The National Credit Union Administration has been warning CUs about interest rate risk for years.
Back in January 2014 -- when interest rates were near zero -- NCUA advised credit unions to "identify and mitigate forward-looking risks before they threaten the viability of credit unions and the stability of the Share Insurance Fund." The regulator also warned that "interest rate risk is the most significant risk the [credit union] industry faces right now."
So now that it seems increasingly likely that the Federal Reserve will start
The key way for credit unions to mitigate interest rate risk is to understand the specific risks they have within their institutions, said Dean Rohne, principal of financial institutions at Clifton-Larson-Allen LLP, an investment advisor and accountancy firm.
"Most credit unions have some form of asset/liability management function within [them]. By understanding how their balance sheet will perform in both a rising rate or declining rate environment -- they can plan accordingly."
Indeed, many credit unions have purchased shorter-term investments to help mitigate the risk of rising interest rates. "The even [bigger] item on the balance sheet is [in] the loan area, which comprises most of the assets at a majority of credit unions," Rohne explained. "Here, credit unions have for the most part sold many of the mortgage loans (with 15- and 30-year maturities) to manage their interest rate risk."
NCUA Chief Economist Ralph Monaco said that the way interest rates affect credit unions depends on how and why they rise and whether they do so uniformly across all maturities. "If [interest] rates rise uniformly across the yield curve, net interest margins might not change all that much," Monaco said.
"But, overall, the general tendency would likely be for net interest margins to compress. Rising short[-term interest] rates would put upward pressure on interest rate expense -- a key question is how much credit unions need to match market rate increases to maintain [their] deposits. History says that they can move relatively slowly, as they have in the past. But consumers may be hungry for yield and move funds across institutions more quickly than they did in the past."
Another important consideration is how swiftly rates change, he added. "If the rate of change is gradual and unfolds over an extended period of time, credit unions may be able to adjust smoothly and re-price their share and loan rates without much adverse effect," Monaco stated. "But if the rate of changes is swift and severe, it can be more harmful."
Another way for a CU to prepare for higher rates is to reduce – or adjust -- its exposure to long-term investments and loans, especially those funded with short-term liabilities, say industry insiders.
Ben Lemoine, an advisor at Catalyst Strategic Solutions, a wholly-owned subsidiary of Catalyst Corporate Federal Credit Union, Plano, Texas, recommended CUs manage the duration of their assets based on the IRR exposure that their executives feel comfortable undertaking.
"Given a low-interest rate environment, credit unions typically shorten durations to mitigate IRR, but a common mistake is to remain on the sidelines for higher interest rates ahead," Lemoine warned. "This has proven to be a costly mistake over the past seven years as interest rates have remained near all-time lows. Credit unions should continue to balance their investment and loan portfolios with short-, medium-, and longer-term duration assets."
He added that riding the yield curve in a "prudent manner" by managing duration and price volatilities is the "soundest approach to a profitable balance sheet."
But Lemoine cautioned that the yield curve does not always move in a parallel manner and there is a misconception that higher rates always mean higher net interest margins. "If the longer end of the yield curve increases along with the short end, this allows credit unions to increase their asset rates (higher loan rates and higher-yielding investments) [and] increase net interest margins, despite the increase in [the] cost of funds," he said. "However, if the short-end of the curve increases faster than the longer end, we could see cost of funds rise faster than asset yields and would ultimately [see] negative impacts on credit union net income."
Already Prepared
Many institutions have already been preparing for a higher interest rate environment.
Mike Schenk, vice president of economics & statistics for the Credit Union National Association, noted that many CUs have been paring back their exposure to long-term assets for the past three years in anticipation of the Fed tightening. "I think they [credit unions] were very concerned about higher rates and the examiners were hammering them for keeping long-term assets," he stated. "Consequently, their holdings of long-term assets have been falling."
J. Owen Cole, director of the division of capital and credit markets, office of examination and insurance at NCUA, said CUs have done a "good job" of diversifying their assets across different loan and investment categories as well as across different maturities.
It's also important to remember that the liabilities side of a balance sheet – deposits – also plays a role here, Cole said.
"Should rates rise significantly -- and/or swiftly -- having some short-term assets on the balance sheet that can re-price more quickly with the rise in market rates cushions some of the adverse impact on earnings," he said. "There are different ways to immunize against the threat from a rising rate scenario. Some credit unions will mitigate this risk by holding more cash or short-term assets. Some credit unions may utilize derivative authority to enter into hedging contracts. Still others may elect to mitigate risk on the liability side by entering into fixed-rate term borrowings or issuing longer-term fixed-rate certificates of deposit."
Lemoine said many CUs are reluctant to add 30-year mortgages below 4.00% on their books. Instead, they have been selling such securities off to third parties, such as Fannie Mae.
"This has helped credit unions continue to provide products that their members require without having to take on lower-yielding, higher IRR products on the balance sheet," he said. "Credit unions should monitor their concentrations in mortgages, but by no means remove them from the balance sheet altogether, even in this low-rate environment."
Douglas M. Winn, president of Wilary Winn Risk Management, LLC a credit union consulting firm that offers ALM services, and based in Saint Paul, Minn., suggests that credit unions can strategically "extend their liabilities." For example, provide incentives to members to move funds from money market to certificate of deposit accounts.
It is crucial for CUs to examine the deposit sides of their balance sheets when considering IRR, according to C. Myers Corp., a Phoenix-based consulting firm that offers strategic, planning, process improvement and ALM services primarily to large (billion-dollar plus) credit unions.
For example, in 2007 prior to the Fed beginning to march interest rates down and ultimately freezing them at near-zero, share certificates (or CDs) accounted for nearly 30% of credit union funding as a percentage of assets. That figure dropped to about 15% at the end of last year.
During the same period of time, regular shares rose to occupy the top spot in funding as a percentage of assets (now at about 30%).
"The near zero rates creates little difference between rates on certificates and non-maturity deposits," C. Meyers explained. "As a result, the average balance on non-maturity deposits has increased materially. For example, the average balance on money markets has increased 72% since 2007, regular shares 64% over the same time frame."
NCUA Preparing Too
The NCUA is in the process of updating interest rate risk management supervisory guidance, which will be published later this year, according to Chairman Debbie Matz.
"As part of this effort, NCUA field staff will transition to the updated IRR examination procedures over the course of 2016,"Matz wrote in a letter on Jan. 16. Examiners, the agency added, will receive specialized training on evaluating IRR in April.
In an interview with Credit Union Journal, Tim Segerson, deputy director of the agency's office of examination and insurance, added: "Examiners will be trained on [IRR] during 2016 -- with concept overview first and more extensive training later in the year."
