By Mark H. Smith, Founder, Mark H. Smith, Inc. and Matthew Jacobsen
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 irrational 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.
Corporate Credit Union
Reliance on a Corporate Credit Union for funding has its own set of potential problems. The Corporate system no longer has nearly unlimited access to borrowing through the U.S. Central FCU and the Central Liquidity Facility (CLF). That access was lost when the U.S. Central FCU failed in 2009 and was subsequently dissolved by NCUA. Without access to the CLF the Corporate System may or may not be able to fund credit union liquidity needs in a widespread crunch scenario.
So let’s look at some of the options available to the credit union for alternative funding using nontraditional sources. We are not advocating any particular strategy. Our goal is simply to identify 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 loans. 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.
There are some advantages to funding a portion of the credit union’s asset-based activities with wholesale funds. Chief among them is lower cost, especially when considering all of the costs associated with securing and servicing incremental retail funding such as member CDs. 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 are likely if rates climb even slightly in the current 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. Funding can be structured in a way in which cost and duration is totally predictable. Lastly, wholesale funding can function as a cap on rates paid for retail funds. For example, if 12 month money is available from the FHLB at .65%, that would effectively cap the maximum rate paid for member deposits on 12 month money.
Potential uses of wholesale funding include liquidity and contingency funding plan utilization. Many credit unions will never utilize a guaranteed line of credit at a Federal Home Loan Bank or Corporate. However, having the line of credit available may be a key part of a contingency funding plan.
Unanticipated loan demand may occur periodically and can be easily met with wholesale funding. Seasonal funding requirements also are facilitated. Interest rate risk management, as mentioned before, also fits within the criteria. Minimizing the cost of funds is sometimes a possibility.
Conspicuous in its absence on our list of alternatives is the notion of borrowing from the Federal Reserve Discount Window or the CLF. 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 Fed Discount Window is by far the choice of the majority of the impacted credit unions.
The Fed Discount Window provides very temporary funding. Loans are often expected to be repaid the next day or certainly within a matter of days. Impacted credit unions clearly should establish that relationship in order to meet the requirement of the NCUA Regulation. However, Fed Discount Window Funding falls outside of the traditional wholesale funding concept.
At times we hear of a misconception that one’s contingency funding plan can only include the Fed Discount Window and the CLF. This is not correct. The Fed Discount Window or CLF are required by the Regulation; however, traditional wholesale funding sources such as Federal Home Loan Bank, Corporate System, or non-member CDs may be very appropriate and totally acceptable in the credit union’s contingency funding plan.
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 a 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 offer low cost and effectively eliminate the early withdrawal issues. They also offer other efficiencies.
There is a downside to wholesale funding. It is 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.
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. As credit union balance sheets become more complex, this may become a more viable strategy 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. It may be something to consider.