The COVID crisis reminds us not to assume the future will resemble the past.
Mervyn King is an economist who led the United Kingdom’s central bank through the financial crisis. He is a keen observer of financial systems, economies and their effects on society. Long before the COVID pandemic, he began using the term “radical uncertainty” to mean that we live in a world of accelerating, unpredictable change. In such a world, recent history may have precious little to tell us about what crazy thing to expect next.
Past experience or performance is often used to project future events. But King argues that in doing so, we may get caught flat-footed by transformative or unprecedented disruptions. And by overzealously extrapolating from past data, we often give ourselves a false sense of precision or confidence about what the future might hold. King believes that in seeking to understand and explain “what is really going on here,” we should rely less on deceptively precise quantitative models and more on constructing narratives, as is done in scenario planning. In short, we should be more ready to exercise judgment based on our broader wisdom about our industry and the world.
It would be hard to find a better example of radical uncertainty than the current moment. Credit unions’ financial results are influenced by the future direction of the economy. That’s hard enough to anticipate in normal times. But today, the most important determinant of economic conditions is the world’s ability to control the spread of COVID — a phenomenon as volatile and non-linear as a spreading wildfire.
Moreover, the state of the economy also depends on the federal government’s ability and willingness to enact new stimulus measures. The complex interaction of the virus, the economy and the government’s response makes it even harder to predict their net effect.
Look, for example, at the U.S. stock market, which soared from late March to mid-October, not because control of the pandemic enabled prosperity, but rather because a failure to control the pandemic demanded debilitating lockdowns—which then inspired interventions by Congress and the Fed which, in turn, juiced the market.
If the gyrations of the stock market are hard to foresee, it’s not much easier to anticipate some of the key factors that will determine credit unions’ fortunes. How much will loan delinquencies rise as the effects of eviction moratoriums, loan forbearance periods and enhanced unemployment benefits fade? That depends on the course of the virus, the effect of public health restrictions and governments’ responses—all wickedly complex, interdependent factors.
When radical uncertainty is the order of the day, resilience is a key factor for the success of credit unions. Those that have accumulated excess net worth, of course, are at an advantage. Larger credit unions generally have greater economies of scale than smaller ones, meaning they operate more efficiently. Larger credit unions can also offer a wider array of products and services, and generate more income that can be used to bet on new initiatives or adapt to change.
Since the COVID crisis began some eight months ago, credit unions’ resilience has been tested. Like nearly all institutions, they’ve had to transform the operation of their retail and office environments to address virus safety concerns. They’ve also faced challenges of financial management—beginning with an avalanche of deposits.
In the first four months of the pandemic, starting roughly at the end of January, total deposits in U.S. commercial banks increased by more than $2 trillion. Credit unions saw total shares and deposits increase by 15.8% in the year ending June 30, according to data from the NCUA.
Deposits mushroomed partly because uncertainty about the future is encouraging more saving among consumers. Some saved extra income from government stimulus payments. More savings resulted when travel, entertainment, and other discretionary spending became less practical.
Surely for some credit unions, the initial increase in liquidity was welcome. But as new deposits swell the size of a credit union’s balance sheet, its net worth remains constant. That means the credit union suffers a drop in its net worth ratio (net worth expressed as a percentage of total assets). This doesn’t necessarily increase financial risk if the excess deposits are held in safe, liquid assets. It can, however, cause headaches with regulators, who require credit unions to maintain a minimum net worth ratio—regardless of the composition of their assets. Also, if credit unions don’t quickly put the cash to use by making new loans, profitability can suffer.
The profitability problem has been exacerbated by the rapid fall in interest rates that accompanied the pandemic-induced recession. Because deposit rates can’t be lowered enough to match the steep drop in loan rates, net interest margins are squeezed.
In the second quarter of 2020, credit unions saw average net interest margins nearly 10% below those of a year prior. The surge in refinancing can offset lower margins temporarily by generating fee income, but as more homeowners refinance, net interest margins could fall further.
Amidst the pandemic and recession, it’s easy to forget that the credit union industry was already facing profound change. Financial technology firms (“fintechs”) see banking as ripe for disruption, and they’re growing exponentially. Since 2016, more than half of U.S. residential mortgages were originated by nonbank lenders, such as Quicken Loans. From 2010 to 2019, global venture capital investment in Fintechs grew by a factor of 28—to $53.3 billion. That’s equal to 30% of the net worth of the entire U.S. credit union industry. This kind of growth means fintech innovators have the potential to alter credit unions’ competitive landscape with little notice.
In a world of radical uncertainty, although financial resilience is necessary, it’s not sufficient. Successful credit union leaders will apply wisdom, creativity and sound judgment to continue thriving through whatever unknown crises—and opportunities—will come next.
