Asset-Liability Committees (ALCO) may have become complacent over the last 8 years due to the lack of movement in market rates. Many credit unions I have worked with have been strategically focused on preserving or growing their loan portfolios, while deposit pricing was glossed over due to the inability to further boost the net interest margin from the cost of funds side. Now that it appears more rate hikes are likely during 2017, and many are cheering the possibility of widening margins and better net profits, it would be appropriate to review the responsibilities of the ALCO and give some thought to possible improvements.
The ALCO should be comprised of strong decision makers from key areas of the organization. Their breadth of knowledge and wide range of experience enables them to have productive discussions as they review many of the components making up the profitability of the credit union. They are also charged with anticipating problems, weaknesses and exposures and with developing possible solutions or responses. It takes solid and reliable data and reports, from external and internal sources, to arrive at strong recommendations and a well formulated course of action for the credit union.
Below is a list of topics that should be included in the ALCO discussion in addition to monitoring potential exposure to changing interest rates.
Evaluate current loan rates for competitiveness but also review to make sure loan pricing strategies are profitable. I have witnessed some credit union loan rates that did not cover the credit union’s underwriting costs, cost of funds, or default rates. If the loan rates are not profitable, it would be best to forego the loan and keep the funds in comparable term investments.
Another item to consider is how loan rates are modeled in the interest rate risk analysis. Many models assume rates on new loans increasing 1 to 1 or a beta of 1%. When loan rates are forecasted to increase the full magnitude of the rate shock, while cost of funds are assumed to have lower betas, the outcomes of the IRR analysis are typically positive. Many credit unions are still competing for the good credit and striving to grow their loan portfolios. This may require a lag in loan rates and less than a 1 to 1 increase. This will negatively impact the overall interest rate risk and may lead to lower earnings than previously projected or anticipated. Knowing the impact of this scenario on the credit union’s forecasted earnings would be valuable.
Other loan products or loan grades may be explored and possibly developed to keep loan income trending upwards. Many of the credit unions we work with have very low interest rate risk and could afford to extend terms or hold more mortgage products. These products are viable options for many institutions and should not be ignored when reviewing the balance sheet composition.
Automobile loan terms should also be reviewed and loan concentrations addressed, such as a high volume of loans coming from one dealer or one loan officer. As of 3rd quarter 2016, Experian Information Solutions reports new loan terms averaging 68 months and subprime and deep subprime loans having longer terms. Knowing how much of the automobile loan portfolio has terms over 60 months or the amount of concentration in subprime loans may be important. The ALCO should discuss and be fully aware of the credit union’s lending practices and of possible interest rate and credit risk as the lending practices change.
While history has demonstrated that most credit unions have a strong core funding source that is not highly volatile or rate sensitive, some of the money currently parked in regular shares may be more likely to leave the credit union or migrate to higher yielding products. We have seen CD balances decline since 2009 while regular share balances have increased. We have also witnessed a surge of deposits into credit unions during the same time. As interest rates increase, is this money going to stay in the system? As the difference between regular share rates and certificates widens, will the funds move out of regular shares and back into certificates? Because we cannot possibly predict with 100% accuracy how depositors will behave as interest rates change, a stress test should be applied and evaluated to focus on alternative balance sheet compositions. Mismanaging rates on deposits will have a negative impact on liquidity or on the net interest margin.
While credit unions are familiar with and invest in FDIC insured certificates of deposit (CD’s), many do not fully utilize the other asset classes allowed under NCUA investment guidelines. The ALCO should review and discuss the advantages and disadvantages of investing in government bonds, municipal bonds, and U.S. Agency mortgage backed securities. These other assets classes may offer higher yields and have strong secondary markets allowing for more actionable liquidity solutions than insured certificates of deposit. In conjunction with this discussion, the investment terms should also be evaluated. If the credit union would not hesitate to make a 5-year automobile loan, it would also make sense to invest in other 5-year instruments if the yield is commensurate. Holding excessive short term or overnight funds helps to mitigate interest rate and liquidity risks, but earning opportunities are missed. Fine tuning the risk/reward tradeoff is essential to maximizing earnings.
Additional items to consider in the ALCO discussions could be liquidity position impacted by loan growth, local economic factors, age of membership, and deposit run-off, to name a few.
Managing a profitable and growing credit union while remaining fully interest rate risk avoidant is an unreasonable expectation. As net interest margins may be further compromised due to rates going up, funding sources shifting and becoming more expensive than anticipated, and loan yields taking much longer to reach full value due to competition, credit unions may need to develop more aggressive pricing structures that will require a strong, active, and engaged ALCO.