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					Note: This policy should only be used as a starting point.

                                          CREDIT UNION
                                       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.
                              ASSET/LIABILITY COMMITTEE


     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.



     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
     following information:

     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
            configured institutions

     6.     Mismatches between anticipated levels of interest-sensitive assets and interest
            sensitive liabilities

     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


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
rate changes.
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
              loans appropriately.


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
   reserve transfers.
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.

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