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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.

 

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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.

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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.

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Raging Payment Battle Requires Purposeful Strategic Thinking

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Today, July 12, is Amazon’s Prime Day.  As part of the event, they are encouraging their members to apply for their Amazon Prime Store Card, which, among other features, offers 5% back on eligible Amazon purchases.

The raging battle for payments continues to escalate.  Amazon is just one more threat to interchange income.  If you want interchange income to continue to be a primary source of revenue, then you must fight this constant battle with constant strategic thinking.  The right business questions need to be asked – and answered – in order to turn strategic thinking into strategic action.  Specific to Amazon, business questions that can be asked could include:

  • How much interchange income are we earning from members’ transactions with Amazon?
  • What would it cost us if we lost 25% or 50% of the Amazon-related interchange income to Amazon?
  • Which members of ours use our card with Amazon and carry a balance?
  • What actions can we take now to protect, and maybe increase, this interchange income?
  • If payments are a critical component of our strategy, how does our strategic thinking need to change so that we are proactive instead of reactive in this arena?

Regarding the questions above, considerations include:

  • Embrace the brutal fact that providing various payment options to your members increases costs and does not guarantee member usage and engagement.  You must be deliberate about creating and monitoring initiatives that promote valuable member engagement
  • Decide if interchange income is going to be a major and/or permanent source of income for you.  If it is, you can’t always be reacting to what traditional and non-traditional competitors do.  You may consider creating a position of CPO (Chief Payments Officer), who has the mandate to increase member usage of credit, debit, and prepaid cards
  • Take a critical look at your business model, with the intention of removing non-value add products, services, and back office processes, to free up resources for those things that do add value for your membership and potential members

You can read more about Amazon Prime and their credit card here.

In an upcoming blog, we’ll discuss the broader payments battlefield, and how purposeful strategic thinking can keep you in the battle.

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NCUA – Rethinking NEV

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It’s no secret that the NCUA is planning to implement new guidance for net economic value (NEV) testing this year.

From NCUA’s recent open meeting, some key elements of the new guidance include:

  • Non-maturity deposit (NMD) values will be capped at a premium, not to exceed 1% in the current rate environment.
  • NMD benefit will not exceed 4% in a +300 bp rate environment.
  • NMD guidelines may need to be re-calibrated over time.
  • Risk thresholds:

NEV Supervisory Test - Risk Thresholds Source: NCUA Board Briefing

The new test is being designed to support the NCUA’s responsibility with respect to understanding risks to the insurance fund, and is intended to create greater comparability between credit unions. Credit unions will still be expected to run their own A/LM analyses, to understand risks to earnings and net worth, and support their internal risk management and decision-making.

Having modeled thousands of NEV simulations, NMD values are arguably the most significant wildcard.  For most of our clients, we already model at least two views of NEV: one using their base case assumptions for NMDs and another showing shares at par. Historically, NEV with shares at par was used by examiners to get the same comparability concept, and to limit the variety of deposit assumptions.

Shares at par ascribes no market value to the shares, thereby removing any benefit of low cost deposits from the analysis. The new guidance then, at least with respect to shares at par, would be some improvement. Keep in mind, though, that any standardization of deposit values would hide any material differences in deposit pricing between credit unions.

However, no matter how much rethinking of NEV occurs…

…NEV, even with standardized assumptions, is still not going to address fundamental business issues. For example:

  • NEV doesn’t recognize the different earnings contributions and the risk/return trade-offs that exist between assets.
    • Overnight investments earning 0.50% devalue less and perform better in NEV than a fixed-rate loan yielding 4.00%. It’s important to note that the loan contributes greater revenue in the current rate environment, as well as in a +300 bp rate environment.
    • A $10 million purchase of a new headquarters would not show any hurt to NEV results because the asset would not devalue as rates increase, but it would have an impact on earnings over a very long-term horizon.
    • Moving from mortgages to autos would reduce NEV volatility in a rising rate environment, but NEV would not show you the possible reduction in earnings power.
  • The standardized assumptions still do not distinguish between pricing for share drafts, regular shares, and money markets. Therefore, a credit union could pay 1 bp on all NMDs or 100 bps, and the NEV results would not be different. But of course, the earnings would be drastically different.
  • NEV won’t tell you if you’re making or losing money. The previous bullet is a great example of this fact. For this reason and many more, NEV won’t show you risks to profitability and if the decisions you’ve made, or are considering will cause your net worth to fall below Well Capitalized.

To sum it up, NCUA has a new test. Passing NCUA’s test does not replace the need to understand short- and long-term profitability, risks to profitability, and risks to net worth. Understanding and managing these risks are directly related to creating a relevant and sustainable business model.