In the past few years, credit unions of all sizes have faced uncertain economic conditions. Rarely has the industry experienced a time when interest rates have remained so historically low for so long, consistently driving downward pressure on income from outstanding loans. At the same time, profitability has been up, aided by low provisions for loan losses and gain on the sale of loans and investments.
The trouble is that these loan loss provisions aren’t sustainable and may not remain at current levels in the near future. This is why managing interest-rate risk, as the NCUA has increasingly been pressuring credit unions to do, is so important.
But where should credit unions start? One place to begin is by examining their net interest margin (NIM), a measure of interest income generated and the amount of interest paid out — i.e., the equivalent of gross profit margin at a commercial enterprise. NIM is influenced by several components, including the shape of the yield curve, yield on loans and investments, cost of funds, composition of assets, and income lost as a result of nonperforming assets. Taken together, these factors make interpreting NIM, assigning specific cause and effect, and evaluating performance a complex undertaking.
The average NIM, based on NCUA data for all federally insured credit unions, was 2.93% for the year ending on December 31, 2012. This period also marked the third consecutive year in which NIM decreased.
The yield on average loans was 5.42% for the year ending on December 31, 2012. Again, this marked a significant decline from a decade ago.
What does this environment mean for loan growth? If new loans are granted at these lower rates, the average outstanding loan will generate lower interest income. What’s more, many newly originated loans may come from previously rejected ones, adding risk to the loan portfolio. Is the reduced income worth the extra risk for credit unions?
Of course, risk-based pricing (when properly implemented) can help financial cooperatives reduce credit exposure. However, competition is intense, and many institutions are underpricing rates to attract borrowers.
In terms of the cost of funds, 2012 was the sixth consecutive year in which rates dropped. Cost of funds for the year ending on December 31, 2012 was 0.73%. This represents a sizable decrease from the previous decade.
In the current environment, deposit pricing is crucial to NIM. While credit unions want to give back to their members by raising yields, the result is lower earnings. Does that mean they should lower deposit yields? Perhaps, but doing so could cause deposits to leave credit unions in search of another institution’s higher rate offerings.
Finally, credit unions have been able to withstand the recent financial crisis with strong capital. While capital dipped in the wake of the recession, levels have been on the rise the past few years and are approaching the high-water marks reached more than a decade ago.
Since credit unions rely almost solely on retained earnings to increase capital, NIM is critical. Over the next year, will asset growth outpace capital growth or vice versa? What about over the next five years? Undercapitalized credit unions may have to rely on competitive strategies since their net worth ratio doesn’t allow for taking on additional risk. Conversely, credit unions with a higher net worth ratio can take advantage of higher capital and take on additional risk.
Over the past few years, both yield on loans and cost of funds have fallen, the former more precipitously. With the Federal Reserve appearing to want to keep rates low, or at least on a very slow rise, continued margin pressure is anticipated. NIM monitoring through asset liability management is imperative in this environment.
As a result, many institutions are trying to mitigate the impact of the flat yield curve and better predict results. Is your institution looking to stay short in its portfolio and not take on extensive duration risk until rates rise? Are you positioned to grow loans and continue to reduce nonperforming assets in this increasingly competitive market? Evaluating NIM may limit your interest-rate risk by helping you set rates and alter your asset mix accordingly.
Carrie Kennedy has practiced public accounting since 1997, with a focus on credit unions and other financial institutions. She performs internal audits, supervisory audits, annual opinion audits, and loan reviews. You can reach her at (509) 777-0160 or email@example.com.
A leader in assurance, tax, consulting, risk management, transaction, and wealth services, Moss Adams has a staff of over 2,000 that includes more than 260 partners. We provide services to over 300 credit unions and other financial institutions.