Interest-rate risk is a common concern lately. Financial institutions have increased their holdings of longer-term assets, and most experts expect interest rates to increase soon.
Federal-funds futures trading shows signs of short-term interest-rate increases beginning later in 2011. And if financial institution funding cost increases outpace gains in asset yields, earnings could decline.
It has happened before. In 1970, 87% of thrift institution assets were in residential “1-4 family” mortgages, and they averaged 83% of assets during the decade. Yes, 83% of assets, not 83% of loans!
Moreover, federally chartered thrifts couldn’t originate adjustable-rate mortgages (ARM). And shorter-term balloon mortgages were essentially replaced by more consumer-friendly 30-year, fixed-rate mortgages.
Thrifts weren’t granted authority to originate ARMs until April 1981. So nearly all assets were concentrated in 30-year, fixed-rate mortgages until the early ’80s.
The U.S. economy suffered double-digit inflation throughout most of the ’70s. To address this, Federal Reserve Chairman Paul Volcker shifted the Fed’s focus from keeping short-term interest rates low to controlling money supply growth. By July 1981, the fed-funds interest rate reached a cyclical high of 22.4%, averaging 16.4% that year.
Not surprisingly, thrifts regulated by the Office of Thrift Supervision racked up incredible losses, as quickly repricing deposits sent funding costs rocketing above slowly increasing asset yields.
Thrifts that didn’t follow the market quickly experienced massive deposit outflows, because money market mutual fund yields adjusted to the new market realities in real time. Industry return on assets totaled -0.74% in 1981 and -0.63% in 1982.
Fast forward to the Federal Financial Institutions Examination Council’s January 2010 interest-rate risk advisory, which contained interagency guidance stressing the “importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the interest-rate risk exposures of depository institutions.”
Underlining that concern, NCUA published a proposal in March 2011 to amend its regulations to require federally insured credit unions to have an effective interest-rate risk program and a written policy addressing interest-rate risk management. The proposal, which was open for comment until May 23, includes new regulatory provisions and interest-rate risk policy and management guidance.
Federally insured credit unions with assets of less than $10 million wouldn’t be required to have a written policy or a program. Those with assets of $10 million to $50 million would be exempt, too, if their total first mortgages in portfolio, plus total investments with maturities longer than five years, equal less than 100% of their net worth.
While appropriate and reasonable management of interest-rate risk is very important, CUNA has concerns about any new regulation in this area. At the very least, the appropriateness of the proposed asset triggers and asset concentration schemes is questionable.
CUNA’s concerns extend to the comprehensive interest-rate risk guidance in the proposal’s appendix. Too often in the past, guidance like this became regulation by default.
Credit union decision makers realize it’s vitally important to measure, monitor, and control all risk. But credit unions generally don’t reflect high levels of interest-rate risk, and certainly don’t look anything like the thrifts of the early ’80s.
At year-end 2010, first mortgages represented 40% of loans but only 24% of total assets (not 83%). Fixed-rate mortgages with terms greater than 15 years represented 37% of total credit union mortgages but represented only 14% of total loans and 9% of total assets. And while longer-term investments (three or more years to maturity) represented nearly 24% of total investments, this exposure also equaled only 9% of total assets.
Interest-rate risk concerns are valid, but the need for new interest-rate risk regulations is questionable, and the danger of detailed guidance transformed to regulation is worrisome.
MIKE SCHENK is CUNA’s vice president, economics and statistics. Contact him at 608-231-4228.