Managing Risk - Interest Rates, Net Interest Margin, and Capital

Recent Economic Activity

At the end of the first quarter and throughout the second quarter, the U.S. economy experienced one of the largest, if not the largest, economic shocks in history. The Federal Reserve Bank reacted swiftly in lowering the Federal Funds rate to a near-zero target and implemented various additional asset purchase programs. In addition, the federal government initiated numerous fiscal stimulus programs to aide businesses and unemployed workers. Some have proclaimed that given how this was an event-driven economic shock coupled with large and immediate responses, that a quick, “V” shaped recovery could occur. But should you really plan for this when making decisions now and throughout the next 12 to 18 months?

Federal Reserve Federal Funds Rate Projection

On June 10th, 2020, the Federal Reserve released its economic and federal funds rate projections through 2022. These projections are provided by Federal Reserve Board members. The median 2020, 2021, and 2022 projections for annualized real GDP growth were -6.5%, 5.0%, and 3.5%. From a risk management perspective, it is worth noting that the lowest of these forecasts for GDP growth were -10.0%, -1.0%, and 2.0%, respectively. Median unemployment rate projections were 9.3%, 6.5%, and 5.5%. The highest unemployment projection was 14.0%, 12.0%, and 8.0%. Given the above, Federal Reserve Board members were generally not expecting an increase in the federal funds rate through the remainder of 2020, 2021, and 2022.  

Outlook and Considerations For the Future

The reality is that even at this time, the outlook remains highly uncertain which means risk assessments with a broad array of possible outcomes should be evaluated and considered. Credit unions should see this elevated risk environment as a marathon over at least the next 12 to 18 months. Below are some considerations for the current and the forecasted environment:

In general, member deposit growth accelerated during the first quarter and continued into the second quarter for most credit unions. This is due to typical seasonal share growth and also from government stimulus and benefit programs. However, in looking at the last couple of economic declines, member share growth increased during these time periods as well. Some attribute this to members being more reluctant to spend given the economic environment. Will this continue over the next 12 to 18 months? Although the past has seen this reaction, it does not mean that it is a certainty going forward and credit unions should continue to monitor member deposits.  In addition, if the credit union has not already, consideration should be given to rapidly lowering deposit rates given the current and forecasted environment. Deposits can often become stickier during these times as concern is more about safety and not deposit rates. Many members have much higher priorities right now then what they are earning on a regular share account.

During prosperous times, some loan rates can become mispriced as current risk is relatively low and competition for loans is high. Financial institutions may set rates lower than risk would warrant to try and keep loan volumes growing. However, now is not the time for this type of aggressive practice. The risk impact of mispricing loans in the current and forecasted environment becomes much more severe. Focus on optimizing pricing and risk in originating new loans.

During the first and second quarters, many credit unions experienced immediate net interest margin pressures as investment market rates moved down swiftly. Those with larger investment portfolios experienced this the most and especially if there were a lot of overnight and maturing investment volumes. Given the economic and interest rate outlook described above, net interest margin pressures will continue for the foreseeable future. This impact, coupled with expected higher loan loss provisioning, will lower net income for most credit unions relative to their 2020 budgets and throughout 2021 and 2022. Some are expecting ROA to be negative for many credit unions in 2021. From a risk management perspective, evaluating scenarios to include a “capital burndown” is appropriate. Most credit unions have continued to build capital throughout the past several years and are well prepared for this type of analysis and the potential outcome. Now is the time to understand these possibilities and prepare the Board of Directors for this type of risk outcome.