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How is Your Modeling Positioned to Capture NCUA’s “Chief Concern”?

October 9, 2014

In the most recent NCUA Economic Update, John Worth (Chief Economist, NCUA) outlined NCUA’s chief concern regarding the impact of a changing rate environment, given an interpretation of recent Federal Reserve comments and data analysis. See below for a key quote from the video:

“If the increase in short rates is larger than the increase in loan rates, that is if the yield curve becomes flatter, credit unions could likely see a narrowing of net interest margins. We have already noted that non-interest income has moved lower recently. If that trend continues while net interest margins are also shrinking, many credit unions will face declining net income or even losses. Here at NCUA, our chief concern is that credit unions are aware and prepared for this possibility. Credit unions should have a firm idea of how their income statements and balance sheets are affected by a rapid rise in short-term rates, and they should have a plan for dealing with the potential consequences [emphasis added].”

Credit unions that rely on static balance sheet measures of non-interest income volatility, net economic value simulations and parallel rate changes will miss the impact on their financial structures of NCUA’s chief concern – the simultaneous impacts of a compressed net interest margin and a decline in non-interest income. As conventional methods of risk management lack the ability to quantify this key risk, credit unions using such methods must turn instead to their budgeting process. However, does the current budget process enable “what-if” scenario analysis that can incorporate the possibility of rising short-term rates? Said differently, how could your credit union’s earnings and financial structure change if cost of funds increases and new asset yields remain stagnant, thus further compressing already historically low net interest margins?

Understanding the possible impacts to planned strategies in the event rates begin changing in 2015 would add valuable information to the decision-making process. Let’s say a budget “what-if” includes a rate change and margin increase through lagged deposit pricing assumptions and aggressive movements in loan and investment portfolio new volume rates. The impact on the base budget in this “what-if” should be fairly clear – earnings increase. This is especially true if such a change in rates does nothing to alter assumptions regarding consumer behavior (i.e., projected loan volumes and deposit funding mix from the base budget do not change).

Management teams should include an analysis of the impact on earnings and financial structures from an increase in short-term rates only, leaving long-term rates flat, in their budget “what-ifs” (projections) and scenario analysis. This is especially important if the risk management tool utilized in the A/LM process lacks the ability to inform the credit union of this risk.

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