By Mark H. Smith, Inc. Staff
Credit union managers are faced with a myriad of risk management decisions every day. These decisions have consequences, many of which can affect return on assets and the overall health and safety of the credit union.
When managers assess the many risk factors, they also need to determine a course of action that is appropriate based on those assessments. The action can be steered by the answers to the following questions:
- What are the potential costs and benefits of the action?
- What is the potential magnitude of error if the outcome is not as expected?
- What is the risk or opportunity loss of doing nothing?
We should point out that doing nothing is often a valid consideration and can be the right choice at times. For example, during the last financial crisis, private label mortgage-backed securities were being pitched with much fervor as they offered nice returns and collateral values with little to no risk because they were forecasted to not go down. We now know in hindsight that choosing not to invest in many of these securities (i.e. do nothing in this space) may have suited us all better. Generally, when someone has said that an investment with a very healthy return and the collateral has no risk, a wise course of action is to turn and run. However, we digress.
On the flip side, if managers choose to do nothing, it is important they ask and be able to answer why they are doing nothing. Are you choosing to do nothing simply to be on the safe side or to avoid potential criticism?
In the very competitive environment that credit unions operate, the risk of doing nothing can be as detrimental as being very aggressive. Many times we have seen credit union managers not make the decisions that may be best for their credit union because they do not want to spend resources and energy on increased regulatory scrutiny. This is a valid consideration; however, as the Greek philosopher Aristotle once said, "Criticism is something we can avoid easily by saying nothing, doing nothing, and being nothing."
This brings us to the interest rate risk decision that credit unions have been faced with for the past several years and particularly the past several quarters. The question that looms is, should I invest in term investments with excess liquidity to help support margin, or hold off in light of the potential for higher rates? The corresponding question pertaining to the loan portfolio is, how aggressive should we be in obtaining new fixed rate longer term loan volumes in light of a potential rising rate environment? There is of course no easy, one way or the other, clear-cut answer to these questions and each set of credit union managers and boards may also have different risk tolerances.
There is a risk and return “weighing” that occurs with all of these types of decisions and particularly in this environment where the return versus the risk is certainly not the best we have ever seen.
As many have experienced, regulators will certainly expect management to know the outcome and exposure if interest rates were to rise quickly, and they often expect management to operate under this worst case scenario. But, the focus here is to emphasize there is also risk if no plan is created for the eventuality that interest rates remain low. Have you fully considered the possibility that interest rates continue status quo, or rise very, very slowly over the next several quarters or years? What if the Federal Reserve’s decision turns out to be a one (or two or three) small step and then done event? Making the decision to hold off altogether with either of these choices (i.e. do nothing) may lower your interest rate risk profile now and reduce potential scrutiny, but at what cost? What is the total cost of doing nothing?
There are varying factors such as capital levels, net interest margins, current balance sheet mix, field of membership, board and management knowledge and expertise, credit union philosophy, and local economic events that influence how a credit union will approach assessing and determining prudent interest rate risk tolerances. Finding the right interest rate risk/return balance should be given careful thought by boards and/or ALCOs with periodic evaluation of the plan to determine if the course of action is still appropriate and within risk tolerance levels. When considering potential outcomes, managers should always include the option that interest rates may not change and that management is not changing current strategies. Thus, the scenario of doing nothing.
One example of a course of action might be continuously filling and/or building your investment maturity ladder where excess liquidity is available. Another may be to wait and then make a large investment at a particular point in time when rates change. This option envelopes a degree of heightened speculation and the risk that the point does not arrive, or the arrival is prolonged. How much could the total cost (or opportunity loss) be during that interim time period? Doing nothing, holding excess short term liquidity, and not having a plan if rates do not increase, or raise slowly over a more prolonged period of time than initially thought also runs the risk of further interest margin erosion. We at Mark H. Smith, Inc. would suggest that having a well-structured investment maturity ladder should be a constant. The same holds true for the loan portfolio. There may be some advantages to holding a well-structured and varied loan portfolio that includes some long term loan products. The key to this approach is a periodic evaluation to determine if the loan and investment portfolio durations should be shortened or lengthened.
In summary, the choice of doing nothing can also present a variety of risks that need to be considered in making decisions. We suggest potential criticism NOT be a factor in your decision. Doing nothing may be a valid selection but only make that selection after the full costs of doing nothing are weighed. As was once said, "There’s as much risk in doing nothing as in doing something."