Next week, the Fed will meet to discuss whether or not
they should adjust the overnight rate. Currently the
overnight rate is 1.25%, and it is highly speculated
that the Fed will decide to cut rates either 25 or 50
basis points. While a Fed rate cut impacts lending,
borrowing and savings rates across the board, it has
a direct and immediate impact on short-term investments.
Credit unions have a high percentage of their investments
in overnight and other short-term accounts, and will
lose a substantial amount of investment income if the
rates are cut.
In the first quarter of 2003, credit unions grew their
short-term investments 31%. These short-term investments,
defined as cash and cash equivalents, now make up one-third
of the industry's investment portfolio and total $72
If the Federal Reserve lowered interest rates 25 basis
points, it could cost credit unions $180 million in
yield. If the rates were lowered 50 basis points, as
some analysts anticipate, the loss in investment income
could be as high as $360 million.
There are a few strategies to compensate for this loss
of income. The first strategy would be to lengthen the
duration of their investments. When rates were cut in
November of 2002, credit unions increased the portion
of their portfolio in 1-3 year investments nine percentage
points. By lengthening their investments, credit unions
can earn higher yields and reduce their potential losses.
Many credit unions will not, however, be able to implement
this strategy. The industry's short-term deposits have
been the driving force for share growth for some time
now. These short-term deposits have been used to fund
lending, which has been fueled by mortgage lending.
Long-term loans funded through short-term savings create
potential ALM issues (asset and liability management).
These potential ALM issues caused the growth of short-term
investments seen in the first quarter, and a Fed rate
cut will do nothing to solve the issues, so many credit
unions will have to maintain a high percentage of their
The other strategy for credit unions will be to increase
their income in other areas. Credit unions would prefer
to generate more interest income through shorter-term
auto and unsecured loans. However, credit unions have
had trouble generating loans other than mortgage loans
recently, so they may have to focus their efforts on
generating more fee income. As was written
a couple of weeks ago, credit unions may already
be facing a loss of some fee income due to a reduction
of debit interchange income. Credit unions will have
to look to other areas of fee income generation to overcome
two potential income obstacles. This provides an opportunity
for suppliers to help credit unions generate enough
income to compensate for recent and potential declines
in earning power.
If credit unions cannot find a way to increase their
interest or fee income, then they will have to control
costs. Credit unions could, and almost certainly will,
pass through the rate deductions to their dividends.
The amount they pay on savings accounts will probably
be reduced a comparable amount to the rate cut. This
reduction in interest expense will help alleviate the
pain of less interest income. The amount that credit
unions cut those dividend rates will depend on their
success, or lack thereof, in generating additional income.