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Interest Rates Have Risen – Now What?

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The 3-month Treasury rate has moved more in the last 8 months than it has in the preceding 8 years.  For many who think of A/LM in a time of rising rates, it can be time to calibrate pricing strategies, non-maturity deposit withdrawal assumptions, or loan prepayment speed assumptions.  Others may begin to consider strategic liquidity options, such as borrowings or locking in brokered CD funds to hedge against an assumption that rates may continue to rise.  However, as a CFO, have you considered the following:

  • How many of your senior managers have not had a role of responsibility when short-term rates have increased?
  • How many of your key front-line staff have never seen a rate increase in their professional careers?
  • Are you facing an uphill battle when trying to discuss risk management with others in the organization when earnings are up, loan demand is strong, and current economic indicators point to expansion?

A/LM is much more than inputting data into a model and generating report output.  Strategic thinking CFOs understand it is more about the conversation surrounding running a business than it is about looking at reports – and they have structured their risk modeling around addressing business questions first.  While there are many areas to consider, let’s touch on one – funding risks and how consumer behaviors driving deposit activities may be different going forward.

Consider that CD rates are up for many institutions – nationwide.  Let’s now look at recent retail experience – consider that a recent Pew Research Center study, released in late 2016, found that 79% of adults in the U.S. have purchased online.  Beyond just online, over half of those surveyed have purchased with a smartphone.  Further, consumer purchases initiated through a social media link are increasing as well.  In 2007, during a survey with comparable questions, only 49% of adults responded that they had made a purchase online (Source: Digital Commerce 360).

What does shopping online have to do with A/LM?  Quite frankly, a lot.  Consider how consumer borrowing behavior and credit union lending strategies have been impacted by online lenders and increased FinTech competition.  Don’t just focus on the “A,” and lose sight of the “L,” in asset/liability management.  The liabilities are critical to understand in the A/L equation – and how might member deposits react to rising rates now that nearly everyone has some established comfort level with making purchases online?  In the mid-2000s, how many of your deposits were lost to (or how many of your deposit strategies were impacted by) the orange bouncing ball of ING Direct?  Since that time, there has been a 60% increase in the number of adults making purchases online.

Beyond members, how might front-line staff react to members wanting to transfer funds or close CD accounts?  Front-line staff are more than just those in-branch or at the teller window – how might staff members in the call center or ITM department respond to similar requests?  For those staff members that are traditionally viewed as “back office” (such as the wire department or ACH/Electronic Funds department), are they now the new first line of interaction if members were to transfer funds to seek yield elsewhere?

A/LM goes well beyond just producing end of month or end of quarter reports from a model – it should be forward-looking, and it should help address risk-related business questions that decision makers are facing today.  Ask yourself if you are proactively answering these business questions.

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Testing a Negative Rate Scenario? Consider These Questions First

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There has been a lot of buzz recently about the potential for negative interest rates to hit U.S. financial markets at some point.  Short-term rates have been negative in Europe since June 2014, and the Bank of Japan made the move in January of this year.

European Central Bank rates fall below zero in 2014

Before you test this scenario from an asset/liability management perspective, there are several strategic questions that should be evaluated.  Consider the following:

  • How would loan rates change? Would your credit union’s floor rates on certain loan categories stay the same – meaning even if market rates drop, the loan rates will not decrease further, as the credit union would want to be compensated for liquidity, credit risk, or other concerns?
  • How might loan demand be impacted? This question could be difficult to answer because loan demand is often multifaceted, driven by factors other than just the current level of rates, such as the overall strength of the economy or the direction in which housing values are moving.
  • Could deposit rates drop further, or is there a scenario where the credit union would charge members a fee to hold deposits? If so, how might your members respond? If a “negative rate” comes in the form of fees, and if members have deposits at 3 or 4 different institutions, would they pay fees at multiple institutions or consolidate their balances to minimize the fee impact?  How could this impact liquidity and liquidity planning?
  • If members are charged for their deposit balances, would they be more likely to use those funds to pay down loan balances, resulting in a drop in loan-to-assets?
  • Would important sources of non-interest income be impacted, such as NSF, ODP, or interchange income?
  • What are some changes your biggest competitors might make? How would this impact your credit union’s response to negative rates?

There are many additional questions that could be considered.  The value in discussing these types of scenarios is not that every single question is asked and answered, but that key stakeholders are thinking strategically about events that could materially impact the future of their credit union.  Even if this specific scenario never plays out, thinking through how the credit union might respond and practicing the process can be worthwhile, and can then better inform any asset/liability management modeling you consider.

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Is Now a Good Time to Increase Deposit Rates?

Over the past few weeks there has been some increased discussion in ALCO and board meetings about increasing deposit rates in the near future. Some credit unions have already increased deposit rates, while other decision makers are feeling pressure to do so.

Although short-term Treasury rates, which typically drive deposit rates, have changed very little in the past six months, there are other reasons why some feel compelled to increase deposit rates.

When we ask why they are considering raising deposit rates, the most common response is:

“Loan demand is starting to increase and we want to reward our depositors, who have faced rock-bottom dividend rates for the past five to six years.”

Before a decision is made we highly encourage decision makers to compare their deposit rates to those of money market mutual funds, which are not insured by the full faith of the government. A quick search will show money market mutual fund yields of roughly one to five basis points.

Conventional wisdom should suggest that the extra risk of the money market mutual fund comes with extra return – but, currently that is often not the case with credit unions, as they often pay higher dividend rates without the added risk. Beyond providing additional safety, credit unions also bear the cost of infrastructure (such as branches/call centers) to attract and support deposits.

While it is understandable to want to give back to depositors in the form of higher rates, remember that it could be another few years of short-term rates continuing at historically-low levels. Many are expecting the margin to continue to decline, even with improvement in loan demand. Increasing deposit rates would put even more pressure on the margin.

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Is NEV Capturing The Risk Of Declining Asset Yields?

Short and long-term market rates have been at—or near—record lows for almost 3.5 years.  This has resulted in credit unions continually replacing higher-yielding assets with lower-yielding assets.  This is creating earnings challenges at many institutions, particularly as the cost of funds is nearing a “floor.”

So, is your NEV analysis reflecting this risk?  The answer for most credit unions is no.  Loan yields have decreased steadily, but offering rates (often used to discount loans in NEV) have decreased much faster.  In many cases this has resulted in loan valuations improving from an NEV perspective, even as the yields and revenue are decreasing.

Consider a credit union auto portfolio that yielded 6% in 2010.  Lower-yielding loans have been booked since then, and have taken the yield down to 5%.  If the NEV discount rate being used is 3.5%, an economic value gain today of ~3% would be produced (a different gain could be generated depending on principal cash flows, prepayment assumptions, etc.).  The credit union might be happy that they are holding autos at a gain, but since they don’t plan to sell them anyway, the reality of lower yields and less revenue is a very unappealing prospect.  NEV does an inadequate job of capturing the risk of declining asset yields (along with ignoring net operating expenses and earnings).  Credit unions should be cautious if NEV is used in the decision-making process, and make sure they are aware of the limitations of NEV.

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Investing At “Record” Low Rates…

The Fed’s first 3-year “forecast” revealed that almost half of the Fed Governors believe the Fed will keep short-term rates very low through 2014.  Coupled with continued weak loan demand, many credit unions feel like they are forced to do more with investments.  These two factors may cause more credit unions to extend investments moving forward into 2014.  Here are a couple of things to consider:

  1. Ask yourself, does that make sense? Regardless of what your broker tells you, it is always a good idea to apply the “reasonableness test” to any new investments that your credit union is evaluating.  Honest mistakes can be made.  A recent example is a broker showing a credit union a 13% market devaluation in a +300 basis point (bp) rate change on a 15-year final maturity callable.  The mistake was made because the market value model that was used showed the callable being called at the 5-year point, even in a 300bp rate increase.  In reality, a 15-year final maturity callable should devalue by roughly 30% in a 300bp rate change.  Callables will NOT get called if rates rise.   Make sure your credit union is evaluating the risk to final maturity if you consider investments with optionality, like callables, or mortgage-related products.  Buying long maturity callables with the expectation that they will be called can be a risky strategy
  2. How does this fit within policy? All investment decisions of relevance should be examined from an overall risk perspective, to ensure the new purchases still fit within policy limits.  Not just investment concentration limits, but overall aggregate risk policy limits (calculating impact on overall financial results)

There are many other areas that could be considered, such as overall credit union strategy and how new investments fit within this strategy.  Is the credit union positioned for long-term success if rates stay low and loan demand remains weak?  Lengthening investments can provide some revenue relief in the short-term, but will not provide relief from the long-term structural and operational challenges that many institutions are facing in this environment.