By Mark H. Smith, Founder, Mark H. Smith, Inc.
Rates have been at historic lows for over six years. The Fed has (sort of) promised a modest rate hike later in 2015. The most common question we hear at Mark H. Smith Incorporated (MHSI) is, what will my non-maturity shares and deposits (NMS) do when rates rise? Historically, we know that NMS have exhibited very low to moderate rate sensitivity in a rising rate scenario. There is no certainty, however, that they will repeat this historical behavior. The most recent interest rate run up from 2004 to 2006 was ten years ago. There is a component of NMS shares that surged into the system during the financial crisis that may or may not be rate sensitive. And, many credit unions have watched as members rolled maturing CDs into NMS.
Credit union executives are tasked by regulation with the responsibility of estimating and managing interest rate risk (IRR). With NMS still comprising a majority of shares and deposits for most credit unions, estimating IRR is problematical unless we make assumptions with respect to future NMS behavior. The various assumptions you make with respect to future NMS behavior in a rising rate environment could drive divergent forecasts for either very low levels of IRR, or high levels of IRR, all for the exact same balance sheet.
The challenge arises when we look closely at NMS. We know through experience that NMS, in practice, exhibit characteristics different from their category. That is, their legal category would be a short term deposit with exposure to repricing risk in a rising rate environment. Their substance is that NMS are often long term relationships with low exposure to repricing risk. If modeled based on their substance the outcome is a lower estimate of IRR.
There are two issues that arise at this point. First is that if, in forecasting IRR, we rely on favorable assumptions for NMS that turn out to be overly optimistic, we may be in for an unpleasant surprise when rates do increase. Second is that both state and NCUA examiners are often very reluctant to accept the favorable impact the NMS have on IRR forecasts. The regulatory response is often a request to run the NMS at book (par) value. That response is directly contradicted in the recently adopted NCUA IRR rule in which NCUA specifically acknowledges that shares have value. The only real question should be how much value one should allow.
MHSI believe that shares have value and that value should be recognized in both the income simulation and NEV analysis. Credit unions should have a process for valuing shares and have the right to push back when regulators object for the sole reason that they don’t like the favorable outcomes. Let’s examine some of the options available to credit unions to help them anticipate how shares might behave under various circumstances and attach value to the anticipated behavior. We see these options as:
- WAGS and TWAGS – Everyone knows about a Wild A—d Guess. A TWAG is a thoughtful WAG. These have worked for a long time. For small credit unions it’s not unreasonable to think that the CEO and credit union staff are closely connected to the membership and can make a thoughtful estimate of the future behavior of NMS as to decay and rate sensitivity. However, this approach is often coming under fire by regulators –even for small credit unions.
- External Indexes Performed by Third Parties – An index may not be a perfect match to your balance sheet but is still a better assumption that a WAG or TWAG. There are some old indexes and studies out there such as the NERA (commissioned by NCUA almost 15 years ago) and the work done by the Office of Thrift Supervision (OTS) until it was dissolved in 2011. Both of these resources seem too old to have current validity.
The only current index based on credit union data that we are aware of is provided by McGuire Performance Systems. This index is based on the current analysis that McGuire performs for about 70 credit unions. MHSI has purchased this index for share value guidance for our own clients. For additional information you can go directly to McGuire.
- A simple internal study of your deposit characteristics – This project can be as simple or as complex as your expertise, time, and resources allow. Here is a simple example of how simple it can be. Using the Fed Funds Index as an example, go back to the low point of interest rates in August 2003. The index stood at 89 basis points. Then measure the highest rate for the cycle paid in July 2007 at 533 basis points. For Fed Funds, that works out to an upward swing of 444 basis points for the upward part of the cycle.
Now, using your quarterly call reports for the same periods, obtain the same low to high figures for a class of your shares, let’s say regular shares. You may find, for example, the low to high range for your shares for the same period was from 100 basis points to 250 basis points, or a swing of 150 basis points.
We have already discovered a gem of information that we can use. When the Fed Funds rate moved upward 444 basis points, we only raised our regular share rates 150 basis points. This information is much more useful than a WAG or even a TWAG.
If you have the time and the skills you may continue down this road and complete a complex share study if you choose. Even the basis information gained from 15 minutes of effort would be helpful to you.
- An External Deposit Study performed by consultants who, hopefully, can provide sound statistically based guidance as to how your NMS may behave under various future circumstances. This level of analysis provides the highest level of assurance possible as to future NMS behavior. But, understandably, it falls short of any guarantee.
It’s frustrating to present a problem and not be able to offer a solution. But there is no one-size-fits-all answer for this challenge. We do offer the follow suggestions as to how to proceed:
Take an inventory of your resources and make a decision as to what is available from internal resources and funds to attack the problem.
- Discuss options with your ALCO and board.
- If your decision is to make changes in your balance sheet, do it now. Don’t wait for rates to move.
- If your decision requires a modification to your written policies, do it now.
- Implement a feedback system in your organization that will provide you with timely data and analysis. This is very important if you have a branch network or a large online presence.
- As events proceed don’t hesitate to modify your plans and decisions in a timely manner. The traditional flow of decisions and the meetings that approve decisions may not be sufficient if rates move quickly or if NMS don’t behave as anticipated. You may need to call a special meeting. Don’t wait for the next ALCO or board meeting if it’s scheduled a month in the future.
Managing NMS is a complex challenge. Every credit union is a little bit different. We don’t have all of the answers, but we do have insight and would welcome your questions if you feel this insight could be helpful. We wish you success.