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ALM Risk Measurement Tables

December 22, 2004

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All financial institutions are required to perform some type of interest-rate risk assessment, (i.e., asset/liability management analysis). As new tools are adopted such as net economic value (NEV) and net interest income simulation (NII), it is the responsibility of officials to set limits of acceptable risk.As a practical matter, bank and credit union policymakers need look no further than to their respective regulatory agencies for guidance in this regard. For example, the Office of Thrift Supervision (OTS) has adopted a risk-measurement table that defines minimal, moderate, significant, and high amounts of interest-rate risk for the thrift institutions within its jurisdiction. It is worth noting that the OTS has selected the NEV ratio as the only meaningful measure of risk exposure. The OTS risk measurement table is demonstrated below. The table can be found in the OTS website,www.ots.treas.gov. To find the information, select "Data & Research" and then "Statistical Releases." Under the interest-rate risk section, there is a report labeled "Quarterly Review of Interest Rate Risk," which contains the table. For OTS regulated institutions, a 200 b.p. shock test is performed. Each row in the table presents a range of "post shock" NEV ratios. The basis-point difference (multiplied by 100) between a thrift's NEV ratio in its base case scenario and the up 200 b.p. scenario is calculated, identifying in which column the credit union's risk is categorized. For example, if your base case NEV ratio is 10 percent and the up 200 b.p. NEV ratio is 8.50 percent, the difference is 150 b.p. In this case, you would fall within the second column, second row and would be classified as having "minimal" amounts of interest-rate risk.
Post-Shock - NEV Ratio Under 100b.p. 101 - 200b.p. 201 - 400b.p. Above 400b.p.
Over 10% Minimal Minimal Minimal Moderate
6% to 10% Minimal Minimal Moderate Significant
4% to 6% Minimal Moderate Significant High
Below 4% Moderate Significant High High

While the OTS has adopted one ratio to measure, NCUA suggests five tests. These tests are merely guidelines based on an immediate and sustained up 300 b.p. interest-rate environment, and may be found at NCUA's website,www.ncua.gov. Select "Resources," "Investment/Asset-Liability Management," "ALM Review Procedures," and then "Interest Rate Risk Questionnaire." The table is found within a commentary to Part D, Section 6, cell A 87, and relates to the question, "Based on the credit union's IRR measurement tool, is IRR exposure low, moderate, or high?" The table is shown here:

Basis of Measurement Low Moderate High
Gap - 12 Month +/-10% +/-10% - 20% >+/-20%
Net Interest Income - 12 Month < 20% 20% - 30% >30%
Net Income - 12 Month < 40% 40% - 75% >75%
Net Economic Value - % Change < 25% 25% - 50% >50%
NEV Ratio >6% 4% - 6% < 4%

Although these tables are helpful, please note that asset/liability management is a complex process and that interest-rate risk analysis is more of an art form than science. Assumptions on any test can greatly alter the outcome of analyses. Outcomes can be confusing and sometimes seemingly contradictory. Credit unions with ample capital and modest earnings may find themselves in the low-risk category for the NEV test, yet in the high-risk category when the NII test is applied. When in doubt, ALM First recommends the direction taken by the OTS with emphasis being placed on the NEV ratio.Emily M. Hollis is a CFA and president of ALM First Financial Advisors. Contact her at214-987-0860 ext. 102 orehollis@almfirst.com. Reprinted with permission.

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