Planning for Rising Rates
At first glance, it would seem that financial institutions would benefit from a rising rate environment. More specifically, a steepening of the yield curve should benefit a financial institution that is using short-term liabilities and loaning out long for funding. Under the current economic landscape, both short- and longer-term rates have been artificially suppressed to extremely low levels. Rate increases are resulting in a flattening of the yield curve, which has the potential to zap net interest margin.
A variety of factors affect actual interest rate risk. For example, depending on the type of asset, average duration coupled with the type of funding will have a direct effect on interest rate risk. Other factors, such as interest rate hedges and changes in non-interest components, are also part of the equation.
Another key factor in interest rate risk in a rising-rate environment is “institutional depositors.” More credit unions now serve these large groups, such as school districts or municipalities. These groups can be a significant source of a CU’s deposit funding. The typical institutional depositor utilizes a demand deposit account for day-to-day operational needs and will venture into a money market deposit account and term CD structures for reserve funds not actively being deployed.
However, these depositors fall into the short-term bucket on the liability side. A large percentage of them have access to an array of financial institutions, broker-dealers or investment advisors that provide a conduit to the fixed-income market, thus adding a level of rate sensitivity. That is, there’s a heightened risk in a rising-rate environment that these institutional depositors may move to a competitor should their rate needs not be met.
With short-term yields hovering around 1 percent, a 25-basis-point increase is the equivalent of a 25 percent increase in interest. Institutional investors, when presented a variety of investment options, are going to seek those that actively move with rising rates. An effective strategy for creating stability among institutional depositors, and to lock in interest expense (interest rate times the principal amount of the deposit), is to offer a market-indexed rate for non-maturity deposits (deposits that can be withdrawn at any time). Understanding these competitive pressures will allow a credit union to attract and maintain stable institutional depositors.
Furthermore, this strategy can help reduce unnecessary repricing for other deposit accounts at the credit union. The thought process is to not offer a blanket pricing strategy to all depositors—since all depositors do not react the same. By targeting segments, based on established criteria, a CU can control interest expense and maintain or even develop institutional depositors without unnecessarily repricing natural person members of the CU.
This is not unlike risk-based lending nor the special attention CUs give to setting rates for member business lending.
A market-based pricing strategy also gives a credit union the ability to deploy a hedging strategy to mitigate interest rate risk. Typically, the hedging of deposits is overlooked, but it can be a powerful way to lock in your cost of funds. By focusing on a segment of depositors like institutional depositors, a credit union can create enough scale to “move the needle” with respect to its interest rate risk position. This can be an alternative to Federal Home Loan Bank advances, which require collateral and erode the availability of contingency funding.
By leveraging market-based pricing with a segment of depositors and hedging it to match asset duration, a credit union can gain peace of mind in deposit stability and associated interest rate costs. With reduced volatility in the deposit portfolio, a credit union can proactively engage in loan growth without worrying about funding instability impeding growth. Furthermore, market-based indexes (whether the full rate or a modified rate) are good candidates for hedging. The flexibility in deposit hedges, allows a credit union to hedge precise points along the curve, effectively matching duration against its loan portfolio.
D. James (Jim) Lutter is SVP/trading and operations at PMA Financial Network, Inc., Naperville, Ill., and PMA Securities, Inc. where he oversees PMA Funding, a service of both companies that provides over 1,000 financial institutions with a broad array of cost effective funding alternatives. Lutter is a registered representative with PMA Securities, Inc. and investment advisor representative with Prudent Man Advisors, Inc.
Todd A. Terrazas joined PMA Financial Network, Inc. in 2014 as a financial analyst for the firm’s Credit Risk Management team. He now serves as business development and product manager for PMA Funding, where he is responsible for developing financial institution partner relationships and managing funding product solutions and association affiliations.