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 answers to the following questions can steer the action:
- 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 great fervor, offering nice returns and collateral values with little to no risk because they were forecasted not to 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 provides 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?
For the very competitive environment in which credit unions operate, the risk of doing nothing can be as detrimental as being overly aggressive. Often 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. Avoiding regulatory criticism 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.”
Credit unions continue to make important decisions concerning interest rate risk, facing the question, should I invest in term investments with excess liquidity to help support margin, or hold off given the potential for even higher rates? On the other side, what if interest rates have now peaked and have a flat to downward bias? Will the credit union be giving up return by not extending investments? The corresponding question about the loan portfolio is, how aggressive should we be in obtaining new fixed rate longer-term loans if an increase in interest rates is looming? 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 these types of decisions and particularly in this environment when the yield curve is less sloped, and the return versus the risk is certainly not ideal.
Regulators expect management to know the outcome and exposure if interest rates were to rise quickly, but they often expect management to operate under this worst-case scenario which may be in the best interest of the share insurance fund but not the best interest of the credit union’s profits. While interest rates remained extremely low for many years, some credit union managers held onto excess cash and waited, “did nothing” in anticipation that interest rates would soon increase and minimize regulatory criticism. Interest rates finally did start increasing approximately three years ago, and we have seen many credit unions benefit from the increase in interest rates with results much different than the regulatory bodies warned would happen (i.e. expanding not contracting net interest margins). A major reason for the increased profitability is due to a significant portion of credit unions’ funding sources consisting of regular shares and share drafts. Not understanding interest rate risk and the balance sheet composition of both assets and liabilities and managing from the position of risk avoidance, or “doing nothing” may lead to missed income opportunities.
One example of a course of action might be continuously filling and 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. 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 period? We at Mark H. Smith, Inc. suggest that having a well-structured investment maturity ladder should be a constant. The question becomes, when should the credit union consider extending the ladder if interest rate increases have peaked? The same holds 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 also a periodic evaluation to determine if the loan portfolio composition is adequate or should be adjusted either shorter or longer.
The focus here is to emphasize there is a risk if no plan is created or evaluated under multiple interest rate scenarios. Credit union managers should consider all interest rate possibilities, from rates remaining status quo, rising further, or possibly decreasing. Not having a plan (i.e., do nothing) or managing the balance sheet very conservatively, may lower your interest rate risk profile 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, the 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 ALCOs with periodic evaluation of the plan to determine if the course of action is still appropriate and within risk tolerance levels.
In summary, the choice of doing nothing can also present a variety of risks that need to be considered in decision making. We suggest that 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.”