What Goes Down Must Come Up — But When?

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Depending on the headlines you read — and whether you're a glass-half-full or glass-half-empty forecaster — the troubled economy may yet be on a long, slow rebound, meaning flat, low rates for a while.

But one thing all economists can agree on: interest rates have nowhere to go but up — it's when rates begin to rise that's still out for debate. Since the Federal Open Market Committee first cut interest rates to an historic zero to 25 % in December 2008, that level has remained unchanged. But rates will rise; and the question isn't so much when, but whether we are prepared for the risk potential.

Measure and Monitor-ALM Modeling

Determining the level of risk your credit union should take always is challenging, whether you're dealing with credit, interest-rate, or liquidity risk. Add today's low interest rate environment, and it makes for particularly demanding pressures on net interest margins and return on assets. Each credit union is unique with different risk tolerance levels, capital levels, and member needs. Financial institutions should not focus solely on setting random maximum limits on loan types, but instead focus on the realignment of other parts of the balance sheet should one particular loan product bring value to it and its members.

In other words, while some institutions might garner too much interest-rate risk with the majority of its loans in fixed-rate mortgages, others will be fine.

Interest-rate risk should be managed and credit unions should be measuring and monitoring the systems they currently have in place to ensure that risk is within set boundaries. But what determines how much risk you should take? Two key measurement tools are essential to help you better understand your credit union's interest-rate risk: net economic value (NEV) analysis and net interest income analysis (NII). Performing a NEV analysis helps to determine the amount of interest-rate risk on your balance sheet within different rate scenarios, while an NII analysis measures income volatility within different scenarios.

With rates inevitably poised to begin rising, it is imperative to model anticipated balance sheet changes before they occur to gauge the impact on interest-rate risk. It is also prudent to perform what-if scenarios to help understand what an increase in loans held on the balance sheet would have on NEV ratios and NEV percent changes. By doing so, your credit union will have a more accurate picture of its exposure to interest-rate risk and will be better prepared to manage it effectively.

What-if Analysis

A simple "what-if" would be to analyze your balance sheet given an up-500 basis point change. Although an immediate rise of an up-500 scenario is absurd, the test would reveal results of an up-200 rate movement. In this environment, your then up-300 economic value would be the current up-500 scenario with the up-200 scenario being the new base. The chart above provides an example. This credit union moves from a low regulatory measure of interest-rate risk to a measure very close to a high-risk designation, as its assets lose more value than liabilities gain.

Of course, this test is not perfect, for rates will not rise 200 basis points overnight. A more precise analysis would be to conduct a forward NEV analysis with a snapshot of your balance sheet and book rates after a gradual rise of 200 basis points over a period of time. However, the test does provide a simple tool that can provide adequate information. If you accept a moderate amount of interest-rate risk and the result of this test is less than a 45 % NEV change with an NEV ratio greater than 6%, you should feel comfortable adding mortgages up to that level.

Flat or Rising-Maintain the Strategy

If you determine that too much risk in inherent, here are a few strategy choices you can use to decreased excessive risk exposures:

• Hedge away your risk. Surprised? Yes, hedge away your risk! Hedging seems to be a scary word, but hedging away interest-rate risk works and derivatives have been used by financial institutions for decades. The collapse of the financial markets brought a minimal amount of losses on derivatives that were comprised to minimize interest rate risk. These should not be confused with credit default swaps which hedge away credit risk. Their collapse brought huge losses to the financial community. Credit default swaps were only in existence for a few years and as credit losses occurred, those that were "long" credit had to make payments to counterparties at multiples of what they were paid. Your worst case for hedging against rising rates with interest rate swaps is if rates move to zero. This can be calculated and assessed. Although this type of "insurance" needs education, it works if utilized properly, and it allows an institution to retain longer duration assets on its books.

• Look to consumer loans. These typically have shorter maturities, less extension risk, and less price volatility compared with mortgage loans. So, there is less interest-rate risk and impact to NEV.

• Promote certificates. To lock in funding costs, you can provide CD options. If rates begin to rise, there is a possibility of margin compression as prepayments slow, reducing the amount of funds to reinvest at higher rates. However, if a portion of deposits and borrowings have term maturities, this will help keep liability costs lower and maintain margins.

• Increase duration on liabilities. Credit unions can help offset the increase in interest rates by extending liability duration, which will help reduce NEV risk. As liability prices decrease in rising scenarios, the result will be an increase in the economic value loss of liabilities. This benefits the credit union, as liability losses offset asset losses in a rising-rate environment.

• Buy shorter-term securities. Credit unions can invest in shorter maturity securities or in floating-rate investments. With floating-rate investments, the yield resets higher in a rising-rate environment with minimal price volatility. Credit unions should invest any excess cash in maturity ladders with monthly maturities to ensure liquidity.

Emily Hollis, CFA, is a partner in ALM First Financial Advisors.

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