The historically low interest-rate cycle during the past six years has forced credit unions to make significant adjustments.
Even though NCUA focuses on rising interest rates, credit unions shouldn’t dismiss the possibility that interest rates will increase only slightly during the next couple of years. And flat rates could be as dangerous to many credit unions as rising rates.
Chief financial officers (CFOs), and credit union management in general, have zeroed in on the effects of market interest rates to credit union operations. Their primary considerations from a strategic standpoint are capital levels, margins, earnings, and growth expectations.
Execute stress tests
It’s essential that your credit union invest the time and resources necessary for appropriate asset/liability management (ALM) and interest-rate risk modeling capabilities to fit your balance sheet complexity.
Your board and senior management team must understand the economic trade-off between earnings risk and asset-valuation risk. Capturing margin at the risk of incurring net economic value volatility can prompt intense scrutiny from NCUA examiners.
Each credit union has a unique profile with a unique risk tolerance. It’s imperative your credit union undergo many “what-if ” scenarios (stress tests) regarding interest-rate shifts to demonstrate your ability to absorb potential swings.
Incurring time risk while avoiding credit risk has often been prudent since the recent credit crisis, and continues to be a valid consideration. The X-factor: We can’t count on the low end of the curve to remain low.
It’s difficult to make assumptions about how your core deposits might react if and when rates rise. Quantifying the maturity on a “nonmaturity” deposit seems an exercise in futility, but you can use industry-accepted models.SIDEBAR:
The National Economic Research Association devised a range of one to five years depending on product type, based on an extensive 1990s study. More recently, many have adopted a model from the Financial Accounting Standards Board that relies on data specific to your credit union’s history.
Err on the side of caution by considering various scenarios.
Employ rising-rate strategies
Credit unions generally employ two basic strategies to prepare for rising interest rates: shorten asset duration and/or increase liability duration. In January, NCUA approved a final rule allowing federal credit unions to use a third method: The use of limited derivatives, which Credit Union Magazine explored in our May issue.
You can shorten asset duration by:
If you purchase fixed-rate mortgage-backed securities or issue residential mortgages, limit your potential exposure to option risk—particularly extension risk.
While issuing long-term certificates of deposit might seem to extend liability duration, consider the possibility that substantial rate increases could prompt members to cash in their certificates early if the penalty for doing so isn’t severe enough.READ:
A portion of nonmaturity deposits isn’t very sensitive to interest-rate movements. But because interest rates have been so low for so long, members’ future actions might not follow historical patterns. Many vendors offer statistical analysis of your members’ behavior, but it’s important to stress test and measure sensitivity of risk exposure under a variety of potential outcomes.
Borrowing funds from the Federal Home Loan Bank (FHLB) or a corporate credit union might be the best option for lengthening liability duration. By contract, the issuer of the long-term debt can’t call the debt before maturity, unless the credit union allows otherwise. This gives your credit union better control of interest-rate risk.
Consider multiple scenarios and diversify your balance sheet so you’re not exposed to excessive risks in any rate scenario. And remember that rates won’t move in unison across the yield curve. Changes within the yield curve might have a greater impact than a paral-lel shift of the curve.
Next: Guard against shrinking portfolios