Interest Rates: Predicting the Unpredictable (and Predictable)
Almost every expert opinion about future interest rates since the Great Recession has predicted an increase in long term rates. NCUA has identified interest rate risk as the "most significant risk the industry faces right now."
While the experts and regulators continue to agree that higher rates are coming, the markets have stubbornly refused to agree. To be sure, rates will increase. Maybe soon&... or maybe, much later. The predictions just haven't been correct yet. As Nobel Laureate Niels Bohr remarked, "Prediction is very difficult, especially with respect to the future." As we write this, the 10-year U.S. Treasury bond is just 2.53%. Think long term rates can't go lower? Ask Germany, where the 10-year bond is now at 1.35%.
Good risk management requires looking at more than just one scenario of higher rates (both short- and long-term). Management can take some basic steps to prepare for interest rate variability:
- Take into account the effects of low, flat, and higher interest rate scenarios in planning. It's good to stress test for both short-term and long-term IRR exposure. Don't place a "one direction" bet on rates; the cost of being wrong is too high in any direction.
- Actually use the stress testing information instead of placing it on the shelf once the report is finished in order to make business decisions to better balance risk and reward.
- Understand the differences in effective duration, volatility and total return of different investment and loan portfolio products in these. Manage the credit union's effective duration by focusing on cash flow and re-price sensitivity.
- Make use of regulatory website tools available to monitor your long-term asset and Supervisory Interest Rate Risk Threshold (SIRRT) ratios as early indicators of a trend in extended duration.
- Focus on the behavior of principal cash flows in each environment and the stability of funding. Stress test your loan and securities portfolios for changes in liquidity and principal cash flow. Is your contingency funding plan established? Remember that higher short-term rates can create greater pressure on funding costs than a spike in long-term rates.
- Be careful about maintaining excessive amounts of short-term cash. This is an expensive strategy especially since the Fed will likely signal far in advance through their forward guidance changes in short-term rates. Don't "fight the Fed." The cost in earnings is too high.
- Regulators can also take some basic steps in assessing interest rate volatility:
- A few state regulators have changed "CAMEL" to "CAMELS." This exam strategy separates cash liquidity and interest rate sensitivity (the "S") as two distinct risk assessments each with its own assessment tools. NCUA and other state regulators should also consider this change to bring appropriate focus to each of these risk components.
- Good regulatory assessments in the exam process should expect credit unions to test for a variety of rate scenarios not just a rapidly rising rate environment. There is also substantial risk to earnings in a long-term low rate environment, such as Japan has experienced for more than a decade or the deflation concerns currently playing out in Europe.
Will rates rise? Definitely. However, when one reflects on the last five years and the continued expectations of interest rates going higher, which hasn't yet materialized, it's clear that effective risk management means being prepared for multiple scenarios. "Measure, monitor, and manage risk while focusing on principal cash flow" is a sound approach in all interest rate environments — up, down and flat.
Ronald L. McDaniel serves on the National Association of State Credit Union Supervisors' (NASCUS) Credit Union Advisory Council, and is the president/CEO of the Glendale, Calif.-based California CU. Mark L. Lovewell is EVP of California CU. Ron can be reached at RMcDaniel@californiacu.org and Mark at MarkL@californiacu.org.