Digital Finance: Why Exploring Your Secondary Market Options Is Critical
While digital financial trends and fintech partnerships can benefit CUs, they can also impact a CU’s liquidity profile.
Digital finance trends such as automation and artificial intelligence are helping lenders use technology to make better credit decisions more efficiently. While these tools and growing fintech partnerships can benefit credit unions and their members, they can also impact an institution’s liquidity profile. As credit unions leverage digital finance opportunities to enhance scalable loan origination, many institutions are finding themselves in need of new funding solutions to keep the loan engine running.
As we head into 2023, the team at ALM First expects interest in securitizations to pick up significantly within the industry. Credit unions that have traditionally turned to the participation market to access liquidity have been struggling to find buyers for their loan pools. For many, there is a greater need to explore both loan participation and securitization options.
Securitizations require a larger size sale to overcome higher fixed costs but can help cooperatives gain access to a significantly larger investor pool. Standardized data and legal docs make future sales more scalable. However, available sectors are more limited than participations and therefore only appropriate for certain asset classes – not specialty or niche loan products.
Liquidity has been a hot topic for several months already and we expect liquidity management discussions to continue into the new year. While some of the traditional seasonal liquidity patterns we’ve come to expect during bonus and tax season will undoubtedly impact deposit levels in the first quarter or two of 2023, there may be less of a benefit to those seasonal components in the year ahead. With consumers increasingly tapping their existing borrowing lines, they may be more likely to pay down debt versus increasing their savings rate next year.
Utilizing Slack Availability in Your Balance Sheet Wisely
Utilizing slack availability or “renting” the balance sheet can help credit unions continue lending by opening new channels for scalable originations and sales or securitization. When priced effectively, these activities can also generate a positive return on investment, allowing cooperatives to reinvest in critical areas for growth in the future such as technology or operational expenses. While these types of investments may not always be intriguing, they are critical for long-term success.
We often compare building a balance sheet to filling a box. There is a finite capacity to add assets and the goal of any financial institution should be to maximize aggregate value. Opportunity cost is always important to consider, but especially at times when the box is at or near its full capacity.
The key to any balance sheet strategy, including originating loans with digital finance components or with the goal of securitization or sale, is remaining flexible and agile on pricing up front. Hedging interest rate risk is also critical. If you add assets that you cannot sell in secondary markets because those markets are not functioning or you’ve mispriced your loans, then your institution may be more susceptible to price and rate movements (if unhedged).
In the current buyers’ market with more credit unions seeking funding for organic growth than focusing on participations, proper diversification remains paramount and low Return on Equity (ROE) assets should be avoided or mitigated. These assets take up space on a balance sheet at the expense of more profitable assets. For example, low-coupon, high-fee auto loans represent a common depository asset class with poor ROE that takes up space on the balance sheet.
Preparing Now for Next Year’s Challenges
With CUNA, Goldman Sachs and others forecasting a “mild recession” in 2023, we expect most of next year to be very challenging for financial depositories. Our advice for credit unions is to focus on getting as ahead of the curve as possible by looking ahead at likely scenarios and risk factors for your institution. Considering your liquidity, credit and other risks now, and creating plans to help address or manage each of those risks, could help your institution welcome the new year at a stronger starting point.
Loan production is likely to slow down next year as the Fed’s rate increases have their intended impact. However, many credit unions remain behind the curve in terms of increasing their own loan rates to keep pace. Now is the time to develop a disciplined loan evaluation process to help originate profitable loans that have enough spread to clear the secondary market. If cooperatives find themselves unable to sell assets to create liquidity, they may need to slow down production or price their loans more aggressively to warrant a place on their balance sheets.
Remember, there is no one silver bullet to maximizing digital finance opportunities or building a better balance sheet. Neither securitizations nor participations will always be the best solution for every situation, so be sure to explore all your options. The market is so fluid, it’s best to keep your institution’s options open as you plan for 2023 and beyond.
Travis Goodman is Principal of ALM First Financial Advisors in Dallas.