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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

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Prolonged Low Rate Environment?

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For months many have been watching and wondering when the inevitable increase in market rates might materialize.  Now, with some economists projecting that rates will stay at historic lows for another 12-18 months, credit unions should evaluate how, or if, they can continue to maintain net interest margin and ROA.

Not all institutions have room to lower deposits enough to mitigate the continued erosion in the yield on assets.  In a sense, deposit pricing is reaching a “floor” for many credit unions.  All else being equal, ROA will continue to erode and interest rate risk profiles will weaken as higher-rate loans and investments roll off, being replaced with lower yielding assets.

So what should credit unions do?  Common strategies include looking beyond the margin and evaluating expenses, as well as potential new sources of non-interest income.  As mentioned in previous posts, some institutions are stretching for yield, either in loans or investments.  If this strategy is employed, institutions need to carefully monitor the impact on the risk profile, and make sure decisions are tested beforehand and fit within the credit union’s philosophy and A/LM policy/guidelines.

Finally, some institutions have chosen to not take any drastic steps at this time, and have instead begun to adjust expectations at both the employee and board level, re-evaluating what success looks like in this environment.  One potential saving grace is that loan losses seem to be stabilizing in many areas, but should not be taken for granted given what institutions have experienced over the last two years.