Interest rate risk (IRR) has been the dominant topic of regulatory warnings since 2011. NCUA has issued frequent cautions in regulatory policy and in public statements from board members and the chief economist. In examinations, regulators have issued documents of resolutions (DORs) directing credit unions to reposition investments, extend liabilities through borrowing, and sell longer-term assets — sometimes incurring immediate losses.
These short-term model-induced examiner directives jeopardize both current and future earnings and the resulting capital levels, which is the very thing that protects the insurance fund in the first place.
In its 2013 plan, NCUA even set an internal performance goal of limiting the industry’s net long-term asset ratio to less than 35% — an objective it did not achieve (actual 35.9% page 53 NCUA Annual Report).
Frequently, NCUA’s cautions are premised on the observation that rates are at historical lows and can go nowhere but up. This view ignores another potential scenario, the two decades of Japanese economic experience of continuous historically low rates and a stagnant economy.
Although NCUA’s four-year record of IRR jeremiads has forced credit unions to make decisions that have reduced income, there is yet a bigger issue. NCUA’s statements demonstrate a misunderstanding of how credit unions, as cooperatives, manage interest rate risk. Moreover, the agency overlooks credit unions’ successful track record from prior cycles of historically low rates.
Reviewing past data shows both how credit unions manage this element of ALM and why the industry is well positioned today.
Lessons From 2004-2006: A Time Of Historically Low Rates
As shown in the Fed Funds chart below, short-term interest rates rose 4%, or 400 basis points, in the 24 months from June 2004 to June 2006. This rise was from a base rate of 1%, which was characterized as a historically low rate similar to the descriptions of today’s environment.
How did credit unions perform in this real world 400-basis-point shock test over 24 months?
The short answer is that the whole movement prospered.
When the three-year period of low rates followed by the 400-basis-point rise is viewed in the context of a full decade of performance — 2002 through 2011 — this three-year period is a time of faster growth and higher earnings than the 10-year averages.
The chart below compares the 10-year performance period and the three years contained therein.
How Credit Unions Managed During Rising Rates
The system’s success from June ’03 to June ’06 was due to three factors:
Rising rates generally occur in a strong economy. The strong economy stimulates demand for consumer credit and borrowing. Loan growth is vital to interest rate management and credit earnings.
The credit union model depends on gaining and sustaining member-owner relationships, which in turn provide a unique funding structure centered on non-maturity core saving accounts. In most credit unions, these accounts have administered, not market-driven, rate settings.
Credit unions’ asset composition generates significant short-term cash flows that provide for repricing opportunities as rates rise or fall.
The chart below, comparing the credit union financial condition one year prior to the June 2004 rate increase and the same ratios in June 2006, after the rate increase stopped, demonstrates how these cooperative advantages contributed to performance during this 400-basis-point rise.
The Situation For Cooperatives Today
The credit union financial position at June 2014 is similar to the situation in June 2003, or one year before the 400-basis-point increase engineered by the Federal Reserve.
Core deposits — regular shares and share drafts — are 49% today, identical to the earlier period.
Credit unions’ cost of funds — at 53 basis points — is double the overnight rate at the Federal Reserve. This situation is parallel to June 2003 when credit unions were paying 2.03% and the Fed Funds rate was 1%.
On the asset side, loans and investments at June 2014 are structured to provide ample liquidity for repricing opportunities in a rising rate environment: (1) Investments are liquid; cash and investments maturing in one year represent 42% of total investments of $390 billion. (2) Cash flow from loan principal and interest payments due in one year are approximately 39% of the outstanding loan balances.
Net worth at 10.76% is higher than the June 2003 of 10.44%.
Core Deposits Are Key To Flexible Asset-Liability Management
Credit union funding reliance on non-maturity core deposits means the industry has more flexibility in pricing funding strategies than do their financial counterparts.
Federal Reserve Governor Jeremy Stein in a speech to the American Economic Association singled out this advantage for banks in 2013.
“A stable deposit franchise gives a bank the ability to ride out transitory valuation changes of the sort that might come from noise-trader shocks or fire sales, without being forced to liquidate assets at temporarily depressed prices,” Stein said. “As a result traditional banks with stable funding have an advantage relative to their shadow banking counterparts in holding those assets where transitory re-pricing risk is high for a given level of underlying fundamental cash flow risk.”
The “stable deposit franchise” advantage is even greater for credit unions than for banks. For example, at March 30, 2014, credit union funding relying on rate-sensitive deposits above the $250,000 insured limit and borrowed funds was only 6.8% of total assets. The ratio for the banking industry at the end of the first quarter was 43.6%.
This cooperative structural funding advantage is again demonstrated by the two-year period of rising rates beginning in June 2004. While short-term rates rose 400 basis points in 24 months, the collective credit union industry’s cost of funds rose only 40 basis points — in part because the industry was paying over market rate, or twice the 1% Fed Funds effective rate at the beginning of the increase. As a result, credit unions’ funding options did not have to react in lock step to the Fed’s 25-basis-point increases.
Slower increases in share dividends than market rises did not inhibit share growth. Shares grew at the same pace in this rising rate period, 5.3%, as the 10-year overall annual growth of 5.4%.
The Fallacy Of Using Bank Experience
NCUA’s frequent expressions of IRR concern are based on two faulty premises.
Firstly, many of the assumptions used in examiner analysis are from ALM shock test results using the banking industry’s models. Examiners often reject the validity of the credit unions’ non-maturity core deposit assumptions because these are so much at variance with the data used in the banking industry. This error overlooks the difference in cooperative funding strategies versus banks.
But this leads to a second error when reviewing credit union balance sheets. This is the belief that interest rate risk is just a matter of proper balance sheet programming. That is, structure the assets, often the investment portfolio, so that the model gives the right outcome in a shock test and a credit union’s future will be OK.
This error forgets the first rule of modeling, which is that all models are wrong; some are useful.
A Dynamic Process And A Local Focus
Static programming to pass shock tests is not how ALM management is done in the real world. ALM management is a dynamic process that involves daily decisions on pricing loans and shares, on the term of investments, and what loan products to market to sustain an acceptable margin.
There are many product and pricing variables that managers use to balance local market forces and institutional success. Local rates, competition, and economic conditions often vary from national averages. The effectiveness of these ongoing decisions is how ALM is really accomplished. It is a continuous management process, not one that is activated when rates rise or fall.
Another observation from the 2004-2006 experience is the importance of growing the loan portfolio. During this period of rising rates, loans grew at an annual rate of 11.3% versus the 10-year growth of 4.66%. Loans are the most valuable asset credit unions can put on the balance sheet. The 9.9% growth rate at June 2014 suggests that credit unions are again demonstrating their capability to succeed in this vital area of performance.
NCUA’s Disconnect In Its ALM Guidance
NCUA’s frequent announcements concerning interest rate risk shows a critical disconnect with the industry. Credit union managers make daily judgments about, and if necessary adjustments to, the institution’s pricing strategies and asset mix.
The agency’s frequent harping on this topic is reminiscent of the following story: Two young fish swimming along meet an older fish swimming the other way. The older fish nods at them and says, “Morning boys. How’s the water?” The two young fish swim on for a bit, and eventually one of them looks over at the other and asks, “What the hell is water?”
Concerning IRR management, credit unions should suggest that NCUA jump in because the water is just fine!