Most liquidity concerns today revolve around having too much liquidity without viable investment opportunities. However, after the recent (and sustained) flight to safety, some credit unions are beginning to consider the potential impact of liquidity leaving insured financial institutions.

In the short-term, a liquidity event may be significant deposit run-off or draws on unfunded loan commitments (i.e. HELOCs or credit cards). Responses to such events may include reducing member lines of credit, increasing borrowings, selling AFS investments, or some combination of the above. However, prior to relying on these actions, management teams should evaluate their contractual ability to exercise certain options. Some important considerations include:

1. Can unfunded loan commitments be revoked? If so, what are notice or disclosure requirements? If the loan is business-purposed, are there any special considerations needed?
2. If an unfunded loan commitment can be reduced, are there limiting conditions? For example, some real estate-backed lines of credit may be reduced without advance notice only if the collateral value has declined since the approval of the loan. If home values have appreciated, the credit union may not be able to reduce lines.
3. What AFS investments, if any, are encumbered through line of credit contracts with a correspondent financial institution?
4. If the credit union’s safekeeper also provides a committed secured line of credit, what operational concerns are there if the credit union advances funds through the line and also plans to sell investments?
5. What is the cutoff time or advance notice requirement for drawing on a committed credit facility? Does the cutoff time or advance notice requirement change based upon the terms under which the credit union is requesting funds, even if through the same correspondent financial institution (i.e. repurchase agreement vs. term borrowing)?

Many credit unions may have materially more considerations to make than those noted above. Every credit union should evaluate liquidity options and understand potential courses of action well before they are needed.

More institutions are being presented with NCUA’s Interest Rate Risk Questionnaire in advance of examinations and being asked to fill them out. During the preparation for an examination, this may seem like the last thing a busy management team should be concerned with, but it should be taken as an opportunity to refresh credit union management teams on how they approach interest rate risk management.

Think of filling this questionnaire out as sort of a pre-test; it provides an advance look at questions an examiner will likely
ask – or will at least seek to answer – during the course of an exam. Below are some sample questions, along with considerations that should be made in determining how to answer:

1) Are the IRR measures and tests sufficiently rigorous to capture the credit union’s IRR?
The answer to this question should be addressed taking into consideration each specific credit union’s financial structure and complexity, but some key considerations should be:

• Does the analysis look beyond the traditional 300 basis point rate shock? Does it automatically twist the yield curve?
• Do you stress test key assumptions at least annually? Key assumptions minimally include deposit behaviors and prepayment speeds.
• Do income simulations extend beyond two years?
• If NEV is used, do decision-makers understand that three significant sources of risk (high operating expense structures, increasing credit risk which impacts provision expense, and threats to non-interest income) do not impact NEV? It is prudent to assess these threats to earnings and net worth outside of NEV simulations.

2) Do the management and board understand the level and nature of IRR taken by the credit union?
Many management teams may be hesitant to answer this question because it could be taken in so many different contexts (and there are so many different levels of understanding). In responding to this question, consider:

• Can our management and board articulate if the credit union has interest rate risk present in the structure, and if so, at what market rate level does this materially impact earnings?
• Can our management and board comment on whether the credit union is within risk tolerance levels (limits)?
• Can our management and board comment on the potential interest rate risk impact of executing on board-approved long-term strategic plans (i.e., “Are we planning on taking more or less interest rate risk, and why?”)?

The above questions are only two of the over 100 included in the questionnaire. While there is a lot to consider, if presented with the opportunity to fill this out in advance of an exam, taking it as a preparation step or a “pre-test” should help to ensure a more productive conversation concerning interest rate risk in the upcoming exam.

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Below are some questions to consider when implementing strategic planning:

• Does everyone know their part? Sometimes, participants in a strategic planning meeting do not understand why they are there.  They may be in the meeting because someone asked them to attend, but they don’t understand that their opinion might be valuable.  Everyone should feel comfortable speaking up, asking questions and pushing back when appropriate.  To do this, everyone in attendance should know why they are investing their time in the meeting
• Are personal agendas left at the door? Some participants might believe that a strategic planning meeting is the perfect opportunity to include their personal agendas in the credit union’s future plans.  For instance, a participant might want to beef up technology for personal ease of banking.  But if the credit union’s target market and chief source of profitable income abhors technology, then this agenda should be left at the door.  Setting decision filters that are kept top of mind as strategic decisions are made can help keep the group focused
• Is the group abiding by the agenda? To make best use of everyone’s time, the group can self-monitor discussions to make sure they continue to be productive—even if they have diverted into a tangent topic.  As long as the discussion furthers the credit union’s goals, it can sometimes be healthy to veer from the agenda.  But if the group’s strategic discussion has dissolved to off-topic items that do not benefit the goal of the meeting, it may be time to refocus or take a quick break

Credit unions must strike a delicate balance between serving members and being profitable.  Strategic planning that is strategically planned can help guide decision-making as you strive to achieve that balance.

When conducting a recent credit union model validation, we were asked why the model showed a loss on 30-year mortgages when the credit union intended to show a market value gain.  The account was discounted to the yield curve plus a spread with the intention of having the discount rate equal to current offering rates.  Given that the yield on the account was materially higher than the discount rate, a market value gain would have reasonably been expected.  Digging further into the details revealed the cause of this issue:  slower-than-average assumed prepayment assumptions.

The credit union’s decision to slow down prepayment assumptions pushed more maturing cash flows further out on the yield curve, to a point on the curve where the discount rate was actually higher than the portfolio yield.  The cash flows further out on the curve were at a sizable loss, enough of a loss to wipe out all of the gains on the maturing cash flows at the shorter end of the curve.  In the end, the credit union made adjustments to deliver a result more in line with its expectations of the portfolio’s value.

While this example represents an unusual situation, the takeaway here is simply to stay on the lookout for unexpected results. Always ensure that your modeling results make sense to you. Understand and verify the accuracy of any unexpected results, or make adjustments as appropriate to correct the problem.

Unsurprisingly, many credit union leaders continue to watch their net interest margins erode in this continued, low rate environment. In fact, net interest margins have dropped to levels not experienced in over 20 years, dropping below 3% throughout all of 2012 trending down to 2.93% as of December 31, 2012 according to NCUA aggregate data.

What can be surprising is the improvement in ROA reflected in NCUA’s aggregate data. Let’s examine how much better ROA actually is compared to December 2011. While many will point to the overall ROA, it’s interesting to examine the difference if you ignored the impact of stabilization expense and NCUSIF premium. The improvement in ROA year-over-year as of December 31, 2012 is only 7 bps compared to an almost 20 bp improvement if you factor in the decrease in these expenses.

Regardless, with margins continuing to decline, how sustainable are current levels and trends of increased ROA? As you review financials within your ALCO, consider the following objective:

Communicate the impact of components of earnings that have experienced aberrations. Adjustments demonstrate the difference between the earnings reported on financials and the earnings that can be considered core to the institution.

Following are a few examples of aberrations that may be inflating ROAs unsustainably:

• Record levels of mortgage originations/sales
• Unsustainably-low PLL
• Gains from the sale of investments?

2013 budgets may plan on some or all of these things continuing. Consider stress testing the budget to see the effect if these items do not continue. Furthermore, go beyond one year and stretch out the budget where 2014 and beyond does not count on these items continuing; this can help uncover a potential squeeze to earnings. Then test the impact to the risk profile of this future position.

Yield tables provide a wealth of information to evaluate prospective investment purchases.  Take the example below.  The screen shows the coupon and the prices as well as possible prepayment speed, yield and average life depending on the rate environment.

Keep in mind the importance of the prepayment assumption when there are large premiums (as indicated by the 108-13 Price).  The calculated yield would be materially lower if any of the historic prepayment speeds were used.  For example, looking at the -100bp rate environment, the prepayment speed is 712 PSA which matches the 6-month experience of this investment.  The yield with the higher prepayment speed is now almost breakeven at 0.071% compared to the 0.825% with the 460 PSA.   The difference in yield is drastic and likely changes the decision a credit union would make.

The question is, why is a lower prepayment speed being used?  It could be an expectation that prepayments will slow in the future or it could be that the higher resulting yield makes the investment look more attractive.  Historical prepayment behavior may not be an accurate predictor of future prepayment behavior, so the prepayments could slow down.  However, using history is a reasonable starting point for understanding what the possible yield is.  From there, decision-makers should test a range of prepayment speeds in order to understand the yield impact and make sure they are comfortable with the possibilities.

This is a statement heard more frequently in the past couple of years.  For those thinking it, here are some questions worth considering.

Question 1:  Is my lending process working for me?

The economy shows glimmers of improvement, with home values up and consistent increases in new auto sales as some evidence.  Before turning to investments, make sure your core business is maximized.  It is important to count your business – every day; as noted in the article Thriving In A World Of Shrinking Margins, questions to consider include:

• How many loan applications are we getting? How many are we approving? How many are we funding?
• If our approvals are low (compared to the number of applications), are we attracting the wrong borrowers and, in the process, hurting our reputation?
• If our funding rate is low (compared to the number of approvals), what can we do to improve it?

Question 2:  Is my business model working for me?

If you feel your loan department is doing the best it can, then a bigger question may need to be asked: Are we chasing the right target market? Consider that, at the end of 2000, the credit union industry had 20% of its loans in new autos and 20% of its loans in used autos.  Fast forward to 2007, as the recent recession was about to flex its muscles, the numbers had dropped to 16%, respectively.  As of September 2012, the percentages stood at 10% and 18%, respectively.  The numbers represent a declining market share in new autos.

Count your business and find other numbers that can tell a story:

• How many branch transactions do you have today relative to just 3 years ago?
• How many online banking and mobile transactions do you have today compared to 3 years ago?
• Segment your borrowers by age and you may be surprised that your borrowers are not as young as you think.

The trends in auto loans, branch use, electronic transactions and the shifting demographic of borrowers are signs that a business model that was successful in 2000 may need some fine tuning for a sustainable future.

A fine-tuned business model may realign priorities and resources and you may not need to rely so much on your investment portfolio.

Question 3:  Is it a good thing that my investment portfolio is not working for me?

Some credit unions have a high loan-to-asset ratio and strong earnings and still feel like they’re leaving money on the table because their relatively small investment portfolio is earning little. Before focusing on the performance of one slice of your financial structure, understand how the whole structure is working together. It may be that a low-yielding investment portfolio may be providing you with interest rate risk protection you need from the longer-term loans you made for the benefit of your membership.

As members continue to adopt online channels, the online “face” of your credit union may be the only face many of your members see on a regular basis. Is that online/mobile experience on par with the branch or phone experience you strive for?

In the rush to keep up with expensive technology advances, credit unions sometimes implement solutions intended to bridge a gap until more time or money is available to “do it right.” As those decisions are being made it’s important to understand how your members want to interact online and to focus on making those functions easy and efficient to use.

Online account opening, which may be a potential member’s first interaction with the credit union, is sometimes plagued with too many screens, timing out after a short interval, or not saving the member’s work if they need to leave and return. This is akin to someone in the branch wadding up and throwing away the member’s application if they took too long to answer! Other factors that diminish the member’s online experience are loan applications that force the member to enter information that the credit union already has (usually due to systems that aren’t integrated) and mobile applications that are slow to load or do not make critical functions easily accessible.

With mobile banking representing about 8% of transactions and online banking at 53%, these channels will continue to increase in use and already represent the main avenue of interaction for many members. Understand what your members want to do online and do it on par with the member experience via other channels. It’s just as important as making sure the paint isn’t peeling off the walls in a branch.

Source:  Banks Make Smartphone Connection, WSJ, 2/11/13