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Derivatives – Another Option For Helping Mitigate Interest Rate Risk

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The Federal Reserve signaled their expectation to continue Fed Funds rate increases in 2017, but substantial uncertainty remains about when and where market rates will move.  Credit unions can find it challenging to achieve a desirable ROA today while maintaining an acceptable level of risk should market rates increase.  Decision-makers have a variety of options available for attacking interest rate risk challenges, and derivatives can be another useful arrow in the ALCO quiver.

Some of our clients are using or considering derivatives as a tool for mitigating interest rate risk.  While c. myers does not sell derivatives, we regularly model their impact on our clients’ financial structures to show the risk and reward trade-offs.

Derivatives can be thought of as purchasing insurance.  As an example, consider your purchase of an auto insurance policy.  You pay a premium to provide protection for your car from accidents, theft, etc.  The premium may be paid over the course of years.  If the car is never damaged or stolen, the insurance protection is never used or realized.  Overall of course, you’re probably happy that the insurance wasn’t needed.  Was the insurance valuable?  Was it worthwhile?

Derivatives operate similarly to protect against interest rate risk.  There are a variety of derivatives available to credit unions.  To illustrate some of the key attributes, let’s consider caps and swaps.

A cap is insurance purchased for a fixed price up front and provides protection for a specific time frame (the term) for market rates that go above a specific level (the strike rate).  Credit unions establish a notional balance, say $100 million, which never exchanges hands but is used like a principal balance for determining the interest payments.  If market rates increase to a point where they exceed the strike rate, the difference between the market rate and the strike rate is applied against the notional balance and paid to the credit union.  The cost of this insurance is largely determined based on the strike rate and term desired by the credit union, but again it is known and fixed up front.

Unlike a cap, an interest rate swap is not purchased for a fixed price.  In fact, there is no up-front cost for the swap.  Rather, two parties agree to pay each other different interest rates on a given notional amount for the term of the swap.  One party will pay a fixed rate, while the other will pay a variable rate based on an index such as LIBOR.  The idea is that as market rates increase, the variable rate could at some point exceed the fixed rate payment and offer protection to the fixed rate payer.  Consider the following interest rate swap example with a notional amount of $100 million, where the credit union pays a fixed 2.25% rate and receives
1-month LIBOR.

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In this example, for simplification, an instantaneous rate change was assumed.  However, the timing and direction of market rate changes will ultimately determine the resulting cost or benefit of the swap over its term.

Derivatives can be a valuable tool for credit unions to consider within their interest rate risk management strategy.  When deciding whether to use derivatives, it is important to understand both the expected interest rate risk protection, as well as the potential costs within a range of rate environments.  It also makes sense to ask how the protection may change over time and whether there are circumstances that might make the protection not as valuable.  For more detailed information about derivatives and understanding key considerations, please see our c. notes paper, Considering Derivatives?

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3 Common Lending Misconceptions to Avoid

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In a recent blog, we posed 4 questions that you should answer about your lending experience.  Today, we want to drill down a little further into some common beliefs that have, more often than not, been disproven by the data.

1.  We prioritize service for our direct members. Do you think that the loans you make directly to your members should take longer than loans initiated through dealerships?  Most would say no, but it’s common to see that times for approval and funding are slower for direct lending channels.  On the surface it doesn’t make sense, but the dealer space is competitive.  Credit unions know they must act quickly or lose the deal, so those processes are designed for speed. It’s not that credit unions want to make their “real” members jump through hoops and wait longer while offering a streamlined process for booking loans to people they don’t know at lower rates, it’s often a lack of focus on improving direct lending processes.
Action Item: Don’t go by your gut.  Actually count your lending business by tracking how long it takes for the different channels.  Hint: Look at it by credit tier, too.
2.  We are staffed appropriately for when our members want to do business. Lending data often shows a dip in the number of loan applications 17-02-cl-blog(apps) that come in during lunch time.  This seems counter intuitive until you look at staffing during those times.  People need to eat, so it is common for fewer representatives to be available just when members want to drop by at lunch to talk about a loan.  A mid-day dip in loan apps could mean that members are walking away or hanging up because the wait is too long.
Action Item: Track application received times for branches and call centers, and look at scheduling if they drop in during lunch.  Note: When we analyze by channel, we don’t generally see any slowdown in online and mobile applications during lunch.
3.  Approval times for our online and mobile apps are longer than branch/call center because most of them come in outside of business hours. The numbers don’t usually bear this out.  While some apps are received outside of hours, the bulk of online and mobile apps are typically received throughout the week during business hours.  If that’s the case and those members are waiting longer for a decision, it could indicate a poor process for handling those apps.  Consider that members who choose to apply via digital channels may be expecting a fast, easy, FinTech-like experience.  Credit unions that deliver a clunky experience run the risk of not getting a second chance.  Even if the software interface isn’t where you want it to be, the rest of the process can still be fast and efficient.
Action Item: Track the approval times for online and mobile apps.  Track those that come in during business hours separately for a clearer view of the member experience.  Hint: Look at them by credit tier, too; don’t assume they are all low credit or frivolous applications.  It is true that digital apps have some unique challenges, but there is big growth in this channel, so getting great at processing them is key.

The biggest challenge in validating assumptions is simply recognizing that they exist.  Any time you find yourself saying, “Oh that’s because…,” pause for a moment to consider whether it’s actually an assumption.

There is a treasure trove of data at the fingertips of most credit unions that can be used to ferret out the truth about assumptions once they’re identified.  The 3 misconceptions in this blog were uncovered by going beyond looking at overall funding ratios and other common high-level metrics.

Slicing and dicing the data that’s readily available by credit tier, product, delivery channel, branch, and time received, to name a few, and tracking trends over time creates actionable business intelligence that sparks the necessary questions.  Expanding queries beyond lending to account opening and other areas could also reveal many meaningful, valuable process improvement opportunities.

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Interest Rate Risk Management: Timing of Earnings Matters

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Would it surprise you that some interest rate risk mitigation strategies actually add risk for a period of time?  In the end, these strategies may be effective at mitigating interest rate risk but it may take years for the effectiveness to be felt.  The challenge is that many methods used to test mitigation options, like NEV, don’t show decision-makers the full picture.  The reality is that earnings and the timing of earnings matter when understanding the impact of different decisions.

Take for example, a credit union that decides to sell $90.0 million of its 30-year fixed rate mortgages earning 3.61% and reinvest in auto participations earning 1.90% to mitigate interest rate risk.  No surprise that such a move hurts earnings today.  In fact, it would hurt earnings by 23 bps.

What is not obvious, though, is that in a +300 bp interest rate environment they would give up more cumulative revenue with a strategy to hold auto participations than with a strategy to hold fixed-rate mortgages over a four-year time horizon.  Year-by-year and cumulative revenues for both strategies are summarized below:

The credit union would earn more revenue holding fixed-rate mortgages than holding auto participations for each of the next three years.  It is not until Year 4 that the strategy change pays off and they earn more holding auto participations.  Over the four-year period, the credit union would earn a cumulative $15.0 million with mortgages versus $13.5 million with auto participations in the +300 bp increase.  Timing of earnings matters.

Using only NEV to evaluate this strategy might lead the credit union to pull the trigger on it.  In this case, the credit union is using NCUA’s NMS values from the NEV Supervisory Test.  When comparing the proposed strategy to the base, the NEV in the current rate environment is unchanged at 10.75% – meaning the restructure neither helps nor hurts the current NEV.

However, after selling the mortgages, the volatility decreased in the +300 bp environment leaving a higher NEV ratio (see example above).  An added benefit is that the credit union would now be considered low risk under NCUA’s NEV Supervisory Test thresholds.  Said differently, the NEV results show decision-makers would not have to sacrifice a thing in the current rate environment while significantly reducing risk in a +300 bp interest rate change.

Earnings (see Beginning ROA), on the other hand, show there is sacrifice in the current rate environment and more risk to earnings and net worth in a +300 bp rate environment over a four-year time frame.

The moral of this story is not that all credit unions should always hold mortgages because they will earn more than other alternatives.  Certainly, not.  It should be clear, though, that NEV provides credit union decision-makers with a limited picture.  Earnings and the timing of earnings matter.  In this particular example, the credit union may decide to execute the strategy, but decision-makers understand, in advance, that even if interest rates rise quickly, it could take about four years before the alternative strategy will contribute positive earnings and start to reduce interest rate risk.

For more in-depth ways to use ALM as actionable business intelligence, please click here for our c. notes.

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Pay Attention to Liquidity

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As we conclude our budget and forecasting work with many credit unions, we continue to see expectations for loan growth to exceed share growth in 2017. Combining this trend with an assumption for higher interest rates could squeeze liquidity positions in 2017.

Callable bonds may no longer get called and mortgage related assets will extend if rates increase. In addition, deposit growth could slow or shift to more expensive deposits.

While we recently posted a blog on liquidity, we felt it was important to give another reminder to do advance planning in this arena.

Test your liquidity position under various scenarios. If you see pressure beyond your comfort zone, now is the time to have the strategic conversations about how the credit union will be prepared to respond without sacrificing longer-term strategic objectives.

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Focusing on Branch Profitability, Solely, Misses the Mark: 4 Things to Consider

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As consumers’ preferences continue to evolve, it is becoming painfully clear that focusing solely on branch profitability will provide an incomplete or even misleading picture for decision-makers.

Think of it this way.   Traditional branch profitability analyses often reward branches for living off the past. 

Consider a branch that has a large loan portfolio, creating a lot of revenue, ultimately leading to today’s high ROA for that branch.  However after taking a closer look, it may turn out that this branch hasn’t produced many loans over the past year.  In fact, they are one of the lower ranked branches in terms of loan production.  However, the high ROA shown in a traditional branch profitability analysis is the result of living off loan production from years ago.

Evaluation in terms of current ROA alone may result in missed opportunities to realign resources today in order to have intentional focus on strategic objectives and evolving trends.

The following outlines 4 things to consider that is guaranteed to enhance business intelligence with respect to delivery channel effectiveness.

1.  Expand the evaluation to all delivery channels.  Credit unions are investing heavily in self-service options for members.  Effective adoption of these options is key to remaining relevant for many credit unions.  A focus during on-boarding has proven to help with adoption and engagement of new self-service options

2.  Align measures of success for each delivery channel with the credit union’s strategy.  This requires decision-makers to be intentional about the purpose of each branch, the contact center, and digital delivery channels

3.  Take a holistic approach to metrics.  Rank them to align with the credit union’s strategy.  For example:

  • Membership Growth
    • Not all growth is created equal.  This can be evaluated by segments if there is a strategic emphasis on the type of membership growth
    • Assigning indirect autos to the closest branch can significantly skew results.  Consider evaluating and managing the indirect channel as a stand-alone delivery channel
    • The same holds true for membership acquired digitally.  If a branch is credited, decision-makers will not have clarity with respect to the effectiveness of their digital delivery strategy or the physical branch
  • Value-Add vs. Routine Transactions
    • Work with your team to distinguish value-add from routine transactions, then rank delivery channels accordingly.  For example, many are revamping branches to remove routine transactions so that value-add and complex transactions can be effectively and efficiently handled.  In this case, the metric would evolve around reducing routine in-branch transactions and increasing value-add transactions
  • Member Engagement & Feedback
    • Comprehensive delivery channel evaluations should incorporate what the members are saying about their experiences with the different touch-points.  Credit unions are investing heavily in digital delivery.  It is not uncommon to hear that member satisfaction with digital delivery is lower than that provided in branches.  If this is true for your credit union, ask yourself how this can impact member engagement and how the gap in member satisfaction can be narrowed
    • If the credit union has strategic emphasis on particular demographic segments, consider establishing metrics that align with this focus
  • Loan Growth
    • Rank current balance, short-term, intermediate-term, and long-term performance independently.  This addresses a common flaw of profitability studies that can focus too heavily on older loans
    • Rank major segments of lending by balance and recent production.  This provides an early warning if production is falling off
  • Share Growth
    • Consider category evaluations.  Delivery channels that rank high for regular shares or checking may benefit the credit union differently than those with a heavy reliance on money markets or CDs

4.  Weighting Is Key

  • Each of the above can be important to monitor, but not all of them will contribute equally to the credit union’s performance or strategy.  Consider the credit union’s strategic objectives and then use these objectives to help weight the importance of each category.  This intentional view of production and member experience, connected to strategy, creates better business intelligence for decision-makers than a traditional branch profitability analysis

Having a broader understanding of delivery channels in terms of contribution to strategic objectives and the trends exhibited is the first step.  This can then be combined with profitability estimates if desired.

As the financial services industry becomes more complex, it is important for decision-makers to have the right type of business intelligence so they can take action and make necessary course corrections, timely.