Four Simple Rules for Balance Sheet Management

To use a baseball analogy, hit singles rather than swing for the fences.

July 16, 2012

Credit unions continue to face significant headwinds and challenges to performance. Regulatory issues, weak loan growth, and an uncertain interest-rate outlook are weighing heavily on margins and net worth.

As credit union managers struggle with this environment, it’s helpful to remember a few simple rules for prudent balance-sheet management.

1. Keep assets deployed

In the past two years, credit unions have experienced a substantial change in their asset mix, moving away from loans and into investments.

Simultaneously, share growth has continued to be steady or strong at most credit unions. As a result, average loan-to-share ratios for U.S. credit unions are now lower than they’ve been in at least five years, and the trend may not reverse soon.

In the midst of this excess liquidity, credit unions need to keep assets productively deployed to avoid a drag on revenue.

Over the past two years or so, large balances sitting in Fed funds have amounted to a painful and mistaken bet on rising interest rates. It’s better to keep the balance sheet fully engaged and hitting on all cylinders rather than sitting on a large funds balance earning nearly nothing.

2. Manage cash flow and liquidity

It has always been our contention that managing interest-rate risk on a credit union balance sheet is largely a function of cash-flow management.

Traditionally, there’s no better hedge against rising interest rates than a steady stream of predictable cash flow that can be redeployed into new, higher-yielding assets.

In terms of the investment portfolio, cash flow and the volatility of cash flow also determine such things as duration and convexity, key measures of price risk for bonds. In a very real sense, financial assets are simply streams of cash flow to be managed for optimal reward and acceptable risk.

Subscribe to Credit Union MagazineAlong those same lines, credit unions should always remember the role of the investment portfolio as a vehicle for managing liquidity. Proper identification of bonds and bond-types that provide reasonably consistent and predictable cash flow, as well as securities that are readily sold in the secondary market, is critical.

The risk/reward relationship for securities should be viewed with an eye toward liquidity risk. When purchasing a bond or considering alternatives, portfolio managers should take a hard look at the cash flow uncertainty or optionality, as well as the underlying price sensitivity.

3. Focus on balance-sheet risk

A credit union can be thought of as a system of interrelated functions. The three primary functions are lending, funding, and investments.

Any decision or strategy that impacts one of these areas will necessary affect the other two. For example, if an illiquid bond is purchased, it can become a drag on net worth and a constraint on the overall balance sheet, including the ability to make loans to members.

Therefore, look carefully at the asset/liability posture of the balance sheet with respect to interest-rate risk before putting an investment strategy into place.

4. Don’t reach for yield

Credit unions continue to operate in a historically unprecedented rate environment with excess liquidity and increasing margin pressures. This is when credit union managers can be tempted to reach for yield without adequate regard for the cost in terms of price or liquidity risk.

In this kind of environment, there are many types and structures of bonds that show attractive nominal yields, but often they contain greater risk than is desired or acceptable. Think through the risks of long-maturity callable or step-up structures, for example.

Now is when investment officers and portfolio managers should concentrate on high-grade credit and reasonable returns rather than high nominal yield and unreasonable options risk. Often, the highest “stated” yield doesn’t produce the best all-in return.

To use a baseball analogy, hit singles and doubles right now. Don’t swing for the fences.

JEFFREY CAUGHRON is associate partner for The Baker Group LP. Contact him at 800-937-2257.