BY CYNTHIA R. WALKER – CEO
NCUA’s Supervisory Focus for 2017 and 2018 included both interest rate risk and liquidity risk. I expect both will remain on their supervisory priority list for 2019. We have observed that regulators have been monitoring liquidity more closely due to their take on the emerging trends related to on-balance sheet liquidity. Liquidity represents a credit union’s ability to meet share withdrawals and other operational demands and to fund assets.
During this year we have consulted with numerous credit unions that are experiencing liquidity pressures more now than at any time in the last 10 years. For managers that have come on during this time, this may be the first time in their career that interest rate risk or liquidity have required closer monitoring or management.
After the financial crisis, the industry experienced a large inflow of deposits as members took a more conservative financial stance and chose to move to safer investments or improve their own liquidity. Over this time, the credit union industry continued to see steady deposit growth and in 2015 topped the $1 trillion milestones. The total number of credit union members grew plus the average deposit per member moved from $5.6 thousand in 2008 to $8.2 thousand.
When we drill down and look at credit unions with assets from $10 million to $250 million since the beginning of 2015, deposits grew 12.3%. During this same 3-year period, loan growth was 24.75%.
CREDIT UNIONS $10M TO $250M
TOTAL LOANS AND TOTAL DEPOSITS
The loans to total assets ratio for this class of credit unions is about 55%, indicating quite a few liquidity options should still be available and the liquidity pressures may be more of a timing issue between investment maturities and funding needs.
Over the last year, credit unions are starting to see rate sensitive deposits shift internally or leave the credit union for better yielding options. Cost of funds for U.S. credit unions rose 15 basis points and experts anticipate there will be more competition for deposits as short-term interest rates continue to increase. This will cause net interest margins to compress. Conversely, liquidity pressures may mount if the credit union chooses to hold deposit rates down and members move deposits to higher yielding options in the marketplace. Evaluating and anticipating how shares will behave under this changing rate environment is a very important issue from an interest rate and liquidity perspective.
CREDIT UNIONS $10M TO $250M
CASH & DEPOSITS & SHORT-TERM INVESTMENTS TO TOTAL ASSETS
This is where the balancing act between interest rate risk, liquidity and earnings becomes tricky and the three-legged stool analogy comes into play. Interest rate risk and liquidity risk are leg one and two, with earnings being the third leg.
As short-term interest rates have increased, the cost of funds increased by a fraction of the change, and we have observed an improvement in net interest margins as investments yields have increased. The loan growth has helped, although loan yield increases have not been much of a factor. Interest rate risk has been kept at bay due to a major portion of funding remaining in lower rate-sensitive deposits. This leg of the stool has been stable so far.
The liquidity leg has also been stable for most smaller credit unions. Those with a high loan to asset ratio that are experiencing industry trends for loans and deposits have experienced increases in liquidity risk. Credit unions with a lower loan to asset ratio and a higher short-term investment ratio have been able to fund lending growth plus absorb some deposit losses. Conceptually shorter terms in the investment portfolio equal lower yield and earnings. Accepting a lower yield for shorter-term investments for the sake of liquidity has helped liquidity but also helped with potential interest rate risk. For the most part, the liquidity and the earnings legs of the stool are holding.
This balance could become more challenging moving into 2019. It appears the feds will continue to increase rates in the coming months, but maybe not as aggressively as 2018. If pressure to raise deposit rates higher or quicker than loan and investment yields adjust, net interest margins will compress (interest rate risk). Liquidity may be stressed, if the credit union chooses not to match market rates and deposits flow out or if deposit growth is slower than loan growth (liquidity risk). Additional considerations as you evaluate and forecast stresses to liquidity would be the possibility of a recession, increased unemployment, or other events that cause a decline in deposits. Holding too much liquidity in lower yielding instruments or erroneous loan pricing could results in lower earnings than could have been realized (earnings risk). There is usually a cost to being completely risk avoidant. Each of these scenarios plus many others not mentioned could cause the equilibrium and balance of the three-legged stool to become mismatched or unstable. Constant estimating, anticipating, forecasting, managing and monitoring of interest rate risk and liquidity risk while trying to maximizing earning is essential for the long-term success of the credit union.