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Understanding Credit Union Risk Profiles with Quantitative Risk Analysis
Employing Uncertainty for a Clearer Vision
Introduction
Whether watching television, listening to the radio or reading the newspaper, it is difficult to avoid the constant stream of information related to the financial and economic difficulties being encountered around the globe. Not only are these issues critical for financial institutions and regulators but the state of economy is at the top of the mind for most consumers.
The financial crisis of 2008 and 2009 has actually proved to be beneficial for the reputation of the credit union industry. While many large brand-name financial institutions are going through difficulties, credit unions have appeared to be a calm port in the storm. Leading up to the crisis many large banks delved deeply into opaque financial instruments and made large numbers of risky loans, but the credit union industry continued to exercise prudent management and stable lending practices. However, in spite of sound management practices, credit unions are also encountering unprecedented levels of risk as the world moves into an uncertain financial future.
For credit union executive management teams (CEO, CFO, VP, ALM Director) the task of identifying, understanding and managing the risks affecting their institution are a top priority. It is a challenge, however, to manage and mitigate risk without having the best possible understanding of the uncertainties contained in a balance sheet, investment portfolio and operational structure. Even when there is a good view into specific areas of risk exposure it can be difficult to quantify those risks in a clear manner so as to understand the effectiveness and impact of the proposed risk mitigating actions.
This whitepaper will introduce and discuss quantitative risk analysis1 techniques that can provide credit union executives a tool for better understanding the risks embedded in their business and the possible outcomes from proposed management strategies, decisions and actions. If applied correctly, quantitative risk analysis will allow a credit union management team to not only forecast the possible future range of vital metrics (e.g. Net Income, Return on Assets, Net Worth) but also the probability of those particular outcomes. In addition, this paper will discuss some of the hidden pitfalls that must be avoided when applying quantitative risk analysis.
What is Quantitative Risk Analysis and why can it help you?
Quantitative Risk Analysis is a very powerful set of tools that can be applied by credit unions to better understand and manage the uncertainties encountered in any number of areas including, for example, risks to profitability, risks to net capital, liquidity risk and a wide range of ratio analyses.
Credit unions face an environment that typically involves a significant amount of uncertainty and variability. Quantitative Risk Analysis is a process that identifies and quantifies the uncertainty and variability associated with the functioning of the credit union and then develops a 'probabilistic model7' to represent the system. The output of a quantitative risk model provides a view of the risk and uncertainty associated with the operation of the overall system as well as the component parts.
For example, the output from a quantitative risk analysis model can answer many questions such as: "Based on the uncertainty of future interest rates what is the possible range of a credit union’s net worth ratio 12 months in the future?" with the answer in the form of "There is a 60% likelihood that XYZ FCU's Net Worth Ratio will end 2010 between 8% and 9% with a 10% probability of being below 7%."
Uncertainties and risks in a quantitative risk analysis model are usually represented by a probability distribution. For example a credit union’s operating expenses are no longer estimated as single points of low, mid and high as in traditional modeling. Instead, operating expenses would now be represented by a range of possible values along with the probability of each particular value.
If you have found the information above useful and would like to read the entire whitepaper, please complete the form below and the full paper will be emailed to you.
If you have any questions or comments about this whitepaper or would like to discuss your risk-based decision support needs, please contact Tony Gurule via phone at (303) 768-8669 or email at tony@voseconsulting.com.
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