NCUA's Net Economic Value (NEV) Framework with Todd Miller

I listened to it and one of my team members, Todd Miller, who is Got a great background in this, also listened to it, and we're going to talk through our immediate take on having just heard NCUA's webinar on their changes to Interest Rate Risk Supervisory Framework, which was outlined in letter 22 CU09, issued just this month. Todd, how are you doing today?

I did a follow up on that when rates started going up. And so this will actually be yours and my second discussion on this, but the third actual podcast I've had on this particular topic, but if you could, for people who haven't listened to. Some of the podcasts that you have been on, if you could give a little bit of your background at NC, and then they'll quickly realize why it makes sense to listen to this episode and hear what you have to say relative to this topic.

So in my 10 years as A capital market specialist did a lot of training for NCOA examiners on the review of interest rate risk and liquidity and had a hand in developing some of these tools that they use today. And if I didn't, staff that worked for me certainly did very close to all of these topics, especially over the last 10 years.

arena. Yeah. with where NCUA has come since the early 2000s and where they're at coming up to today's webinar.

That's when NCUA determined that we were going to use, or the agency was going to use, premiums of one in 4 percent for non maturity shares. You'll have to excuse me if I say we, sometimes I think I'm still with NCUA. I spent so much time. With that family, but that was addressing a problem. There were parties out there that had very large non maturity share premiums. It wasn't a lot of them, but there was a number of them where those premiums would be 15%, 20%, even on occasions, 30%.

And in those situations, the credit union could essentially have about a hundred percent of their loans in fixed rate, long term real estate, and the models would say they're fine. So. I would rephrase it as credit unions were using model results to justify what they were doing and not using their models to inform their decision making, so to speak. So, to just alleviate all of that, NCUA came up with the 1 and 4 percent premiums. They did a lot of research.

Everyone's models on the asset side of the balance sheet look very much the same. Most of the liability side look very much the same. But then you come to these non maturity shares and results were all over the place and very inconsistent. So NCA said, we'll make this consistent. We'll create some bright lines. It will avoid us from having these discussions with credit unions. It's a one size fits all approach.

That works for most of the time, and it did accomplish what the agency wanted in terms of some consistency of measurement and helping them compare risk in one credit unit to another credit unit. It accomplished that very well.

And as you said, you could have people going with as a lowest 4 percent and as high as 30%. The numbers come out so much differently. This provides context to NCUA so they can take their quarterly data and take a look at it and see who those outliers are. So that perhaps they could say, Okay.

Because they're outliers here, we might want to send a capital market specialist into those credit unions so that we could see if they have the systems in place and the programs in place to mitigate whatever risks those numbers might show or that there actually might not be any risk. Does that sound right? That

And in fact, their guidance in 2016 was very inconsistent. from the way they manage other risks. They've always talked about it's examiner judgment. We need to look at a given risk area in light of other risks areas. So we need to aggregate risks together and their approach in 2016 says if you hit this bright line, you're going to get a document or resolution and we're going to ask you to de risk.

So, It's like a sledgehammer to a problem that just really needed something as simple as a Dremel tool. They went way overboard with it, and it was very inconsistent with their other examination procedures in that and everything else. Let's look at aggregate risk here. They said, Here's a silo. There's zero examiner judgment. We're going to look at this one factor. We're not going to consider how much credit risk you have. We're not going to consider how much liquidity risk you have.

We're not going to consider that accrediting with 2 percent operating expenses can accept a lot more interest rate risk than accrediting with, say, 2 4 percent operating expenses. So from that one aspect, this bright line that they created in 2016 was actually not really consistent with the rest of their exam guide and the rest of their processes.

And when you really come down to this program update in this new issuance that they issued here last month, and that we talked about today, they really just fix that. And really brought the world back to let's be more consistent with the way we evaluate all these other risk areas. We do evaluate risk in light of other risk areas. We are going to allow a measure of examiner judgment.

We are going to go back where this test they use, and they're still going to use the test is a scope determinant and it helps them find outliers. So it's still useful for that. They're going to use it for that. That's. more consistent with the way they examine all the other areas of risk. So in the big scheme of things, I would just say they're maybe fixing a mistake they made in 2016.

Other people might not categorize it like that, but the reality is that policy has cost a lot of angst for a lot of credit unions here this year.

In every other area determines whether or not you get a document resolution, whether you get an examiner, funny, let me back up setting aside bank secrecy act, where there are some required document resolutions and things like that, based on agreements with other agencies, this really gets this whole interest rate risk topic more aligned with the rest of their exam program, which. Again, comes back to examiner judgment.

Todd, one other thing you mentioned is, if someone, if the, if someone has extremely low operating expenses or extremely high net worth, yet they have some issues with their. Uh, interest rate risk calculation here, the ENT or the NEB, whichever, whichever, whichever way you want to call it, if they have a lot of other positives, those can be mitigating factors that may result in the examiner using that judgment and concluding that the credit union does not need a document of resolution.

Anything you'd like to expand on relative to the statement I just made?

The letter is very specific as to when you'll get a document or resolution. It's more consistent with other practices and that you're going to get a document or resolution if your risk is high enough to cause. Some undue risk to the insurance fund. Our management risk management practices are severely deficient. Now you can have that number, but if your risk management processes are good and you have control of your risks and other areas, you're probably not going to get a door.

I'm sure there's still going to be some uncomfortable discussions about your risk position and what is really management doing to recognize that and assessing. If they need to do something with it, pardon on, I thought it was interesting. They had a slide during today's webinar on contributing factors and results. Some of this is because we just had a huge surge in deposits over 2020 and 2021. During the pandemic, they grew over 20%, both of those years.

So capital ratios dropped across the industry. So we're starting out at a lower point than perhaps we were when this policy was enacted. It is interesting that growth has slowed tremendously since then. And in fact, from March to June, there's been almost no show share growth, but it's hitting this whole high risk. It's hit a very specific number of credit unions.

And they talked a little bit around it during the webinar, but The ones that it's really impacted the most are these credit unions with lower loan to share ratios. So you have a group of credit unions that are relying on their investment portfolio for earnings, not just liquidity management, but they have large investment portfolios that are really serving as their loan portfolio.

So they have zero credit risk, but they've taken on duration and extended the maturity of their investments because it's a core piece of their earnings. While the rise in interest rate risks. or interest rates, it's dropped the value of those significantly. And you can see it on the FPR just nationally. I think it's around, they mentioned it during the webinar, 17 percent of net worth is sitting in these unrealized losses and investments.

So those criteria have been hit really hard in terms of triggering extreme risk on that supervisory test. But also the parties that have the most mitigating factors, they typically have very low operating expenses. And because they're not making loans, they have almost no credit risk. So they need to be taking on interest rate risk to generate earnings. And it's all reasonable.

And Many of these credit unions were just showing up as moderate risk in December, all of a sudden, now they're extreme went from

It does away with that entire extreme risk rating. It's gone. They've just eliminated it. Now we just have low, medium, high. So, they've eliminated that entire risk rating, which was appropriate. Policy in 2016 also took away examiner flexibility. They were not allowed to alter that rating. at all. It was a numerical rating. This new guidance in the letter, it gives the examiner some judgment back.

Now, it does say it should be rare for credit unions to lower that risk rating, but it does create an environment where they can. And then, of course, the absolute largest thing it does is the 2016 guidance required a document of resolution and a de risking plan. That has done away with. They've created some specific criteria where A document of resolution is still appropriate, but for a lot of credit unions, not for a lot, it's hard to judge.

For many credit unions, the document of resolution is probably not going to be appropriate. They laid out conditions for when they might still need a document of resolution, and that's undue risk to the insurance fund. A credit union really hasn't reacted appropriately to these rising interest rates. Risks. It's a big change in risk rating and should be talking about their various loan and investment and pricing strategies and they probably need to change them or at least reassess them.

So there's a category of folks that have not done that may still find themselves with the door, even at a high risk rating. And then the third piece, and this has always been a reason for having a document or resolution. It lays out if a criterion has material issues or weaknesses in their governance of risk. And that's always required the door in regardless of the area. So that's really not a new policy. It's just reaffirming a policy that's already existed.

But that was the biggest change is they deleted the extreme risk, gave their examiner judgment back. Doors are not automatic. Now they need a safety and soundness reason for giving you a door, basically.

So, They're talking about assets, and I guess NCUA has been doing this for a long time to justify budget growth, to justify new departments. Assets are growing, so the world is getting more complex. And that's not necessarily the case, and in here, that, those two sentences infer that complexity is increasing.

But the fact of the matter is, if you pull down NCUA's call reports for June, uh, This year, long term fixed rate real estate loans have moved from 23. 2 percent of assets in 2018 to 22. 39 percent at June of 2022. So in four years. Exposure to fixed rate real estate loans as a percentage of assets. It's actually come down a little bit. It hasn't gone up. Now, total real estate loans have gone up, but as a percentage of assets, no, it's come down.

Another big piece of that is commercial loans because they throw all these commercial loans into long term assets. They went from 4. 88 percent of assets in 2018 to 5. 88 percent today. It's very much an insignificant change. So it's one of those things, NCU, and they say that a lot, that growth equals complexity.

But really when you look at that balance sheet composition and how they're funding those assets, it hasn't really changed, they leave out the funding side of it, which hasn't gotten any more complex either. I just find it interesting. They throw that into all their letters. They use it a lot. Assets are growing. World is getting more complex. Not really. Assets are growing, but complexity is not changing very quickly in aggregate across the industry.

There might be individual parties that increased a lot, but across the industry, no, that complexity has not really changed since 2018.

So in the webinar, there was some discussions about the liquidity, the requirement for liquidity policies and different things like that. And there's, there were also references and you might have the slide in front of you, but references to the upside down nature of the investment portfolios collectively in credit unions, where, where the net worth is. A certain percentage of the net worth is eaten up by the fact that these investments are underwater.

And of course, they don't have to recognize that if it's in a whole to maturity category. However, there are some situations where credit unions need to worry about that longer term if that. If they have a big investment portfolio and if that loss keeps going up, that can have some ramifications on their liquidity in different ways. But one of those ways is the relationships that they have for borrowing.

I've heard you speak to me on that offline, but can you highlight, highlight that here for our listeners?

I think there's a few things going on with liquidity risk and there's a lot of indicators that it's increasing. So, first. A lot of creditors and lenders, they look at your gap equity as opposed to your regulatory equity. And while regulatory equity isn't falling because it doesn't consider these investment losses, gap equity is falling pretty significantly too. It's down a From about 11. 2 in 2019 to 9. 99 today on an aggregate basis, you look at the investment portfolio. Let's see.

I have a call report in front of me. I'll get to it here. Fair market value of hold to maturity investments is down to 94 percent of book value. And that unrealized loss on available for sale investments is 7. 5 percent at June. Credit unions don't like to sell investments.

At a loss, one of NCOA's internal models that they used to use years ago, it had an indicator for investment losses greater than 2 percent because just intuitively history shows when you're more than 2 percent underwater, you typically don't want to sell those investments. They're still available to pledge, but that's a secondary source of liquidity and your haircuts are going to get larger, especially if a credit union starts having asset quality problems.

Generally, if asset quality is good, they can still use those investments to assess. wholesale funding. A couple of other things going on that they don't talk about behind the scenes is we have these very large inflation numbers. No one really talks about them. But if you go look at deposit growth since March of this year, It's 0. 2%. Deposit growth is ended. People are struggling to pay bills and I'm sure that has an impact on that whole deposit growth, which is almost nothing.

When I looked for March to June across the industry, all your asset growth was from borrowed money. So borrowed money is growing very rapidly and then we have these rising rates. So what is the cost of that borrowed money? Right now it's not showing up in cost of funds yet because all that borrowing is shifting to overnight. Historically, credit unions, they would borrow long term to fund loans. They would borrow long term to hedge interest rate risk.

Now you're seeing just an explosive growth in overnight borrowed money. And that's funding growth in the industry, and that's just from March to June. And so those are kind of indicators that, hey, liquidity problems might be coming down the pike for individual credit unions. And so you got a combination and borrowings are going up, investment values are falling, gap net worth is falling. We have these large inflation numbers, which potentially means parts of the economy are slowing down.

People are having troubles playing bills. I remember one of our clients, we were having a conversation or they had us look at their credit committee meetings and their cost of fuel oil for that one person, their members tripled from last year. And so they had just a segment of their middle class members are going to struggle just because of the increase. Costs in heating costs this winter. So there's lots of little warning indicators around liquidity.

And so they did mention during the podcast today, there is a liquidity regulation, you are supposed to have a contingency funding plan. You do have to have the access to the federal reserve or the CLF, if you're over 250 million. So just as a side note, even though this is a podcast about interest rate risk. The industry would do well to go reassess their liquidity risk at an individual party level and see if strategies about that might need to change as well.

Can be at one or all of those and of course, obviously, depending on their size, but other factors are potentially painting some credit unions in a corner because of the fact of the value of their portfolios because of the fact that maybe they've already accessed some of their lines and as numbers start to deteriorate, those. Sources tend to look a little bit more closely at the credit union. I think you've said they put, they may start monitoring and put them on some sort of watch list.

It's something you definitely want to get ahead of before you end up having some of those things evaporate under you. And as I've heard said before, liquidity doesn't matter until it matters. And when, and then it's the only thing that matters.

Delinquency isn't coming up anywhere yet in credit unions. So that's a good thing, but you might start seeing it become elevated and that becomes a watchword with liquidity issues too, is when credit risk starts going up and you start seeing elevated delinquency and elevated charge offs, then the liquidity risk will Really start accelerating.

And they alluded to that a little bit in this letter. It's, wait, we haven't seen an interest rate risk increase like this in a long time. And so that level of uncertainty, it always creates risk management challenges. So. It's a tough time for management teams and boards of directors.

to the webinar if they haven't listened to it themselves.

A lot of that really comes down to, you need to have good risk management practices in place. The words they use during the webinar is your risk management processes need to be commensurate with your risk level. And that's Regulatory language that's been used for decades. Sometimes it's hard for credit needs to put their finger around. What does that actually mean? But many credit use vendors. They have peers. Let's have some discussions with that.

Let's have some discussions with your examiners ahead of time of what they might think that. may also mean. They'll pretty much say you won't get a door under two conditions and that's if your risk management processes are acceptable and commensurate or if the crediting has already taken steps to act on their high risk rating so they've noticed their risk has gone up. So They've went back and they've come up with a plan. We're going to change our pricing strategy.

We're going to slow the growth of long term assets, whatever that may be. What they're looking for, does the credit union already have a plan to maybe start reining in their risk level or containing it or reducing it? So it's those two pieces are the big takeaways. You're not going to get a door if you have really good risk management. Practices and governance across your credit union are if your risk is elevated, has your management team done something to rein that back in?

Do you have a plan to contain this rising risk? So those are the two big takeaways. If you want to avoid a door and get a good risk rating is make sure your risk management processes are Acceptable and consistent. And I think for some of the credit is that already got a door. They did have good risk management processes. I think the examiners were very reluctant to give them a door.

They knew one wasn't necessary, but they had this agency policy that says I have to give you a door that has happened to places that have very That have risk management practices that are commensurate with their risk, but the second piece for the smaller, moderate credit unions, and if you haven't got an exam yet, and you are going to hit their new high risk ratings, do make sure and do a self assessment. Have we addressed these issues? Have we paid attention to our rising risk levels?

Do we have some discussions in our ALCO committee? What are we going to do about it? Are we going to talk about our earnings challenges? And I really, let's go back and look at everything. Is your credit risk management where it needs to be? Have we assessed how this changing marketplace might impact your liquidity risk and credit risk down the road? So continue doing what you're doing. If you have good practices in place, you should be fine.

You obviously, if they want to hold what they've got to, they've got to let that play out, but they can change what it is they're adding to their book. I know one of the things. You and I, again, have talked about, so one scenario, one of the things that drives this is if your liabilities are mostly in the core deposits, the share, the regular share deposits that have no term.

You can try and attract and move that money by creating rates that might help move that money, but it really relies on what your members are willing to do. And then it also has an impact on the bottom line. The other thing you can do is, You can, you can start borrowing longer term to make your numbers come out a little bit better.

Any thoughts relative to anything I just threw out on the table there on what might make sense, what doesn't make sense, what thing credit unions could consider when they're looking at different levers that they can pull to. Reduce their

Internet lenders are fighting with everybody for loan dollars because even though rates are going up, there's still such a big spread between loans and investments. People are fighting for loan dollars. So loan yields are coming down. That's fascinating. You normally, you would think about, okay, we can pay a higher amount of money to borrow, to fund loans. You can pay a higher amount to borrow, but you might not have the loans there to grant. Sure. A positive spread.

So there's costs to borrowing money. You can do all of those things. The challenge for credit unions is, and it's kind of contrary to what you might think, is the credit unions with the most non maturity shares, which are in effect the most stable funding, are the ones that are being punished the most under this supervisory test. They have the biggest impact, even though they're, in effect, Have the least risk and the most stable funding.

So it's one of those one size fits all approaches is somewhat dangerous to people. I think the credit is, they just have to look at all their levelers and it's a manner of managing earnings. And that is really challenging right now. People doing things to manage those earnings. They're competing for loans. You're seeing more people purchasing loans. They alluded toward the webinar. One of the biggest issues is it's longer duration investments and.

That's Cartagena's reaching out there for earnings. It's not there in the loan marketplace because people aren't raising loan rates the way they need to. Consumer loans, the real estate loans are going up because the secondary market does impact those real estate loan rates to a great deal. People want to keep that liquidity available. So people price those to the secondary market. So they do move with treasury rates, all these other consumer loans.

And I would suspect we've seen this in the last recession back, In 2006 2007, commercial loans tend to get underpriced, too. And while it's only 5 percent of Cretien's assets, the Cretien's that are in that business, they need to pay attention to their pricing because quite often you see that get underpriced, too. And that has consequences when delinquency starts rising. Later, sure, and see if it starts visiting. I would just throw one last thing out there.

And I guess maybe this is a piece of what you asked me about what they can do in terms of funding, but it's go look at your concentration risk levels everywhere. And that's on your share side and on your house that side. I think you're going to see your examiners. They're going to start.

Scrutinizing those concentration risk levels a little bit more, and I already elevated it a couple years ago with a letter on concentration risk, but I think you might see an even more enhanced focus on it going forward.

So. Credit unions, as you and I know, since May, a lot of credit unions have received document resolutions simply because, perhaps simply because the previous guidance required that the examiner give the credit union a document resolution. if they were rated as extreme. So there were a couple different questions relative to, all right, so I got a document resolution. What happens now that I was rated extreme, which required me to get a document resolution? Now extreme doesn't exist.

What is NCUA going to do relative to that? Any thoughts relative to the, or could you summarize what you heard as the answers that they gave relative to that? Any thoughts on that?

What wasn't said is what criteria are they going to use to assess those doors, and are they going to contact you if your door might be modified, or are they not going to contact you if your door is not modified. So they're going to turn it back over to the regional directors to go through and assess doors that have already been issued and determine what happens with them. And. Like I said, the interesting part of the webinar is they didn't say what criteria the regions will use to do that.

In the new guidance, there's a whole set of extra steps for examiners to go through and assess the sources, how that interest, what made that rating change. And you have clients, they went from moderate to extreme in a quarter, even though their balance sheets didn't change, the guidance. Says examiners in the future are going to assess what caused that.

I'm just going to surmise that for these credit unions that have already received doors that the regions have to go back and reassess is they'll have their examiners go back and look at that. What caused it? Why did it occur? Was it just a market change? Is the credit unions other? practices. So I think they'll just go back and review those exam reports in light of this new workbook and guidance. That's what I'm going to guess is going to happen.

Although I don't know that's speculation on my part. It is speculation. They don't say. And NCUA is short of staffing and they're short of resources. So, you know, this is a big time commitment to go back and how does that play into everything? I don't know. They didn't say that.

There is this nuance now, though, when you push things back towards judgment, it gets harder and harder to treat everybody fairly because Todd, as you and I know, everybody has a little bit different judgment. Every examiner has a little bit different risk tolerance. Every credit union has a little bit. different risk tolerance.

My advice to a credit union, if you had a document resolution and you listen to this webinar, and hopefully you listen to this podcast, I would reach out to your examiner and engage a conversation saying, Hey, we really want to talk to you about the things we've done. You, you, they probably already know it, but highlight to them again, make them aware of the fact that they're going to be reevaluating that and put your best facts forward. Relative to the document of resolution.

And some of the reality is some of the things in there you're going to want to do anyway, but whether or not you need that document resolution is something that is definitely up for play here.

We took out an extreme risk rating. We said a door isn't required, but they actually added exam steps to their whole interest rate risk review. And they were very clear the intensity of our interest rate risk review. It's not going down. It's probably going to go up. This is not going to make your life any easier. It might mean you don't get a door, but The examiner's scrutiny of interest rate risk, it's not going to change. It's still going to be elevated.

In fact, it's going to go up for a certain group of credit unions that hit that high risk threshold on that supervisory test. They were pretty clear in the webinar that What we're doing isn't going to go down. It's going to go up. You might not get a door, but our review is going to get more thorough and more intense.

They've armed the examiners with some more exam steps that will lead to some more difficult conversations. But when you get to the other side of that, those conversations, hopefully you can demonstrate that you've put good things in place, and then perhaps you'll learn a thing or two from those conversations that can help you guide your own credit union even NCWA is pointing out, but again, you nailed it right there.

That this issue isn't going away, and so we will be asking those difficult questions regardless of whether or not guidance requires a door or not. That's a great point. point and again a highlight of the webinar today.

Because the examiners didn't have to scrutinize them closely and the simple fact of the matter is, there are probably pretty names out there that might be moderate risk for that supervisory test that they do deserve a door and they probably have. Taking on more risk than they should have.

And maybe some of those people will get caught now because the examiners don't get that automatic get out of jail free card where we're going to reduce our scope and level of review just because the numbers are moderate and they'll turn that focus back on governance a little bit. And that's a positive thing. If you really want to see your share insurance fund protected, that goes the other way as well.

Anything I should have asked you or anything that pops into your mind that a credit union might want to take into consideration as they're negotiating these difficult waters of the world today?

And it's easy to view your examiner as an enemy, but the reality is if you open the door and communicate with them up front, they can become a resource for your credit union and you can smooth a lot of things over and you can reduce a lot of exam anxiety and reduce the difficulty of these questions. If you're communicating with your examiner up front, so pick up the phone, call them occasionally.

A lot of this stuff you can get put aside and you create a lot of trust and credibility with them and life can become a lot easier for you if you have open, honest and consistent communications with your examiner and that. Kind of came out during the webinar too in the answering question session. So I would say that's one takeaway. Don't necessarily treat that examiner and COA as an enemy.

They're part of the cost of doing business, but you can turn them into a partner if you communicate effectively with them.

They're going to come towards your direction. If you're building a good program and you're communicating that to them, they're going to be able to better understand what's going on and then use that examiner judgment in a way that is. reasonable in dealing with the credit union. So great point. The communication is always a key. Todd, I really appreciate you.

And I've been talking about the letter coming out and then we heard that as soon as the letter came out, they mentioned that the, this webinar was going to be happening. And I'm glad this worked into both of our schedules so that we could listen to what NCUA had to say. We could record this to give our take on it and we can get it out to the listeners real quick. Next week, this will be the episode and thanks again for.

Listening to the webinar today and sharing your wisdom with our listeners on the podcast.