Lower market interest rates are good for credit unions-NOT!

Recently, a well-known credit union economist stated that Fed rate cuts are good for credit union bottom lines because it increases the upward slope on the yield curve (a paraphrase). An examination of the graph exhibit shows a different reality. The chart shown here compiles Net Interest Income (NII) for all U.S. credit unions with more than $50 million in total assets. (Net Interest Income is the total amount of interest income earned on loans and investment minus total interest expense and dividends paid.) This figure is expressed as a percentage of average assets. A rise in this ratio represents an earnings increase and a decline represents an earnings decrease. The trend line shows this ratio from 1996 through 2000. Clearly, lower interest rates reduce NII and higher rates increase NII. When short-term market interest rates fall (as represented by the one-year UST yield), credit union earnings drop three to six months later. When interest rates rise, earnings increase three to six months later. This positive correlation, by definition, implies that credit union balance sheets have assets repricing faster and to a greater degree than funding liabilities. This is contrary to popular belief, but entirely true and predictable. An additional point of consideration is related to loan portfolio quality. The economy of the United States has prospered for so long that the concept of a long, deep downturn is off of most people’s radar screens (to use a modern phrase). However, a sustained, low interest rate environment is indicative of significant economic weakness and malaise. This is the environment where loan losses are rampant. Students of financial institution safety and soundness will clearly identify loan problems as the greatest risk as compared to interest rate risk. The implications of the view that credit unions are helped by lower market interest rates are huge. Routine strategic decisions would be made incorrectly. Risks would be assumed wrongly in lending and investing. Safety and soundness could be compromised by the incorrect view. It is vital that each credit union determines its reality position. A first step may be to check its historical Net Interest Income against a market rate benchmark. If the results are different than your prior belief, it may be time to reevaluate your asset/liability and interest rate risk modeling. Validation of your reality may also be considered through outside consultation.