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Long-Term CDs – Questionable Cost of Funds Protection

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The 10-year Treasury closed below 1.40% 3 days in July!

The flattening of the yield curve has many folks worried about further pressure on net interest margins. Some, though, are hoping to extract a benefit by locking in long-term funding at historically low interest rates. As an Asset/Liability Management (A/LM) strategy, this approach employs the trade-off between paying something more today for protection in a potential rising rate environment in the future.

The use of long-term, competitively priced Certificates of Deposit (CDs) is one common approach to achieving this goal. But there are risks in making that strategy work.

Consider a credit union offering these competitive CD rates:

CD Term TableA member selects the 7-year CD earning 1.80% and invests $100,000. At the end of 2 years, the credit union has paid $3,600 in interest on the CD as expected. The credit union and the member are happy. Then, at the end of year 2, CD market interest rates increase by 100 bps.

How would a member be expected to react?

  • Calculating The Advantage to WithdrawWith 5 years remaining in the term, a comparable 5-year CD would be about 2.65% (1.65%
    from the table above plus the 100 bp market interest rate increase), versus the 1.80% currently being earned.
  • The difference of 85 bps equates to an opportunity to earn an additional $4,250 over the remaining term.
  • The member must also pay the early withdrawal penalty of 6 months interest, which equates to $900.
  • A net benefit to the member (advantage to withdraw) of $3,350 is left to pay off the original CD and reinvest in the new CD.
  • Considering the financial analysis, the member opts to pay the penalty and closes the CD.

The credit union paid the member a higher CD rate during the first 2 years for protection it did not receive in years 3-7 when CD market interest rates had increased.

Why did the strategy not work? 

The opportunity to earn more interest on a new CD when market interest rates increased greatly outweighed the penalty to early withdrawal.  This is an issue for any long-term CDs that include an option for early withdrawal.  If market interest rates become more favorable early into the life of the CD, the number of years remaining will often create a benefit that outweighs typical early withdrawal penalties.  Contributing to the issue is the flat yield curve, which means even small market interest rate increases can create a net member benefit using shorter-term CDs.

In fact, using the example above, at the beginning of the 7-year term the market interest rate would only need to go up 13 bps for there to be an advantage for the member to withdraw early.

By the end of year 2, with 5 years remaining on the CD, the rate would only need to go up 19 bps.

Consider again the 7-year $100,000 CD, and let’s look at the net benefit to the member each year if CD market interest rates changed by +100 bps or +200 bps. The net benefit is calculated simply as:

  • New CD expected lifetime interest earned (keeping the overall maturity at the original 7 years)
  • Minus the existing CD interest lost through maturity by closing the CD
  • Minus the early withdrawal penalty

In the table above, notice that when using a 6-month penalty, the member benefit is positive until the end of year 4 for a +100 bp rate increase.  This means that if the CD market interest rate were to go up by 100 bps in any of the first 4 years, the member could reasonably be expected to close the CD.  Beyond the end of year 5, in a +100 bp rate increase, the early withdrawal penalty provides a disincentive to close the CD.  Notice too, that a 6-month early withdrawal penalty leaves the member with a positive benefit through year 6 in a +200 bp rate increase.

The following tables increase the penalty by an additional 6 months each. A 12-month penalty creates disincentive after 3 years in a +100 bp rate in increase, and begins to create some disincentive after 5 years in a +200 bp rate increase. An 18-month penalty encourages the member to stay in the CD for 2 years in a +100 bp rate change.

The point is that the longer the CD, the more difficult it can be to design it to provide effective cost of funds protection in a rising interest rate environment. Typical early withdrawal penalties are not likely to be enough to make the interest rate risk strategy successful.

Credit unions may need to consider stiffer penalties for members that want to lock in a long-term investment. If the objective is risk mitigation, an option could be to have the penalty be half the term. Another option that is more complicated to explain and disclose, is to have the penalty equal to the replacement cost (present value). Each option has a trade-off and it is important to balance member perspective. An option is to have a materially lower rate with the traditional penalty and then label the more aggressive rate an investment CD (stiffer penalty). Of course, management might also consider other A/LM tools, such as long-term, non-callable borrowings, to help protect the cost of funds in a rising rate environment.

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Has Your ALM Technology Emerged From the Dark Ages?

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In this wonderful world of amazing technological advances, member-facing technology provides convenience and ease of access that was unimaginable in the past.  Huge strides have also been made in supporting technologies, such as putting relevant data at employees’ fingertips for cross-selling, automated loan decisioning, and mining member data for marketing opportunities.  The same can be done for asset/liability management (ALM).

ALM modeling used to require hours to run on early computers and, before that, you can imagine how long it took to do the calculations using paper and pencil. Of course, those early methodologies had to be simple and it was impossible to render results quickly, so people got used to slow analyses that were already irrelevant by the time they were complete.  ALM was relegated to a dusty back room and offered to regulators to satisfy their check boxes.

Fast-forward to today – if ALM is not being used to make business decisions in real time, it may signal the need for a mindset change.  A vast array of decisions – from changing the loan portfolio to adding branches or reducing operating expense – can be tested for their impact on profitability and the risk profile.  Imagine sitting around a table discussing ideas and initiatives, and testing their potential profitability under numerous economic conditions.

ALM modeling has come a long way and deserves a place at that table, serving as one of the pillars good decision-making rests on.  This type of decision-making links strategy and desired financial performance for long-term success.

Now more than ever, it is important to view ALM as a powerful weapon to help remain relevant as competition and consumer preferences continue to change. Demand more from your ALM and start using it to help gain and maintain that competitive edge.

 

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Be Clear on Your Objective of Doing a Core Deposit Study

Earlier this week we presented at a virtual roundtable with 100+ CFOs, and one of the most common questions centered around the benefits, or lack thereof, of doing core deposit studies for use in net economic value (NEV).

It is important to study member behavior with respect to deposits, including migration, pricing strategy, and competitive and economic environments.

Below are just a few examples of this type of information for the credit union industry. It is prudent for each credit union to understand its unique patterns of member behavior.

Example: Distribution of deposits has changed over time and through various economic cycles.

Percentage of Assets

Example: Pricing strategy has changed through various economic cycles.

MMKT CUs Over 1B
Example: Average balances relative to new accounts has changed since the last rate peak.

Deposit Growth

If you are willing to dig deeper, it is extremely valuable to understand how your deposit balances by age have changed over time ̶ a potential looming issue is that for most credit unions, large deposits are held by the older generation.

The objective of this type of business intelligence is to inform strategy. These risks can impact the credit union’s cost of funds in different environments (impacting profitability), and can be critical in identifying liquidity risks. These issues are very different than the objective of typical core deposit studies, which is to estimate decay rates and maturities of non-maturity deposits to be used most often in NEV. NCUA has released a new NEV test that standardizes the value of non-maturity deposits in the current rate environment and +300 bp shock.

So, if you are thinking about studying your deposits, be clear on your objective before spending money. If your primary objective is to use NEV, you may want to evaluate the cost/benefit in light of NCUA’s new standardization.

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Strategic Implementation: Huddle Daily for Strategic Success

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Institutions are in a constant state of change. Core conversions, new products, and improving processes are just a few examples of change that credit unions go through to help support strategic initiatives; inherent in any of these changes is a need for behavior change.

Often institutions focus on the change itself. The change is implemented, employees are trained, and the institution moves on to the next project. The trouble is old habits are easy to fall back into and hard to change. Employees may have been trained, but the institution hasn’t ensured that their behaviors have changed. As a result, people are trying to use a new core system the same way as the old core system, for example, instead of utilizing the features of the new core to the fullest.

A practice we’ve found to be key in changing behavior is a daily huddle. The objective of the huddle is for everyone in a department or group to meet daily to discuss progress towards a metric or goal, and let everyone provide updates on their projects and tasks. As this is done, the manager or leader can do quick check-ins with employees to make sure process changes are being followed, and encourage others to pitch in if someone needs help or is still unclear about how a specific task is to be completed. Ultimately, the huddle helps create an environment of individual and group accountability.

Tips for daily huddles:

  • Keep it short—the huddle should be 15-20 minutes, with each person providing a brief status update on their projects. Encourage people to limit their “war stories” during this meeting.
  • Ask questions—though the huddle is meant to be short, ask clarifying questions to make sure people are on track and process changes are being followed. Keep asking until you’re clear, as everyone will benefit from the conversation.
  • Have folks stand—this keeps with the idea that the huddle is to provide brief updates and helps people stay engaged and not “settle in” for a meeting.
  • Go computerless—computers are distracting and they become a crutch for people to fall back on for their updates. Each person should arrive ready to share their progress and know their numbers without a computer. This creates a powerful habit of taking ownership and accountability for the status of one’s work.
  • Start with the goal(s) and progress—remind the group what everyone is working towards and the progress made.
  • Focus on one or two goals max—there are no shortage of goals and things that need to be accomplished. Pick the one or two goals that are the highest priority, and focus on those.
  • Call out successes—it’s important to acknowledge when things go well and celebrate those successes. Doing so will help build momentum as people start to see the positive impact of their work.
  • Share learnings—share what worked or didn’t work, so everyone can learn and benefit from the successes and failures that occur along the way.
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Strategy and Risk Management – Is Leadership in Sync?

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Understanding and prioritizing strategy has never been more complex, especially as new disruption continues within the industry. Beyond delivering valued products and services profitably to members while remaining safe and sound, decision-makers face new threats to remaining relevant as non-traditional competitors create inroads into financial services. With limited resources, success can depend on choosing the right path.

Creating an optimal strategic focus requires decision-makers to share a common understanding of threats to the business, and a clear assessment as to which of those threats warrant attention and resources. This is where linking risk management practices to strategic planning can provide effective guidance.

Consider the following simple, yet powerful, exercise with your team:

    1. Begin with a high-level review of the financial results and risk reporting you prepare and review every month or quarter: monthly financials, key ratios, A/LM results, credit policies, etc.
    2. Identify critical risk areas (see the example below), starting with elements from financial and risk reporting, then allowing the group to add to the list as necessary.

      Note: We are using relevancy as a broad category to describe the myriad of new competitive pressures and changing member expectations. This should be customized for your credit union’s uniqueness.

    3. As a group, rank each risk on a scale of 0-10 (0=Low Risk, 10=High Risk).Rank your risk level from 0-10

THE VALUE
Here’s where this exercise can create significant value, as decision-makers begin to link results with their gut feeling and appetite for risk. What is your level of risk? Where does it exist? Where would you most want to see improvement? For some, these discussions may identify:

  • A lack of understanding of a specific risk (an opportunity for training)
  • Difficulty comparing and ranking different risks (an opportunity to share different perspectives)
  • Differing opinions (a need to achieve consensus)

Each of these outcomes can create opportunities for the credit union such as:

  • Taking strategic discussions to the next level
  • Advancing risk management
  • Refining focus and allocation of resources

In addition to aligning strategic planning with risk assessments and management, consider the benefit of knowing that the leadership team shares a deeper, common understanding of the risks facing the credit union and the reasons driving strategic priorities.

As the credit union industry changes and faces new competitive pressures, linking strategic planning and risk management could be key to ensuring ongoing success.