The National Credit Union Administration (NCUA) released its 2023 Supervisory Priorities on January
18, highlighting key areas of focus for the agency in the year ahead.
Many of the priorities highlight risks that arose in 2022, along with several new areas of focus.
NCUA’s 2023 Priorities fall under the following categories:
- Interest Rate Risk (IRR)
- Liquidity Risk
- Credit Risk
- Fraud Prevention and Detection
- Information Security (Cybersecurity)
- Consumer Financial Protection
- Current Expected Credit Loss (CECL) Implementation
- Succession Planning
- Support for Small Credit Unions and Minority Depository Institutions
- Post Examination Survey
In this article, we will focus on the risks most pertinent to accounting and finance functions and discuss
how management teams can prepare for heightened supervision of each risk area. While sound
oversight and management of all risk areas remains important, understanding the NCUA’s 2023
Priorities can help industry professionals address key areas projected to experience heightened levels of
stress and increased regulatory focus.
2022 brought many challenges for financial institutions particularly with IRR and liquidity risk due to the rapid rise in market rates throughout the year. Credit risk, although still very strong from a historical perspective, is an increased area of focus given the rising threat of a recession and continued pressure on consumers and businesses from high inflation. Closely related to credit risk – and in the works for many years – is the implementation of the Current Expected Credit Loss (CECL) methodology for the allowance for credit losses (ACL) that finally takes effect in 2023.
Interest Rate Risk
Interest rates rose significantly across the yield curve in 2022, elevating IRR and the related exposure to
earnings and capital. Last year also brought changes to the NCUA’s IRR program with the addition of
the Sensitivity to Market Risk component to the CAMELS rating system and supervisory framework
updates in September 2022, which provided timely adjustments to the Supervisory Test and related risk
categories.
The 2023 Supervisory Priorities specifically state that examiners will focus on IRR management
practices such as:
- the reasonableness of key assumptions,
- the control of overall IRR exposure,
- communication of results, and
- proactive actions to remain within safe and sound policy limits
Regardless of whether an institution partners with an outsourced service provider or conducts ALM
modeling in house to help it manage IRR, each area of supervisory focus within this risk category will
require a high degree of diligence by management teams. For example:
- Documenting key assumptions should be done in consultation with staff or service providers directly tasked with modeling to ensure that assumptions accurately reflect the unique characteristics of the credit union’s membership base.
- Assumption documentation should be supported with quantitative analysis such as regression analyses for behavioral assumptions on non-maturity deposits (i.e., beta and maturity) and staticpool analysis for deposit decay rates.
- Key assumptions should be stress tested on a regular basis to determine the impact of error margins on overall modeled IRR, and sensitivity of the risk position to changes in key market factors.
Communicating results and ensuring compliance with board approved policy limits remains an important
aspect of any risk management function. Management teams should review committee structures to
determine if business areas are appropriately represented in asset/liability committees to help ensure
that strategic decisions made across the organizations are properly vetted for potential impacts to IRR
exposure. Along these lines, management teams should ensure that committee minutes contain
sufficient details so that examiners, the board, and others can track discussion of risk trends and related
risk management decisions.
Liquidity Risk
In addition to heightening IRR, the significant increase in interest rates in 2022 led to a significant
increase in liquidity risk, driven by the simultaneous occurrence of several events. Increasing rates
resulted in a significant decline in the market value of securities portfolios (“structural” liquidity) and
caused a slowdown in prepayments for some loans and investment holdings (“cash flow” liquidity). In
addition, returned consumer spending coupled with below-market loan rates further stressed the
industry’s liquidity position. This was probably best seen in auto lending where credit unions experienced
record highs in loan volume during the year. All these factors resulted in a drawdown of balance sheet
liquidity and an increased reliance on borrowings and non-member funding.
Much like IRR, the 2023 Priorities center on an institution’s ability to measure, monitor, and control
liquidity risk. Management teams should ensure risk management framework considers the current and
prospective sources of liquidity compared to funding needs. They should also ensure current policies,
procedures, and risk limits remain in-line with the overall risk tolerance of the institution.
Paramount in liquidity risk management and controlling liquidity risk is proper risk-based pricing,
adequate on balance sheet liquidity, ample contingent funding capacity and well-designed contingency
funding plans. Well controlled liquidity risk considers the cost and benefit of lending and investing that
consider market-based benchmarks to ensure asset and liability pricing considers the risk of the asset
and the incremental cost of the funding source. Sound pricing decisions will ensure that the usage of on
balance sheet liquidity or the drawing of contingent funding is measured and accretive to the institution’s
profitability. In addition, minimum levels of on balance sheet liquidity and contingent funding should be
detailed in policy along with provisions for periodically testing liquidity sources. On balance sheet and
contingent funding should be stressed in meaningful ways to model changing cash balances, collateral
values, and cash inflows and outflows.
Credit Risk
Credit conditions have been very strong over the past several years; however, high inflation, rising
interest rates, and the potential for an increase in unemployment rates, may lead to an increased number
of borrowers facing financial hardship. This could result in a reduced ability, or an inability for those
borrowers to meet scheduled debt payments. In addition, after significant appreciation of real estate and
consumer collateral values over the past several years, collateral values have largely stabilized and in
some asset classes, started to decline. The potential for increased delinquencies and lower recovery
rates underscores the importance of sound credit risk management practices in 2023.
The 2023 Priorities state that examiners will review the soundness of existing lending programs, any
adjustments made to loan underwriting standards, portfolio monitoring practices, and loan workout
strategies for borrowers facing financial hardships. Management teams should take this opportunity to
review lending policies and portfolio risk management practices for potential weaknesses. Strong risk management practices center on strong underwriting practices that adequately compensate an institution for the level of risk undertaken, fully analyze a borrower’s ability to repay debt, and properly value and secure collateral pledged. From a macro-portfolio perspective, independent loan reviews and engagements for loan portfolio stress testing are valuable risk management practices that can aid in proactively identifying weaknesses in underwriting and emerging credit concerns among borrowers.
CECL Implementation
Closely related to credit risk is the implementation of the CECL methodology, which was originally
introduced by the Financial Accounting Standards Board (FASB) in 2016. The 2023 Priorities state that
examiners will closely review the following related to CECL implementation:
- ACL policies and procedures
- Documentation of an ACL reserving methodology, including logic for model selection and related input data, modeling assumptions, and qualitative adjustments
- Adherence to GAAP (if applicable)
Management teams should carefully review ACL policies and procedures and, if outsourced, work to
understand the mechanics of the model employed. Although not required prior to implementation, CECL
models should be validated on a periodic basis by an independent party. In addition, qualitative
adjustments should be made with well supported narrative linking adjustments to characteristics
inherent to the institution.
Other Supervisory Priorities
As detailed in the introduction, the NCUA has a myriad of non-capital markets and non-credit risk
priorities. The 2023 Priorities will also focus on succession planning, enhancing fraud prevention and
detection, strengthening cybersecurity measures and continuing to review compliance with consumer
financial protection laws and regulations to ensure the safety of credit unions and their members. These
risk areas are equally as important and represent opportunities for management teams to improve risk
management practices further.
Preparing For Your Next Exam
After last year’s market volatility and continued uncertainty regarding the economic outlook, 2023 is already shaping up to be a challenging year. The NCUA supervisory priorities appropriately highlight many risk areas that are top of mind among the industry. For credit unions to continue to effectively serve and meet the needs of their members, risk exposures must be appropriately measured, monitored and controlled. Many of the priorities outlined by the NCUA can be tackled in the normal course of business, through focused allocation of internal resources. However, management teams may desire an external perspective and engage third parties for risk modeling and consulting. Regardless of the approach, enhancing risk management practices to address 2023 Priorities will facilitate smoother regulatory reviews and an overall improved preparedness for the economic uncertainty facing the industry.
Looking for a trusted partner to assist with risk management? Contact ALM First’s team of
experienced professionals today to discuss your credit union’s needs.
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