Managing in a Rising Interest Rate Environment
Managing interest rate risk will become a critical strategic objective for most credit unions as the economy continues to grow and interest rates continue to increase. The good news so far in this improving economy is that even as interest rates have been heading up, they are still affordable. However, net income margins will come under increasing pressure because for most credit unions, a rising interest rate environment reduces net income and capital levels. The reason for this is that most credit union balance sheets are liability-sensitive in which their liabilities generally re-price faster than do their assets. As a result, cost of funds will increase faster than asset yields, which, in turn, reduces net income. Add the fact that for credit unions which relied heavily on the previous mortgage refinance boom to maintain fee income levels, rising interest rates will force fee income to fall off its record setting pace as mortgage lending declines to more normal conditions. Rising interest rates also affect the fair value of credit union assets and liabilities, and in turn, their capital levels. Some rising interest rate risk scenarios to carefully watch for include: * Increasing rates could mean slower loan payments on variable rate loans that could lead to higher credit losses and increased loan loss provisions that lower earnings. Loan prepayments could considerably slow down which increases the average loan term. This leads to lower cash flows for reinvestment at higher rates. As rates rise, higher yielding loans and investments reduce the market value of existing loan and investment portfolios. This means less cash when selling existing assets. The cost of shares generally increases faster than the return on loans which reduce earnings and eventually, contributions to capital. For these reasons it will be critical that credit unions of all sizes manage spreads by aggressively marketing loan products and implementing appropriate liability pricing strategies to deal with potential interest rate scenarios. As interest rates rise, it will be imperative that credit unions pick the right mix of product and services to meet not only the needs of their members, but meet their fiscal initiatives as well. Credit unions should use the current environment to aggressively increase their market share in order to achieve higher growth and earnings in the future. More and more credit unions are turning their attention to adjustable non-mortgage loan programs, as well as to credit card portfolio growth. Both are key components to maintaining healthier margins. Smaller credit unions are increasingly seeking partnerships in order to remain aggressive with larger competitors. It is becoming imperative in this rising interest rate environment, for credit unions to view their card portfolios as a strategic growth initiative that combines acquisition, activation, usage, retention and risk management strategies to maintain and enhance net interest margin spreads through increased portfolio growth. Fee-based services such as overdraft protection are continuing to grow in popularity to help credit unions bolster lost fee income from the fading mortgage refinance boom. Debit cards are quickly becoming the new key to cementing a primary financial institution (PFI) relationship with members. A 2004 study by the PULSE EFT Association reveals that more than half of consumers prefer to pay for services at retail outlets with their debit card. To encourage usage in this rising rate environment, more credit unions are offering rewards to differentiate their debit product from those of others. Prepaid debit cards can lead to new revenue streams, greater brand reach, and more members. According to TowerGroup, prepaid cards will alter the bankcard landscape as much as co-branded cards did 15 years ago."Credit unions that offer prepaid debit cards can expect new revenue generation in the form of issuance, reload and maintenance fees, as well as float when cards are reloaded. In short, prepaid cards will continue to deepen member relationships and wallet share. Asset quality, as measured by loan delinquency and charge-off ratios, will become more important as aggressive loan portfolio growth continues. Throughout 2005, net income will continue to come under pressure as market interest rates rise. Managing in this environment will take a steady hand and careful attention to asset-liability management. Here are a few things to consider: Use asset-liability management programs to forecast earnings and capital in various interest rate scenarios to develop clear deployment strategies when rates do change. Measure and track all revenues and costs associated with capital spending plans making sure that the marginal benefit exceeds the marginal cost. Keep the focus on loan growth as the key to preventing a drop in net income. Be aggressive in pricing and marketing. Budget for higher loan-loss provisions. Avoid extending investment maturities significantly, and limit additions to fixed-rate mortgage portfolios. Manage your investment portfolio for return as well as liquidity. In closing, the future certainly looks bright for credit unions that take the time to implement a strategic approach to asset-liability management that focuses on the ability to quickly adapt to ever changing market conditions.