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Interest Rates Have Risen – Now What?

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The 3-month Treasury rate has moved more in the last 8 months than it has in the preceding 8 years.  For many who think of A/LM in a time of rising rates, it can be time to calibrate pricing strategies, non-maturity deposit withdrawal assumptions, or loan prepayment speed assumptions.  Others may begin to consider strategic liquidity options, such as borrowings or locking in brokered CD funds to hedge against an assumption that rates may continue to rise.  However, as a CFO, have you considered the following:

  • How many of your senior managers have not had a role of responsibility when short-term rates have increased?
  • How many of your key front-line staff have never seen a rate increase in their professional careers?
  • Are you facing an uphill battle when trying to discuss risk management with others in the organization when earnings are up, loan demand is strong, and current economic indicators point to expansion?

A/LM is much more than inputting data into a model and generating report output.  Strategic thinking CFOs understand it is more about the conversation surrounding running a business than it is about looking at reports – and they have structured their risk modeling around addressing business questions first.  While there are many areas to consider, let’s touch on one – funding risks and how consumer behaviors driving deposit activities may be different going forward.

Consider that CD rates are up for many institutions – nationwide.  Let’s now look at recent retail experience – consider that a recent Pew Research Center study, released in late 2016, found that 79% of adults in the U.S. have purchased online.  Beyond just online, over half of those surveyed have purchased with a smartphone.  Further, consumer purchases initiated through a social media link are increasing as well.  In 2007, during a survey with comparable questions, only 49% of adults responded that they had made a purchase online (Source: Digital Commerce 360).

What does shopping online have to do with A/LM?  Quite frankly, a lot.  Consider how consumer borrowing behavior and credit union lending strategies have been impacted by online lenders and increased FinTech competition.  Don’t just focus on the “A,” and lose sight of the “L,” in asset/liability management.  The liabilities are critical to understand in the A/L equation – and how might member deposits react to rising rates now that nearly everyone has some established comfort level with making purchases online?  In the mid-2000s, how many of your deposits were lost to (or how many of your deposit strategies were impacted by) the orange bouncing ball of ING Direct?  Since that time, there has been a 60% increase in the number of adults making purchases online.

Beyond members, how might front-line staff react to members wanting to transfer funds or close CD accounts?  Front-line staff are more than just those in-branch or at the teller window – how might staff members in the call center or ITM department respond to similar requests?  For those staff members that are traditionally viewed as “back office” (such as the wire department or ACH/Electronic Funds department), are they now the new first line of interaction if members were to transfer funds to seek yield elsewhere?

A/LM goes well beyond just producing end of month or end of quarter reports from a model – it should be forward-looking, and it should help address risk-related business questions that decision makers are facing today.  Ask yourself if you are proactively answering these business questions.

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Happy Thanksgiving!

On behalf of all of us at c. myers, we wish you a wonderful Thanksgiving holiday.

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6 Dos and Don’ts of the NCUA’s NEV Supervisory Test

Consider the following as you implement the NCUA’s NEV Supervisory Test:

DO make sure to understand your answers by running NEV with the non-maturity deposit caps the test uses (currently 1% and 4%) before NCUA comes into your credit union.

DON’T forget why NCUA decided to standardize. One of many reasons is that there is “a significant amount of uncertainty surrounding valuation methods” for non-maturity deposits. If you are going to continue to use results of core deposit studies to determine non-maturity deposit values, it will be critical for your board and management to be absolutely clear on how these results will be used, if at all, in decision-making. For example, when testing what-ifs, which assumptions set will drive decisions if one set gives the green light and the other the red light?

DO make sure your policy represents your credit union’s appetite for risk. NCUA has clearly stated this. Avoid saying in policy, “We will accept a moderate level of risk using the thresholds identified in NCUA’s supervisory test.”

DON’T stop your asset/liability management (ALM) at the NEV supervisory test. By definition, any type of standardization means that the unique risks of an institution are not captured. To help with standardization and comparison across credit unions, the new NEV test treats all non-maturity deposits the same, credit union to credit union. As a result, the standardization ignores each credit union’s pricing, not to mention ignoring the pricing on each category such as regular shares, checking, and money markets.

DO remind your board and management that NEV does not quantify profitability (earnings) or risks to profitability and net worth. Earnings do matter. Earnings are what credit unions need to pay for products, services, and delivery channels that will keep them relevant. A simple way to remember that NEV does not quantify profitability is that it does not factor in non-interest income and operating expenses.

DON’T forget that the timing of earnings and risks to earnings matters. NEV collapses all future cash flows to represent what the value would be today if shock interest rate environments were to occur. By definition, this can’t show decision-makers the timing of risks to earnings and, ultimately, net worth.

The world is becoming more complex. This complexity can bring opportunities and risks. The most important thing to remember is that ALM can and should be used to provide decision-makers with actionable business intelligence. The new NEV supervisory test is not designed to provide actionable business intelligence; it is simply a scoping tool.

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Long-Term CDs – Questionable Cost of Funds Protection

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The 10-year Treasury closed below 1.40% 3 days in July!

The flattening of the yield curve has many folks worried about further pressure on net interest margins. Some, though, are hoping to extract a benefit by locking in long-term funding at historically low interest rates. As an Asset/Liability Management (A/LM) strategy, this approach employs the trade-off between paying something more today for protection in a potential rising rate environment in the future.

The use of long-term, competitively priced Certificates of Deposit (CDs) is one common approach to achieving this goal. But there are risks in making that strategy work.

Consider a credit union offering these competitive CD rates:

CD Term TableA member selects the 7-year CD earning 1.80% and invests $100,000. At the end of 2 years, the credit union has paid $3,600 in interest on the CD as expected. The credit union and the member are happy. Then, at the end of year 2, CD market interest rates increase by 100 bps.

How would a member be expected to react?

  • Calculating The Advantage to WithdrawWith 5 years remaining in the term, a comparable 5-year CD would be about 2.65% (1.65%
    from the table above plus the 100 bp market interest rate increase), versus the 1.80% currently being earned.
  • The difference of 85 bps equates to an opportunity to earn an additional $4,250 over the remaining term.
  • The member must also pay the early withdrawal penalty of 6 months interest, which equates to $900.
  • A net benefit to the member (advantage to withdraw) of $3,350 is left to pay off the original CD and reinvest in the new CD.
  • Considering the financial analysis, the member opts to pay the penalty and closes the CD.

The credit union paid the member a higher CD rate during the first 2 years for protection it did not receive in years 3-7 when CD market interest rates had increased.

Why did the strategy not work? 

The opportunity to earn more interest on a new CD when market interest rates increased greatly outweighed the penalty to early withdrawal.  This is an issue for any long-term CDs that include an option for early withdrawal.  If market interest rates become more favorable early into the life of the CD, the number of years remaining will often create a benefit that outweighs typical early withdrawal penalties.  Contributing to the issue is the flat yield curve, which means even small market interest rate increases can create a net member benefit using shorter-term CDs.

In fact, using the example above, at the beginning of the 7-year term the market interest rate would only need to go up 13 bps for there to be an advantage for the member to withdraw early.

By the end of year 2, with 5 years remaining on the CD, the rate would only need to go up 19 bps.

Consider again the 7-year $100,000 CD, and let’s look at the net benefit to the member each year if CD market interest rates changed by +100 bps or +200 bps. The net benefit is calculated simply as:

  • New CD expected lifetime interest earned (keeping the overall maturity at the original 7 years)
  • Minus the existing CD interest lost through maturity by closing the CD
  • Minus the early withdrawal penalty

In the table above, notice that when using a 6-month penalty, the member benefit is positive until the end of year 4 for a +100 bp rate increase.  This means that if the CD market interest rate were to go up by 100 bps in any of the first 4 years, the member could reasonably be expected to close the CD.  Beyond the end of year 5, in a +100 bp rate increase, the early withdrawal penalty provides a disincentive to close the CD.  Notice too, that a 6-month early withdrawal penalty leaves the member with a positive benefit through year 6 in a +200 bp rate increase.

The following tables increase the penalty by an additional 6 months each. A 12-month penalty creates disincentive after 3 years in a +100 bp rate in increase, and begins to create some disincentive after 5 years in a +200 bp rate increase. An 18-month penalty encourages the member to stay in the CD for 2 years in a +100 bp rate change.

The point is that the longer the CD, the more difficult it can be to design it to provide effective cost of funds protection in a rising interest rate environment. Typical early withdrawal penalties are not likely to be enough to make the interest rate risk strategy successful.

Credit unions may need to consider stiffer penalties for members that want to lock in a long-term investment. If the objective is risk mitigation, an option could be to have the penalty be half the term. Another option that is more complicated to explain and disclose, is to have the penalty equal to the replacement cost (present value). Each option has a trade-off and it is important to balance member perspective. An option is to have a materially lower rate with the traditional penalty and then label the more aggressive rate an investment CD (stiffer penalty). Of course, management might also consider other A/LM tools, such as long-term, non-callable borrowings, to help protect the cost of funds in a rising rate environment.

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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.