Don’t Forget to Look Down
August 8, 2018
For a very long time, asset/liability management (A/LM) and managing interest rate risk (IRR) were almost exclusively about what would happen if market rates rose. When rates were near zero, risk limits that looked down to negative rate environments did not receive much consideration. But that’s not the case anymore. The industry needs to dust off its rusty skills and begin thinking again about the effects of falling rates.
One challenge is that many decision-makers who are not immersed in the A/LM world have learned a few “interest rate risk truths” over the last decade:
Mortgages = Bad
Member CDs = Good
Variable-rate Assets = Good
It may take some focus on education to get past this mindset because when rates decrease, those embedded “truths” are turned upside-down. Here are a few things to think about as our environment continues to change:
Fixed-rate mortgages. When mortgage rates were down around 3.5%, some lenders decided that the risk in a rising rate environment wasn’t worth the return. At the time, it didn’t seem like there was much room for interest rates to go down, but now that rates have risen, there is definitely room for them to fall back down. Fixed-rate mortgages made at today’s higher rates would help IRR if rates decrease because they would keep generating income at today’s level for a long time, although some would likely refinance.
Fixed-rate member CDs. With rates rising, many credit unions are promoting longer term fixed-rate CDs to their members in order to lock in funding at today’s rates. If market rates rise, that would help IRR. However, if rates decrease, funding could be locked in at higher-than-market rates, which hurts IRR. You could also expect very few members to exercise their early withdrawal options. Fixed-rate borrowings would have a similar effect.
Variable-rate loans and investments. In the past, the main trade-off when adding variable rate-loans and investments was accepting lower yields in exchange for more flexibility if rates were to increase. Today there is an additional factor to consider, which is the possibility of rates dropping and yields declining on these assets. Another thing to carefully consider when making new variable-rate loans or purchasing new investments is whether there are floors and how low they are. Floors can help offset risk in a decreasing rate environment.
When it comes to asset/liability management, most decisions are neither good nor bad. Rather, it’s about the trade-offs. First, understand how much decisions can hurt if rates change up, down, or stay the same, and understand if they could push you outside of risk limits. While you may believe that rates will continue to rise, or at least not fall, declining rates are now in the range of recent experience, and must be considered.