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Shifting Deposit Trends

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Over the last couple years, credit unions have grown lower-cost deposits.  This growth has largely been the result of a flight to safety that has occurred due to the economic environment.  Certificates of deposit (excluding IRAs) have decreased from a high of about 28% of funding in late 2007 to about 24% as of 3rd quarter 2010.  Regular Shares have increased from about 22% to 24% of funding during this same time period.

Recall that a similar pattern was observed during the flight to safety experienced in the early 2000s.  Also note that the funding mix changed as the economy rebounded from 2004-2006.  By the end of 2006, CDs became a larger part of funding than Regular Shares for the first time ever (see graph below).

It would be nice if we could count on growth in reliable, low-cost funding to continue.  As history has shown us, though, that would probably be a mistake.  We encourage you to model scenarios involving shifts from lower-cost to higher-cost shares as well as funds leaving your institution.  How might this impact your margins, particularly in light of the low-rate assets booked in this low-rate environment?  How might this affect your liquidity position and, consequently, your deposit pricing?  If you were planning to lag on deposit pricing as short-term rates increase, will you be able to do that or will you have to “pay up” to keep money from leaving?  Even if you may not need the money, is your board and management mentally prepared to let the institution shrink?

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Deposit Pricing Lags As Rates Rise

Many financial institutions see an eventual rise in market rates as an opportunity to create greater margin between what they pay on their non-maturity deposits and what they can yield on their new and or variable-rate assets.  This idea is not new.  However, what is different is that many credit unions are building into their model assumptions an ability to lag their deposit pricing increases MORE than what they had actually done in previous environments when rates were on the rise.

A common rationale for this kind of assumption change is based on the fact that many financial institutions are sitting on excess liquidity, have reduced capital ratios and have struggled with earnings in recent years.  Some credit unions feel like there will not be a need or appetite to raise rates as far and as fast as in prior periods.  This could very well be true.  However, should credit unions base their assumptions on the actual history of rates that were paid?  Or, should they use more optimistic assumptions that may or may not ever materialize?  After all, what’s driving up rates could be as important in its effect on deposit pricing as the relative health of financial institutions.  Changing key assumptions in risk simulations should be considered very carefully.  If institutions lower deposit pricing assumptions, it would be a good idea to test and document the impact, and be cautious about making decisions to add risk because there is now “more room” thanks to that assumption change.

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“I Want To Grow Our Investment Portfolio”

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At the moment, there aren’t many credit unions that would make this statement.  Net interest margins continue to be squeezed by the extended low rate environment.  Deposit pricing is nearing the bottom, but there’s still plenty of room for loan and investment yields to decline.  It’s no different for big banks.  Just from the first to second quarter, net interest margins fell 26 basis points at JPMorgan, 17 basis points at Citigroup and 16 basis points at Bank of America.  Deutsche Bank analyst Matt O’Connor commented, “There’s no loan demand, and long-term rates have declined so much.  So as you look out over the next few quarters, it’s potentially a very dire situation for the overall industry.”[1]

Many credit unions also are experiencing low loan demand coupled with high deposit growth.  According to NCUA data, the loan-to-share ratio for credit unions has dropped from 80% in March 2008 to 73% in March 2010 and that typically equals growing investment portfolios.  It has been difficult for some to put the brakes on growth, even while lowering rates to previously unheard of levels.  There are others who want to stick with their growth plan or are reluctant to lower deposit rates further.  What those folks are really saying is, “I want to grow our investment portfolio.”

It doesn’t make much sense when you put it that way.  The critical question is, what is the credit union doing to offset the lower yield on assets that an expanding investment portfolio brings? Some credit unions have been nudged into bad business decisions such as:

  • Loosening underwriting standards in a desperate attempt to add more loans
  • Delving into business lines for which they lack expertise such as business lending
  • Adding indirect and participation loans that are outside of the credit union’s core business and for which the credit risk may not be thoroughly understood
  • Increasing interest rate risk by adding fixed-rate mortgages
  • Increasing interest rate risk by adding longer investments

The current environment is challenging enough without adding the burden of excess deposit growth and expanding investment portfolios.  If this is an issue for your credit union, everyone on the management team needs to understand what steps will need to be taken to compensate.  A non-decision on this issue can lead to small, incremental adjustments that add up to an unintended change in strategy for the credit union.

[1] Low Rates are Squeezing Bank Profits, Bloomberg Businessweek, 07/29/10