and calculates the effect of the change for the next 12-month period.
In conjunction with interest rate risk being quantified via the ECR analysis, a policy of
acceptable levels of risk should be established by the ALCO Committee and/or Board of
Directors. Risk limits should address the risk to earnings arising from mismatches between the
repricing of assets, liabilities and off-balance sheet contracts carried on a historic basis. Since
these mismatches (or “gaps”) pose various risks to interest income, limits are best expressed in
terms of interest income at risk.
Limits on earnings exposure should consider potentially adverse changes in interest rates rather
than anticipated rate moves. Limits should also address acceptable risk levels within each time
frame presented (e.g., up to 90 days, 90 to 360 days).
The credit union’s maximum exposure to interest rate risk, defined as the difference in on-year
rate-sensitive assets and one-year rate-sensitive liabilities as a percentage of total assets, is
plus or minus 10 percent for a +/- 100 bp interest rate scenario and not to exceed plus or
minus 15 percent of total assets for a +/- 200 bp interest rate scenario.
The price volatility of the entire security portfolio (AFS and HTM items) will be stress-tested
quarterly assuming an upward and downward parallel shift in the treasury curve of 300 basis
points. The size and composition of the security portfolio will be monitored so that this stress
test does not reduce capital below 6%.
Liquidity is measured by a credit union’s ability to convert assets to cash with a minimum of loss.
The credit union should be capable of meeting its obligations to its customers at any time. This
means the credit union must be able to meet the projected cash withdrawal requirements of our
depositors, the projected funding requirements of lines and letters of credit, and the short-term
credit needs of our established customers.
On average in any given year, the credit union’s overnight borrowings should not be greater
than overnight deposits. As measured by the regulatory authorities, the liquidity position should
average between 10 and 15 percent. The ratio should be achieved by adhering to the following:
1. Some portion of the investment portfolio should always be maturing in each
quarter. As these securities mature, they will be used either to fund the credit
union’s cash needs or be reinvested.
2. If necessary, the credit union will balance the interest rate risk by buying or selling
Management and board reports are a key link between the risk measurement process and
management decisions. Risk reports allow management to assess the current exposure of the
institution and determine whether the exposure is acceptable or whether action should be taken
to alter the exposure.
The credit union’s Board of Directors will formally approve the credit union’s risk limits under
which management is expected to operate. Each quarter the Board will receive the
asset/liability report, which qualifies the credit union’s interest rate risk to insure that the board
policy is being followed. Any deviations from the risk limits will be discussed and explained by
credit union management at that time.
1. A return on assets that is between .5% and 1.5% before the application of the regular
2. A return on capital between 8% and 12% of total capital. Capital is defined as the total of
the regular reserve (to include the Allowance for Loan Losses), appropriated retained
earnings, and unrestricted retained earnings.
3. A capital to total asset ratio that will remain within 2 percent of 15 percent.
4. A loan portfolio that equals 50 to 60 percent of total assets, with real estate loans not
exceeding 25% of assets.
5. A total loans to total shares ratio of 70% to 80%.
6. An investment portfolio that meets the liquidity needs of the Credit union while not being
so liquid so that profits are unduly penalized. However, the emphasis should be on
sound conservative investments that will be determined by the Investment Committee.
7. The Credit Union will attempt to maintain an interest spread of 3.0 to 4.0 percent.
8. Rate sensitive assets should be no less than a plus or minus 15% when compared with
rates sensitive liabilities with respect to a twelve month gap as determined by Pen Air
Federal Credit Union’s spread management analysis. Rate sensitive liabilities are to be
determined based on the criteria set out in the spread management analysis with core
deposits treated as long term liabilities and not as rate sensitive liabilities for the
purposes of the gap computation.
9. Maintain Allowance for Loan Losses in compliance with NCUA Letter No. 126 dated
September 1991. This will include the actual experience method, which uses the Credit
Union’s historical loss ratio and applies it to total loans outstanding to arrive at the level of
the ALL; and/or, the adjustment method, which involves an individual review of delinquent
loans. Additional adjustments above and beyond the figure needed may be required in
light of current economic conditions, such as base closure or reduction in force.