Policy: Interest Rate Risk PolicyDepartment: ManagementApplicable Laws/Regulations: NCUA Rules and RegulationsLast Reviewed: September 12, 2012BOD Approved: September 24, 2012-----------------------------------------------------------------------------------------------------------------------------------BackgroundThe NCUA defines interest rate risk (IRR) as the vulnerability of the Credit Union’s financial condition to adverse movements in market interest rates. Although some interest rate risk is normal, it still may negatively affect the Credit Union’s earnings and its net economic value of equity. As such, these activities are considered to be safe and sound business practices. The interest rate risk policy and related activities act as a guide for management and the Board to understand and control interest rate risk and to minimize the reduction in income and equity that may result from changing interest rates. The Interest Rate Risk Policy addresses two key elements:

Risk to Earnings: The Credit Union’s earnings are influenced when interest sensitive income and expenses adjust in varied ways in response to higher or lower market rates.

Risk to Net Economic Value of Equity: Interest rate fluctuations affect economic value of equity because the potential change in value depends on many variables, which differ as interest rates change.

PurposeThis Interest Rate Risk (IRR) Policy sets forth the guidelines, procedures, and policies to be followed for measurement, reporting and management of the Credit Union’s interest rate risk. The Interest Rate Risk Policy addresses the following:

Sources of Interest Rate Risk Internal Responsibility / Controls Measuring & Monitoring Treatment of Non-Maturity Deposits IRR Limits Reporting Informed Decision Making Additional What-If Testing Liquidity Policy Changes Annual Review

Sources of Interest Rate Risk

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Interest rate risk is the risk to earnings or value arising from changing interest rates. Interest rate risk is inherent in the credit union business and, by its nature is derived from four primary components:

Repricing Risk: The Credit Union’s exposure to repricing risk is related to the timing of rising and falling interest rates and may be referred to as duration risk or gap. It is the risk of adverse changes to either earnings or capital related asset and liability interest rates that may change at different points over time. Example: The rate paid on share accounts will reset quickly in response to changing interest rates, while the rate earned on long term fixed rate loans will remain in effect until borrowers pay off these loans.

Basis Risk: The interest rate either paid or earned on various instruments may change more or less than other offsetting instruments. The Credit Union may be subject to basis risk resulting from unequal changes in the spread between two or more rates for different instruments with similar maturity dates. Example: The rate paid on short term deposits may rise or fall faster than the rate earned on floating rate loans.

Yield Curve Risk: Short term and long term interest rates may change at different times or with different severity, which can subject the Credit Union to yield curve risk. Example: Short term interest rates, typically associated with deposits, may rise or fall faster or slower than long term interest rates. Since loans are usually longer than deposits, earnings can be affected by these changes.

Option Risk: Interest rate movements may prompt borrowers and/or depositors to change the amount or maturity of instruments they hold. Example: As interest rates fall, borrowers are much more likely to re-finance their debt, in order to take advantage of lower interest rates. In addition, when interest rates are low or expected to rise, depositors may shift money from long term CDs to short term savings accounts with the expectation of earning a higher rate in the future.

Internal Responsibility / Controls Board of Directors: The Board of Directors is responsible for the formulation of IRR

policies, procedures and guidelines and for the annual approval of the Credit Union’s IRR policy. The Board is also responsible for ensuring that management executes an effective interest rate risk program and for periodically assessing if the program sufficiently identifies, measures, monitors and controls interest rate risk at the Credit Union. The Board will delegate authority for day to day IRR duties to the Asset Liability Committee (ALCO). The Board is also responsible for quarterly review of asset liability reports which measure the Credit Union’s financial position and interest rate risk exposure.

Asset Liability Management Committee (ALCO): The President is responsible for implementing all plans for the ALCO committee. ALCO is responsible for determining the optimum interest rate risk management policies and practices so that the Credit Union can achieve its financial goals while adhering to prudent risk management policies. At a minimum, ALCO will meet quarterly to review the Credit Union’s financial position and interest rate risk exposure. Minutes of all meetings will be maintained. It is the responsibility of the ALCO to present IRR reports, financial position and interest rate risk exposure to the Board of Directors at least quarterly.

ALCO will be comprised of the following individuals:

Chief Executive OfficerControllerBoard Treasurer

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Another Board Member as appropriate

Internal Controls: The purpose of internal controls is to ensure the integrity of all elements of the IRR management process, which includes separation of risk taking from risk measurement. The primary method of internal control is out-sourcing of interest rate risk measurement to a third party consultant. While management and the Board are still responsible for monitoring and controlling the Credit Union’s IRR, McQueen Financial Advisors is responsible for running the IRR model and for maintaining the reliability of model inputs. As such, risk taking activities at the Credit Union are separate from risk measurement at McQueen.

Measuring & MonitoringThe Credit Union will utilize an outside vendor to measure various financial goals as well as the Credit Union’s exposure to interest rate risk. Reports will be prepared by McQueen Financial Advisors, Inc. on a quarterly basis and will include testing and/or measurement related to of each of the Credit Union’s specific goals as established in this policy. Quarterly IRR reports will be performed with the assumption of a static balance sheet (no growth assumptions). While including growth assumptions can be useful for budgeting purposes, including them may conceal interest rate risk. Periodically, additional ‘what-if’ IRR reports may be utilized, in order to assess the impact of planned growth or new business initiatives.

McQueen Financial Interest Rate Risk Model: McQueen Financial Advisors is an IRR consultant to the Credit Union and utilizes a proprietary in-house model. As part of its due diligence procedures, the Credit Union receives a copy of the external audit of McQueen’s IRR model.

Model Inputs: During the initial set-up, McQueen was provided with a Chart of Accounts which identified the repricing characteristics of various balance sheet components. Each quarter, detailed loan, deposit and investment files are sent to McQueen Financial Advisors and loaded into the IRR model. These files contain a variety of fields which identify caps, floors, reset dates, maturity dates, call dates and other attributes. McQueen reconciles detailed loan, deposit and investment files to the Credit Union’s balance sheet in order to ensure that each interest sensitive asset and liability is captured.

Assumptions: Primary assumptions include interest sensitivity factors, prepayment speeds, non-maturity deposit decay rates and discount rates. Changes to model assumptions should be based on observable information like historical trends or market conditions. Whenever meaningful model assumptions are changed, management must document an adequate rationale within IRR meeting minutes.

Assumption Support: Because these assumptions impact IRR Model test results, it is important that they be both reasonable and supportable:

Assumption Category SupportInterest Sensitivity Factors: These assumptions relate to the planned change in loan and deposit rates in response to changing market rates.

The Credit Union will periodically review interest rate decisions made during a prior period when the Fed Funds rate was either rising or falling. The results will be compared model assumptions. McQueen Financial Advisors will review the findings for reasonableness. The review will be included in IRR meeting minutes.

Non-Maturity Deposit Decay Rates: Within the ALM model, non-maturity

Because non-maturity deposit retention & decay rates are difficult to predict, the assumed remaining life used

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deposit accounts are assigned retention/decay rates which are used as part of the Net Economic Value of Equity calculations.

to value them will be set at conservatively low terms of 24 to 36 months. To more fully understand the nature of non-maturity accounts, Net Economic Value of Equity calculations will be performed using two methods as described in more detail below.

Prepayment Speed Assumptions: Loan prepayment speed assumptions attempt to measure the percentage of loans which will prepay and are based on loan type, borrower interest rate and the financial incentive to refinance.

For real estate loans, McQueen’s IRR model uses Bloomberg Median Prepayment Speed assumptions, which are the industry standard. For non-real estate loans, conservative and reasonable assumptions are used, which are consistent with McQueen’s experience over a wide range of clients.

Discount Rates: Net Economic Value of Equity test results are highly dependent on the discount rate utilized.

Within the IRR model, discount rates are the US Treasury yield curve, plus an appropriate credit spread. The resulting base discount rate corresponds to the replacement rate for each category as of the report date. This method is widely recognized as the standard method for valuation of financial holdings.

Treatment of Non-Maturity DepositsNon-maturity deposits include any account that does not have a defined maturity date, such as share drafts, regular shares and money market accounts. Because the overall cost of these accounts is lower than most other funding sources, retention of them represents significant value to the Credit Union. Non-maturity deposits are an important source of low-cost funding and the value assigned to them is one component of the Net Economic Value of Equity calculations. As interest rates change, the Net Economic Value of Equity of the Credit Union will also change based on treatment of these accounts within the Model. The Board recognizes that valuing non-maturity deposits is inherently difficult, since member behavior (decay rates) cannot be predicted with certainty. For this reason, two methods will be utilized for measuring the change in value of these deposits:

Method One: Non-maturity deposits will be assigned a discount or premium for each interest rate scenario based on a decay rate and advantage that these accounts hold over other sources of funding. Because the rate paid on non-maturity deposit accounts tends to rise more slowly than the Fed Funds rate, these accounts hold more value when rates rise. The assumed remaining life used to value non-maturity deposits will be set at conservatively low terms of 24 to 36 months. This method captures the added value that non-maturity deposits provide and generally results in lower net economic value sensitivity in the rising interest rate scenarios. Policy limits related to the change in Net Economic Value of Equity will be established using this method for treatment of non-maturity deposits.

Method Two: Using a simple method, non-maturity deposits will be valued at par for every interest rate scenario. This method disregards the advantage that non-maturity deposits hold over alternative funding sources and overstates the Credit Union’s interest rate risk, because it assumes that as rates change that there is no additional benefit to maintaining these accounts. Net Economic Value of Equity will be calculated using this treatment of non-maturity deposits as a worst-case sensitivity analysis.

IRR LimitsMcQueen Financial Advisors, Inc. will report quarterly the following financial ratios:

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Minimum MaximumReturn on Assets 0.25%Total Loans to Deposits 95%Net Interest Spread 3.00%Capital to Assets 12.00%Short Term Liquidity Ratio 50%17/4 Test #1 (Net Worth % Test Result) 4.00%17/4 Test #2 (Net Worth % Change) -50%

McQueen Financial Advisors, Inc. will model the sensitivity to changing interest rates and economic value under a variety of scenarios. The following change limits will be measured and monitored quarterly.

ScenarioMaximum Change to Net Interest Income (Shock Test)

Maximum Change to Net Economic Value of Equity

+/- 100 Basis Points -7% -10%+/- 200 Basis Points -14% -20%+/- 300 Basis Points -21% -30%+/- 400 Basis Points -28% -40%+/- 500 Basis Points -35% -50%

In addition to these IRR risk limits, each quarterly report may include general ratios, non-parallel interest rate shifts or rate changes of a larger magnitude (Up 500 basis points, for example). The results of these tests are for information only. As such, it would not be appropriate to set a policy limit for each ratio that may be included in McQueen’s quarterly reports.

ReportingThe ALCO will review each of the following at least quarterly:

Return on Average Assets Loans to Assets Ratio Loans to Deposits Ratio Net Interest Spread Cumulative 1 and 5 Year Gap Ratios Capital to Assets Ratio Short Term Liquidity Ratio Results of the 17 / 4 Test Net Interest Income Simulation at +-100, +-200, +-300, +-400 & 500 basis points Testing related to the potential change to Net Economic Value of Equity at +-100, +-200, +-

300, +-400 & 500 basis points

It is the responsibility of the CEO to prepare and distribute either the full IRR report or a summary report quarterly to the Board of Directors, which includes each of the bullet points above. During

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periods of very low interest rates, testing related to falling rates may be excluded. For example, when the Fed Funds rate is less than 1.00%, testing related to a minus 200 basis point change is not necessary.

Informed Decision MakingDecisions related to funding, pricing, growth opportunities and business strategies should be based on current IRR as well as the trend of IRR measurement results. Management and the Board of Directors will use IRR reporting to control balance sheet makeup and to guide future activities. Decision making based on IRR results takes on more importance if net worth decreases, income falls or as interest rate risk approaches or violates Board approved levels. In the event that the Credit Union fails to remain within policy limits established in this report, the ALCO and Board of Directors are to be made aware of the situation so that appropriate actions can be taken. Both the causes and any actions considered to correct the situation will be discussed at ALCO meetings and documented. Although each situation may be different, management will consider the following to correct IRR policy exceptions:

Restructuring of the investment portfolio through the sale and reinvestment of securities held as available for sale.

Adjusting deposit pricing or implementing other market-based strategies in an attempt to move more deposits in to or out of the mismatched time frame. Deposit rates are designed to help members achieve their goals for liquidity and/or competitive yields. Rates will be set utilizing all information available, including: Rates offered by local depository financial institutions for similar products. Rates paid on other accounts offered. The overall financial condition, asset-liability position and goals of the Credit Union. The Credit Union’s loan to deposit ratio and need for deposits.

Adjusting loan pricing or implementing other market based strategies in an attempt to move more loans in to or out of the mismatched time frame. Loan rates are designed to provide the Credit Union with a reasonable return at a competitive borrowing rate for the member. Rates will be set utilizing all information available, including: Rates offered by local lending financial institutions for similar products. Rates on other loans offered. The overall financial condition, asset-liability position and goals of the Credit Union.

Explore potential counterparties for the sale of loans and/or loan participations.

Additional What-If TestingEach quarterly IRR report includes a variety of tests which measure interest rate risk over a wide range of possible rising and falling rate scenarios. However, these reports do not measure the impact of changes to either the Credit Union’s balance sheet or to Model assumptions. As such, additional ‘What-If’ IRR reports are called for, in order to assess the impact of planned activities and changes to model assumptions:

Planned Activities: Major business initiatives such as new branches, mergers, significant planned loan growth or extensive changes in the investment portfolio will all impact the Credit Union’s interest rate risk profile. Whenever planned activities are expected to result in a material change to the balance sheet, management will request a ‘What-If’ IRR report before the new strategy is initiated. The purpose of this additional IRR testing is to

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determine if the plans will have a significant impact on the Credit Union’s interest rate risk profile.

Assumption Sensitivity Analysis: Sensitivity analysis helps determine how changes to model assumptions may impact IRR test results. This analysis is important because interest rate risk measurement is highly dependent on assumptions used within the model. Assumption Sensitivity Analysis is performed by changing key model inputs like rate sensitivity factors and prepayment speeds, then comparing the new test results to standard IRR tests. At least annually, McQueen will perform an assumption sensitivity analysis. The results will be utilized in the following ways: To determine if using different assumptions will have a material impact on the Credit

Union’s interest rate risk profile. For example, assumption sensitivity analysis examines how IRR test results may change if future market conditions make it necessary to increase deposit rates faster than originally planned.

Assumption sensitivity analysis is also useful when it is not feasible (and sometimes impossible) to provide support for assumptions used within the model. For example, prepayment speed assumptions are inherently difficult to predict, because a borrower’s incentive to refinance is dependent on prevailing interest rates. A historical analysis of prepayment rates at the Credit Union may be helpful, but estimating future borrower behavior is inherently problematic, since each interest rate cycle is different. Assumption sensitivity analysis is not intended to replace support for model assumptions. Instead, it is intended to help understand IRR over a wider range of scenarios when support for model assumptions is difficult or impossible to compile or when historical trends may not relate to possible future events.

LiquidityThe Credit Union must, at all times, be in a position to meet member obligations by maintaining sufficient cash and/or highly liquid investments which can be converted to cash with minimum risk of loss. Such obligations not only include withdrawals from deposit accounts, but also demands which might be made on the Credit Union to fund loan commitments or to honor line-of-credit draws.

ALCO is responsible for maintaining sufficient liquidity by using one or more of the following: Maintaining adequate overnight funds. Careful attention to investment activities to insure that the available for sale (AFS) portion

of the investment account is maintained at an adequate level as defined in the investment policy.

By staggering maturities of those securities in the held to maturity (HTM) portion of the investment account to insure that an adequate stream of funds will be available to supplement the available for sale (AFS) portion to meet routine cash needs.

Maintaining access to the Central Liquidity Facility, or other sources of borrowed funds. Limiting lending activities when loan demand exceeds available funds or ratios reach

maximum permissible levels.

Policy ChangesChanges to this policy or to IRR limits must be approved by the Board of Directors.

Annual Review

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The ALCO is responsible for changes to this policy and/or procedures which may arise based on implementation of regulatory changes related to interest rate risk or based on changes in the complexity of the Credit Union’s balance sheet or risk profile. The Policy and IRR procedures should be reviewed and re-approved at least annually by management, ALCO, and the Board of Directors and amended as circumstances warrant. The purpose of this review and re-approval of the policy is to ensure that it is commensurate with the size, complexity and risk profile of the Credit Union.

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