[Federal Register Volume 77, Number 22 (Thursday, February 2, 2012)]
[Rules and Regulations]
[Pages 5155-5167]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-2091]

Rules and Regulations
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Federal Register / Vol. 77, No. 22 / Thursday, February 2, 2012 / 
Rules and Regulations

[[Page 5155]]


12 CFR Part 741

RIN 3133-AD66

Interest Rate Risk Policy and Program

AGENCY: National Credit Union Administration (NCUA).

ACTION: Final rule.


SUMMARY: NCUA is issuing a final rule requiring Federally insured 
credit unions to develop and adopt a written policy on interest rate 
risk management and a program to effectively implement that policy, as 
part of their asset liability management responsibilities. The interest 
rate risk policy and implementation program will be among the factors 
NCUA will consider in determining a credit union's insurability. To 
assist credit unions, the final rule includes an appendix setting forth 
guidance on developing an interest rate risk policy and an effective 
implementation program based on generally recognized best practices for 
safely and soundly managing interest rate risk.

DATES: This rule is effective on September 30, 2012.

FOR FURTHER INFORMATION CONTACT: Jeremy Taylor, Senior Capital Markets 
Specialist, Office of Examination and Insurance, National Credit Union 
Administration, 1775 Duke Street, Alexandria, Virginia 22314, or 
telephone: (703) 518-6620.


I. Background
II. Subject-by-Subject Discussion of Comments on Proposed Rule
III. Regulatory Procedures

I. Background \1\

    \1\ President Obama signed the Plain Writing Act of 2010 (Pub. 
L. 111-274) into law on October 13, 2010, to ``improve the 
effectiveness and accountability of Federal agencies to the public 
by promoting clear Government communication that the public can 
understand and use.'' This preamble is written to meet the plain 
writing objectives.

    A. What Is Interest Rate Risk? The term ``interest rate risk'' 
(``IRR'') refers to the vulnerability of a credit union's financial 
condition to adverse movements in market interest rates. Although some 
IRR is a normal part of financial intermediation,\2\ it still may 
negatively affect a credit union's earnings, net worth, and its net 
economic value, which is the difference between the market value of 
assets and the market value of liabilities. Changes in interest rates 
influence a credit union's earnings by altering interest-sensitive 
income and expenses (e.g., loan income and share dividends). Changes in 
interest rates also affect the economic value of a credit union's 
assets and liabilities because the present value of future cash flows 
and, in some cases, the cash flows themselves may change when interest 
rates change. IRR takes several forms: Repricing risk, yield curve 
risk, spread risk, basis risk, and options risk. For definitions of 
these risks, see section IX. of Appendix B following the final rule 
text below.

    \2\ The process of channeling funds from savers to investors.

    B. Why is NCUA Amending the Existing Rule? In the past, NCUA issued 
guidance on asset/liability management and IRR management in Letters to 
Credit Unions.\3\ NCUA believes Federally-insured credit unions 
(``FICUs''), relying on this guidance, generally have managed their IRR 
adequately. However, FICUs have recently experienced increasing 
exposure to IRR due to changes in balance sheet composition and 
increased uncertainty in the financial markets. This increase has 
heightened the importance for FICUs to have strong policies and 
programs explicitly addressing the credit union's management of 
controls for IRR.

    \3\ Letters to Credit Unions: 99-CU-12, Real Estate Lending and 
Balance Sheet Risk Management, Aug. 1999; 00-CU-10, Asset Liability 
Management Examination Procedures, Nov. 2000; 00-CU-13, Liquidity 
and Balance Sheet Risk Management, Dec. 2000; 01-CU-08, Liability 
Management--Highly Rate-Sensitive and Volatile Funding Sources, July 
2001; 01-CU-19, Managing Share Inflows in Uncertain Times, Oct. 
2001; 03-CU-11, Non-Maturity Shares and Balance Sheet Risk, July 
2003; 03-CU-15, Real Estate Concentrations and Interest Rate Risk 
Management for Credit Unions with Large Positions in Fixed-Rate 
Mortgage Portfolios, Sept. 2003; 06-CU-16, Interagency Guidance on 
Nontraditional Mortgage Product Risk, Oct. 2006; 10-CU-06, 
Interagency Advisory on Interest Rate Risk Management, Jan. 6, 2010. 
NCUA plans to issue a Letter to Credit Unions addressing the 
``Interagency Advisory on Interest Rate Risk Management, Frequently 
Asked Questions'' that was issued on January 12, 2012.

    Therefore, it is both timely and appropriate to require certain 
credit unions to have a formal policy addressing IRR management and a 
corresponding program to effectively implement that policy. Further, it 
is incumbent upon NCUA, as steward of the National Credit Union Share 
Insurance Fund (``the Fund''), to consider a credit union's IRR 
management policy and implementation program as a factor in determining 
whether the Fund should insure its member deposits.
    C. What Were the Requirements of the Proposed Rule? The existing 
regulation on insurability of accounts prescribes certain criteria NCUA 
must consider in ``determining the insurability of a credit union * * * 
and in continuing the insurability of its accounts.'' 12 CFR 741.3. 
Among the ``factors * * * to be considered in determining whether the 
credit union's financial condition and policies are both safe and 
sound,'' are the existence of written lending and investment policies. 
Id. Sec.  741.3(b)(2)-(3). IRR management policies and practices are 
absent from the existing factors.
    In response to credit unions' increasing exposure to IRR, NCUA 
issued a proposed rule in March 2011 amending section 741.3(b) to 
require, as an additional factor in determining whether a ``credit 
union's financial condition and policies are both safe and sound,'' the 
existence of a written policy on IRR management and a program to 
effectively implement that policy (together ``an IRR policy and 
program''). 76 FR 16570 (Mar. 24, 2011). The proposed rule set an 
effective date for compliance at three months after the publication of 
the final rule in the Federal Register.
    As proposed, the rule would apply to two categories of FICUs, (a) 
those having more than $50 million in assets; and (b) those having 
assets between $10 million and $50 million whose ratio of first 
mortgage loans, plus investments with maturities greater than five 
years (the

[[Page 5156]]

numerator), equals or exceeds 100% of its net worth (the denominator). 
This ratio is known as the ``Supervisory Interest Rate Risk Threshold 
Ratio'' (``SIRRT ratio'') and is explained in section II.D. of this 
preamble. Conversely, the rule would not apply to FICUs with assets of 
less than $10 million, or to those with assets between $10 million and 
$50 million whose combined first mortgage loans, plus investments with 
maturities greater than five years, are less than 100% of its net 
    To help credit unions understand and meet NCUA's expectations for 
compliance with amended section 741.3(b), the proposed rule included an 
appendix (``Appendix B'') setting forth comprehensive guidance on 
developing both a written policy on IRR management and a program to 
effectively implement that policy.\4\ Appendix B acknowledges that it 
is not possible to establish a ``one-size-fits-all'' template of IRR 
management standards and metrics that would be appropriate for all 
FICUs. Rather, it recognizes that IRR management requires specialized 
judgments based on each credit union's business objectives and ability 
to withstand risk.

    \4\ NCUA plans to introduce a new IRR questionnaire that 
corresponds to Appendix B of the final rule to replace the IRR 
questionnaire presently used by examiners. The present questionnaire 
is located on NCUA's Web site at: http://www.ncua.gov/Resources/CUs/ALM/Pages/ALMReview.aspx.

    Appendix B leaves to each affected credit union's board of 
directors the obligation and responsibility to make those judgments. 
Yet, it also provides them a framework of five fundamental elements of 
an effective IRR management program: A comprehensive, written IRR 
policy; accountable IRR oversight by board of directors and management; 
appropriate IRR measurement and monitoring systems; good internal 
controls; and informed decision-making based on IRR measurement system 
results. It also provides guidelines for determining the adequacy of 
IRR policy and effectiveness of implementation program. The appendix 
also includes guidance for large credit unions with complex or high-
risk balance sheets.

II. Subject-by-Subject Discussion of Comments on Proposed Rule

    The proposed rule was issued with a 60-day comment period that 
expired on May 23, 2011. 76 FR 16570. NCUA received 48 comment letters 
in response--29 from Federally-insured credit unions, 13 from credit 
union industry trade associations, one from an association of state 
credit union supervisory authorities, and 5 from industry consultants. 
Five commenters affirmatively supported the proposed rule; 29 
commenters either opposed the rule or did not state a definitive 
position; and 14 commenters addressed particular aspects of the rule or 
made suggestions for improving it. The comments on the proposed rule 
are addressed as follows:
    A. Authority to Impose Insurability Criteria. A trade association 
compared the existing insurability factors requiring a lending policy 
and an investment policy with the proposed requirement for an IRR 
management policy and implementation program. This commenter 
distinguished between lending and investment authorities and 
limitations that are ``specifically detailed in the Federal Credit 
Union Act'' and the authority to require IRR management, which it 
contends ``is a regulatory directive and is not addressed in the Act.'' 
The suggestion that there is authority in the Act to require the 
existing lending and investment policies but not to require an IRR 
management policy and implementation program is incorrect.\5\ The basis 
for both the existing and proposed factors for insurability is safety 
and soundness. As section 741.3(b) itself confirms, the ``financial 
policies and conditions'' it prescribes are ``factors * * * to be 
considered in determining whether the credit union's financial 
condition and policies are both safe and sound.''

    \5\ The Act itself does contain authority for adding the IRR 
policy and implementation program as an insurability criterion. 
Title II of the Act requires NCUA, when granting insurance to a 
Federal or state credit union, to consider the applicant's 
``history, financial condition and management policies,'' 12 U.S.C. 
1781(c)(1)(A), and to deny insurance if it finds that the 
applicant's ``financial condition and policies are unsafe or 
unsound.'' Id. Sec.  1781(c)(2).

    B. Regulatory Burden and Duplication. A number of commenters said 
that requiring an IRR management policy and implementation program as 
insurability criteria imposes an excessive regulatory burden on credit 
unions, especially in the wake of the regulatory mandates imposed as a 
result of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act, 12 U.S.C. 5301 et seq. Emphasizing this point, some commenters 
protested that other financial regulators have not introduced IRR 
management rules.
    A number of commenters also noted that mechanisms to manage credit 
unions' IRR already exist that are sufficient to monitor and assess 
shifts in IRR and to indicate when corrective action is warranted. For 
example, they cite interagency advisories, NCUA Letters to Credit 
Unions, and credit union examinations themselves. See footnote 3 above. 
NCUA does not dispute the utility of these existing mechanisms, but 
does not agree that they are sufficient in an environment of increased 
risk exposure and interest rate volatility. As detailed in sections C. 
and D. below in this preamble, IRR exposure at credit unions is on the 
rise to the point that it is higher than at peer commercial banks.
    It is unclear that the numerous Letters to Credit Unions NCUA has 
periodically issued, providing supervisory advice and guidance on IRR 
management, has led to improvements in IRR management that are 
sufficient to meet the growing risk exposure and increasing interest 
rate volatility. Appendix B to the final rule is intended to complement 
the existing guidance by providing a framework for each credit union to 
develop its own definitive IRR policy and program. Accordingly, the 
final rule adopts as timely and prudent the proposed requirements for 
an IRR management policy and implementation program as additional 
criteria for insurability.
    C. Need for Interest Rate Risk Policy and Program. A number of 
commenters asserted that NCUA has not demonstrated a need to require an 
IRR management policy and implementation program beyond the conclusion 
that IRR exposure has increased. One commenter contended that the past 
performance of credit unions in managing net interest margins following 
periods of rising rates suggests that an IRR management policy and 
implementation program is unnecessary. Recent relevant data 
demonstrates otherwise.
    NCUA compared IRR exposure since 1996 of credit unions versus 
commercial banks based on growth in real estate loans as a percentage 
of total assets. At year-end 2010, residential mortgages accounted for 
30.7% of credit union assets compared to only 18.4% at peer commercial 
banks. In 1996, residential mortgages as a percent of total assets for 
both credit unions and banks were in the 15-20% range.\6\ While peer 
institutions have retreated from booking mortgage loans, credit unions 
have increased residential mortgage holdings and taken on more interest 
rate risk in the process.

    \6\ See ``Interest Rate Risk Proposal Gets Ahead of the Curve,'' 
The NCUA Report (Apr. 2011, No. 4). This article concluded that the 
IRR exposure of Federally insured credit unions has risen steeply 
since 1996 relative to peer commercial banks.

    Other NCUA data show the percent of credit unions with exposure to 
mortgages, and the median level of

[[Page 5157]]

credit union IRR exposure to net worth by asset size cohort at year-end 
2010, as depicted in Table 1:

    \7\ See ``Size Matters: Another Perspective on IRR,'' The NCUA 
Report (June 2011, No. 6).

    Each of these measures indicates that the risk from changing 
interest rates to credit unions with long-term fixed cash flows 
increases with asset size and the escalation occurs most significantly 
in the $10 million to $50 million asset cohort.
    Credit unions can use sales of real estate loans originated to 
reduce IRR exposure on their balance sheets. In that regard, a trade 
association commented that credit unions' sales of first mortgage 
originations during the current interest rate cycle have increased from 
25-30% of first mortgage loans granted to over 50%. The trade 
association argued that credit unions manage their net interest margin 
in this and other ways. The commenter noted that following a 300 basis 
point increase in the Fed funds rate in 1994 and a 425 basis point 
increase in 2004-2006, credit union net interest margins fell only by 1 
basis point in 1995, by 15 basis points in 2005, and by 11 basis points 
in 2006.
    Credit unions can manage net interest margins, for example, by 
means of share deposit pricing. On this point, the commenter also 
suggested the Federal Reserve is not expected to raise interest rates 
quickly. The commenter also asserted that liquidity at credit unions 
might allow them to offset IRR exposure due to their record levels of 
long-term assets by raising deposit rates more slowly. NCUA notes that 
in January 2012 the Federal Reserve indicated that it expected economic 
conditions to warrant keeping the Federal funds rate at exceptionally 
low levels at least through late 2014.
    NCUA acknowledges the aggregate upward trend over the long term in 
credit unions' sales of first mortgage real estate loans that they 
originated. Most recently, the percentage of first mortgage real estate 
loans sold fell to 44.8% of loans granted year to date in the 3rd 
quarter of 2011, but this was from a high for the full year of 51.9% in 
2010. NCUA notes that the present 44.8% level remains significantly 
greater than the most recent low point of 26.3% of loans sold for the 
year in 2007. The increase is concentrated in the largest credit 
unions, however. For example, the percentage of first mortgage real 
estate loans sold in the $10 million to $50 million asset cohort was 
16.0% of first mortgage real estate loans granted at credit unions year 
to date in the 3rd quarter of 2011, and 14.5% of first mortgage real 
estate loans granted for the year in December 2007.
    NCUA also acknowledges that credit unions use deposit interest 
rates to mitigate the impact of increases in short-term rates on their 
net interest margin. Understanding IRR requires taking into account the 
historical levels of interest rates. Short-term rates presently are 500 
basis points below 2006-2007 levels, and any return even to average 
long-term rates is likely to stress credit unions' ability to manage 
such a change in the level of interest rates. Reluctance to increase 
deposit interest rates sufficiently in an effort to enhance earnings 
and mitigate interest rate risk could trigger unexpected deposit 
outflows and thereby increase a credit union's liquidity risk.
    All these indicators of IRR exposure point to heightened risk for 
credit unions. While acknowledging that credit unions act in various 
ways to manage IRR, the consistent rise in IRR at credit unions 
relative to other peer institutions deserves regulatory attention and 
is warranted as a prerequisite for insurability.
    D. Supervisory Interest Rate Risk Threshold (SIRRT). For credit 
unions in the asset cohort of $10 million to $50 million, the proposed 
and final rules rely on the SIRRT ratio as a reliable indicator of IRR 

A credit union in that asset cohort must develop and adopt an IRR 
policy and program only if its SIRRT ratio equals or exceeds 100% of 
its net worth, i.e., a ratio of 1:1. The rule does not require a credit 
union with assets under $10 million to develop and adopt an IRR policy 
and program, regardless of its SIRRT.
    NCUA has tracked the SIRRT ratio among the population of FICUs as 
an aggregate percentage of their net worth from 2005 (when Call Reports 
started to break out investment maturities at 5 years) to September 
2011. Table 2 below depicts this aggregate ratio:

[[Page 5158]]


    As previously discussed, the percentage of residential real estate 
loans declined from a high point of almost 35% of assets in 2008 to 
30.7% of assets in 2010. See footnote 6 above. However, this does not 
take into account the movement of FICU assets into long-term 
investments since 2008, as the growth in consumer demand for mortgage 
loans slowed during this recessionary period. When these elements are 
included, as Table 2 shows, the SIRRT ratio increased from 256.2% of 
net worth in 2008 to a high of 271.1% in March 2011. The ratio declined 
to 264.8% in September 2011. Nonetheless, since 2005, the ratio has 
increased from 199.1%. In sum, credit union assets that present the 
highest IRR exposure have increased relative to credit union net worth 
and have reached a significantly higher level. The IRR exposure levels 
depicted by the data also indicate that credit unions' net interest 
margin performance, as previously discussed, does not eliminate the 
need for an IRR policy and IRR management program.
    Several commenters questioned the components of the SIRRT 
numerator. Some advocated limiting the maturity of first mortgages to 
match the 5-year maturity limit of investments. Others supported 
excluding adjustable rate mortgages from the numerator. One commenter 
argued that the numerator should distinguish between fixed-rate and 
variable-rate loans.
    NCUA does not believe the components of the numerator of the SIRRT 
ratio should be changed. Adjustable rate mortgages carry modeling risk 
because these loans are complex. Specifically, they have periodic and 
lifetime caps with varying reset dates and margins that must be 
incorporated to reflect risk. These complex mortgages should therefore 
be included in the SIRRT ratio.
    A number of commenters addressed the asset size thresholds for 
subjecting credit unions to the IRR policy and program. Of these, 
several favored raising the asset ``floor'' to $20 million and $50 
million, respectively, thus excluding credit unions below the 
``floor.'' One commenter criticized use of asset thresholds altogether, 
asserting that IRR may be present in credit unions regardless of asset 
size. One commenter agreed that small credit unions should be excluded 
by adhering to the $10 million asset ``floor'' originally proposed.
    The comments on the SIRRT ratio overlook the fundamental reasons 
for reliance on the ratio. Net worth is the reserve of funds available 
to absorb the risks of a credit union, and it is therefore the best 
measure against which to gauge the credit union's risk exposure. A 
credit union where the SIRRT ratio is at or over 1:1 is exposed to IRR 
at a heightened level. This requires additional attention by credit 
unions in the $10 million to $50 million asset cohort to their IRR 
policy and management program in order to manage this risk. At year-end 
2010 in the $10 million to $50 million asset cohort, median first 
mortgages to net worth (56.4%) exceeded the median for all credit 
unions (35.0%). Additional NCUA data also shows at year-end 2010 that 
for credit unions in the $10 million to $50 million asset cohort with a 
SIRRT ratio at or above 1:1, median first mortgages to net worth was 
179.9% of net worth, and median long-term residential mortgages 
repricing at or longer than five years to net worth was 148.1% of net 
worth. By comparison, credit unions in the $10 million to $50 million 
asset cohort with a SIRRT ratio below 1:1 have a 2.7% ratio of median 
first mortgages to net worth and a 28.5% ratio of median long-term 
residential mortgages to net worth. NCUA therefore concludes that the 
SIRRT ratio effectively partitions risk.
    NCUA devised the SIRRT ratio's ``floor'' and ``ceiling'' thresholds 
to minimize regulatory burden and at the same time ensure adequate 
regulatory coverage of total credit union assets. Applying the 
thresholds to the $10 million to $50 million asset cohort achieves both 
of these objectives. Moreover, the data indicates that a credit union's 
IRR exposure as its assets grow is likely to occur at the $10 million 
to $50 million asset range At year-end 2010, among the total population 
of FICUs, 3,184 credit unions had a SIRRT ratio equal to or exceeding 
100% of their net worth, whereas 4,155 credit unions had a SIRRT ratio 
less than 100% of their net worth, thus minimizing regulatory burden. 
At the same time, applying the SIRRT ratio to the $10 million to $50 
million asset cohort would have imposed the IRR policy and program 
requirement on 95.5% of credit union assets, or $873.6 billion out of a 
total of $914.4 billion in credit union assets.
    NCUA reviewed data as of September 30, 2011 for purposes of the 
final rule. The SIRRT ratio is depicted in Table 3 for credit unions by 
asset cohort and it demonstrates the segregation of risk. As shown in 
Table 2 previously, the

[[Page 5159]]

aggregate SIRRT ratio for all credit unions was 264.8%.

    The distribution of the number of credit unions not covered and 
covered by the rule is depicted in Table 4 and it shows that 1,316 
credit unions in the $10 to $50 Million asset cohort would not have 
been covered by the rule, and 54.8% of all credit unions would not have 
been covered by the rule.

    The distribution of credit union assets not covered and covered by 
the rule is depicted in Table 5, which shows that 95.9% of all credit 
union assets would have been covered by the rule based on September 30, 
2011 data.

    Accordingly, the proposed $10 million ``floor'' and the proposed 
$50 million ``ceiling'' thresholds as applied to the SIRRT ratio 
continue to provide effective segregation of risk while reasonably 
minimizing regulatory burden.
    E. Application of the Rule. Many commenters expressed concern about 
how the proposed rule would be applied in practice. Several observed 
that it would impose a ``one-size-fits-all'' set of IRR policies, or be 
used as a checklist by examiners, or viewed by examiners as a mandate, 
or inhibit the flexibility of credit unions, thereby allowing examiners 
to micro-manage them. A number of commenters were concerned that 
examiners would apply the rule subjectively, leading to ``generic 
standards.'' Others predicted that examiners would rely on peer data 
and simplified assumptions. Finally, several noted the absence from the 
rule of an express definition of what constitutes an ``effective 
    It is not the intent of the rule for examiners to subjectively 
impose unduly standardized supervisory oversight. Examiners will be 
expected to apply the standards within a consistent framework based on 
their knowledge of each credit union's operations and available 
resources. While the rule itself does not define what is an ``effective 
program,'' the guidance in Appendix B does. It provides that ``an 
effective IRR management program identifies, measures, monitors, and 
controls IRR

[[Page 5160]]

and is central to safe and sound credit union operations.'' Further, as 
the preamble to the proposed rule also recognized: ``it is impossible 
to establish specific, regulatory requirements for IRR that would be 
appropriate for all FICUs. IRR management involves judgment by a FICU 
based on its own individual mission, structure, and circumstances. Any 
rule must take into account the diversity of FICUs and avoid a one-
size-fits-all approach. Accordingly, FICUs should devise a policy and 
risk management program appropriate to their own situation.'' 76 FR 
16571. The NCUA Board reaffirms the notion that IRR management must be 
individualized, while subject to regulatory oversight and prudent 
insurability standards.
    NCUA acknowledges that using simplifying assumptions to apply the 
rule involves a certain degree of subjectivity, but believes this is a 
necessary part of the supervision process. Any assumption used to 
aggregate data or categorize financial instruments can be a simplifying 
assumption. However, NCUA does not take issue with using such 
assumptions or generic standards so long as these are consistent with 
the best practices described in the January 2010 FFIEC Advisory on 
Interest Rate Risk Management and take into account the size, 
complexity and risk exposure of the credit union. NCUA recognizes the 
use of peer data may be appropriate. Simplifying assumptions are part 
of the practice of IRR management and are an issue only when they cause 
either credit union management or an examiner to underestimate 
complexity. For example, a credit union may use simplifying assumptions 
in the process of modeling IRR, and these can be acceptable so long as 
they do not cause interest rate risk to be misstated.
    To address consistency of application NCUA plans to issue guidance 
and training for examiners, including a questionnaire that is tailored 
specifically to this rule. See footnote 4 above. The commentary in the 
questionnaire emphasizes that the guidance items are not mandatory. 
Credit unions are encouraged to review and discuss these guidance items 
with their examiners.
    F. Guidance on IRR Policy and Program. A number of commenters made 
observations about the role of the specific guidance in Appendix B to 
the rule. Of these, one commenter asked whether Appendix B supersedes 
existing guidance on IRR management. One recommended publishing 
Appendix B on the NCUA Web site when it is adopted. Another recommended 
updating the Examiners Guide to include the guidance in Appendix B.
    NCUA does not intend Appendix B to supplant existing advice on 
specific aspects of IRR management. Existing NCUA Letters to Credit 
Unions address specific aspects of IRR such as real estate lending, 
liquidity, rate-sensitive funding sources, and non-maturity shares. 
These Letters to Credit Unions are consistent with the practices set 
forth in Appendix B and credit unions should continue to heed the 
advice they give. See footnote 3 above. The guidance in Appendix B is 
also complementary to the 2010 Interagency Advisory on Interest Rate 
Risk Management and the 2012 Interagency Advisory on Interest Rate Risk 
Management, Frequently Asked Questions. NCUA will continue to issue 
Letters to Credit Unions relating to IRR management as necessary and 
will update the Examiners Guide accordingly.
    A number of commenters addressed technical aspects of IRR 
measurement methods. Of these, some said Appendix B implied a 
preference for the valuation of non-maturity shares at par. One said 
that credit unions should be free to choose their own method. One noted 
the selection of curves for discounting is debatable. One said a credit 
union offering rate is the most defensible reinvestment rate. One said 
that IRR measures using changes in rates might not fully reflect the 
level of IRR. One said that 300 basis point shocks should not be an 
industry standard for the rule. One said that parallel shock analysis 
is not realistic. One recommended semiannual IRR testing in an IRR 
management program.
    NCUA responds to these and similar technical comments by 
reiterating that it does not seek to endorse certain IRR measures, 
measurement techniques, or assumptions over others. For example, NCUA 
does not prescribe valuing non-maturity shares at par but it 
acknowledges that such measures and the use of historical rate 
scenarios may provide useful information. Similarly, NCUA does not 
require discounting on yield curves or endorse any particular discount 
rate. NCUA does recommend the use of pro forma risk measurement and the 
discipline of utilizing relevant stress tests to better understand IRR 
and to be aware of the scenarios that would have the most detrimental 
impact on earnings, net worth, or net economic value. Base values of 
balance sheet instruments are as integral to stating risk exposure as 
stressed results. Testing should be as frequent as needed for a credit 
union to be fully aware of its IRR exposure and semi-annual IRR testing 
may not be sufficient to manage IRR.
    Several more commenters made observations on the separation of 
credit union responsibilities with respect to IRR. Of these, two 
commented on the separation of risk taking and risk management. One of 
these recommended that NCUA provide examples to suggest appropriate 
separation of duties, and another one said that separation would be 
    NCUA does not believe this section of Appendix B on policy, board 
oversight and credit union structure needs to be amended. The proposed 
rule suggested that credit unions should separate risk-taking and risk 
measurement functions ``if possible'', particularly in the case of 
large, complex or high-risk credit unions. In the case of large, 
complex or high-risk credit unions, the final rule already provides an 
example of separating the investment function from the IRR measurement 
function, e.g. having the IRR measurement function report to an audit 
or supervisory committee. However, it is not the function of this rule 
to prescribe specific organizational structures.
    G. Alternatives to the Proposed Rule. A number of commenters 
suggested that NCUA should focus on the 800 credit unions that lack an 
IRR policy instead of the estimated 75% of credit unions that have such 
policies in place. NCUA does not agree. The data introduced earlier 
indicates that IRR overall is at an unprecedented level; it is not 
limited to a small subset of credit unions.
    Attempting to balance flexibility with regulatory concerns, one 
commenter suggested that an effective IRR program would be one that 
takes assets and liabilities into account, requires management reports 
to the board, and performs tests as directed by regulators. NCUA agrees 
that any rulemaking that addresses IRR should be crafted to not limit 
credit union flexibility, while still considering regulatory concerns. 
For this reason, the guidance in Appendix B is flexible. At the same 
time, shifting interest rates pose a core risk that could jeopardize 
the liquidity and solvency of credit unions. The steady increase in 
this exposure to interest rate changes warrants a high level of 
attention by management and oversight by NCUA and state supervisory 
authorities. The Board therefore believes that an IRR policy and an 
effective IRR management program must be implemented by regulation and 
should not be left solely to the supervisory process.
    H. Effective Date and Implementation of Final Rule. The proposed 
rule prescribed a period of three months

[[Page 5161]]

between publication of the final rule and its effective date for credit 
unions to comply with the rule's new requirements. A number of 
commenters urged making the acclimation period longer than three months 
and some recommended a phase-in period of as long as one year. In view 
of these comments, NCUA has reassessed the steps and the time it will 
take both affected credit unions and itself to acclimate to the final 
    Balancing its concern for a timely response to interest rate risk 
issues against its objective to ensure careful implementation of the 
final rule, the Board has decided to modify the effective date of the 
final rule to September 30, 2012.

III. Regulatory Procedures

    A. Regulatory Flexibility Act. The Regulatory Flexibility Act 
requires NCUA to prepare an analysis to describe any significant 
economic impact a rule may have on a substantial number of small 
entities (primarily those credit unions with less than ten million 
dollars in assets). By its terms, the final rule's requirement to 
develop a written IRR management policy and a program to effectively 
implement the policy do not apply to credit unions with less than $10 
million in assets. Accordingly, this final rule will not have a 
significant economic impact on a substantial number of small credit 
unions and a Regulatory Flexibility Analysis is not warranted.
    B. Paperwork Reduction Act. This final rule requires certain credit 
unions to develop, as prerequisites for insurability of its member 
deposits, a written IRR management policy (``an IRR policy'') and a 
program to effectively implement the policy. The Paperwork Reduction 
Act of 1995 (``PRA'') applies to rulemakings in which an agency by rule 
creates a new paperwork burden on regulated entities or modifies an 
existing burden. 44 U.S.C. 3507(d). For purposes of the PRA, a 
paperwork burden may take the form of either a reporting or a 
recordkeeping requirement, both referred to as information collections. 
NCUA has determined that the requirement to develop an IRR policy 
creates a new information collection requirement. As required, NCUA has 
applied to the Office of Management and Budget (``OMB'') for approval 
of the information collection requirement described below.
    The final rule requires two categories of credit unions to develop 
an IRR policy and program: those having more than $50 million in 
assets; and those having assets between $10 million and $50 million 
whose combined first mortgage loans, plus investments with maturities 
greater than five years, equal or exceed 100% of net worth. As of 
September 30, 2011, 3,246 FICUs (45% of all FICUs) fell in either of 
these two categories. NCUA estimates, however, that 2,446 of the 
affected FICUs (or approximately 75% of them) already have an IRR 
policy in place; they will need only to review the existing IRR policy, 
and make appropriate adjustments where necessary, to comply with the 
final rule. The other 800 affected FICUs (approximately 25% of them) 
will need to newly develop an IRR policy. Periodic review of an 
existing IRR policy should require minimal or no additional burden.
    The final rule is accompanied by an Appendix setting forth 
comprehensive guidance on developing both an IRR policy and program. 
The guidance specifies eight policy items that must be addressed. See 
section II of Appendix B following rule text below. The length of an 
IRR management policy covering these eight policy elements will vary 
according to the credit union's business strategies. A credit union 
offering basic share accounts and short-term loans but no mortgage 
loans, and that makes relatively simple investments, should be able to 
develop a basic IRR policy in one to two hours that establishes, for 
example, maturity limits for loans, the minimum amount of short-term 
funds, and the range of permissible investments. In contrast, credit 
unions with more complex balance sheets, especially those containing 
mortgage loans and complex investments, may warrant a more 
comprehensive IRR management policy that requires additional time to 
    NCUA estimates that addressing the eight policy items will each 
entail an equal time burden of two hours. The maximum time for all 
segments of an IRR policy is therefore estimated at 16 hours. In turn, 
the aggregate information collection burden for affected credit unions 
to comply with the rule is estimated 12,800 hours (800 credit unions x 
16 hours).
    The proposed rule noted that organizations and individuals wishing 
to comment on this information collection requirement should direct 
their comments to the Office of Information and Regulatory Affairs, 
OMB, Attn: Shagufta Ahmed, Room 10226, New Executive Office Building, 
Washington, DC 20503, with a copy to Mary Rupp, Secretary of the Board, 
National Credit Union Administration, 1775 Duke Street, Alexandria, 
Virginia 22314-3428.
    The sole commenter in response to the proposed rule contended that 
the estimate of 16 hours to complete an IRR policy understates the time 
it takes to collect the information, establish limits and review the 
data. That commenter offered no alternative estimate.
    NCUA considers public comments on the collection of information in:
     Evaluating whether the collection of information is 
necessary for the proper performance of the functions of the NCUA, 
including whether the information will have a practical use;
     Evaluating the accuracy of the NCUA's estimate of the 
burden of the collection of information, including the validity of the 
methodology and assumptions used;
     Enhancing the quality, usefulness, and clarity of the 
information to be collected; and
     Minimizing the burden of collection of information on 
those who are to respond, including through the use of appropriate 
automated, electronic, mechanical, or other technological collection 
techniques or other forms of information technology; e.g., permitting 
electronic submission of responses.
    OMB assigned No. 3133-0184 to this rulemaking.
    C. Executive Order 13132. Executive Order 13132 encourages 
independent regulatory agencies to consider the impact of their actions 
on state and local interests. In adherence to fundamental federalism 
principles, NCUA, an independent regulatory agency as defined in 44 
U.S.C. 3502(5), voluntarily complies with the Executive Order. This 
rule will not have substantial direct effects on the states, on the 
relationship between the national government and the states, or on the 
distribution of power and responsibilities among the various levels of 
government. Therefore, this rule does not constitute a policy that has 
federalism implications for purposes of the executive order.
    D. The Treasury and General Government Appropriations Act, 1999--
Assessment of Federal Regulations and Policies on Families. The NCUA 
has determined that this rule will not affect family well-being within 
the meaning of the Treasury and General Government Appropriations Act, 
Pub. L. 105-277, 112 Stat. 2681 (1998).
    E. Small Business Regulatory Enforcement Fairness Act. The Small 
Business Regulatory Enforcement Fairness Act of 1996 (Pub. L. 104-121) 
(SBREFA) provides generally for congressional review of agency rules. A 
reporting requirement is triggered in instances where NCUA issues a 
final rule as defined by section 551 of the APA. 5 U.S.C. 551. The 
Office of

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Management and Budget has determined that this rule is not a major rule 
for purposes of SBREFA. As required by SBREFA, NCUA will file the 
appropriate reports with Congress and the General Accounting Office so 
this rule may be reviewed.

List of Subjects in 12 CFR Part 741

    Credit unions, Requirements for insurance.

    By the National Credit Union Administration Board on January 26, 
Mary F. Rupp,
Secretary of the Board.

    For the reasons set forth above, NCUA amends 12 CFR part 741 as 


1. The authority citation for part 741 continues to read:

    Authority:  12 U.S.C. 1757, 1766(a), 1781-1790 and 1790d; 31 
U.S.C. 3717.

2. In Sec.  741.3, add paragraph (b)(5) to read as follows:

Sec.  741.3  Criteria

* * * * *
    (b) * * *
    (5)(i) The existence of a written interest rate risk policy (IRR 
policy'') and an effective interest rate risk management program 
(``effective IRR program'') as part of asset liability management in 
all Federally- insured credit unions (``FICU'') as follows. All 
measurements are based on the most recent Call Report filing of the 
    (A) A FICU with assets of more than $50 million must adopt a 
written IRR policy and implement an effective IRR program;
    (B) A FICU with assets of $10 million or more but not greater than 
$50 million must adopt a written IRR policy and implement an effective 
IRR program if the total of first mortgage loans it holds combined with 
total investments with maturities greater than five years, as reported 
by the FICU on its most recent Call Report, is equal to or greater than 
100% of its net worth (i.e., a 1:1 ratio);
    (C) A FICU with assets $10 million or more but not greater than $50 
million are not required to comply with this paragraph if the total of 
first mortgage loans it holds, combined with total investments with 
maturities greater than five years, is less than 100% of its net worth 
(i.e., a 1:1 ratio); and
    (D) A FICU with less than $10 million in assets is not required to 
comply with this paragraph regardless of the amount of first mortgage 
loans and total investments with maturities greater than five years it 
    (ii) For purposes of paragraph (b)(5)(i) of this section--
    (A) A FICU is considered to hold a first mortgage loan for its own 
portfolio when it has not demonstrated the intent and ability to sell 
the loan to an independent third party within 120 days of origination;
    (B) Investments are defined in Sec.  703.2 of this chapter. 
Investments with maturities greater than five years are defined as 
those reported by the FICU on the Call Report; and
    (C) Appendix B to this Part 741 provides guidance on how to develop 
an IRR policy and an effective IRR program. The guidance describes 
widely-accepted best practices in the management of interest rate risk 
for the benefit of all FICUs.
* * * * *

3. Part 741 is amended by adding Appendix B to read as follows:

Appendix B to Part 741--Guidance for an Interest Rate Risk Policy and 
an Effective Program

Table of Contents

I. Introduction
    A. Complexity
    B. IRR Exposure
II. IRR Policy
III. IRR Oversight and Management
    A. Board of Directors Oversight
    B. Management Responsibilities
IV. IRR Measurement and Monitoring
    A. Risk Measurement Systems
    B. Risk Measurement Methods
    C. Components of IRR Measurement Methods
V. Internal Controls
VI. Decision-Making Informed by IRR Measurement Systems
VII. Guidelines for Adequacy of IRR Policy and Effectiveness of 
VIII. Additional Guidance for Large Credit Unions With Complex or 
High Risk Balance Sheets
IX. Definitions

I. Introduction

    This appendix provides guidance to FICUs in developing an 
interest rate risk (IRR) policy and program that addresses aspects 
of asset liability management in a single framework. An effective 
IRR management program identifies, measures, monitors, and controls 
IRR and is central to safe and sound credit union operations. Given 
the differences among credit unions, each credit union should use 
the guidance in this appendix to formulate a policy that embodies 
its own practices, metrics and benchmarks appropriate to its 
    These practices should be established in light of the nature of 
the credit union's operations and business, as well as its 
complexity, risk exposure, and size. As these elements increase, 
NCUA believes the IRR practices should be implemented with 
increasing degrees of rigor and diligence to maintain safe and sound 
operations in the area of IRR management. In particular, rigor and 
diligence are required to manage complexity and risk exposure. 
Complexity relates to the intricacy of financial instrument 
structure, and to the composition of assets and liabilities on the 
balance sheet. In the case of financial instruments, the structure 
can have numerous characteristics that act simultaneously to affect 
the behavior of the instrument. In the case of the balance sheet, 
which contains multiple instruments, assets and liabilities can act 
in ways that are compounding or can be offsetting because their 
impact on the IRR level may act in the same or opposite directions. 
High degrees of risk exposure require a credit union to be 
diligently aware of the potential earnings and net worth exposures 
under various interest rate and business environments because the 
margin for error is low.

A. Complexity

    In influencing the behavior of instruments and balance sheet 
composition, complexity is a function of the predictability of the 
cash flows. As cash flows become less predictable, the uncertainty 
of both instrument and balance sheet behavior increases. For 
example, a residential mortgage is subject to prepayments that will 
change at the option of the borrower. Mortgage borrowers may pay off 
their mortgage loans due to geographical relocation, or may increase 
the amount of their monthly payment above the minimum contractual 
schedule due to other changes in the borrower's circumstances. This 
cash flow unpredictability is also found in investments, such as 
collateralized mortgage obligations, because these contain mortgage 
loans. Additionally, cash flow unpredictability affects liabilities. 
For example, nonmaturity share balances vary at the discretion of 
the depositor making deposits and withdrawals, and this may be 
influenced by a credit union's pricing of its share accounts.

B. IRR Exposure

    Exposure to IRR is the vulnerability of a credit union's 
financial condition to adverse movements in market interest rates. 
Although some IRR exposure is a normal part of financial 
intermediation, a high degree of this exposure may negatively affect 
a credit union's earnings and net economic value. Changes in 
interest rates influence a credit union's earnings by altering 
interest-sensitive income and expenses (e.g. loan income and share 
dividends). Changes in interest rates also affect the economic value 
of a credit union's assets and liabilities, because the present 
value of future cash flows and, in some cases, the cash flows 
themselves may change when interest rates change. Consequently, the 
management of a credit union's pricing strategy is critical to the 
control of IRR exposure.
    All FICUs required to have an IRR policy and program should 
incorporate the following five elements into their IRR program:
    1. Board-approved IRR policy.
    2. Oversight by the board of directors and implementation by 
    3. Risk measurement systems assessing the IRR sensitivity of 
earnings and/or asset and liability values.
    4. Internal controls to monitor adherence to IRR limits.

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    5. Decision making that is informed and guided by IRR measures.

II. IRR Policy

    The board of directors is responsible for ensuring the adequacy 
of an IRR policy and its limits. The policy should be consistent 
with the credit union's business strategies and should reflect the 
board's risk tolerance, taking into account the credit union's 
financial condition and risk measurement systems and methods 
commensurate with the balance sheet structure. The policy should 
state actions and authorities required for exceptions to policy, 
limits, and authorizations.
    Credit unions have the option of either creating a separate IRR 
policy or incorporating it into investment, ALM, funds management, 
liquidity or other policies. Regardless of form, credit unions must 
clearly document their IRR policy in writing.
    The scope of the policy will vary depending on the complexity of 
the credit union's balance sheet. For example, a credit union that 
offers short-term loans, invests in non-complex or short-term bullet 
investments (i.e. a debt security that returns 100 percent of 
principal on the maturity date), and offers basic share products may 
not need to create an elaborate policy. The policy for these credit 
unions may limit the loan portfolio maturity, require a minimum 
amount of short-term funds, and restrict the types of permissible 
investments (e.g. Treasuries, bullet investments). More complex 
balance sheets, especially those containing mortgage loans and 
complex investments, may warrant a comprehensive IRR policy due to 
the uncertainty of cash flows.
    The policy should establish responsibilities and procedures for 
identifying, measuring, monitoring, controlling, and reporting IRR, 
and establish risk limits. A written policy should:
     Identify committees, persons or other parties 
responsible for review of the credit union's IRR exposure;
     Direct appropriate actions to ensure management takes 
steps to manage IRR so that IRR exposures are identified, measured, 
monitored, and controlled;
     State the frequency with which management will report 
on measurement results to the board to ensure routine review of 
information that is timely (e.g. current and at least quarterly) and 
in sufficient detail to assess the credit union's IRR profile;
     Set risk limits for IRR exposures based on selected 
measures (e.g. limits for changes in repricing or duration gaps, 
income simulation, asset valuation, or net economic value);
     Choose tests, such as interest rate shocks, that the 
credit union will perform using the selected measures;
     Provide for periodic review of material changes in IRR 
exposures and compliance with board approved policy and risk limits;
     Provide for assessment of the IRR impact of any new 
business activities prior to implementation (e.g. evaluate the IRR 
profile of introducing a new product or service); and
     Provide for at least an annual evaluation of policy to 
determine whether it is still commensurate with the size, 
complexity, and risk profile of the credit union.
    IRR policy limits should maintain risk exposures within prudent 
levels. Examples of limits are as follows:
    GAP: less than I 10 percent change in any given 
period, or cumulatively over 12 months.
    Income Simulation: net interest income after shock change less 
than 20 percent over any 12-month period.
    Asset Valuation: after shock change in book value of net worth 
less than 50 percent, or after shock net worth of 4 percent or 
    Net Economic Value: after shock change in net economic value 
less than 25 percent, or after shock net economic value of 6 percent 
or greater.
    NCUA emphasizes these are only for illustrative purposes, and 
management should establish its own limits that are reasonably 
supported. Where appropriate, management may also set IRR limits for 
individual portfolios, activities, and lines of business.

III. IRR Oversight and Management

A. Board of Directors Oversight

    The board of directors is responsible for oversight of their 
credit union and for approving policy, major strategies, and prudent 
limits regarding IRR. To meet this responsibility, understanding the 
level and nature of IRR taken by the credit union is essential. 
Accordingly, the board should ensure management executes an 
effective IRR program.
    Additionally, the board should annually assess if the IRR 
program sufficiently identifies, measures, monitors, and controls 
the IRR exposure of the credit union. Where necessary, the board may 
consider obtaining professional advice and training to enhance its 
understanding of IRR oversight.

B. Management Responsibilities

    Management is responsible for the daily management of activities 
and operations. In order to implement the board's IRR policy, 
management should:
     Develop and maintain adequate IRR measurement systems;
     Evaluate and understand IRR risk exposures;
     Establish an appropriate system of internal controls 
(e.g. separation between the risk taker and IRR measurement staff);
     Allocate sufficient resources for an effective IRR 
program. For example, a complex credit union with an elevated IRR 
risk profile will likely necessitate a greater allocation of 
resources to identify and focus on IRR exposures;
     Develop and support competent staff with technical 
expertise commensurate with the IRR program;
     Identify the procedures and assumptions involved in 
implementing the IRR measurement systems; and
     Establish clear lines of authority and responsibility 
for managing IRR; and
     Provide a sufficient set of reports to ensure 
compliance with board approved policies.
    Where delegation of management authority by the board occurs, 
this may be to designated committees such as an asset liability 
committee or other equivalent. In credit unions with limited staff, 
these responsibilities may reside with the board or management. 
Significant changes in assumptions, measurement methods, tests 
performed, or other aspects involved in the IRR process should be 
documented and brought to the attention of those responsible.

IV. IRR Measurement and Monitoring

A. Risk Measurement Systems

    Generally, credit unions should have IRR measurement systems 
that capture and measure all material and identified sources of IRR. 
An IRR measurement system quantifies the risk contained in the 
credit union's balance sheet and integrates the important sources of 
IRR faced by a credit union in order to facilitate management of its 
risk exposures. The selection and assessment of appropriate IRR 
measurement systems is the responsibility of credit union boards and 
    Management should:
     Rely on assumptions that are reasonable and 
     Document any changes to assumptions based on observed 
     Monitor positions with uncertain maturities, rates and 
cash flows, such as nonmaturity shares, fixed rate mortgages where 
prepayments may vary, adjustable rate mortgages, and instruments 
with embedded options, such as calls; and
     Require any interest rate risk calculation techniques, 
measures and tests to be sufficiently rigorous to capture risk.

B. Risk Measurement Methods

    The following discussion is intended only as a general guide and 
should not be used by credit unions as an endorsement of a 
particular method. An IRR measurement system may rely on a variety 
of different methods. Common examples of methods available to credit 
unions are GAP analysis, income simulation, asset valuation, and net 
economic value. Any measurement method(s) used by a credit union to 
analyze IRR exposure should correspond with the complexity of the 
credit union's balance sheet so as to identify any material sources 
of IRR.

GAP Analysis

    GAP analysis is a simple IRR measurement method that reports the 
mismatch between rate sensitive assets and rate sensitive 
liabilities over a given time period. GAP can only suffice for 
simple balance sheets that primarily consist of short-term bullet 
type investments and non mortgage-related assets. GAP analysis can 
be static, behavioral, or based on duration.

Income Simulation

    Income simulation is an IRR measurement method used to estimate 
earnings exposure to changes in interest rates. An income simulation 
analysis projects interest cash flows of all assets, liabilities, 
and off-balance sheet instruments in a credit union's portfolio to 
estimate future net interest income over a chosen timeframe. 
Generally, income simulations focus on short-term time horizons 
(e.g. one to three years). Forecasting

[[Page 5164]]

income is assumption sensitive and more uncertain the longer the 
forecast period. Simulations typically include evaluations under a 
base-case scenario, and instantaneous parallel rate shocks, and may 
include alternate interest-rate scenarios. The alternate rate 
scenarios may involve ramped changes in rates, twisting of the yield 
curve, and/or stressed rate environments devised by the user or 
provided by the vendor.

NCUA Asset Valuation Tables

    For credit unions lacking advanced IRR methods that seek simple 
valuation measures, the NCUA Asset Valuation Tables are available 
and prepared quarterly by the NCUA. These are available on the NCUA 
Web site through www.ncua.gov.
    These measures provide an indication of a credit union's 
potential interest rate risk, based on the risk associated with the 
asset categories of greatest concern--(e.g., mortgage loans and 
investment securities).
    The tables provide a simple measure of the potential devaluation 
of a credit union's mortgage loans and investment securities that 
occur during  300 basis point parallel rate shocks, and 
report the resulting impact on net worth.

Net Economic Value (NEV)

    NEV measures the effect of interest rates on the market value of 
net worth by calculating the present value of assets minus the 
present value of liabilities. This calculation measures the long-
term IRR in a credit union's balance sheet at a fixed point in time. 
By capturing the impact of interest rate changes on the value of all 
future cash flows, NEV provides a comprehensive measurement of IRR. 
Generally, NEV computations demonstrate the economic value of net 
worth under current interest rates and shocked interest rate 
    One NEV method is to discount cash flows by a single interest 
rate path. Credit unions with a significant exposure to assets or 
liabilities with embedded options should consider alternative 
measurement methods such as discounting along a yield curve (e.g. 
the U.S. Treasury curve, LIBOR curve) or using multiple interest 
rate paths. Credit unions should apply and document appropriate 
methods, based on available data (e.g. utilizing observed market 
values), when valuing individual or groups of assets and 

C. Components of IRR Measurement Methods

    In the initial setup of IRR measurement, critical decisions are 
made regarding numerous variables in the method. These variables 
include but are not limited to the following.

Chart of Accounts

    Credit unions using an IRR measurement method should define a 
sufficient number of accounts to capture key IRR characteristics 
inherent within their product lines. For example, credit unions with 
significant holdings of adjustable-rate mortgages should 
differentiate balances by periodic and lifetime caps and floors, the 
reset frequency, and the rate index used for rate resets. Similarly, 
credit unions with significant holdings of fixed-rate mortgages 
should differentiate at least by original term, e.g., 30 or 15-year, 
and coupon level to reflect differences in prepayment behaviors.

Aggregation of Data Input

    As the credit union's complexity, risk exposure, and size 
increases, the degree of detail should be based on data that is 
increasingly disaggregated. Because imprecision in the measurement 
process can materially misstate risk levels, management should 
evaluate the potential loss of precision from any aggregation and 
simplification used in its measurement of IRR.

Account Attributes

    Account attributes define a product, including: P\principal 
type, rate type, rate index, repricing interval, new volume maturity 
distribution, accounting accrual basis, prepayment driver, and 
discount rate.


    IRR measurement methods rely on assumptions made by management 
in order to identify IRR. The simplest example is of future interest 
rate scenarios. The management of IRR will require other assumptions 
such as: Projected balance sheet volumes; prepayment rates for loans 
and investment securities; repricing sensitivity, and decay rates of 
nonmaturity shares. Examples of these assumptions follow.

    Example 1.  Credit unions should consider evaluating the balance 
sheet under flat (i.e. static) and/or planned growth scenarios to 
capture IRR exposures. Under a flat scenario, runoff amounts are 
reinvested in their respective asset or liability account. 
Conducting planned growth scenarios allows management to assess the 
IRR impact of the projected change in volume and/or composition of 
the balance sheet.
    Example 2.  Loans and mortgage related securities contain 
prepayment options that enable the borrower to prepay the obligation 
prior to maturity. This prepayment option makes it difficult to 
project the value and earnings stream from these assets because the 
future outstanding principal balance at any given time is unknown. A 
number of factors affect prepayments, including the refinancing 
incentive, seasonality (the particular time of year), seasoning (the 
age of the loan), member mobility, curtailments (additional 
principal payments), and burnout (borrowers who don't respond to 
changes in the level of rates, and pay as scheduled). Prepayment 
speeds may be estimated or derived from numerous national or vendor 
data sources.
    Example 3.  In the process of IRR measurement, the credit union 
must estimate how each account will reprice in response to market 
rate fluctuations. For example, when rates rise 300 basis points, 
the credit union may raise its asset or liability rates in a like 
amount or not, and may choose to lag the timing of its pricing 
    Example 4.  Nonmaturity shares include those accounts with no 
defined maturity such as share drafts, regular shares, and money 
market accounts. Measuring the IRR associated with these accounts is 
difficult because the risk measurement calculations require the user 
to define the principal cash flows and maturity. Credit unions may 
assume that there is no value when measuring the associated IRR and 
carry these values at book value or par. Many credit unions adopt 
this approach because it keeps the measurement method simple.

    Alternatively, a credit union may attribute value to these 
shares (i.e. premium) on the basis that these shares tend to be 
lower cost funds that are core balances by virtue of being 
relatively insensitive to interest rates. This method generally 
results in nonmaturity shares priced/valued in a way that will 
produce an increased net economic value. Therefore, the underlying 
assumptions of the shares require scrutiny.
    Credit unions that forecast share behavior and incorporate those 
assumptions into their risk identification and measurement process 
should perform sensitivity analysis.

V. Internal Controls

    Internal controls are an essential part of a safe and sound IRR 
program. If possible, separation of those responsible for the risk 
taking and risk measuring functions should occur at the credit 
    Staff responsible for maintaining controls should periodically 
assess the overall IRR program as well as compliance with policy. 
Internal audit staff would normally assume this role; however, if 
there is no internal auditor, management, or a supervisory committee 
that is independent of the IRR process, may perform this role. Where 
appropriate, management may also supplement the internal audit with 
outside expertise to assess the IRR program. This review should 
include policy compliance, timeliness, and accuracy of reports given 
to management and the board.
    Audit findings should be reported to the board or supervisory 
committee with recommended corrective actions and timeframes. The 
individuals responsible for maintaining internal controls should 
periodically examine adherence to the policy related to the IRR 

VI. Decision-Making Informed by IRR Measurement Systems

    Management should utilize the results of the credit union's IRR 
measurement systems in making operational decisions such as changing 
balance sheet structure, funding, pricing strategies, and business 
planning. This is particularly the case when measures show a high 
level of IRR or when measurement results approach board-approved 
    NCUA recognizes each credit union has its own individual risk 
profile and tolerance levels. However, when measures of fair value 
indicate net worth is low, declining, or even negative, or income 
simulations indicate reduced earnings, management should be prepared 
to identify steps, if necessary, to bring risk within acceptable 
levels. In any case, management should understand and use their IRR 
measurement results, whether generated internally or externally, in 
the normal course of business. Management should also use the 
results proactively as a tool to adjust asset liability management 
for changes in interest rate environments.

[[Page 5165]]

VII. Guidelines for Adequacy of IRR Policy and Effectiveness of Program

    The following guidelines will assist credit unions in 
determining the adequacy of their IRR policy and the effectiveness 
of their program to manage IRR.

[[Page 5166]]


    NCUA acknowledges both the range of IRR exposures at credit 
unions, and the diverse means that they may use to accomplish an 
effective program to manage this risk. NCUA therefore does not 
stipulate specific quantitative standards or limits for the 
management of IRR applicable to all credit unions, and does not rely 
solely on the results of quantitative approaches to evaluate the 
effectiveness of IRR programs. Assumptions, measures and methods 
used by a credit union in light of its size, complexity and risk 
exposure determine the specific appropriate standard. However, NCUA 
strongly affirms the need for adequate practices for a program to 
effectively manage IRR. For example, policy limits on IRR exposure 
are not adequate if they allow a credit union to operate with an 
exposure that is unsafe or unsound, which means that the credit 
union may suffer material losses under plausible adverse 
circumstances as a result of this exposure. Credit unions that do 
not have a written IRR policy or that do not have an effective IRR 
program are out of compliance with Sec.  741.3 of NCUA's 

VIII. Additional Guidance for Large Credit Unions With Complex or High 
Risk Balance Sheets

    FICUs with assets of $500 million or greater must obtain an 
annual audit of their financial statements performed in accordance 
with generally accepted accounting standards. 12 CFR 715.5, 715.6, 
741.202. For purposes of data collection, NCUA also uses $500 
million and above as its largest credit union asset range. In order 
to gather information and to monitor IRR exposure at larger credit 
unions as it relates to the share insurance fund, NCUA will use this 
as the criterion for definition of large credit unions for purposes 
of this section of the guidance. Given the increased exposure to the 
share insurance fund, NCUA encourages the responsible officials at 
large credit unions that are complex or high risk to fully 
understand all aspects of interest rate risk, including but not 
limited to the credit union's IRR assessment and potential 
directional changes in IRR exposures. For example, the credit union 
should consider the following:
     A policy which provides for the use of outside parties 
to validate the tests and limits commensurate with the risk exposure 
and complexity of the credit union;
     IRR measurement systems that report compliance with 
policy limits as shown both by risks to earnings and net economic 
value of equity under a variety of defined and reasonable interest 
rate scenarios;
     The effect of changes in assumptions on IRR exposure 
results (e.g. the impact of slower or faster prepayments on earnings 
and economic value); and,
     Enhanced levels of separation between risk taking and 
risk assessment (e.g. assignment of resources to separate the 
investments function from IRR measurement, and IRR monitoring and 

IX. Definitions

    Basis risk: The risk to earnings and/or value due to a financial 
institution's holdings

[[Page 5167]]

of multiple instruments, based on different indices that are 
imperfectly correlated.
    Interest rate risk: The risk that changes in market rates will 
adversely affect a credit union's net economic value and/or 
earnings. Interest rate risk generally arises from a mismatch 
between the timing of cash flows from fixed rate instruments, and 
interest rate resets of variable rate instruments, on either side of 
the balance sheet. Thus, as interest rates change, earnings or net 
economic value may decline.
    Option risk: The risk to earnings and/or value due to the effect 
on financial instruments of options associated with these 
instruments. Options are embedded when they are contractual within, 
or directly associated with, the instrument. An example of a 
contractual embedded option is a call option on an agency bond. An 
example of a behavioral embedded option is the right of a 
residential mortgage holder to vary prepayments on the mortgage 
through time, either by making additional premium payments, or by 
paying off the mortgage prior to maturity.
    Repricing risk: The repricing of assets or liabilities following 
market changes can occur in different amounts and/or at different 
times. This risk can cause returns to vary.
    Spread risk: The risk to earnings and/or value resulting from 
variations through time of the spread between assets or liabilities 
to an underlying index such as the Treasury curve.
    Yield curve risk: The risk to earnings and/or value due to 
changes in the level or slope of underlying yield curves. Financial 
instruments can be sensitive to different points on the curve. This 
can cause returns to vary as yield curves change.

[FR Doc. 2012-2091 Filed 2-1-12; 8:45 am]