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What Are Some Things to Consider as Part of the Budget Process?

We help a lot of institutions with the creation of their budgets and long-term forecasts. There are many questions that often arise as part of that process. The most common question is, what rate environment should I plan on?

There is no easy answer to this question; the reality is that whichever environment gets incorporated in the budget has a good chance of being wrong.

Fed Chair, Janet Yellen, described this same challenge during a speech in May:

“I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so.” (Source: Janet Yellen just made one of the most surprising admissions you’ll ever hear from an economist, Yahoo Finance, 5/22/15)

The Federal Open Market Committee (FOMC) will meet September 16 and 17 and many anticipate a decision could be made to increase the Federal Funds target rate for the first time in nearly 10 years. However, forecasts have the potential to not come true, which becomes evident when comparing the Federal Funds rate projection from December 2014 versus the most recent projection.

Federal funds rate projection December 2014

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, Federal Reserve, 12/2014

 

The average expected target range for year-end 2015 and 2016 were 1.12% and 2.54%, respectively. The most recent forecast of Federal Reserve Board Members and Bank Presidents from June 2015 reflects a 2015 and 2016 year-end average that is approximately 0.50% and 1.00% lower than the December 2014 projection.

Federal funds rate projection June 2015

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, Federal Reserve, 6/2015

 

The danger in relying on rate forecasts or projections is the potential for not understanding the risk of rates remaining at the same level they are today. As many management teams begin the planning process and budgeting for next year, a key consideration should be testing the impact on the budget of rates not moving as forecast. In fact, a combination of a base prediction along with a range of expectations around that base path can help uncover potential strains to the margin.

Beyond the rate environment, some other common budget questions have to do with growth. Whatever the credit union may plan in the future, it can be valuable to test the potential of those assumptions being wrong. With advanced modeling capabilities, the time it takes to run each of the following tests should be minimal.

Some example tests:

  • Loan growth has been great for many this year, what if it is slower than expectations going forward?
  • What if, in order to get expected growth, the amount paid for dealer reserves or the yield charged for loans is lower than planned?
  • Loan loss has been very good for many recently, what if it increases to a more normal level?
  • What if non-interest income is materially lower than expected, either due to changes in payments systems, regulations, or other demographic reasons?

Note that the unique exposures of your institution might need very different questions. Our recommendation throughout the budgeting process is to not spend so much time trying to prove that you know what will happen in the future, but rather make sure to focus on reasonable expectations and then test the exposure to the institution if those expectations do not come true.

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Net Economic Value and Business Decisions: Do You Understand the Trade-Offs?

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As a result of running a net economic value shares at par analysis, it appears that some examiners are trying to force credit union CEOs and CFOs to reduce interest rate risk in a rising rate environment by selling assets.

While we won’t argue that some credit unions should consider reducing interest rate risk, using net economic value to make this decision does not give decision-makers and examiners appropriate decision information.

The net economic value analysis will not show the hurt of replacing the asset sold with a lower-yielding, shorter-term asset. It will also not show the hit to earnings and net worth should the assets need to be sold at a loss. Additionally, no one involved in this type of decision will understand the breakeven point of this decision. In other words, decision-makers and examiners should gain an understanding of how high rates would need to go in order to be glad that the credit union took a guaranteed loss and reduced earnings today.

As we said above, it may be a good decision for some credit unions to restructure their interest rate risk profile while rates are still low. However, before taking any action, we encourage decision-makers to work very hard to ensure that they, and their examiners, thoroughly understand the impact of the direct hit to earnings and net worth of selling assets. It would be unfortunate for a credit union to take action based on net economic value analyses and have decision-makers and examiners be surprised by the hit to earnings and net worth.

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Investment Value

In previous posts we have discussed the increase in long-term rates and the potential impact to loan generation as rates rise. Due to long-term rates continuing to climb this week, we thought it would be beneficial to discuss one of the impacts to investments.

From Bloomberg the morning of 7/9:

One thing that has occurred in this low rate environment is that many institutions are reaching out longer with their investment portfolio to pick up more yield. Note that a 1-year investment yields less than many overnights. The longer investments bring more return, but also more risk. This trade-off is magnified as the upside of such a low-yielding long investment is minimal and it does not take a large increase to wipe out the return.

For example, a month ago an institution could have purchased a
5-year bullet with a yield expectation of 1.09%. A month later, as rates increased 39 basis points, the value of that same bond dropped almost 2%. In fact, a 5-year bullet yielding 1.09% can have a 1.09% loss in value after only a 23 basis point increase in rates.

While the intent of the investment purchases may not be to sell the investments in the future, understanding the potential change in value is beneficial, as the value can impact the flexibility an institution has to alter its structure. The recent increase in rates is a reminder of this, but is a small sample compared to some of the larger changes that history has shown us.

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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.