BY MATTHEW JACOBSEN – VICE-PRESIDENT
True to its traditional roots, a credit union has tended to fund the balance sheet with retail shares or deposits borrowed directly from its members. Liquidity has been maintained by relying on the corporate credit union system, as needed.
Historically this strategy has worked just fine. However, there are periods in history when credit unions have been over or under-funded. Without question, retail funding will forever be the life blood of the credit union system. If we look carefully at traditional retail funding, we do see some weaknesses. There may be some advantages to credit unions to augment their balance sheets with alternative funding opportunities. Let’s explore that notion.
Traditional “Retail” Funding
The retail funding option has many advantages, but it also presents some shortcomings that we should consider. Our members are sometimes prone to making decisions on an emotional or behavioral basis. We value this characteristic when it manifests itself as customer loyalty; we are challenged when the same human emotions result in behavior that depletes customer share deposits. Additionally, members are often concentrated in a locale or employment group where an outside event may impact all of one’s depositors in a negative way.
With its access to share insurance (in most cases by the NCUSIF) the credit union can almost always raise funds by offering higher rates. This process can be ponderous and often results in paying interest to depositors who don’t care or in cannibalizing low-cost deposits into higher cost deposits. It’s not high on our list of alternatives unless coupled with a segmentation strategy, so we’ll move right along.
Central Liquidity Facility
The Central Liquidity Facility (CLF) is a special NCUA-operated lending facility for the credit union industry. Natural person credit unions can have access through regular direct membership or through an agent such as a corporate credit union. However, regular direct access requires the purchase of CLF stock and a corporate credit union does not necessarily have to become an agent. In addition, the CLF can only be used in the event of a financial crisis.
Credit unions whose assets exceed $250 million are required to prove access to a government-sponsored liquidity facility, of which there are only two. The CLF and the Federal Reserve Bank Discount Window.
Federal Reserve Bank Discount Window
The Federal Reserve Bank Discount Window provides very temporary funding that ranges from overnight to seasonal borrowing programs. The purpose of the access is to accommodate temporary liquidity/funding needs due to credit union specific or industry liquidity stresses.
As indicated above, the CLF and Federal Reserve Bank Discount Window generally fall outside of the traditional wholesale funding concept as they are essentially only for severe liquidity strains and not meant to be incorporated into strategic liquidity needs. Either the Federal Reserve Bank Discount Window or CLF are required by the regulation for credit unions greater than $250 million in assets. As such, those credit unions need to include one or both as part of their contingency funding plan. More “traditional” wholesale funding sources such as Federal Home Loan Bank, corporate system, or non-member CDs should also be considered for contingency funding plans, but for all credit unions. In addition, these alternatives can potentially be utilized for strategic funding considerations and not just for contingency funding plans.
Let’s look at some of the other options available to the credit union for alternative funding using nontraditional sources. We are not advocating any particular strategy. Our goal is simply to provide a refresher to these alternatives which may be helpful to some credit unions under varying circumstances.
Wholesale (“Alternative”) Funding
An alternative or option available to the credit union would be what is commonly called wholesale or alternative funding. This refers to funds available to the credit union through various intermediaries either as deposits or borrowings. Common sources of wholesale funding are the Federal Home Loan Bank, the corporate credit union system, and internet-based certificates of deposit listing and brokerage services.
At times, there are advantages to funding a portion of the credit union’s asset-based activities with wholesale funds. The interest rate paid may at times be lower or higher than rates paid on member deposits. However, when considering all of the costs associated with securing and servicing incremental retail funding such as member CDs, the cost of wholesale funds can be lower. The wholesale alternative eliminates a majority of the cost of obtaining the CDs and also the marginal costs of servicing the account. In some cases, wholesale funding lowers the risk of early withdrawals by retail depositors, which could happen in a rising interest rate environment. Wholesale funding typically has a low operational impact in that the transaction amounts are very large and very efficiently processed. Funding is readily available, often the same day. Wholesale funding can be structured without offending members. Maturities can be laddered and it’s easy to send the money out the door on maturity if it’s not needed.
Wholesale funding is an efficient tool to mitigate interest rate risk and manage the cost of funds.
A credit union can obtain wholesale funding at a cost for only the needed funding in contrast to increasing member deposit interest rates on more than just the needed funding. Furthermore, funding can be structured in a way in which cost, the amount received, and duration is totally predictable.
Wholesale fund sources come in two flavors: (1) borrowed funds, typically from a Federal Home Loan Bank or corporate credit union, or (2) non-member deposits in the form of jumbo certificates of deposit facilitated through an internet resource or broker.
Listing services are available through the Internet. Many are well-established through years of business practice. They generally function as a referral service. They match buyer and seller who then deal directly with each other. Compensation to the referral service is typically a flat annual fee based on asset size. The fee allows the participant to buy or sell certificates of deposit.
Listing services provide a very efficient source of funds. Amounts are typically large, often at the insurance limit of $250,000. They provide efficiency in the market which allows good rates to rise to the top. Early withdrawal penalties are important. If rates rise without strong penalties, depositors will early withdraw the moment it becomes to their advantage to do so.
New subscribers on a listing service sometime receive favorable treatment because of the way the services operate. Usually, CDs available for purchase are listed with the highest yields first. However, a new participant does not necessarily have to pay the highest rate. This happens because of the nature of the share insurance cap. Purchasers of CDs are limited to one $250,000 CD per institution. If, for example, a CD purchaser wants to buy just $10 million of insured CDs, they need to buy from at least 40 different federally insured financial institutions. New sellers of CDs can often obtain funds at less than high market rates because they are not already owned by all of the major purchasers out there.
Another alternative is to obtain CD funding through a broker. Brokered CDs differ from those of the listing service in that they are issued through a broker as negotiable instruments with a CUSIP. They typically are used by larger institutions. Brokered CDs can at times be obtained at a low cost and effectively eliminate the early withdrawal issues.
There are downsides to wholesale funding. First, they are not core and there is little or no value to the relationship. The counterparty on the other end of your CD is usually a professional investment manager who will always act immediately in the best interests of himself or his employer. When a CD matures, you are starting all over again in the relationship. For this reason, CD funding typically is not considered permanent.
Second, wholesale funding increases financial leverage and may impact the net worth ratio in a negative fashion. This leads regulators to often have a negative bias towards the wholesale funding option. If you choose to employ a wholesale funding strategy, you will need a strategic plan that is carefully crafted to utilize the funding cautiously and productively.
We have endeavored to portray the wholesale-funding option as an alternative resource or backup facility. As credit union balance sheets become more complex, these options become more viable strategies for consideration to provide a smooth and reliable source of funding to the institution. IRR may be mitigated and liquidity risk successfully addressed with near immediate access to funding. Any use of wholesale funding should be considered and analyzed in the context of other liquidity management options such as member deposit interest rate strategies, member loan interest rate strategies, and investment sales. Following such an analysis, it may be something to consider.