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Budgeting Tips For 2013

As the 2013 budgeting season gets into full swing, things have not changed much for most credit unions.  The industry is still facing the challenges of weak loan demand, robust deposit growth and declining asset yields.  Here are a few things to keep in mind as you put together your budget:
  • Make it as realistic as possible.  Unrealistic budgets result in poor decisions and unhappy surprises later in the year
  • Look at recent trends in loan and deposit growth.  If your budgeted loan and deposit growth are very different from trend, you should be able to point to concrete reasons why the trends will change
  • Incorporate balance runoff.  If your budget model doesn’t calculate runoff, try to build in reasonable assumptions to capture how fast portfolio yields will change (most are declining)
  • Don’t stop with 2013.  Carry major trends forward to get a 3-5 year view.  This shows the impact of those trends continuing, which may not have much effect over just one year
  • Do “what-ifs” that focus on assumptions you’re not sure about and have the highest impact such as loan and deposit growth and provision for loan loss.  This is especially important if net worth is an issue.  If the results are unsatisfactory, identify and model solutions so you will know what triggers to pull if things don’t go as planned
  • Consider doing “what-ifs” showing different rate environments. Think about how loan and deposit growth might change if the rate environment changes
  • Evaluate the budget in terms of asset liability management by modeling the resulting interest rate risk if the budget comes true
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Callables and Low Rate Environments

Trying to get any kind of yield on investments is tough when rates are this low. Some credit unions are reaching for yield by purchasing longer-term callables with the justification that “we don’t have to worry much about the risk because they are going to get called.” But consider this, if rates move up even a little bit, most callable bonds will not get called, and the credit union could be stuck with material losses. The example table below demonstrates this potential risk.

The example assumes that a $1M 1/5 callable (callable in 1 year, final maturity in 5 years) is purchased today at 80bp. It shows that, compared to Overnights earning 25bp, this investment would yield an additional $6K in revenue over the course of 1 year, at which point it would be called. However, when you layer on industry-average cost of funds, operating expense and fee income, it reveals that from an ROA perspective this investment loses $19K in year 1. If rates go up at all, the bond will stick around for the full 5 years, and in a +300bp rate environment the bond would lose about $147K over its lifetime when the credit union cost of funds, operating expense and fee income are factored in. If rates returned to levels seen in 2007 (5%), this bond would lose $190K over its lifetime.

Note that for simplicity sake it is assumed that rates move immediately.

Some credit unions can afford to take this risk, some cannot. In any case, the decision to buy longer-term callables should NOT be based solely on the expectation that they will be called; the consequences of being wrong could have a very negative impact on a credit union’s risk profile and future earnings.

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Hot Money In Waiting

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Many credit unions continue to see higher levels of deposit growth despite lowering rates—and even a rising stock market—as members choose safety and certainty over return.  While the flight to safety has been discussed at length, the gradual shift from CDs to share products has received less attention.

Over the past 6 to 12 months, many credit unions have seen decreases in CD balances with a corresponding increase in share balances, in addition to the increase in overall deposit balances.  Such a trend suggests that members are willing to park their money in a lower-paying share account rather than lock their money up in a higher-paying CD in order to have the flexibility to reinvest their money when a better alternative presents itself.  As a result, these balances could be hot money in waiting.

Credit unions should evaluate the change in their liability mix over the last year and consider how any shifts might affect their liquidity concerns, product needs and cost of funds going forward—especially in different rate environments.  Likewise, it would be prudent for institutions to incorporate this additional rate sensitivity into their modeling, particularly if a clear shift can be identified.  Modeling the hot money as 30-50% more sensitive than other share balances is a good place to start.

Whether the impact is large or small, the credit union will be better positioned to handle the reinvestment of hot money should it occur.