When the Federal Reserve's fed funds rate finally begins to rise, the change will mark an interesting progression for credit unions.
Rising rates can mean increased revenue, but also greater interest rate risk for credit unions unprepared for the change.
The distinction between long-term and short-term rates is critical to understanding interest rate risk, according to NCUA Chief Economist John Worth. In terms of safety and soundness, one size does not fit both.
"People talk about rising and falling rates, but it matters whether we're talking about short-term or long-term rates," Worth said." Interest rates are not just an up-down discussion. It's the shape of the yield curve that matters."
When it comes to the spread between the asset yield and the cost of funds, the rate matters less than the percentage of revenue that results, Turner explained. Failure to manage that spread effectively, more so than interest rates themselves, often determine the degree of interest rate risk a credit union can shoulder.
Greater examiner sensitivity to that spread and how well it's being managed could go a long way in strengthening the relationship between institution and regulator, he added.
"In some cases, over the past three years in particular, examiners have given explicit directives to credit unions against real estate lending and have tried to limit investment activities all in the name of protecting the credit union against rising rates," Turner said. "This edict comes from a fundamental theory that financial institutions should not put longer-term assets on their books when rates are about to increase."
Some credit unions find themselves in a tug of war that once again pits profitability against safety as defined by the regulator. Instead of booking, say, a 7-year asset at 4.5%, they are told it is better to book a 3-year asset like a car loan at 1.9%, or invest in a 3-year security at 1.25%.
Because consumer demand has been soft, the credit unions end up investing in securities or certificates of deposit, according to Turner.
"Assessments seem to ignore the fact that balance sheets are not static," Turner said. "Loans put on the books over the past three months may account for 10% of a portfolio today, but as rates increase and additional loans are booked at higher rates, those 10% additions drop to 5% of the total very quickly. In the meantime, the credit union's earning profile has been enhanced during the duration. This seems to be lost in the examination review."
However, both public and private sector economists say credit unions won't see a rise in rates during 2014 due to continued consumer anxiety over job security and ongoing economic uncertainty.
When rates do rise, they also won't rise at the same rate for both short-tem and long-term instruments, and credit unions and their regulators need to be prepared for proper interpretation of these trends.
"Most likely, short-term rates will see very little movement until mid-2015, but longer-term rates will remain very volatile as market forces battle against Fed monetary policy, specifically its bond purchasing program," said Brian Turner, chief strategist for Catalyst Strategic Solutions, part of Catalyst Corporate Federal Credit Union in Plano, Texas. "This could bring shifts between 25 to 50 basis points over the next year."
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