WITH INTEREST RATES RISING, NCUA IS ALMOST CERTAIN TO BE REQUIRED TO ADDRESS ITS INTEREST RATE RISK SUPERVISORY FRAMEWORK OR THE DOR’S WILL BE COMING BY THE HUNDREDS

Many of you have reached out to us with your concerns about the NCUA’s NEV Supervisory Test in the current rising interest rate environment and its rather draconian one-size-fits-all approach of requiring a Document of Resolution (DOR) from the examiners for any credit union in the higher risk categories.

Others of you are probably in the process of expecting such a DOR as a result of recent interest rate hikes and the unforgiving NCUA formula.  It’s probably just a matter of time before you reach out to us.

Well, a lot of credit unions (and a lot of firms like ours that represent credit unions) have also reached out to NCUA about this issue.  And together it seems that this effort has gotten their attention.

From NCUA officials we have spoken to and sources in credit union land that have also been in conversations with NCUA, it appears almost certain that NCUA is going to soon issue clarifying supervisory guidance to their examiners – probably accompanied by a Letter to Credit Unions – that provides some much-needed nuance to the agency’s current NEV Supervisory Test that has been in effect since 2017 but hasn’t faced the type of interest rate activity the market has seen in recent months.

Basically, here’s the issue in a nutshell.  In 2017, after almost a decade of very stable and historically low interest rates, NCUA issued its NEV Supervisory Test with a formula designed to protect against interest rate risk (IRR) for credit unions.  The Supervisory Test was intended, when approved five years ago, to provide an easy-to-follow calculation that any credit union could run at any time to determine how NCUA would view its IRR and upon which NCUA examiners would base the soon-to-be implemented “S” rate sensitivity component of a credit union’s CAMELS rating.

The NCUA made the point that it was addressing any potential leaks in the interest rate risk roof while the sun was shining.  In other words, while rates were historically low and stable, NCUA wanted to put in place a formula that they felt would let their examiners and credit unions know if the roof was subject to leakage when the interest rate storms came.

Of course, as so often happens when a federal regulatory agency tries to implement a single one-size-fits-all formula to “make things easier,” it many times results in unintended consequences because, frankly, every credit union is different.  Every balance sheet is constructed differently.  Each management team utilizes and implements a variety of risk management strategies.

One size seldom, if ever, fits all.

NCUA learned this lesson with its risk-based capital (RBC) regulation which it revised four times, removed over three-fourths of credit unions from being subject to and delayed its implementation for four years.  Today RBC is only a shadow of what it was once proposed to be and has little true applicability to examiners or credit unions alike.

Why?  Because, as stated above, one size seldom fits all.

Some might ask why NCUA didn’t just abandon RBC when it became obvious that the wide differences in credit union balance sheets, fields of membership, risk management appetite and management abilities made a single formula for all credit unions untenable.

The answer is pretty simple.  Pride of authorship.  The agency leadership worked hard to develop RBC and would rather revise or delay it into ineffectiveness than to admit it was not a good idea to start with.

Whether a credit union can manage its net worth in proportion to the risk on its balance sheet is a credit union by credit union question.  And each examiner must examine the risk versus capital equation differently at each credit union.

The same applies to interest rate risk.  Some credit unions have their IRR better managed than others.  The hedging strategies are truly credit union by credit union.  Various levels of liquidity mitigate or worsen the potential risk.

IRR is just real tough to boil down into a single formula.

To their credit, NCUA is coming to recognize this now that the interest rate increases of recent months have brought the first storms onto the roof that their NEV Supervisory Test was designed to protect.  They, as well as credit unions running their formula for the first time in a truly upward rate environment, are being forced to acknowledge that IRR is a case-by-case issue to evaluate.

While they may stick with having a formula as they did when they stuck with RBC despite it being revised and delayed into virtual meaninglessness, it seems very likely that NCUA will soon be instructing its examiners and informing its credit unions that they are going to take a different approach to enforcing the NEV Supervisory Test.

Although there could be some variations before they actually publish their adjustments to the NEV Supervisory Test, it is quite likely that several aspects of the test have not survived the first real interest rate storm and will be adjusted.

First, we believe that the automatic DOR requirement for higher risk IRR categories will be dropped.  If not, the unforgiving nature of the supervisory test could well result in almost a thousand DORs that will have to be managed by both NCUA and the credit unions – many of whom are managing and mitigating the IRR quite effectively.

Secondly, it is quite likely that the Extreme Risk category may be dropped completely.  It carries the most draconian examiner response and, frankly, is the most improperly labeled category of all.

Thirdly, a “de-risking” plan – one of the requirements of the current NEV Supervisory Test – will most likely be required only when an examiner feels that a credit union needs to take some additional action that it is not already taking to manage IRR.  In other words, the ability of and the strategy implemented by credit unions to manage IRR must be taken into consideration before applying either a DOR or a requiring a “de-risking” plan.

Lastly, to move away from the one-size-fits-all application, all quantifiable factors will need to be considered by an examiner before a DOR is issued based upon IRR.  If such an approach is indeed taken by NCUA as we believe is likely to be the case, there will be no automatic DORs coming from the NEV Supervisory Test in this environment as long as the IRR is being effectively managed.

That is not to say that NCUA’s more realistic look at their own NEV Supervisory Test means there will be no DORs for IRR.  But the formula will not drive the DOR.  Other risk management strategies, or the lack thereof, will drive any supervisory action by the examiners.

This is the way IRR should be evaluated by examiners – on a case by case, credit union by credit union basis.

Does the basic methodology of the NEV Supervisory Test of 2017 need a re-visit now that we are in 2022 and facing the first real interest rate increases in over a decade?  I think the answer is clearly yes.

After all, now that interest rates have risen 250 basis points since the beginning of the year, a 300 basis point shock that does not incorporate that 250 basis points of that shock are already being managed creates a situation whereby the NEV Supervisory Test essentially is requiring a 550 basis point shock to avoid a DOR.

NCUA has some smart folks that certainly recognize this fact.  I believe that, over time, they will revise significantly the NEV Supervisory Text itself.

Until then, however, there seems to be a realistic recognition and movement at the agency to revise the current application of the NEV Supervisory Test and to recognize the need for a credit union by credit union approach to its application.

So, continue to monitor and continue to manage your IRR.  But, if our interactions with several NCUA officials and staff are any indication (and we believe they are), you should most likely expect some written clarification to both examiners and credit unions before the end of the year – probably this fall.

And it will be well received, most likely by both.  But certainly by credit unions.

Until next time.

Dennis Dollar