This is a tough-it-out era that credit unions will long remember.
“There is no untapped loan demand at this point,” says Jerry Boebel, a financial management consultant with ProfitStars. “There’s no silver bullet for increasing loan demand. Credit unions are being forced to sit on cash. They need to manage their deposit rates and operational costs.”
Not long ago Boebel would have said credit unions have seen the floor and that lending would pick up. But the earthquake in Japan sent a huge amount of money back into safe havens.
“There’s no way to predict an event like Japan’s earthquake,” he says. “But you can create rate-shock scenarios that address the effects of a dramatic, unforeseen event. A good example of that occurred three years ago when financial institutions used rate shocks of 5% and 10% to test the real estate markets. But nobody could have foreseen the 60% drop in real estate values in some markets.”
And that, says Boebel, is where asset/liability management (ALM) comes in. No person can predict the future but everyone can say, “What if?” and plan accordingly.
Using software that can test any rate shock or unlikely scenario in seconds, ALM can help credit unions respond adeptly to the economy—even if the best they can do is sit tight or settle for lower yields.
“Credit unions that use ALM effectively fight the temptation to lower their lending criteria or sacrifice future margins for higher yields today,” says Boebel. “They’re not sacrificing the future.”
How can credit unions boost their margins as deposits continue to outpace loans? “They have to be creative in offering new products and services,” says Jon Heath, senior financial consultant at Fiserv. “Credit unions must be creative to obtain loans by cutting rates or offering longer terms.”
Do credit unions have any more room to lower deposit rates? Heath says that depends on the credit union, its membership, and the particular area’s economic environment.
“In general, members aren’t as sensitive to lowering rates on regular share types, or even eliminating interest on share drafts,” Heath says. “Credit unions can still offer higher rates on certificates, which provide a more manageable cash flow.”
If credit unions can’t make loans, Heath says their only alternative is to invest excess funds. “With excess liquidity, credit unions must be careful with long-term investments and associated risks. They must consider future implications.”
A plausible option for excess funds—probably the least risky at this point—is the bank certificate of deposit, says Heath. “Even so, you have to be aware of the financial institution you’re investing in. Typically riskier are complex coupon formulas where the rate is based on a pool of many rates.
“Our advice to credit unions: Don’t make any investment you can’t account for in terms of where the money goes and how it’s performing,” he adds. “Also, understand what a broker tells you about an investment’s structure and what it’s supposed to pay out.”
Next: Bolder steps
“Some credit unions enjoy healthy returns on assets because they’re doing their homework,” says Emily Hollis, partner at ALM First Financial Advisors. “They’re not doing all prime loans. Some are going down a credit tier but protecting against the risk by pricing loans correctly,” which requires rigorously appraising members and doing ALM forecasting.
“Some credit unions in California and Florida are countering the effects of downsized housing markets by merging, often as equals,” Hollis says. “Others are looking into derivatives, a strategy that requires a lot of knowledge to do correctly. Then they’re cutting expenses and hedging.”
Many larger credit unions are taking a special interest in hedging, Hollis says. Adding mortgages to their balance sheets puts credit unions in a quandary: When will rates rise? Should they sell now and sit on a small yield but be safe? What if rates rose quickly—or not at all?
“With ALM you can simulate these scenarios,” Hollis says. “But often the result makes a credit union say, ‘We don’t want to look like this.’ So if we say, ‘Then sell your mortgage portfolio,’ and they say ‘no,’ we recommend hedging. Hedging is like taking out an insurance policy: Chances are you won’t need it over the short-term.”
Boebel says some credit union managers perform ALM only because it’s required. “Much of their reluctance comes from what’s involved: training, buying software, and dealing with outside vendors.
It’s one more resource to invest in compared to, say, hiring a loan officer, whose expense and revenue generation are quick to appear. ALM is more abstract, and its good effects are harder to see.”
Boebel sees a noticeable shift to outsourcing some ALM functions. “But outsourcing doesn’t absolve management from understanding the product, its uses, and its underlying assumptions.”
Heath says outsourcing appears to be an easy solution to keep examiners off credit unions’ backs. “The drawback, though, is that you’re three months behind in knowing what’s going on in the market. That’s fine as long as things are going smoothly. But rapid market change will find you unprepared.”
Heath advises making ALM part of every decision.
“ALM involves constant planning for possible future scenarios even if they never come true,” he says. “Everything you want to ask about increasing income, dealing with increased liquidity, reducing share rates, and how members might react are easily modeled with ALM.”