Cashflow modeling is used to measure liquidty, rate, market, and concentration risks in the credit union’s balance sheet. The findings produced by the model are highly dependent upon the asssumptions that are assigned. Assumptions play a critical role in model calculations affecting the model outcome. Every credit union using a cashflow model should strive to have the most accurate assumptions assigned to the model. The final responsibility for assumption accuracy rest with the credit union.
The following are the assumptions required for modeling risks:
Assumption 1: Discount Rates:
Loans/Share Deposits:
It is recommended that the discount rates assigned for loans and shares are the client’s actual current pricing. This assumes that they are within the mix of the competitive market. The credit union’s current rates are the true market rates in their geographic market.
The model summarizes discount rates into general balance sheet categories. For example, “new auto loans” encompasses many types of product offerings with different terms and rates. The product rate used in the model should be the most common rate for this loan type.
It is recommended that specific procedures are set up by the client in determining this common rate on all model accounts: loans and shares. This information is provided to the modeler each time the model is updated.
The Alco should review these rates and approved and place the approval in the Alco minutes.
Investments:
The discount rates being assigned in the model are typically based on the treasury curve +/- a spread. The position on the curve is determined by the investment type and average duration of the securities being purchased.
The credit union should determine the type of securities that will be purchased and provide the modeler with the expected yield, variable versus fixed rate pricing, and the term or repricing frequency of the new purchases.
Procedures should also be defined in how these rates are determined. These procedures should be documented in the Asset/Liability Management Policy.
Assumption 2: Prepayment Speeds:
Loans:
Projecting prepayment speeds on loans for numerous rate scenarios is a significant challenge. It is always the best estimates whether defined by the modeler or the credit union. The modeler typically uses history, internet AI, outside broker analysis and the state of the economy to quantify reasonableness.
Investments: Mortgage-backed/Asset-backed Securities
When determining the prepayment speeds on cashflow investments, the modeler uses two methods in determining the default prepayment speeds. At the time of purchase on all cashflow securities, it is required to complete a “Shock Analysis” usually prepared by the client’s broker. The modeler will use this analysis when provided. If nothing is provided by the client, general prepayment speeds are used that are published by brokers for ARMs’, Hybrids’ and Fixed Rate MBS’ and ABSs’.
Assumption 3. Market Value of Non-maturing Shares:
It is highly recommended that the credit union use the NCUA Stated Values Method in valuing non-maturing shares.
The credit union can also elect to use custom decay factors based upon actual decay history.
Decay factors are required for liquidity calculations. A typical credit union uses the following decay periods: Demand – 30 months, Savings – 36 months, Clubs -12 months, and Money Market-12 months.
Assumption 4. “Beta” pricing of non-maturing shares:
The definition of “beta” pricing is how much the rate being offered on non-maturing shares changes as the rates shift in the various rate shocks.
Non-maturing shares rates are typically non-elastic to price. This means the rates are determined by the credit union and change very little in the different rate shock scenarios.
It is highly recommended that each credit union provide custom rate changes for the different rate scenarios to the modeler. The “betas” can vary widely based upon credit union strategy, and the competitive market.
Assumptions are estimates: Back-testing
Using these assumptions in a casjflow model produces risk measurements results that are used by the credit union to manage its risks positions and expected returns. It is important and required by auditors and regulators to back-test input and output for the expected outcome. The responsibility for back testing lies with the credit union Alco. It provides positive proof to the Board and Management that the that the model findings are providing proper the best risk measurment accuracy compared with policy limits and the management of each.
Back-testing is a “team” process where both the credit union and the modeler are required to work as a team for success. Back-testing procedures should be developed and documented in the Asset/Liability Management Policy.