Meager Margins

CU net interest margins could drop below 3% for the first time in history.

December 12, 2011

Credit union net interest margins (NIM) are again under downward pressure with little hope of a turnaround until 2013. Credit unions reported NIM (yield on assets minus cost of funds) of 3.15% in second-quarter 2011, down from 3.25% for all of 2010.

On a positive note, that was one basis point (bp) higher than second-quarter NIM reported by commercial banks. The Federal Reserve’s exceptionally low interest-rate policy and a weak economic recovery could plausibly push credit union margins below 3% for the first time in history, during the next two years.

Declining NIM is nothing new. During the past 30 years, credit union NIM fell from more than 5% (500 bp) in the early 1980s, to the 4% range in the 1990s, and to the low 3% range today. The main reason for this long-run secular decline: increased competition. The main cause of the increased competition: financial institution deregulation.

The ongoing weak economic recovery and the Fed’s policies to stimulate the economy likely will cause asset yields to drop faster than funding costs next year. Credit union asset yields fell to a record low 4.08% in second-quarter 2011 because credit union investment portfolios grew faster than loan portfolios, and amortizing loan and maturing investment balances repriced into lower-rate products.

CUNA’s economists are forecasting 2012 deposit balances will grow 5%, while loan balances will increase only 3%. This means the average credit union investment portfolio will increase more than 7%.

This excess liquidity will punish credit union NIM because many short-term investment yields are lower than credit union deposit interest rates. Credit unions must weigh the marginal risk (credit and interest rate) versus the marginal return (additional yield on assets) of alternative assets to attempt to boost NIM.

Credit union cost of funds also fell to a record low of 0.93% in the second quarter, down from 2.78% in 2007—the year before the start of the recession. Repricing of maturing share certificates into today’s low interest-rate environment, combined with the transfer of maturing share certificate balances into money market deposit accounts, will continue to drive down funding costs. Expect funding costs to fall 5 bp each quarter through 2012.

Unfortunately, asset yields might fall 8 bp each quarter for the next six quarters, pushing margins below 3%.

When can we expect a margin turnaround? On Nov. 2, the Fed reiterated its belief that low rates of resource utilization and a subdued outlook for inflation will warrant exceptionally low federal-funds interest rates at least through mid-2013. So rising short-term market interest rates in 2013 will increase yields on credit union short-term investments, pushing up overall asset yields.

Also, credit unions’ excess liquidity position in 2013 will allow deposit interest rates to lag increases in market interest rates, keeping funding costs in check.

This scenario is dependent on economic recovery. CUNA’s economists estimate gross domestic product growth will be 3% in 2012—approximately the long-run trend (40 years) growth rate for the U.S. economy.

If the economy gives us a nice surprise and grows 4% to 5% in 2012, the Fed could act sooner and begin to raise short-term interest rates at the end of 2012. We can only hope.

STEVE RICK is CUNA’s senior economist for the Credit Union National Association. Contact him at 608-231-4285.