What-Ifs Help the Budget Process

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Testing ideas and running what-ifs is a powerful way for decision-makers to understand the impact of decisions under consideration in real-time (for more on this, please refer to our blog, Has your ALM technology Emerged from the Dark Ages?).  The power of what-ifs can also be applied to the budgeting process, and help link decisions made in the budget to the impact on a credit union’s risk by answering three risk-related business questions:

  1. How much could current earnings change if decisions under consideration are implemented?
  2. What are the profitability and risk trade-offs of decisions under consideration if rates change?
  3. What is the break-even point of decisions under consideration?

Budgets help answer the first question and don’t address the next two questions. The answers to these two questions could impact the credit union’s ability to deliver on its strategy.

Credit unions should create a target financial structure by running their budget through their risk model to understand the overall risk of the budget coming true (for more on this, please refer to our blog, Testing the Budget’s Interest Rate Risk). What-ifs help decision-makers evaluate the risk trade-offs of key decisions and forecasts during the budgeting process.

Not all decisions need to be run through the risk model during the budget process – this is how the target financial structure is helpful. Rather, decision-makers can test three or four of the key decisions or expectations that are driving the budget, both for revenue and expenses, and run a what-if to quickly understand the risk impact.

An example might be that the lending department believes they can generate a high amount of growth in mortgages in the coming year. This would be a key driver of revenue for the credit union. Decision-makers can run a what-if on this expectation and determine if they are comfortable with the risk/return trade-off.

Using what-ifs allow decision-makers to be more nimble during the budgeting process, and make changes along the way if they determine the risk/return trade-offs of key initiatives are out of their comfort zone.

Long-Term CDs – Questionable Cost of Funds Protection

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The 10-year Treasury closed below 1.40% 3 days in July!

The flattening of the yield curve has many folks worried about further pressure on net interest margins. Some, though, are hoping to extract a benefit by locking in long-term funding at historically low interest rates. As an Asset/Liability Management (A/LM) strategy, this approach employs the trade-off between paying something more today for protection in a potential rising rate environment in the future.

The use of long-term, competitively priced Certificates of Deposit (CDs) is one common approach to achieving this goal. But there are risks in making that strategy work.

Consider a credit union offering these competitive CD rates:

CD Term TableA member selects the 7-year CD earning 1.80% and invests $100,000. At the end of 2 years, the credit union has paid $3,600 in interest on the CD as expected. The credit union and the member are happy. Then, at the end of year 2, CD market interest rates increase by 100 bps.

How would a member be expected to react?

  • Calculating The Advantage to WithdrawWith 5 years remaining in the term, a comparable 5-year CD would be about 2.65% (1.65%
    from the table above plus the 100 bp market interest rate increase), versus the 1.80% currently being earned.
  • The difference of 85 bps equates to an opportunity to earn an additional $4,250 over the remaining term.
  • The member must also pay the early withdrawal penalty of 6 months interest, which equates to $900.
  • A net benefit to the member (advantage to withdraw) of $3,350 is left to pay off the original CD and reinvest in the new CD.
  • Considering the financial analysis, the member opts to pay the penalty and closes the CD.

The credit union paid the member a higher CD rate during the first 2 years for protection it did not receive in years 3-7 when CD market interest rates had increased.

Why did the strategy not work? 

The opportunity to earn more interest on a new CD when market interest rates increased greatly outweighed the penalty to early withdrawal.  This is an issue for any long-term CDs that include an option for early withdrawal.  If market interest rates become more favorable early into the life of the CD, the number of years remaining will often create a benefit that outweighs typical early withdrawal penalties.  Contributing to the issue is the flat yield curve, which means even small market interest rate increases can create a net member benefit using shorter-term CDs.

In fact, using the example above, at the beginning of the 7-year term the market interest rate would only need to go up 13 bps for there to be an advantage for the member to withdraw early.

By the end of year 2, with 5 years remaining on the CD, the rate would only need to go up 19 bps.

Consider again the 7-year $100,000 CD, and let’s look at the net benefit to the member each year if CD market interest rates changed by +100 bps or +200 bps. The net benefit is calculated simply as:

  • New CD expected lifetime interest earned (keeping the overall maturity at the original 7 years)
  • Minus the existing CD interest lost through maturity by closing the CD
  • Minus the early withdrawal penalty

In the table above, notice that when using a 6-month penalty, the member benefit is positive until the end of year 4 for a +100 bp rate increase.  This means that if the CD market interest rate were to go up by 100 bps in any of the first 4 years, the member could reasonably be expected to close the CD.  Beyond the end of year 5, in a +100 bp rate increase, the early withdrawal penalty provides a disincentive to close the CD.  Notice too, that a 6-month early withdrawal penalty leaves the member with a positive benefit through year 6 in a +200 bp rate increase.

The following tables increase the penalty by an additional 6 months each. A 12-month penalty creates disincentive after 3 years in a +100 bp rate in increase, and begins to create some disincentive after 5 years in a +200 bp rate increase. An 18-month penalty encourages the member to stay in the CD for 2 years in a +100 bp rate change.

The point is that the longer the CD, the more difficult it can be to design it to provide effective cost of funds protection in a rising interest rate environment. Typical early withdrawal penalties are not likely to be enough to make the interest rate risk strategy successful.

Credit unions may need to consider stiffer penalties for members that want to lock in a long-term investment. If the objective is risk mitigation, an option could be to have the penalty be half the term. Another option that is more complicated to explain and disclose, is to have the penalty equal to the replacement cost (present value). Each option has a trade-off and it is important to balance member perspective. An option is to have a materially lower rate with the traditional penalty and then label the more aggressive rate an investment CD (stiffer penalty). Of course, management might also consider other A/LM tools, such as long-term, non-callable borrowings, to help protect the cost of funds in a rising rate environment.

Has Your ALM Technology Emerged From the Dark Ages?

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In this wonderful world of amazing technological advances, member-facing technology provides convenience and ease of access that was unimaginable in the past.  Huge strides have also been made in supporting technologies, such as putting relevant data at employees’ fingertips for cross-selling, automated loan decisioning, and mining member data for marketing opportunities.  The same can be done for asset/liability management (ALM).

ALM modeling used to require hours to run on early computers and, before that, you can imagine how long it took to do the calculations using paper and pencil. Of course, those early methodologies had to be simple and it was impossible to render results quickly, so people got used to slow analyses that were already irrelevant by the time they were complete.  ALM was relegated to a dusty back room and offered to regulators to satisfy their check boxes.

Fast-forward to today – if ALM is not being used to make business decisions in real time, it may signal the need for a mindset change.  A vast array of decisions – from changing the loan portfolio to adding branches or reducing operating expense – can be tested for their impact on profitability and the risk profile.  Imagine sitting around a table discussing ideas and initiatives, and testing their potential profitability under numerous economic conditions.

ALM modeling has come a long way and deserves a place at that table, serving as one of the pillars good decision-making rests on.  This type of decision-making links strategy and desired financial performance for long-term success.

Now more than ever, it is important to view ALM as a powerful weapon to help remain relevant as competition and consumer preferences continue to change. Demand more from your ALM and start using it to help gain and maintain that competitive edge.

 

Interest Rate Risk in an Auto Loan – Really?

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The competitive landscape for auto loans has fundamentally changed over the last 15 years.  There are more non-traditional lenders vying for autos and non-credit union lenders have been saturating the indirect lending market.

These trends put pressure on pricing and take a bite out of the auto lending pie.  As a result, financial institutions are getting creative with pricing and terms.  As this occurs, questions to consider need to evolve.

One example is the increase in 10-year auto loans, which we are seeing as we conduct interest rate risk simulations.

Consider:

  • How might prepayments differ from a shorter-term auto loan?
  • Is it reasonable to assume that a consumer wanting a 10-year auto will prepay the loan at the same rate as a 5-year auto loan?

There is not an abundant amount of prepayment data on this type of loan to answer the questions above, so, test the impact.  In the table below, notice the escalation in average life as well as the balance remaining after three years and five years.  If the prepayment rate on this term of auto loan is 10% then more than half of the balance would remain after three years, and nearly one-third would remain after five years.

10 Year Auto Loan Table SM 080416

So yes, these loans bring more interest rate risk.  If these types of loans become more prevalent, it will be important to change mindsets with respect to interest rate risk and auto loans, not to mention the risk of negative equity that comes hand in hand with the extended term.

Consider the potential impact of CECL on longer-term auto loans.  For example:

  • What if the auto loan is actually underwater for a material portion of the time it is outstanding?
  • Do the potential risks mean financial institutions should not do long-term auto loans?  There is no easy answer or one-size-fits-all response.  Each executive team needs to decide their product offering in light of their value proposition, appetite for risk, and financial strength.

What we do know is that the questions need to evolve to appropriately identify and manage the risk.

Be Clear on Your Objective of Doing a Core Deposit Study

Earlier this week we presented at a virtual roundtable with 100+ CFOs, and one of the most common questions centered around the benefits, or lack thereof, of doing core deposit studies for use in net economic value (NEV).

It is important to study member behavior with respect to deposits, including migration, pricing strategy, and competitive and economic environments.

Below are just a few examples of this type of information for the credit union industry. It is prudent for each credit union to understand its unique patterns of member behavior.

Example: Distribution of deposits has changed over time and through various economic cycles.

Percentage of Assets

Example: Pricing strategy has changed through various economic cycles.

MMKT CUs Over 1B
Example: Average balances relative to new accounts has changed since the last rate peak.

Deposit Growth

If you are willing to dig deeper, it is extremely valuable to understand how your deposit balances by age have changed over time ̶ a potential looming issue is that for most credit unions, large deposits are held by the older generation.

The objective of this type of business intelligence is to inform strategy. These risks can impact the credit union’s cost of funds in different environments (impacting profitability), and can be critical in identifying liquidity risks. These issues are very different than the objective of typical core deposit studies, which is to estimate decay rates and maturities of non-maturity deposits to be used most often in NEV. NCUA has released a new NEV test that standardizes the value of non-maturity deposits in the current rate environment and +300 bp shock.

So, if you are thinking about studying your deposits, be clear on your objective before spending money. If your primary objective is to use NEV, you may want to evaluate the cost/benefit in light of NCUA’s new standardization.