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Jul 17 2020

Managing Risk – Interest Rates, Net Interest Margin, and Capital

Article, IRR Topics

Written by Matthew Jacobsen

3 min read

Recent Economic Activity

At the end of the first quarter and throughout the second quarter, the U.S. economy experienced one of the largest, if not the largest, economic shocks in history. The Federal Reserve Bank reacted swiftly in lowering the Federal Funds rate to a near-zero target and implemented various additional asset purchase programs. In addition, the federal government initiated numerous fiscal stimulus programs to aide businesses and unemployed workers. Some have proclaimed that given how this was an event-driven economic shock coupled with large and immediate responses, that a quick, “V” shaped recovery could occur. But should you really plan for this when making decisions now and throughout the next 12 to 18 months?

Federal Reserve Federal Funds Rate Projection

On June 10^th, 2020, the Federal Reserve released its economic and federal funds rate projections through 2022. These projections are provided by Federal Reserve Board members. The median 2020, 2021, and 2022 projections for annualized real GDP growth were -6.5%, 5.0%, and 3.5%. From a risk management perspective, it is worth noting that the lowest of these forecasts for GDP growth were -10.0%, -1.0%, and 2.0%, respectively. Median unemployment rate projections were 9.3%, 6.5%, and 5.5%. The highest unemployment projection was 14.0%, 12.0%, and 8.0%. Given the above, Federal Reserve Board members were generally not expecting an increase in the federal funds rate through the remainder of 2020, 2021, and 2022.

Outlook and Considerations For the Future

The reality is that even at this time, the outlook remains highly uncertain which means risk assessments with a broad array of possible outcomes should be evaluated and considered. Credit unions should see this elevated risk environment as a marathon over at least the next 12 to 18 months. Below are some considerations for the current and the forecasted environment:

In general, member deposit growth accelerated during the first quarter and continued into the second quarter for most credit unions. This is due to typical seasonal share growth and also from government stimulus and benefit programs. However, in looking at the last couple of economic declines, member share growth increased during these time periods as well. Some attribute this to members being more reluctant to spend given the economic environment. Will this continue over the next 12 to 18 months? Although the past has seen this reaction, it does not mean that it is a certainty going forward and credit unions should continue to monitor member deposits. In addition, if the credit union has not already, consideration should be given to rapidly lowering deposit rates given the current and forecasted environment. Deposits can often become stickier during these times as concern is more about safety and not deposit rates. Many members have much higher priorities right now then what they are earning on a regular share account.

During prosperous times, some loan rates can become mispriced as current risk is relatively low and competition for loans is high. Financial institutions may set rates lower than risk would warrant to try and keep loan volumes growing. However, now is not the time for this type of aggressive practice. The risk impact of mispricing loans in the current and forecasted environment becomes much more severe. Focus on optimizing pricing and risk in originating new loans.

During the first and second quarters, many credit unions experienced immediate net interest margin pressures as investment market rates moved down swiftly. Those with larger investment portfolios experienced this the most and especially if there were a lot of overnight and maturing investment volumes. Given the economic and interest rate outlook described above, net interest margin pressures will continue for the foreseeable future. This impact, coupled with expected higher loan loss provisioning, will lower net income for most credit unions relative to their 2020 budgets and throughout 2021 and 2022. Some are expecting ROA to be negative for many credit unions in 2021. From a risk management perspective, evaluating scenarios to include a “capital burndown” is appropriate. Most credit unions have continued to build capital throughout the past several years and are well prepared for this type of analysis and the potential outcome. Now is the time to understand these possibilities and prepare the Board of Directors for this type of risk outcome.

Related/Popular Articles

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.