Managing in a Rising-Rate Environment

John Ehmann, thePoint
January 6, 2005

Don't be too comfortable with the recent 10 basis point (bp) uptick in interest margins we experienced in the third quarter. The bigger picture shows that net interest margins have been steadily declining over the past 10 years, and that trend is expected to continue. The recent reprieve is due largely to the Federal Reserve raising the fed funds rate by 75 bp over the past few months, along with credit unions holding deposit rates steady.

Looking forward, many credit unions should be able to fight off margin compression from expected rising rates over the near term, but only until liquidity pressures come into play. Not everyone may be so fortunate, however. Credit unions with high concentrations of long-term fixed-rate real estate loans will find it more difficult to keep margins up. For nearly all credit unions, the most significant wild card in the longer term is the impact equity markets will have on credit union liquidity and the resulting pressure credit unions will face to increase deposit rates.

Understand Your Risk Position

It's more important than ever to have sound asset liability management (ALM) practices in place. If you don't, you won't know if you're taking on too much risk or leaving money on the table. To capture an accurate picture of your risk exposure, use both net income simulation (NIS) and net economic value (NEV) analysis. NIS measures the impact on future earnings, and NEV measures the impact on your balance sheet's value.

Make sure your ALM model or outsource provider is up to the task. Ask yourself whether or not you're able to adequately model:

The embedded options in mortgage loans, asset-backed securities, and callable securities Rate caps and floors on adjustable-rate instruments Member sensitivity of non-maturity deposits Future interest rates and a flattening yield curve If not, you could be working with less than reliable results. These areas warrant particular attention because they can have a significant influence on your risk position. Your examiner will pay close attention to these areas as well.

Interest Rate Strategies

Sometimes it's easier to identify what not to do. Here are some common mistakes credit unions make when they expect significant interest rate changes or occur.

Don't bet on interest rates. Instead, establish a disciplined investment strategy and stick to it, regardless of the rate environment. Diversification and a laddered approach are your best bets, not interest rates. Here's a good example. A credit union with a 60% loan-to-share ratio is holding a significant portion of their investments in overnight funds in anticipation of rising rates. That might appear reasonable at first glance, but the problem is that this has been the credit union's strategy for the past 18 months. This credit union left a lot of yield on the table between the time they bet on rates rising and when rates actually increased.

Don't make a living off the yield curve. We shouldn't lose sight that credit unions are primarily in the business of making loans, not buying investments. To the extent you can, take on interest-rate risk in the loan portfolio, and use your investment portfolio to mitigate the risk.

Don't give away the store on deposits. Liquidity pressures will make it difficult enough to keep your rate-sensitive members. Don't compound the problem by overpaying non-rate-sensitive members. Segment these two groups of members, and develop pricing strategies appropriate for each. Core deposit studies can help determine your members' sensitivity. Common examples of pricing strategies include tiered savings and CD specials.

Adapt quickly to changing rates. Keep on top of the changing rate environment, and use your ALM model to measure your interest rate risk exposure at least monthly. Know when to cut your losses and restructure your balance sheet.

The best way to manage through rising rates is to keep it simple. Understand how your credit union will be affected by rising rates, adopt sound ALM practices, and use them to make prudent lending, funding, and investment decisions.

John Ehmann is assistant vice president of CUNA Mutual Group. Contact Ehmann at john.ehmann@cunamutual.com or 800-937-2644, ext. 7709. This story first appeared in The Point for Credit Union Research and Advice at www.thepoint.cuna.org and is reprinted with permission.