As credit unions develop contingent funding scenarios to test against contingency funding plans, the solution to a liquidity event is perhaps as important as ensuring the scenario is both realistic and rigorous.
In working with various credit unions, solutions to liquidity scenarios range from CD promotions to brokered (non-member) deposits to borrowings and lastly, to selling investments. If a contingent scenario also includes a change in interest rates, selling investments may seem unpalatable due to the loss. However, what is the decision driver that is being considered when evaluating alternatives? Is it focused on earnings or focused on net worth?
Take the example of two potential solutions below. Option A solves $10M of deposit run-off from the liability side of the balance sheet replacing the deposits with another liability â€“ Promotional CDs. Option B solves the deposit run-off from the asset side of the balance sheet selling term investments at a loss.
Above, Option A impacts 1-year earnings ($175), all else being equal. Option B impacts 1-year earnings ($500). However, compare the resulting net worth ratios. Option A results in a ratio of 9.89%, which decreases from the beginning net worth ratio, but Option B results in a ratio of 10.39%, which increases from the beginning net worth ratio.
If the liquidity scenario cannot resolve itself through normal balance sheet runoff, which could be the case if the runoff occurred over a very short time horizon, any potential solution should consider not only earnings for the current period, but more importantly the impact to net worth. This is especially important if the loss of liquidity occurs as rates rise â€“ â€śnormalâ€ť balance sheet runoff may slow materially as rates rise and existing assets extend.
Remember, the NCUA has recently commented â€śNet worth is the reserve of funds available to absorb the risks of the credit union, and it is therefore the best measure against which to gauge the credit unionâ€™s risk.â€ť