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Jun 22 2017

Interest Rate Risk, Too Little or Too Much?

Article

Written by webmaster

4 min read

When we talk with credit unions about the results of their interest rate risk analysis, we are often asked the question, how do my credit union’s results compare to my peers or to the industry? The answer is not always applicable because credit unions vary quite a bit from one another. The differences can include: What the starting net worth ratio is; how much of the credit union’s funding is in CDs or rate-sensitive money markets vs regular shares and share drafts; and how much of their assets are longer-term to name just a few of the variables.

With the implementation of the new Supervisory Test by NCUA, the question of how our clients compare to each other piqued our curiosity. While most of our clients fell into the low-risk classification (with a few in the moderate range), we did not know the exact ratios. After a review of the results of over 300 clients, we found that 92.4% are in the low-risk range, 7.3% are moderate-risk, and less than 1% fall in the high-risk category. Of the moderate-risk group, 45.5% of those started out with a current net worth ratio of less than 8%, another 36.4% had a current net worth ratio between 8% and 9%, and the remainder had a net worth ratio of 9% or above.

These statistics led me to another question. Are credit unions taking on enough risk, and can the results of the interest rate risk analysis be utilized to better manage the credit union? The IRR analysis should be a tool to help manage interest rate risk, not just avoid it. While the regulatory environment may be one of risk avoidance, the following actions will help the management team use the results of the IRR analysis to balance the risk/reward trade-off and possibly improve earnings:

Thoroughly review and understand the assumptions.
Ensure that accurate data is entered into the model.
Make sure that the assumptions best reflect the balance sheet and repricing characteristics.
Put a Back-test in place to compare the results to actual for reliability.
Establish policy limits that correctly reflect risk tolerance.

Fully utilizing and incorporating the results of your IRR analysis into the management process will help management optimize the balance sheet composition while understanding the risk to earning and the value of net worth if interest rates change.

The major components contributing to the low level of risk with our clients and other credit unions are: the sizable percentage of deposits in regular share and share drafts that have low rate sensitivities; deposits that are stable and stay at the credit union for extended periods of time; shorter-term investment portfolios; and a substantial percentage of consumer loans with two-to-three-year turnover. When there is doubt that the low interest rate risk results are reliable, history has shown otherwise. In the last rates up cycle, credit union net interest income (NII) also increased. There was a lag in the improvement but it did improve due to the factors listed above.

To play with possible changes to a credit union’s balance sheet, I took a credit union with the following: a net worth ratio of 11.8%, a net interest margin of 271 basis points, an ROA of 42 basis points, moderate tolerance to interest rate risk based on their policy limits, and little to no interest rate risk in both the income simulation and the NEV analysis. With this data, I then tested how much their balance sheet could shift to cause their interest rate risk to approach policy limits and possibly raise regulatory concern. Their balance sheet would need to significantly change. By significantly, I mean moving over 50% of total assets into 15-year mortgage loans, shortening the average lives of all non-maturity deposits to 30 months or less, and assuming that at least 50% of all deposits are very rate sensitive with betas of .95% or 1.00%. Even in this scenario, the credit union’s IRR did not fall to alarming regulatory levels. There are two reasons why: 9% of total assets remained in overnight investments, and 17% and 12% of deposits are in regular shares and share drafts, respectively.

Common mistakes I see credit unions making in this area include keeping investment and loan portfolios too short, being risk avoidant instead of risk managers, having policies that do not accurately reflect credit union practices that are either too liberal to too restrictive, and not utilizing the IRR results to structure the balance sheet for better earnings.

It appears a majority of credit unions are in the low risk range and could possibly take on more exposure to improve earnings. It might be time to review your credit union’s balance sheet composition, identify its strengths and weaknesses, discuss your IRR analysis, and recheck the policy limits. Once this is complete, it would be valuable to evaluate whether your credit union has too much interest rate risk or not enough. Would it be beneficial to explore getting a little closer to policy limits for the possibility of increased earnings? Can the trends be tracked and adjustments made if necessary? Before any changes are incorporated, document the thought process and discussions and be prepared to have a conversation with your regulator if it comes up. Comprehensive Board and ALCO minutes, running some what-if scenarios through your IRR analysis, along with doing some sensitivity testing of key assumptions, will help support the credit unions actions. It will also help the credit union develop a plan for positive and prosperous performance in the future, regardless of what interest rates do.

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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.