April 10, 2014
Credit Union Management magazine’s Web-only “CFO Focus” column runs the second Thursday of the month.
At CommunityAmerica Credit Union, we use funds transfer pricing as a key component of pricing strategies, an integral part of risk-adjusted profitability management, and a major piece of interest rate risk management. Importantly, FTP was the first key component implemented when we were developing the ability to understand and manage our CU’s profitability.
Four major elements contribute to the profitability, or lack thereof, at credit unions: net interest margin, fees, credit losses, and originating and servicing expense (operating expenses).
At CommunityAmerica CU, we use a different tool to focus on each major element. FTP focuses on the margin. Even without other tools—such as credit risk, activity-based costing, and economic capital—needed for a complete understanding of what drives profitability, FTP still represents a powerful tool to assist in margin management.
What is FTP? It is simply a methodology that allows a financial institution to separate the margin contributions of sources of funds from uses of funds. By decomposing the net interest margin, the margin contributions of deposits and borrowings can be separated from the margin contributions of loans and investments. That decomposition actually splits the net interest margin into three pieces; loan (asset) margin, deposit (liability) margin, and interest rate risk margin.
What is the interest rate risk margin and why do I care? Well, like most credit unions, CommunityAmerica CU tends to borrow short and lend long. That is, the durations of our deposits and investments tend to be much shorter than the duration of our loans. So long as we have an upward sloping yield curve, we make additional margin by taking the interest rate risk associated with the re-pricing of deposits, by funding longer duration assets with shorter duration liabilities. As long as yield curves remain stable or fall, things tend to work well. But when rates start to rise, flatten, or invert, and the shorter deposit durations start to re-price upward, that interest rate risk margin can quickly disappear or even go negative.
In essence, we have three contributors to margin profitability. Margin brought by gathering deposits at rates below alternative market rates such as borrowings. Margin brought by generating loans at rates above alternative market rates such as investments. And, margin contributed by taking interest rate risk, which is typically managed through hedging strategies.
Why is this important? It’s important because it is much easier to manage each of the components separately than to manage net interest margin as a whole. It also provides the ability to consistently compare the contributions of deposit gatherers and loan generators while holding CU leaders accountable for interest rate risk management.
So, how does it work at CommunityAmerica CU? Here, we use what is called “matched maturity” FTP. We don’t want to give the interest rate risk portion of the margin to the business unit. They can’t control it and have little to no ability to manage it. Their job is to price loans and deposits profitably. It is finance’s job to manage interest rate risk. The only FTP methodology that truly allows separation of the interest rate risk margin is matched maturity FTP.
Matched maturity FTP depends on the establishment of a yield curve for pricing alternative sources of funds—such as borrowings—and alternative uses of funds, such as investments. In a world with an upward sloping yield curve, longer duration deposits demand higher rates than those that are shorter, and longer duration loans are priced at rates greater than those whose durations are shorter.
At CommunityAmerica CU, our primary alternative to gathering member deposits is the use of Federal Home Loan Bank advances. Similarly, our primary alternative to making member loans is the use of investments, such as U.S. Treasuries or Agencies. As a result, we use a combination of the FHLB advance rate yield curve and Agency investment yield curve.
Rather than using the FHLB curve for transfer pricing deposits and the Agency curve for transfer pricing loans, we average the curves to give us one curve for both purposes. Many financial institutions utilize LIBOR and Swap curves for FTP, but since we actively participate in FHLB and Agency markets and do not routinely play in LIBOR/Swap markets, we feel our curves better represent the way we do business.
Now that we have established the FTP yield curve, we can start transfer pricing. If a deposit gatherer brings in a one-year maturity share certificate, we can look at the curve to determine what it would cost us to borrow one-year money and compare the certificate rate offered to the alternative cost of borrowing.
Similarly, if a loan originator brings in a loan with a 3-year duration, we can look at the curve to determine what we could make if we simply invested the money at a three-year maturity and compare the loan rate to the investment alternative. If those are our only asset and liability, we can look at the mismatch between the one-year rate and three-year rate on the yield curve to determine the portion of the margin contributed to interest rate risk. See the figure below.
It is apparent from the diagram that, in this example, a larger part of the margin comes from interest rate risk than either loan or deposit pricing. By separating the mismatch margin we can see the direct effect on the net interest margin from pricing the deposit. Similarly, we can see the impact on the net interest margin from pricing the loan.
This structure provides both guidance for product pricing and discipline when facing the temptation to chase rates by removing the margin associated with interest rate risk. It allows the business unit to focus on what it controls—pricing and product margins—while finance manages the interest rate risk.
FTP methodologies have a number of other uses and, when used in conjunction with risk-adjusted profitability management, their power is increased dramatically. But, even in isolation, FTP is a powerful tool for margin management that aids in understanding the various margin components and providing the capability to manage margins more effectively.
CUES member Richard Baumgartner is chief financial officer of $1.8 billion CommunityAmerica Credit Union, Lenexa, Kans.