Manage Risk In A Rising-Rate Environment By Tom Manley, CFA (this article courtesy of Credit Union Magazine.com.)
Determining the level of risk your credit union should take always is challenging, whether you’re dealing with credit, interest-rate, or liquidity risk. Add today’s flat yield curve and it makes for an especially demanding environment, placing pressures on net-interest margins and return on assets.
To maintain margins in the current environment, many credit unions are faced with increasing their risk. But what determines how much risk is too much? Two key measurement tools can help you better understand your credit union’s interest-rate risk: net economic value (NEV) analysis and net interest income analysis (NII).
Performing a NEV analysis helps to determine the amount of interest-rate risk on your balance sheet within different rate scenarios, while a NII analysis measures income volatility within different scenarios.
Setting a strategy
Before your credit union develops a plan for managing risk, the board and management must determine what they want to achieve. What are your overall goals and objectives? What strategies will you use to get there? What’s your credit union’s appetite for risk?
How you manage risk in a rising-rate environment (or any other phase of the economic cycle) largely depends on the answers to these questions, within regulatory confines, of course.
It’s easy to fall into the trap of focusing on managing investments rather than making loans. But remember, a credit union’s best investment almost always is a loan to a member. Loans continue to be credit union’s core business, not to mention a key member service. So it makes sense to develop a strategy that allows you to keep your loan pipeline full.
Also, pay attention to your long-term asset/liability management (ALM) approach. Some tactics are appropriate whether rates rise or fall. For example, should you sell off loan portfolios to make room for more growth? Does it make sense to introduce a new higher-risk, higher-return investment product? What about redeeming certificates before their maturity dates?
Analyzing liquidity/borrowing needs
A major risk confronting credit unions today is not having adequate liquidity to meet members’ borrowing demands. But how can you focus on making loans when liquidity is tight? With a spread of only 20 to 30 basis points between the two- and 10-year Treasuries, the flat yield curve clearly poses a problem for financial institutions needing liquidity.
And, as the Federal Reserve continues to raise the targeted federal funds rate, some credit unions may have to raise their liability costs to maintain deposits. Yet, because of fundamental and technological issues, longer-term Treasury rates aren’t increasing, so credit unions can’t increase loan yields.
One way to help mitigate this risk is to perform a thorough liquidity/borrowing analysis, thus working to improve liquidity at a critical time. Although credit unions sometimes shy away from this approach, borrowing can be an excellent strategy, if a well-thought-out plan is developed that focuses on carefully analyzing your borrowing options.
Typically, you have two choices:
1. Increase your credit union’s deposit rates. However, this may not be the best option because it takes time to draw additional funds into your credit union.
2. Borrow funds from your corporate credit union or a federal home loan bank. This option offers an immediate impact and may be less expensive. As well, you can use these borrowed funds to manage your credit union’s day to-day cash-management needs or support increased loan demand.
As part of your credit union’s borrowing analysis, consider comparing different borrowing structures. For example, take a look at short- vs. long-term rates, and fixed- vs. floating-rate instruments. Compare the costs of borrowing and increased liability in different interest-rate scenarios. This will reveal the impact on both NII and NEV. After the board and management have reviewed the borrowing analysis, your credit union can implement its risk-management strategy with confidence.
Keep your tools nearby
Implementing a borrowing strategy often is a sound way to meet members’ needs and improve your credit union’s liquidity risk. However, the only way to be sure your strategy will work as planned is to measure its effects periodically using NII and NEV analyses to ensure that your credit union remains within its risk parameters.
Right now, tight liquidity, pressures on the bottom line, and a desire to serve members with borrowing needs present daunting challenges. But by determining how much interest-rate or liquidity risk your credit union is comfortable taking, performing a thorough borrowing analysis, and then developing a solid plan for obtaining liquidity when it’s needed, your credit union can meet this challenge head on.
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