Increasing Incidence of High-Risk in NCUA’s NEV Supervisory Test

The resulting balance sheet sensitivity is categorized as shown in Figure 2 using the shocked NEV Percent Change and NEV Ratio in the +300 basis point scenario. As outlined in this NCUA fact sheet, the test was developed in response to the significant degree of uncertainty surrounding the valuation of NMDs and the desire to create a cross-comparable standardized treatment. The treatment uses a 99.00 price in the base scenario (1% benefit to economic value) and a 95.04 price in the +300 basis point scenario (a 4 percent decline from base) for NMD valuations. The test was initially calibrated using deposit-study data from hundreds of credit unions. The 1 percent base value indicates a deposit franchise premium benefit, which was observed from the dataset. The mean and median values were used to initially calibrate the base price but were not indexed to adjust for changes in market conditions. The non-indexed NMD values (set to 99.00 in each quarterly test) represent an important factor in the increasing frequency of High/Extreme risk results. Consider a hypothetical example to illustrate this concept: a perfectly balanced asset-liability (AL) profile, meaning the economic value (EV) of equity is immunized to changes in interest rates, as shown in Figure 3. Note as EV of equity remains stable, the NEV Ratio increases due to falling asset values from higher discounting rates. This balance sheet’s NEV Supervisory Test result would be in the Low category: 8.26% post-shock NEV ratio and -28.61% NEV Percent Change. Now, if we assume a +100 basis point scenario happens and use the +100 scenario values as the base to rerun the Supervisory Test, as seen in Figure 4, the result becomes Moderate: 6.47% post-shock NEV ratio and -33.35% NEV Percent Change. As shown, the interest rate risk of the hypothetical entity was actually improved by higher rates, but the increased test risk result stems from the lower asset value in the base (from higher discount rates). Of course, the impact of higher rates is dependent on the asset duration, defined as sensitivity of fair value to changes in interest rates. We used 2.50% in this example. Institutions with lower asset duration are much more resilient to a deteriorating test result from higher interest rates, as seen in Figure 5. Using a 1% asset duration and a 10% capital ratio, the test results in Low in even a +300 basis point rate shock. On the other hand, a 4% asset duration, while having a Moderate result in the base, becomes Extreme in just the +100 scenario. With High/Extreme results now occurring nearly 50% if the time, the question of whether recalibration is warranted has become very timely. In the NCUA’s initial fact sheet, the administration mentioned that it expected to review the NEV Supervisory Test “over time to address changes in market conditions and potential shifts in credit union risk profiles,” and “assess the....--> Just over 6 years ago, the National Credit Union Administration (NCUA) announced key changes to interest rate risk supervision during its June 16, 2016 board meeting, which included the rollout of the Net Economic Value (NEV) Supervisory Test. Developed to help identify potential instances of unsafe and unsound risk exposure within the industry, the test has become a mainstay of the regulatory interest rate risk measurement process, and we run hundreds of these tests each quarter at ALM First to help credit union clients monitor the assessment’s results and prepare for examinations. For ALM practitioners familiar with the design of the...

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