Posts

/by

Of Bulls and Bears – Margin Impact from Changing Yield Curves

,

After the blog published on April 21, 2016, we have received a number of comments regarding why we were silent on the industry “conventional wisdom” that a wider yield curve can provide stronger net interest margin, and that a narrower yield curve can squeeze the margin. This can be true, but often is not. All else being equal, a wider yield curve would produce stronger margins. However, real life seldom results in an “all else being equal” outcome. Business, and the economic climate, are not static. There are constant changes to the regulatory, economic, and competitive landscape that can (and does) change consumer behavior – and the changes in consumer behavior result in changes and shifts in credit union financial structures.

Bear Flattener

If we were to apply “conventional wisdom” to the most recent “bear flattener,” which occurred from 2004 to the end of 2005, real world results are not what would be expected. In June 2004, the industry net interest margin was 3.26%. In June 2006, the industry margin had barely moved down, reaching 3.20%. This barely quantifiable movement in margin happened when the yield curve moved from roughly 350 basis points (bps) to about 20 bps – a reduction in steepness by more than 300 bps.

Using the “all else being equal” argument, margins may have been squeezed more. However, there was a mitigating factor that helped to preserve the margin – the loan-to-asset ratio for the industry increased more than 5% over that same time frame. The increase in the loan-to-asset ratio helped to offset margin pressures that could have been realized if “all else being equal” loan demand had not increased.

Bear Steepener

Applying the same conventional wisdom to a recent “bear steepener,” which occurred from 2012 to 2013 long-term rates increased more than 100 bps, translating to a yield curve that is roughly 100 bps wider than it was December 2012. However, net interest margin for the industry dropped from 2.94% to 2.80%. Comparing the end of 2012 to the end of 2015, the yield curve has been consistently steeper and loan-to-asset ratios jumped 7% (to 65%), but the margin of 2.86% has not rebounded to the 2012 level.

Now, some may argue that there were so many other variables and moving pieces in the broader economic climate, “all else being equal” or using an “apples to apples” comparison, margins should have increased. That may be the case. The same arguments are brought up in relation to static income simulation. Breaking it down into the fundamental components, everyone realizes that real life isn’t static – things change, member demands and consumer behaviors shift, and the competitive landscape has a significant impact on credit union earnings and risk profiles. The entire reason for the thought that wider yield curves bring stronger margins is a lack of change in the composition of assets and liabilities in static income simulation. This is antiquated thinking that has resulted in potentially misleading “conventional wisdom.”

Conventional Wisdom can be Misleading

As an industry, we have seen yield curves widen (steepen) and yield curves narrow (flatten), loan-to-asset ratios increase and loan-to-asset ratios decrease, with inconclusive correlations between changes in the yield curve in relationship to actual bottom-line net interest margins. Credit union management teams, boards of directors, and even regulators should be concerned with an assumption of static replacement regardless of the change in the environment, as it is often misleading. For decades we have been modeling a huge range of yield curves and environments, and this experience has taught us the importance of modeling how members may respond differently in these environments. Additionally, it has demonstrated that better business decisions can be made by first understanding the potential profitability (or losses) from the existing structure, prior to layering on guesses about what the new business may be able to do in all of the different environments.

/by

Key Business Questions

,

When credit unions evaluate changes in strategy or financial structure, the focus from an A/LM perspective is often on valuation and net interest margin.  However, these traditional approaches to measuring risk will not answer several critical business questions.  Consider, does NEV or net interest income analysis allow a credit union to see:

  • Under what rate environments could the decisions we have made and implemented cause us to have materially reduced or negative earnings?
  • Under what rate environments could our existing business cause us to no longer be Well Capitalized from interest rate risk?  How does the answer change as other risks are aggregated?
  • What does our new business need to earn going forward in order to achieve our net worth and asset size goals and offset existing risks?
Key components of risk will be missed in the analysis process if there is not a consistent focus on understanding long-term, bottom-line profitability, as well as incorporating the aggregation of other unexpected events.  Remember your credit union only puts net worth dollars at risk through bottom-line negative earnings.  Do your A/LM tools allow you to see when negative earnings could occur, and when they do, what the magnitude could be?  If not, consider what risks might be missing.
/by

Shrinking Margins Yet Higher ROAs? The Sustainability Question…

,

Unsurprisingly, many credit union leaders continue to watch their net interest margins erode in this continued, low rate environment. In fact, net interest margins have dropped to levels not experienced in over 20 years, dropping below 3% throughout all of 2012 trending down to 2.93% as of December 31, 2012 according to NCUA aggregate data.

What can be surprising is the improvement in ROA reflected in NCUA’s aggregate data. Let’s examine how much better ROA actually is compared to December 2011. While many will point to the overall ROA, it’s interesting to examine the difference if you ignored the impact of stabilization expense and NCUSIF premium. The improvement in ROA year-over-year as of December 31, 2012 is only 7 bps compared to an almost 20 bp improvement if you factor in the decrease in these expenses.


Regardless, with margins continuing to decline, how sustainable are current levels and trends of increased ROA? As you review financials within your ALCO, consider the following objective:

Communicate the impact of components of earnings that have experienced aberrations. Adjustments demonstrate the difference between the earnings reported on financials and the earnings that can be considered core to the institution.

Following are a few examples of aberrations that may be inflating ROAs unsustainably:

  • Record levels of mortgage originations/sales
  • Unsustainably-low PLL
  • Gains from the sale of investments?

2013 budgets may plan on some or all of these things continuing. Consider stress testing the budget to see the effect if these items do not continue. Furthermore, go beyond one year and stretch out the budget where 2014 and beyond does not count on these items continuing; this can help uncover a potential squeeze to earnings. Then test the impact to the risk profile of this future position.

/by

What If The Fed Rate Projection Is Right?

This is a question credit unions should try to answer as part of their ongoing long-term forecasting process.  The FOMC reaffirmed on Wednesday (December 12) that they do not anticipate raising rates until 2015.

Source:  Federal Reserve

So what happens to earnings and net worth if rates stay at historic lows for two more years, and then start to rise? Instinctively, the net interest margin should be squeezed over the next two years as assets continue to reprice down without a corresponding reduction in the cost of funds. The big unknown is: how much and how fast will rates rise?

Credit unions may need to run a series of “what-ifs” to understand the impact. “What-ifs” should include rates rising over different time periods (i.e., 12 months, 24 months, etc.) and increase to different levels (i.e., 100bps, 200bps, 300bps).  It would also be prudent to test changes in balance sheet mix, as rates may rise for different reasons.  If the economy is booming, then the credit union may be able to originate more loans.  This would help the bottom line and possibly mitigate the impact of the lower-yielding assets brought on in 2013 and 2014.  However, if the economy is stagnant, loan growth could be an issue—which would hurt earnings and net worth.

Decision-makers should review the series of “what-ifs” and discuss any areas of concern.  Credit unions should run additional “what-ifs” that address their concerns—particularly in cases where success measures would not be met or the credit union’s ability to deliver on its strategic objectives is threatened.

/by

Perfecting The Process

Looking over the last 12 months, what has happened to your credit union’s net interest margin? If yours is like most credit unions, the answer is it has declined. Competition for loans and low interest rates continue to erode yield on assets.  Cost of funds has declined but (for most places) not enough to completely offset the reduction in asset yields.

If interest rates remain low throughout 2012, the yield on assets will continue to decline.  Can the cost of funds be reduced further?  For some, the answer is yes; however, others are at, or near, the floor.

Below the margin, many credit unions have made cuts to operating expenses over the last couple of years.  Most of the “low hanging fruit” has been picked.  Some credit union managers are feeling they have done everything they can do with operating expenses, yet earnings still aren’t where they would like them to be.  What can you cut after you’ve cut everything?

Sustainable expense reductions often come not from cuts, but from improving processes.  Have you examined and mapped out all the processes at your credit union? If so, were you surprised (shocked?) by what you learned?  We’re doing what!?!

Improving processes to remove unnecessary steps, to move members through the process faster and free up employee time, can both reduce expenses and increase revenue.  Remember that every minute a frontline employee spends completing a non-value-add step in a process is a minute less they spend interacting with members.