By Mark H. Smith, Founder

 

The November issue of Credit Union Magazine bore the following message on its cover: “Expect a Surge in Lending.” With unemployment at its lowest point in almost a decade, the CUNA Economics Department is forecasting that the demand for lending will continue to improve in 2016. Economic factors considered in this forecast include improving consumer balance sheets, continued low interest rates, pent-up demand, and high consumer confidence. As with many of you, we have our fingers crossed here at Mark H. Smith, Inc. that Mike Schenk and his associates at CUNA economics are correct in their forecast.

Almost all credit unions would welcome an increase in loan demand and the resulting increase in loans-to-total- assets ratio. After all, that is the basic credit union strategy: borrowing from the savers and loaning the funds to the borrowers. The concept of one-third to one-half of total assets in an investment portfolio has never been a good fit in the credit union business model and it will be nice to begin moving away from that condition.

Nevertheless, a potentially major change, albeit gradual, calls for some thinking and strategizing with regard to the credit union’s balance sheet. The large investment portfolios that many credit unions now carry are typically short-to-medium-term. This balance sheet mix has often led to a forecast of low interest rate risk due, in part, to the short-term investment portfolios. Credit union executives should be aware of the potential for changes in interest rate risk and also liquidity risk when total loans become a larger part of the asset mix.

Here are some things to consider as your balance sheet changes:

Types of Loans – The type of new loans to be made is important. What will be their repricing characteristics? What will be their liquidity characteristics? How will the new loans impact interest rate risk and liquidity risk?

Credit Risk – Over the decades credit unions have become very adept at making quality loans. It should be a given that credit quality will remain high.

Funding Sources – Where is the funding for new loans coming from? The characteristics of the funding for the new loans should be carefully scrutinized. Will the credit union need to seek new funding sources such as increased member savings or possibly wholesale funding? Many credit unions will find the source of funding already available within the balance sheet located in the investment portfolio. In other words, investments will be redeemed and the proceeds loaned to members. If increased lending is funded from short-term investments, it may impact interest rate risk and liquidity risk.

Liquidity Risk — Loans typically do not bear the same liquidity characteristics as an investment portfolio. Loans may not be readily marketable or easily converted to cash. Key liquidity indicators should be forecasted and consideration given to forecasted changes.

Interest Rate Risk — Whether taking on new funding sources or simply reorganizing the balance sheet with more loans and fewer investments, the potential for interest rate risk is impacted. For example, if you are using your short-term investment portfolio to fund mortgage loans, the potential for interest rate risk may increase significantly. Loans of a shorter duration, such as automobiles and unsecured loans, will have a lesser impact.

Forecasting the What-ifs – You should model significant changes in your balance sheet. We suggest you look into the future and make estimates of how your balance may be comprised in twelve months. If you see loans increasing by more than 10% the time to model is now. Using your in-house model (or working with your outsourced ALM provider) we recommend that you model your balance sheet twelve months out and estimate the level of interest rate risk and liquidity risk that may come about. If you are a client of Mark H. Smith, Inc., we invite you to give us a call and we will help you in this process.

It may be safe to say that many of you would welcome these challenges. We are all hopeful that Mr. Schenk’s forecast comes to pass. We wish you success.