Why be concerned about your credit union's liquidity when mostof us are flushed with funds resulting from an inflow of fundsassociated with a flight to safety and loan portfolio outflows dueto lack of loan demand?

Rising interest rates typically are used to manage economicrecoveries so it is likely rising rates will be accompanied by areturn of flight-to-safety funds to the market and a spike in loandemand, putting many, in short order, back in the tight liquidityenvironment of a several years back.

Many credit unions have rate floors under their variable rateloans. As rates move up, rates on these loans won't reprice for awhile, but your cost of funds will.

Also, many credit union balance sheet structures consist oflong-term fixed rate assets in the form of mortgages andinvestments, which may have resulted in a short-term boost to theirearnings at the expense of increased interest rate risk concernswhen rates rise. The result is further compression of already tightmargins.

The objective of a viable liquidity strategy is to provide aframework to minimize the adverse effects of a significant andsustained liquidity crisis. This can result from changing economicor interest rate conditions, deposit outflows, unusually strongloan demand, intense competition, an international crisis, or anyother factors that can deplete the liquidity of your creditunion.

In the event of a serious and sustained liquidity crisis,various strategies, of which some would beconsidered preventative, must be implemented prior to theonset of a crisis. Other strategies are reactive and may beimplemented immediately. The strategies will differ in terms of theimplementation time, costs, risks, financial implications andregulatory consequences.

The first place to look for sources of liquidity is within yourown balance sheet structure.

Loan Payments andPrepayments — A credit union may write loans with longrepayment schedules. Track and test loan payments and prepaymentsin all economic environments to estimate the level of cash inflowsto the credit union under a variety of scenarios. As a reminder,when interest rates are falling, prepayments will increase, andwhen rates are rising, prepayments will slow down. Loan demand thatexceeds the runoff of existing loans is a major contributor toliquidity problems as such monitor the net volume of new loansrelative to the projected runoff of existing loans and other cashflows such as investment maturities. Management should review andadjust loan rates as necessary in an attempt to ensure a reasonablebalance between loan demand, runoff, other cash flows and theloan/asset ratio.

IncreasingMember Deposits — To bring about aninflow of deposit funds without cannibalizing previously depositedfunds is often referred to as “disparity” or “segmentation”strategies. They are designed to identify depositors based on ratesensitivity and encourage an inflow of deposits when needed. Youshould be forecasting your liquidity needs and anticipating thoseneeds in the marketing of your deposit products.

Selling of Loans— Mortgage loans written to conforming loan standards can normallybe sold in a short period of time with one major issue to remember:Loans will be sold at their market price, which may be more or lessthan their book value, depending on the current level of interestrates. Other types of loans have the potential for sale as well,i.e. consumer loans.

InvestmentMaturities — The primary role of the investment portfolio isto provide liquidity by means of a laddered structure withpredictable cash flows.

Selling ofSecurities — The sale of securities is a reactive strategy.The extent to which securities may be sold to meet liquidity needsdepends on the accounting classification and the amount of marketlosses resulting from the sale. Liquidity concerns are usuallyaccompanied by market conditions that depress bond prices and thus,the sale of investments may result in realized losses, depending onthe maturity and/or embedded options in the instrument beingsold.

Non-MemberDeposits — Non-member deposits, also referred to as brokeredfunds, can provide near-immediate and short-term funding. Notethese come at a high price and the funds are very rate sensitive,i.e., “hot money”.

Contingency and Alternative FundingSources:

Loans from theCorporates — The corporate credit union is still the lenderof first choice for a majority of credit unions. Loans fall intotwo major categories: A line of credit and a term loan.

• A Line of Credit — These come in two varieties: committed anduncommitted. A committed line, most common, the credit union pays afee based on the size of the line and its duration. There is acontractual assurance that the funds will be available to thecredit union when those funds are needed. An uncommitted lineof credit, funds may be available based on the lender's — thecorporate — ability and willingness to fund. Generally, there is nocharge for an uncommitted line of credit, but the certainty ofobtaining the funds when you need them could be in doubt.
• Term Loans — These involve a specific amount borrowed for aspecific period of time. It may be a bullet loan with the principaldue in full at maturity, or an amortizing loan similar to aninstallment loan. Rates can be fixed or variable.

Wholesalefunding — These borrowing sources may be used to complementroutine cash management activities or in the early stages of anemerging liquidity problem. However, be aware that funding aliquidity crisis with large amounts of short-term borrowings on asustained basis increases interest rate risk as such borrowingsre-price on short notice, often daily. Consider longer-term fundingsources and diversify the borrowings over time when borrowings areexpected to be sizable and sustained.

A wholesale funding source that has become more popular inrecent years with credit unions is the FHLB. The applicationprocess is involved, however, with that said, an excellentexercise. There are also requirements for becoming a member. TheFHLB is a quasi-government organization with the objective ofsupporting and providing loans to financial institutions that makefirst mortgage real estate loans or that purchase and holdmortgage-backed securities.

These organizations offer a diverse line of lending services toqualifying credit unions. Much like the corporate system, liquidityfrom the FHLB involves lines of credit and/or term loans at fixedor adjustable rates often at more favorable rates than thecorporates.

While the aforementioned examples to manage liquidity are notmutually exclusive they do represent avenues prior to the start ofthe next economic cycle. Interest rates have for all practicalpurposes have bottomed out. It may be an opportune time to reviewyour credit union's policy and contingency plans beforehand.

EdwardLis is vice president of finance at Fulton County FederalCredit Union in Gloversville, N.Y.