The Federal Reserve Bank's fed funds target has not changed for seven years, keeping rates low for an unprecedented time. Simultaneously, consumers moved billions into the deposit accounts of banks and credit unions while credit unions added record levels of long-term assets (see the accompanying graph on page 2 of mortgage loans, for example). As a result, effective liquidity management for credit unions has perhaps elevated in importance to a level never seen before while potentially becoming a competitive advantage (or disadvantage).
Regulators began adjusting supervision of liquidity with last year's new liquidity rule and their focus will likely increase in the coming months. Guidance on "How to Comply with NCUA Regulation §741.12 Liquidity and Contingency Funding Plans," implemented in March 2014 mandated that credit unions with assets of $250 million or more must have a written liquidity policy providing a framework for managing liquidity and a list of contingent liquidity sources that can be employed under adverse circumstances. The credit union must also have a contingency funding plan that clearly sets out strategies for addressing liquidity shortfalls in emergencies and establish access to at least one contingent federal liquidity source: The Discount Window and/or the Central Liquidity Facility.
Which banks and credit unions are best at managing liquidity will only be learned over time. The market leaders on earnings, capital, margins and liquidity over a sustained period of time will likely be those that grew but also focused on how they've grown and likely viewed borrowing lines in terms of opportunistic funding, not just an emergency source.
Liquidity Capability Requires Comprehensive Analysis
The credit union industry loan to share ratio was lower in June 2015 (75.5%) versus December 2008 (83.1%). However, most other call report ratios related to liquidity risk (and interest rate risk) are currently either close to 2008 levels or significantly different, in a way that flags concern. Sandler O'Neill analysis indicates that while most credit unions are successfully managing liquidity; some credit unions are perhaps too liquid, which restricts income and capital accumulation, while others may not have enough liquidity. Of the 487 credit unions with assets greater than $500 million, cash as a percentage of assets ranges from .13% to 43.4% while the average is 7.62%. Relying on just one or two ratios can be very misleading, so we also share the information in the tables here.
How much of the money market and regular share balances that flowed into credit unions since 2008 will seek higher rates as the Fed shifts strategy? This is unknown and requires that the credit union have margins that accommodate offering competitive rates and enough liquidity to cover possible outflows (Liquidity Coverage Ratio). The margin and LCR of local competitors will also play an important role and perhaps more so than in the past.
Call report data does not provide enough information to draw confident conclusions regarding margin and liquidity risk. A more thorough analysis will include cash flow from the loan and investment portfolios as well as an understanding of what could be considered fickle or "hot" money in non-term deposits (regular shares, money markets). Borrowed funds maturing over the next year is also important, among other things.
Drive Both Your Car and That of Those Around You
Remember that lesson from your driver's education days? Sometimes, to avoid an accident, we have to anticipate what the other driver will do before he does it.
In our discussions with credit unions, a competitive analysis provides additional insight into how the credit union should manage liquidity and also how their competitor is, or is not, vulnerable. Which depositories enjoy the combination of competitive net interest margin/ROA with suitable liquidity? Consumers are going to be on the prowl for increased yield on their deposited dollar, as rates rise. If they can move their funds to a different product within their current banking relationship at a satisfactory rate, they will. If the credit union's margin cannot accommodate an acceptable rate, will the funds move out? If the member decides to move his or her funds, the credit union will need the liquidity to meet the demand withdrawal.
As rates rise, the market value on loans and investments erodes. If a credit union finds itself short on cash, assets will need to be sold or borrowing lines (if available) will need to be tapped. The loss on sale of longer duration assets and investments with imbedded options (such as callable securities) may be more than capital (or board directors) can bear.
Analysis of a credit union's liquidity position should include market value risk of assets and also the key ratios of local competitors. Clearly from the data shown on the previous page, in aggregate banks have a higher percentage of cash to deposits than credit unions. That difference in liquidity is significant.
Due to the individual composition of how balance sheets have evolved, there is no industry standard LCR. This calls for institutions to develop a customized LCR and perhaps make changes to the balance sheet in order to meet desired liquidity coverage, while facing the likelihood of higher regulatory expectation as well.
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