Appendix B to Part 741 - Guidance for an IRR Policy and Effective Program

National Credit Union Administration

Pt. 741, App. B

APPENDIX B TO PART 741—GUIDANCE FOR
AN INTEREST RATE RISK POLICY AND
AN EFFECTIVE PROGRAM
TABLE OF CONTENTS

A. Complexity

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

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.

I. INTRODUCTION

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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.

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 operations.
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

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.

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Pt. 741, App. B

12 CFR Ch. VII (1–1–18 Edition)

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

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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 greater.
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

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National Credit Union Administration

Pt. 741, App. B

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

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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.
Management should:
• Rely on assumptions that are reasonable
and supportable;
• Document any changes to assumptions
based on observed information;
• 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 income
is assumption sensitive and more uncertain
the longer the forecast period. Simulations
typically include evaluations under a basecase 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.

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Pt. 741, App. B

12 CFR Ch. VII (1–1–18 Edition)

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 scenarios.
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 liabilities.

Assumptions

Account Attributes

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 change.
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.

Account attributes define a product, including: Principal type, rate type, rate
index, repricing interval, new volume matu-

Alternatively, a credit union may attribute value to these shares (i.e. premium)
on the basis that these shares tend to be

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.
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rity distribution, accounting accrual basis,
prepayment driver, and discount rate.

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National Credit Union Administration

Pt. 741, App. B

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

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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 union.
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 program.
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 limits.
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.
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.

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12 CFR Ch. VII (1–1–18 Edition)

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ER02FE12.012

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Pt. 741, App. B

Pt. 741, App. B

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 un-

sound, 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 § 741.3 of NCUA’s regulations.
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

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National Credit Union Administration

Pt. 741, App. C

12 CFR Ch. VII (1–1–18 Edition)

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 oversight).

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.
[77 FR 5162, Feb. 2, 2012, as amended at 77 FR
57990, Sept. 19, 2012]

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IX. DEFINITIONS
Basis risk: The risk to earnings and/or
value due to a financial institution’s holdings 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

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