February 13, 2014
Credit Union Management magazine’s Web-only “CFO Focus” column runs the second Thursday of the month.
It seems that most pronouncements about interest rate risk focus exclusively on asset choices:
“…credit unions are increasingly reaching for yield by lengthening the maturity structure of their investment portfolio…” John Worth, NCUA chief economist, 12/20/2013.
Importantly, the key indicator that examiners use in identifying risky institutions completely ignores the bottom half of the balance sheet. This key ratio is the supervisory interest rate risk threshold, or SIRRT, which equals:
(total first mortgages held + total investments with maturities greater than five years) / net worth.
Liabilities are not nearly as interesting as loans or investments, I’ll give you that. However, the neglected half of the balance sheet provides us with more current opportunities to mitigate interest rate risk than the asset side.
|Non-maturity deposits to total deposits ratio (NCUA call report data) vs. the nominal yield on the US Treasury two-year note.|
As short-term interest rates have bottomed out and appear to be set to rise again, we find the proportion of non-maturity deposits to total funding to be at a 10-year high. Members, wary of being locked in at low rates, have let their CDs mature and roll over into demand deposits at credit unions. This shift in deposit mix has helped to keep credit unions’ cost of funds down, but this concentration puts credit union margins at greater risk as rates begin to rise.
Many risk managers argue that these core deposits are not nearly as rate sensitive as their contractual terms would indicate. Empirical studies offer support for the belief that non-maturity depositors do not expect to earn market yields on these accounts and that the balances will be persistent as market rates rise. Perhaps. The problem with these studies is that they typically consider only one factor: the level of interest rates. In reality, depositor behaviors are driven by dozens of factors:
- consumer/business sentiment,
- consumer savings rates,
- unemployment rates (local and national),
- industry consolidation,
- depositor demographics,
- shrinking local and state governments,
- innovation in deposit products and
- tightening credit standards.
I don’t necessarily propose that core deposits will be 100 percent sensitive as rates rise; I simply submit that their behavior is extremely difficult to predict. Said another way, an uncertain instrument is a risky instrument.
Risk management is about measuring the effect of uncertainty on your objectives. Managers can mitigate the risk in current credit union balance sheets by reducing their dependency on deposits with uncertain characteristics and increasing exposure to funding with defined characteristics.
- Fixed-rate borrowings – Contrary to popular credit union sentiment, borrowing funds is not a sign of weakness. Conceptually, this is the easiest way to hedge against rising rates. You can develop a borrowing strategy in which all the characteristics of the instruments and the effects they have on your net interest margin are known and predictable. Credit unions have multiple channels at their disposal including Federal Home Loan Bank membership and corporate credit union offerings.
- Promote term deposits – This is easier said than done. You’re attempting to get a member who is even more susceptible to interest rate risk than the credit union to take some of your risk from you. Still, term deposits can be an effective hedge, even in small amounts and for short terms. Every dollar of fixed funding will help.
- Interest rate derivatives – Similar to borrowing, derivatives are not nearly as stigmatized as they were in the past. (Here’s the derivatives rule the National Credit Union Administration proposed in May.) A pay fixed/receive floating rate swap is a relatively simple instrument. This is an agreement where the credit union would agree to pay a fixed rate of interest on a notional amount (face amount used to calculate payments on the instrument) and receive interest based on rates that float with market conditions from a counter party. It could be argued that the effects a pay fixed/receive floating rate has on income and valuation are much easier to model than core deposit behaviors.
This entire discussion begs the question, “If all these hedges are considered good risk management, why aren’t they being used more?” Just like any insurance policy, future protection has a current cost associated with it. Credit union net interest margins are very thin at the moment, and it is difficult to justify paying these insurance premiums until asset yields increase. How much of your current earnings are you willing to spend to protect future earnings? As your asset/liability committee analyzes this question, also consider these two tenets of sound risk management:
- All-time lows (or highs for that matter) do not last forever. If you wait for rates to rise 200 basis points before locking in funding, you will have missed a good opportunity. The benefits of dollar-cost averaging are undeniable.
- Diversification is the secret sauce for all risk management challenges. Reducing dependence on non-maturity deposits, even if just a little bit, will help to mitigate risk levels.
Jerry Boebel is the consulting services senior manager for ProfitStars®. His team works with credit unions of all sizes consulting on interest rate risk management, liquidity risk management, asset/liability management and budgeting. Visit the ProfitStars website to learn more.