Net Interest Margins Continue to Shrink at Credit Unions

Credit union consultant Mike Higgins said he expects net interest margins to contract in the second quarter as credit unions raise savings rates faster than their yields on loans.

“Credit unions are well capitalized and will be able to weather the storm; however, it’s going to be a tough slog for a while,” Higgins said.

NCUA data for the first quarter showed the cost of funds increased faster than loan yield, and a sample of monthly credit union data monitored by Higgins showed that trend continued for both April and May.

Members, who for years had little reason to pay attention to their savings rates, had their eyes opened by the Fed raising the Fed Funds Overnight Rate from 0.08% in February 2022 to 5.08% since May this year.

“Everyone is paying attention now and technology makes movement of funds easy,” Higgins said. “Dollars are flowing out of transactional accounts and into higher cost certificates or into brokerage houses (Schwab, Edward Jones, etc.).”

The low rates prevailing over the past decade led many credit unions to place a lower priority on attracting and keeping deposits.

“It is a muscle that has atrophied,” Higgins said. “It will need to be re-worked into shape, but in an environment where everyone else is doing the exact same thing, meaning competition is going to be tough, and heightened by those desperate for funds.”

The Federal Open Market Committee raised rates at 10 meetings in a row before pausing at its most recent meeting held June 13-14. Fed Chair Jerome Powell said then the Fed skipped a rate hike, but that further hikes might come over its next four meetings from July to December.

NAFCU Chief Economist Curt Long said the minutes of the June meeting released Wednesday show most FOMC members were leaning toward raising rates at the July 25-26 meeting.

“Interim data could cause a change in course, but with just three weeks until the next meeting, time is running short,” Long said. “Credit unions should expect one hike in July and one additional hike in the fourth quarter.”

Higgins said the current high interest rates might present challenges, but they are not new and not likely to return to pandemic-era levels. The last time the Fed Funds Overnight Rate topped 5% was 2007. Back then, credit union cost of funds was 3.19%, while it was only 1.17% in this year’s first quarter.

“If the Fed Funds Rate stays where it is (or creeps higher as signaled recently), cost of funds will continue to rise,” Higgins said.

Higgins said the last decade of low rates is a statistical outlier in the history of Fed Funds. Since 1954, the median Fed Funds Rate was between 4.0% and 4.5%.

“My opinion is we are reverting to the mean, and it is entirely possible rates will stay in that range for the longer term,” Higgins said. “Financial institutions did just fine in that rate environment, and will do so again, it’s just the rapid amount of change that is creating some pain in the short run.”

A fast rise in rates, like the one that has occurred since early 2022, has led members to take out fewer loans and stop making extra payments on the loans they do have.

“Think of the member with a 3% mortgage or a 2% vehicle loan,” Higgins said. “There is no incentive to pay that off when they could earn 5% on a deposit product instead. The member owns the option on the contract, not the credit union.”

“Credit unions can adapt to change, but rapid change, given the behavioral aspect of liabilities and the contractual aspect of assets will create some near-term challenges,” he said.

Of course, the result for credit unions is lower cash flow from loan payments and less money to redeploy at higher rates.

Last week, the Madison, Wis.-based Filene Research Institute published Higgins’ “Credit Union Financial Performance Indicators” report on first-quarter results. It showed credit union net operating income (net income but substituting actual net charge-offs for loan loss provisions) was an annualized 0.79% in the first quarter. That was down from 0.95% in the fourth quarter, but remained near the 10-year average of 0.81%.

But Higgins found other signs of trouble ahead in the first-quarter:

• Net interest income fell in hard dollars from the previous quarter, and the net interest margin fell 6 basis points to 3.01%.
• Operating non-interest income fell at an annualized rate of 13.2%, and was 35.8% of non-interest expense — lower than any point in the past 10 years. “Without non-interest income, credit unions would be unprofitable; this income source represents 1.04% of assets, greater than the 0.79% operating ROA this quarter.”
• Net revenue, which is the sum of net interest income (excluding provision for loan loss expense) and non-interest income, fell at an annualized rate of 4.6% from the fourth quarter to the first quarter.

“Net revenue is the canary in the coal mine of a fixed cost industry,” he said. “When that wanes, it’s difficult for expense to follow lockstep.”