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Feb 15 2017

Has Your Alco Become Complacent?

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Written by webmaster

4 min read

Asset-Liability Committees (ALCO) may have become complacent over the last 8 years due to the lack of movement in market rates. Many credit unions I have worked with have been strategically focused on preserving or growing their loan portfolios, while deposit pricing was glossed over due to the inability to further boost the net interest margin from the cost of funds side. Now that it appears more rate hikes are likely during 2017, and many are cheering the possibility of widening margins and better net profits, it would be appropriate to review the responsibilities of the ALCO and give some thought to possible improvements.

The ALCO should be comprised of strong decision makers from key areas of the organization. Their breadth of knowledge and wide range of experience enables them to have productive discussions as they review many of the components making up the profitability of the credit union. They are also charged with anticipating problems, weaknesses and exposures and with developing possible solutions or responses. It takes solid and reliable data and reports, from external and internal sources, to arrive at strong recommendations and a well formulated course of action for the credit union.

Below is a list of topics that should be included in the ALCO discussion in addition to monitoring potential exposure to changing interest rates.

Current and forecasted loan rates.

Evaluate current loan rates for competitiveness but also review to make sure loan pricing strategies are profitable. I have witnessed some credit union loan rates that did not cover the credit union’s underwriting costs, cost of funds, or default rates. If the loan rates are not profitable, it would be best to forego the loan and keep the funds in comparable term investments.

Another item to consider is how loan rates are modeled in the interest rate risk analysis. Many models assume rates on new loans increasing 1 to 1 or a beta of 1%. When loan rates are forecasted to increase the full magnitude of the rate shock, while cost of funds are assumed to have lower betas, the outcomes of the IRR analysis are typically positive. Many credit unions are still competing for the good credit and striving to grow their loan portfolios. This may require a lag in loan rates and less than a 1 to 1 increase. This will negatively impact the overall interest rate risk and may lead to lower earnings than previously projected or anticipated. Knowing the impact of this scenario on the credit union’s forecasted earnings would be valuable.

Other loan products or loan grades may be explored and possibly developed to keep loan income trending upwards. Many of the credit unions we work with have very low interest rate risk and could afford to extend terms or hold more mortgage products. These products are viable options for many institutions and should not be ignored when reviewing the balance sheet composition.

Automobile loan terms should also be reviewed and loan concentrations addressed, such as a high volume of loans coming from one dealer or one loan officer. As of 3rd quarter 2016, Experian Information Solutions reports new loan terms averaging 68 months and subprime and deep subprime loans having longer terms. Knowing how much of the automobile loan portfolio has terms over 60 months or the amount of concentration in subprime loans may be important. The ALCO should discuss and be fully aware of the credit union’s lending practices and of possible interest rate and credit risk as the lending practices change.

Current and forecasted funding rates.

While history has demonstrated that most credit unions have a strong core funding source that is not highly volatile or rate sensitive, some of the money currently parked in regular shares may be more likely to leave the credit union or migrate to higher yielding products. We have seen CD balances decline since 2009 while regular share balances have increased. We have also witnessed a surge of deposits into credit unions during the same time. As interest rates increase, is this money going to stay in the system? As the difference between regular share rates and certificates widens, will the funds move out of regular shares and back into certificates? Because we cannot possibly predict with 100% accuracy how depositors will behave as interest rates change, a stress test should be applied and evaluated to focus on alternative balance sheet compositions. Mismanaging rates on deposits will have a negative impact on liquidity or on the net interest margin.

Investment strategies and liquidity options.

While credit unions are familiar with and invest in FDIC insured certificates of deposit (CD’s), many do not fully utilize the other asset classes allowed under NCUA investment guidelines. The ALCO should review and discuss the advantages and disadvantages of investing in government bonds, municipal bonds, and U.S. Agency mortgage backed securities. These other assets classes may offer higher yields and have strong secondary markets allowing for more actionable liquidity solutions than insured certificates of deposit. In conjunction with this discussion, the investment terms should also be evaluated. If the credit union would not hesitate to make a 5-year automobile loan, it would also make sense to invest in other 5-year instruments if the yield is commensurate. Holding excessive short term or overnight funds helps to mitigate interest rate and liquidity risks, but earning opportunities are missed. Fine tuning the risk/reward tradeoff is essential to maximizing earnings.

Additional items to consider in the ALCO discussions could be liquidity position impacted by loan growth, local economic factors, age of membership, and deposit run-off, to name a few.

Managing a profitable and growing credit union while remaining fully interest rate risk avoidant is an unreasonable expectation. As net interest margins may be further compromised due to rates going up, funding sources shifting and becoming more expensive than anticipated, and loan yields taking much longer to reach full value due to competition, credit unions may need to develop more aggressive pricing structures that will require a strong, active, and engaged ALCO.

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Jan 14 2021

Five Top Credit Union Topics For 2021

As we move into 2021, the following topics might be worth discussing and considering with your management team.

Earnings

During the first half of 2020, net interest margins came under substantial pressure as market interest rates were shocked dramatically downward. Net interest margins are expected to remain under downward pressure throughout 2021 as investment portfolios continue to reprice lower and share growth continues.

One of the easiest and quickest responses to declining interest income is to address the cost of funds. Many credit unions still have room to decrease their cost of funds, as shown in the September 2020 ending period graph below.

Source: NCUA

Delinquency

Based on the September 2020 call report data, loan delinquencies and net charge-offs remained low and were below September 2019 delinquencies. Loan forbearance and other assistance programs in place through the entirety of 2020 may have helped delinquencies. Also, certain sectors of the economy are not as impacted as others. The unemployment rate is expected to continue drifting lower in 2021. However, as the assistance programs are lifted, delinquencies and charge-offs are expected to increase as unemployment remains substantially above the years leading up to the pandemic.

Source: MHSI Online Peer Analysis Module through September 2020

Credit Union Philosophy

Serving the underserved has always been a hallmark of credit unions, and now more than ever, there is an opportunity to do this for many credit union members. As these times have been challenging, credit unions can continue to evaluate and prioritize how to best serve members in the coming year, especially those under financial stress. Exploring how to provide service to those that are underbanked might be an opportunity. One option may include evaluating risk-based lending policies and programs, especially given the robust liquidity on most credit union balance sheets. New and alternative avenues to bolster income should continue to be explored.

Digital and Technology

As the pandemic shifts and prolongs, credit unions should evaluate if their electronic delivery channels meet members and potential members’ needs. Moving to or improving digital delivery channels should be accelerated and prioritized. Digital delivery should include evaluating loan origination and servicing channels to maximize new loan volumes. Online and remote financial services will continue to grow and may be the preferred way members access and manage their financial activities.

Balance Sheet Growth

Before the pandemic, many experts anticipated credit union loan growth to taper off but remain positive. After the first quarter of 2021, loan production became unpredictable, however, by the end of the third quarter, annualized loan growth was 6.34%. Real estate lending, driven by the abruptly lower interest rate environment, helped with the growth. Experts anticipate loan growth to be around 6.0% to 6.5% over the next 12 months as the economy recovers.

The first few months of 2021 may see strong share growth as the second round of government assistance and stimulus takes hold, and households remain reluctant to spend until signs of COVID easing and warmer weather occur. Share growth last year increased at an annualized rate of over 18% and is expected to be approximately 8.0% to 10.0% in the coming year. If double-digit growth continues, earnings sufficient enough to sustain capital will be critical. If economic conditions improve and overall consumer activity increases, loan growth and increasing long-term interest rates could counter some of the anticipated income pressures. Fortunately, the credit union industry is very well capitalized and able to ride out the adverse conditions and absorb some more growth, even if earnings are reduced.

Nov 04 2020

The Bottom of the Frog Market

Several years back, I went to Mexico for a vacation. While there, I found a ceramic hand-painted frog-shaped planter that I wanted. My husband loves the hunt, and his quest began. Every time we saw a frog-planter, he would start negotiating with the vendor to get the lowest possible price. We searched for several days and would stop in different towns and check the markets while enjoying our vacation and exploring. When we found a frog, he would inquire about the price and negotiate for further discounts. After a few days and no success at getting the cost of the frog below a certain point, my husband declared, “we have hit the bottom of the frog market.”

…

The Bottom of the Frog MarketRead More »

Sep 30 2020

Economic Uncertainties and Interest Rate Certainties – Asset Allocation Assessments and Considerations

Future GDP Projections

In September, the Federal Reserve Chairman spoke publicly on several occasions and reiterated that the central bank is committed to helping the economy “for as long as it takes.” He noted continued improvements in the economy, but also acknowledged a highly uncertain path ahead. The September FOMC (Federal Open Market Committee) projections are now projecting a full-year GDP decline of 3.7%. This is substantially better than their previous expectation of a 6.5% decline. However, they lowered their 2021 outlook from 5.0% to 4.0% and their 2022 outlook from 3.5% to 3.0%. Their 2023 outlook is at 2.50%.

Interest Rates and Economic Uncertainties

The FOMC also indicated that they would allow inflation to run above 2.0% on a sustained basis before any federal funds rate increases. As such, most individual members of the Committee indicated that the federal funds rate could remain close to zero through 2023. Some economists and analysts even think that we may not see an increase in the federal funds rate until 2024 or 2025. They believe that it will take up to five years for the global economy to fully recover to pre-pandemic levels.

The risks to the FOMC economic growth projections are high. Even the Chairman of the FOMC acknowledged the economic uncertainty of the path ahead. Following the sharp rebound in many economic data measures and drop in the unemployment rate, some recent measures have disappointed compared to expectations and some are indicating a recovery that is stalling. At the current time of this article, the nature of further fiscal stimulus continues to be negotiated in congress and some are not expecting a resolution until after the presidential election. Of course this only adds to the current economic uncertainty.

What is highly certain over the short to medium term timeframe is that interest rates will not likely be increasing more than just relatively minor fluctuations in the medium to long end of the U.S. Treasury yield curve. It is more likely that potential risks on the horizon could drive medium and longer-term U.S. Treasury yields even lower.

Reassessing Balance Sheet Strategy

Given the above outlook, it would certainly seem that some credit union balance sheet strategies of recent years should be reevaluated for the foreseeable future. Reassessing asset allocation strategies is possibly more relevant at the current time than at any time in the past several years. For example, the credit union may want to ask itself how much should we be redeploying assets into two to three year investment CDs given current interest rates on those maturities. If the answer is less than previous years, then what are the alternatives we can explore.

Priorities Going Forward

In exploring alternatives, the first priority for credit unions is of course serving members. Assessments and considerations could include expanding the types of loans offered, reevaluating risk based lending allocations, increasing real estate concentrations, debt consolidation programs, and loan payment support alternatives to name just a few. Secondary to the first priority are considerations such as allocations to loan participations and alternative investments. For example, should the credit union assess CUSO or similar investment possibilities. What are all of the possibilities for these type of investments that may be available to the credit union? After all, an alternative of earning five basis points at the corporate credit union with too much of assets is not likely to accomplish any priorities or goals for the credit union.

The present time and foreseeable future is a great time for credit unions to really show how they can serve and support members during these challenging times. Being there for your members is for sure the highest purpose for the credit union and always assessing ways to provide service and assistance to them will always be the credit union’s first priority. In addition and secondarily, now more than any time in recent years it may make sense to really take a deep dive into the above asset allocation assessments, considerations, and possibilities. Ideally, the best answers going forward would combine the first priority with the second to optimize balance sheet performance while best serving members.