For almost a decade, short term interest rates have been manipulated and driven down to historically low levels by the Federal Reserve. Even today, short term rates remain near lows. For some financial managers in the credit union sector, that’s all they have known. Many credit union CFO’s and financial managers have never personally experienced high rates or rising rates in their professional capacity. They have only heard about them and read about them in history books. But we all know that, at least for some of us, it takes personal experience to internalize and feel the impact of an event.
From a regulatory standpoint, it appears that regulators continue to be concerned about the potential for interest rate risk (IRR). The topic remains on NCUA’s list of regulatory priorities for 2017. Additionally, the agency has gone to great efforts to revamp its regulatory approach to IRR as announced in a Letter to Credit Unions 16-CU-08. We suggest that all credit unions review the revised IRR supervisory procedures covered in the letter.
It is important to remember that in a historical context, credit unions have performed well when rates have moved up quickly. In the 2004-06 run up, the target rate for Fed Funds moved 425 basis points in about two years. Credit unions performed well during this period. In fact, in this real-world event, which represented a true ramped shock, credit unions as a group increased net interest income slightly.
The key to the industry performance was non-maturity shares. System-wide regular shares and checking rates paid by credit unions increased only 50 to 150 basis points. In many cases credit unions chose not to pay any interest on checking accounts. Credit union money market rates did increase at a greater rate, but in most cases lagged the market. In previous rates-up shock scenarios in the 1990s and even in the granddaddy of all rates-up scenarios in the early 1980s, credit union non-maturity shares have performed well and allowed credit unions to operate successfully and withstand, to a considerable extent, the negative impact of rising rates.
An additional factor in credit unions’ success in the last rates-up scenario was the impact of the credit unions’ investment portfolios. For many of you, your investment portfolio represents a significant portion of your assets. For the most part, issues held by credit unions mature in five years or less, allowing financial managers to reprice their investment portfolio on an expedited basis and control or manage margin compression.
Let’s look at the current state of affairs from two perspectives: That of the regulators, and then, that of operating your own credit unions.
The NCUA continues to regard IRR as a major risk factor. A large portion of regular shares and share draft accounts have been a key component to improved credit union performance when rates have risen quickly. While there is a strong understanding of how rates and deposits behaved in past rates up cycles, federal regulators and credit union managers have concerns as to the performance of non-maturity shares in future rising rate periods. With those questions in mind, combined with the possibility of several rate increases during 2017, NCUA will continue, and credit union management should continue, to put a strong emphasis on IRR.
Effective January 1, 2017, NCUA adopted a standardized measurement of interest rate risk in the form of the Net Economic Value Supervisory Test. One purpose of this test is to establish a uniform and transparent estimate of market risk for examination purposes. Another is to guide exam staff as to the scale and scope of their review so it fits the credit union’s level of risk. Finally, it should improve the agencies efficiency and effectiveness.
The Net Economic Value Supervisory Test measures interest rate risk exposure relative to capital under a prescribed interest rate shock scenario using standard non-maturity share valuations. NCUA is clear these valuation assumptions are for exam purposes and should not be construed as recommended assumptions for ongoing interest rate risk management. During my career in the credit union industry for almost 40 years, I have observed that when NCUA puts out a number, some credit unions, especially those on the smaller side, are tempted to adopt that number and manage to it. While the NEV Supervisory test provides valuable information, and should improve the exam process, we caution against using the standard non-maturity share valuations exclusively as they have the potential to overestimate IRR and hinder earnings.
For our ALMPro clients, we included the NEV Supervisory Test in the report along with several additional scenarios for comparison purposes to help management strategize and plan if non-maturity deposit behaviors turn out to be different than history has demonstrated. In addition, we recommend periodically performing sensitivity testing of key assumptions within the interest rate risk model allowing the credit union to see the likely impact of various scenarios on its financial performance. For those credit unions not analyzing alternative scenarios and conducting sensitivity testing, we suggest they begin.
Multiple scenarios, including those put forth by NCUA, certainly provide valuable information when it comes to measuring, monitoring, and managing interest rate risk. We also counsel not adopting risk guidelines based on the NCUA supervisory test. Risk guidelines should be based on the unique financial profile and characteristics of each individual credit union.
From an operational perspective, we at Mark H. Smith Inc. see IRR for most small and midsized credit unions as low to moderate. Such risk appears to be manageable based on outcomes from previous rates-up cycles and current IRR modeling, combined with additional sensitivity testing. Credit unions should continue to monitor and estimate IRR and, in those instances where IRR appears to be greater than desired, take proactive measures to lower the estimated risk.
The Federal Reserve Open Market Committee is expected to raise the Fed Funds target range by 25 basis points two to three times in 2017. We believe that for a majority of small and midsize credit unions, such a rise would be very manageable. It may present the opportunity to put some added basis points into the net interest margin and allow many credit unions to begin operating more profitably.
We wish you success in all of your endeavors in 2017. If you have questions or would like to further discuss some of the points in this article, feel free to give us a call.