As Greek philosopher Heraclitus of Ephesus warned way back in 500 B.C., the only constant is change. Credit unions might be well-served to keep this in mind, especially when it comes to managing their balance sheets in light of today's dynamic economic environment.
When the Federal Reserve dropped its Fed funds rate to close to 0% in November 2008, many credit unions changed their approaches to balance sheet management. Now that economic indicators have prompted the Fed to promise a rate rise in the near future, those credit unions will soon learn how well they have managed those balance sheets, and so will their regulator.
Evident, too, will be how tightly margins have been squeezed between what credit unions earn on investments, loans and other assets, and how much they pay in interest on share savings accounts and other liabilities. Credit unions that find themselves upside down in their balance between the two may have some explaining to do, NCUA Chief Economist John Worth said.
Credit unions with stable deposits that are unaffected by rising rates on loans, credit cards or other products – which have interest rates that can rise as the rate environment expands – will be in a good position to embrace future changes, Worth said. However, credit unions with less stable deposits and loan portfolios that are top-heavy with 30-year, fixed-rate mortgages locked in at lower interest rates, and other products that can't expand with the marketplace, could face problems.
"No credit union is completely like either one of those scenarios, and they all will be affected by rising rates to varying degrees," Worth said. "Asset liability management means understanding how you fare under a wide range of rate environments and then managing to those environments."
Worth believes most credit unions have managed their balance sheets well in light of the challenges and opportunities the changing environment has brought, particularly given the dramatic rise in consumer loans over the past year. However, the economist stressed, there is no perfect institutional profile, and all credit unions are unique both in their circumstances and balance sheet management style.
"We want credit unions to be robust in response to a wide variety of interest rate environments, planning for a diversity of those environments, and having balance sheets that reflect safety and soundness under a lot of interest rate scenarios," Worth said. "Diverse balance sheets will fare better in a rising rate environment."
In the perennial debate of large-asset credit unions vs. small ones, Worth acknowledges that smaller institutions in general have faced their own challenges during the recession and recovery. Size matters, but asset liability management challenges in the face of a changing rate environment is not simply a matter of the size of an institution's asset base.
The cost of funds has challenged some small institutions that lack the liquidity to pay a volatile or rising cost of funds, Worth noted. Smaller credit unions also tend to have lower loan-to-share ratios due to a lower loan demand, and may lack the membership base or resources to increase that demand.
"Add to that higher operating expenses and that just exacerbates the situation," Worth said. "But you still can't generalize about small credit unions."
Rising rates and potential margin squeezes are also one of NAFCU's major concerns, NAFCU Chief Economist and Director of Research Curt Long said. The cost of funds will continue to be an issue in an ongoing dynamic environment, he added.
"Net interest margins are something we've kept an eye on," Long said. "They haven't moved that much, and the margins are doing okay for the industry, mostly for large credit unions."
Once again, Long said, the cost of funds is the culprit, and their affordability is less of a challenge for large credit unions than it is for smaller ones. That affordability is part of the margin squeeze that is hitting some credit unions more dramatically than others, he added.
"When the rates fall, they fall for everyone," Long said. 'They're falling on the loan side, but on the share side they've bottomed out. Once you hit 0%, you can't fall any further."
But rates also have a tendency to rise, and falling and rising rates generally don't operate in tandem, causing gaps that credit unions must have the assets to accommodate, he added. Credit unions with long-term, fixed-rate assets have less flexibility, finding themselves struggling to a greater degree.
This is not the first time rates have gone up, Long noted, citing the 400 basis-point Fed funds increase between 2004 and 2006. General credit union performance during that period remained strong.
"We went through the material loss review [at the time] and couldn't find any credit unions that had failed due to interest rate risk," Long said. "Looking at numbers today and considering the track record that credit unions have had, we feel they are making a lot of progress toward being in a good position for a rise in rates."
When those rates will rise is "the million-dollar question," Long said. June would be the first likely month, he said, adding that he favors a gradual increase. CUNA experts agreed, but the association was more definitive in both its timetable for rising rates, as well as how high those rates will go.
"We believe the Fed will act sooner rather than later and that the first move will come in June with a jump of up to 25 basis points," CUNA Vice President of Economics and Statistics Mike Schenk said. "That will be a shot across the bow and send a message to the market that we're serious about this, and that it's coming, and coming soon. "
Schenk predicted that subsequent increases of 25 basis points will be announced during the Federal Open Market Committee meetings in September, October and November, for a total Fed funds rate increase of 1% by year-end 2015. The Fed funds rate will continue to rise in a similar manner throughout next year, he predicted, for a total increase of 2% by year-end 2016.
The rising rate will have a distinct impact on credit unions' cost of funds, Schenk agreed. Despite that, net interest margins will likely hold steady, remaining relatively stable throughout the rising-rate environment, he added.
"We will see credit unions raising rates as the Fed funds rate goes up, or lagging those increases to allow deposits to run off," Schenk said. "The second scenario is more likely and we believe there's hot money sitting in liquid credit union savings accounts that will run off into the money market."
In the face of increased loan demand and savings run-offs, Schenk suggested that credit unions keep a close eye on interest rate risk in order to prepare for the rising rate environment. He also stressed the need for adequate liquidity that will enable credit unions to take full advantage of the new prosperity that a higher-rate environment will offer financial institutions of all types.
"Be in the position to meet the loan demand that will continue through this forecast horizon," Schenk said. "Differentiate your institution, differentiate the value you bring your members and community, and insure that the people you serve recognize the transformative power of cooperatives."
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