Everyone would likely agree that interest rates are at an all-time low, and the only place to go is up. The question is how soon and how much. Former NCUA Chairman Dennis Dollar has suggested that while interest rates may climb a couple of hundred basis points, they will continue to stay at a low level for several years. If this is true, credit unions are in the long-term position of having to manage low net yields.
When rates do start to rise, the net yield will be squeezed even further because loan rate changes won't be felt as quickly as deposit rate changes, and as rates rise, borrowing traditionally slows.
Regardless of your credit union's size, there are several things you can do using asset and liability management software and related business processes to plan and prepare for changes in rates and other market conditions.
ALM tools can help credit unions evaluate-and mitigate-each of the following types of risk by creating scenarios that predict multiple outcomes:
* Interest Rate Risk: the changes in the market interest rates that impact financial performance. As rates rise, you can lower your risk by not purchasing long-term investments. At the same time, try to drag your heels as much as possible before increasing share rates. The best way to see this impact is by using the modeling portion of your ALM system. It should take into account the average life of loans, investments and shares, and use those in conjunction with proposed rate shifts to show how income will be affected.
* Liquidity Risk: the potential that current loan and/or deposit withdrawal demand will exceed the availability of liquid assets. Exposure is minimized by managing the maturity of investments, also called laddering, to match potential member borrowing and/or withdrawal requests. Your ALM tool can help with this matching by a examining the detailed cash flow reports along with forecasted balance sheet and income statements.
* Credit Risk: the risk that the quality of the loan portfolio will be impaired. Delinquency control is the ticket here. However, layoffs in your field of membership can also impact credit risk. Once again, use your ALM tool to see the impact of increased delinquency by changing delinquency percentages and loan write-offs to see the possible impact on net income.
* Concentration Risk: the exposure associated with inadequate diversification of the investment portfolio or concentrating loans to a particular borrower. Your management and your ALM committee should regularly review your investment portfolio to make sure that investments are appropriately diversified among multiple institutions.
You cannot eliminate risk, but you can mitigate and control it by being prepared.
Since net yields will continue to be low, it is important to consider other ways to increase income. Your ALM tool can also help you evaluate opportunities by easily creating assorted revenue scenarios. Following are some examples:
Be creative when looking at where you can generate income and what the increase would mean. Considering increases in fee income? Your modeling program can help you see not only the impact of new or changed fees, but can also help you determine what fee levels you may want to charge.
Examine the programs you offer and analyze what members use and pay for them. After all, it's not fair for members who do not use a product or service to have to subsidize it. If you find that many members are paying for a service that only a few members use, change the offering so that members who use it also pay for it.
Examine the performance of each product or service you offer. Look at the direct income and direct expenses. Also analyze indirect income or expenses, such as management compensation, not directly related to the product and assign appropriate portions of these expenses to products. If you find that the income of expenses are not at effective levels, use your ALM tool to create "what if" scenarios based on various changes to your products and services.
No institution is immune from changes in outside rates and other market conditions. With change occurring much more rapidly, institutions can no longer afford to produce a budget model only once a year. Think of your ALM solution as a key decision-making tool that can allow the CU to see the possible impact of its decisions almost immediately.
How To Make A Decision
When choosing an ALM system, focus on selecting one that is easy to use, can manage different types of risk scenarios, is scalable and can track your progress toward your credit union's goals.
A good ALM tool is easy to use but still allows you to create as complex a scenario as you wish. It should have the ability to manage different types of risk and take into account balance sheet risks.
It should also easily shift rates by product or related product groups, including tying products to an index. It should have an easy way to model interest rate changes. For example, it must be able to increase rates on all non-certificate share rates by a quarter percent and have the ability to tie loan or certificate rates to an index, such as the Prime Rate, so shifts in the index automatically shift products tied to that index.
It should also have cost analysis capabilities to help you examine the direct and indirect income and expense for each product or service you offer. This provides you the ability to analyze the viability of current and prospective offerings and also the affects of various adjustment scenarios before you make changes.
Finally, the tool you select must help you establish, track and manage your goals. This means it should include the ability to examine historical data for trends, current data for strengths and weaknesses and compare current data to the goals you have established.
Be sure to have documentation of past decisions available. This information creates a usable history from which to understand potential impacts and fine-tune assumptions for future scenarios.
Establish an ALM committee. Its job should be to examine what is going on both within and outside of the credit union and to make recommendations for required changes. The group should meet at least monthly or more often as conditions warrant. Conditions can change far too rapidly to meet quarterly or less.
Train the committee members on how to use your ALM solution and analyze its output. The return on the time and money you spend educating board and committee members will come back to you many times over in the results. By doing this, committee members are better able to understand different scenario results and can then make better, more informed decisions and recommendations.
Some people have a difficult time getting used to forecasting without concrete information. Don't let this stop you. In fact, lack of firm information provides a more compelling reason to perform multiple forecasts.
For example, run a report from your core system showing member loan pre-payments and early payoffs. Then, create a scenario using a long-term (such as 13 months) average of loan repayments by loan type. Use this to compute loan turnover, which can help with forecasting future loan repayments. Your ALM tool should allow you to extend or contract payment streams based upon the interest rate scenario you project.
As you can see, using an educated guess based upon factual information is far better than doing nothing, and using an ALM tool-and possibly a full ALM solution-makes forecasting much more accurate and effective.
ALM can help you prepare for almost anything. As you know, rates will rise. When they do, you must already be armed with a cohesive strategy. Don't wait for a problem to arise. Every credit union should proactively use an ALM tool to predict multiple rate scenarios and manage their goals. But remember that it's not all just technology. You have to analyze and potentially change some business processes, so you can spend your energy capitalizing on income opportunities you identify and planning strategies to handle your forecasted scenarios.
Jon Heath is an ALM consultant and Subject Matter Expert with IntegraSys, a Fiserv unit.
