Last week, the Federal Reserve gave the financial markets some indication as to the direction of their policy heading into 2006. For the first time in over a year, the Fed dropped the word “accommodative” from the accompanying statement released by the Open Market Committee. The bond market interpreted the change in language as a sign the Fed feels inflation is in check, hence a signal that we are in the final stage of the 18-month old interest rate tightening cycle.
With last week’s hike in fed funds to 4.25 percent, the spread between the overnight rate and the benchmark 10-year note narrowed to 26 basis points, the tightest margin since April 2001. This is an extremely noteworthy event. Many credit unions use the 10-year note to benchmark rates on loans to members. Given the tight spread, it is difficult to comprehend how credit unions will be compensated by these loans, if the rates they are paying on deposits (funding) are moving directionally with the overnight rate.
How credit unions manage their balance sheets in such a narrow spread environment was the subject of a Callahan and WesCorp webcast last month – Maximizing Margins. Although a number of subjects were discussed on the webcast, the primary focus was on the continuing margin compression credit unions are facing – and likely will continue to face – in 2006.
In terms of managing margin compression, WesCorp Vice President Dave Trinder used the webcast to highlight strategies for different areas of the balance sheet to increase net interest margin:
- Minimize excess liquidity by putting lower yielding assets to work.
- Adjust pricing (Loans & Shares) to reflect current market rates/conditions
- Increase interest rate risk if it makes sense to do so, given the current profile risk profile.
- Review credit underwriting guidelines and adopt risk-based pricing, or some other methodology.
- Optimizing excess capital with leverage and explore whether borrowings make sense.
Trinder stressed the necessity of considering each individual credit unions balance sheet ratios, risk profile and internal operating guidelines before determining whether these strategies make good financial sense.