A Balance Sheet Balancing Act

ALM tools help CUs determine which loans best fit their balance sheets.

April 11, 2012

It doesn't take a mind reader to know one of the top questions facing credit unions: “Will we be able to increase lending this year?”

The answer is yes, says Denny DeGroote, manager of asset/liability management (ALM) for The Members Group. “Lending is expected to increase this year—but will it go to credit unions? That’s the $64,000 question. It all depends on how good of a job credit unions do in getting people in the door.”

But DeGroote’s ALM background tells him there’s more to lending than just getting bodies into the lobby: Do credit unions know how to forecast what loans will benefit them in the near- and long-term? What loans will proper use of ALM lead them to make?

But first, many credit unions have to get past certain misperceptions about ALM, says Michelle Flynn, president of Objective Advisors Inc. “Most of the time their negative association with ALM is because they’ve had a bad experience with regulators and are looking for help to avoid a repeat experience.

“Some don’t buy into it at all—they think it’s too assumption-driven and view ALM as a little black box that sits in the corner,” she continues. “Our primary goal is to demystify ALM and help credit unions see it’s the best piece of technology at their disposal for making educated, realistic forecasts about the future.”

Back to borrowing

After two years of paying down debt, consumers will be preparing to take advantage of low-cost loans, says Mark DeBree, director of ALM services at Catalyst Strategic Solutions. From a credit union perspective, auto loans are ideal.

“They’re the best bet for credit unions right now in terms of risk and return,” he says. “Auto loans don’t have the added risk of mortgages, while still offering a healthy return.”

DeBree says credit unions have gotten creative in their efforts to compete with captive finance companies and other providers. The most effective credit union niche he has seen is in indirect auto lending programs where credit unions maintain control over loan decisions.

But besides control, there’s still the matter of feasibility. “Credit unions sometimes accept loans without considering their effect on the balance sheet,” DeBree says. “They should think of themselves as portfolio managers and view that portfolio like they’d view their own 401(k): Just as you wouldn’t put all your eggs in one basket or focus on only high-risk investments, credit unions should consider which loans best fit their balance sheets.”

Flynn thinks part of scoping out feasibility is anticipating how interest rates will change. “The greatest challenge over the next couple years will be maintaining net interest margins while also preparing for the eventual increase in rates. Loans having durations in the three- to five-year range are a good fit for most credit unions.

“This intermediate term duration will allow credit unions to adjust the rates on these loans over the next several years,” she continues, “instead of being locked into longer-term loans at historically low rates.”

DeGroote also is mindful of interest-rate increases, but thinks they won’t occur before late in the year. “If they rise, it won’t be until after the election. This traditionally is the case, but it’s even more likely today given the general uncertainty of the economy.”

When rates do rise, he says, it will create a squeeze on spreads as credit unions pay more for deposits and have lower-rate loans on the books.

Next: Earning assets

Ideally, credit unions’ earning assets must have a fair portion in both long-term investments and short-term loans that turn over more frequently, DeGroote says. “Credit unions have to recognize which elements are in their control and which aren’t. If interest rates rise and competitors begin raising their deposit rates, credit unions can’t control this. They’ll have to pay more for funds or watch them walk out the door.”

He says the focus needs to be on elements credit unions can control. “A basic rule of ALM is a balanced ledger. As the cost of funds increases, credit unions must adjust pricing accordingly on the other side of the ledger to maintain a sufficient spread.”

ALM providers say common mistakes credit unions make with ALM involve their motivation for using it and how they manage it. “Looking at ALM as a one-time exercise to satisfy examiners is a mistake,” says DeGroote. “It comes down to managing both sides of the ledger competently and consistently, quarter in and quarter out.

“Credit unions must also do a better job of innovating and listening to members to develop strategies,” he continues. “They need to consider their market area and find different ways to generate revenue.”

Flynn agrees member feedback is crucial, especially when competing with other providers for good loans. “The key is finding out what types of loans your members are most interested in at this time and then structuring them in the best way for the credit union. One idea is to spend some time talking with a group of 10 to 20 members to get their feedback.”

Other mistakes credit unions make, she adds, include underestimating the power of ALM technology as a forecasting tool and not involving key decision makers in the process.

“ALM allows you to test different pricing and structure options,” Flynn says. “Once you’re satisfied with the specific characteristics of the loan, you can go out into the lending market with more confidence.”

DeBree advises taking the necessary time to conduct ALM, not rushing through assumptions or the fact-gathering process. “For example, an ALM assumption that factors in 30-year, 6% mortgages would not be realistic. The models have to be plausible. Also, doing ALM purely as a way to satisfy regulatory requirements means never learning how to integrate it as an important decision tool.”

Flynn suggests two steps to enhance the ALM process:

  1. Make realistic assumptions about the speed at which members prepay auto loans and mortgages. Base one set of assumptions on your own credit union’s unique prepay experience, in addition to the prepayment speeds being predicted for the country as a whole; and
  2. Model troubled debt restructurings accurately. Don’t base them on overly optimistic expectations.

DeGroote reminds credit unions that the composition of their deposit accountholders will change as rates increase because consumers are more sensitive to savings rates than they used to be.

“They’re shopping for bargains,” he says. “That’s where the ability to inspire loyalty becomes incredibly important. Credit union management must put more effort into inspiring loyalty than ever before.”