Now is a Good Time to Prepare for Liquidity Changes
Why be concerned about your credit union’s liquidity when most of us are flushed with funds resulting from an inflow of funds associated with a flight to safety and loan portfolio outflows due to lack of loan demand?
Rising interest rates typically are used to manage economic recoveries so it is likely rising rates will be accompanied by a return of flight-to-safety funds to the market and a spike in loan demand, putting many, in short order, back in the tight liquidity environment of a several years back.
Many credit unions have rate floors under their variable rate loans. As rates move up, rates on these loans won’t reprice for a while, but your cost of funds will.
Also, many credit union balance sheet structures consist of long-term fixed rate assets in the form of mortgages and investments, which may have resulted in a short-term boost to their earnings at the expense of increased interest rate risk concerns when rates rise. The result is further compression of already tight margins.
The objective of a viable liquidity strategy is to provide a framework to minimize the adverse effects of a significant and sustained liquidity crisis. This can result from changing economic or interest rate conditions, deposit outflows, unusually strong loan demand, intense competition, an international crisis, or any other factors that can deplete the liquidity of your credit union.
In the event of a serious and sustained liquidity crisis, various strategies, of which some would be considered preventative, must be implemented prior to the onset of a crisis. Other strategies are reactive and may be implemented immediately. The strategies will differ in terms of the implementation time, costs, risks, financial implications and regulatory consequences.
The first place to look for sources of liquidity is within your own balance sheet structure.
Loan Payments and Prepayments — A credit union may write loans with long repayment schedules. Track and test loan payments and prepayments in all economic environments to estimate the level of cash inflows to the credit union under a variety of scenarios. As a reminder, when interest rates are falling, prepayments will increase, and when rates are rising, prepayments will slow down. Loan demand that exceeds the runoff of existing loans is a major contributor to liquidity problems as such monitor the net volume of new loans relative to the projected runoff of existing loans and other cash flows such as investment maturities. Management should review and adjust loan rates as necessary in an attempt to ensure a reasonable balance between loan demand, runoff, other cash flows and the loan/asset ratio.
Increasing Member Deposits — To bring about an inflow of deposit funds without cannibalizing previously deposited funds is often referred to as "disparity" or "segmentation" strategies. They are designed to identify depositors based on rate sensitivity and encourage an inflow of deposits when needed. You should be forecasting your liquidity needs and anticipating those needs in the marketing of your deposit products.
Selling of Loans — Mortgage loans written to conforming loan standards can normally be 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 less than their book value, depending on the current level of interest rates. Other types of loans have the potential for sale as well, i.e. consumer loans.
Investment Maturities — The primary role of the investment portfolio is to provide liquidity by means of a laddered structure with predictable cash flows.
Selling of Securities — The sale of securities is a reactive strategy. The extent to which securities may be sold to meet liquidity needs depends on the accounting classification and the amount of market losses resulting from the sale. Liquidity concerns are usually accompanied by market conditions that depress bond prices and thus, the sale of investments may result in realized losses, depending on the maturity and/or embedded options in the instrument being sold.
Non-Member Deposits — Non-member deposits, also referred to as brokered funds, can provide near-immediate and short-term funding. Note these come at a high price and the funds are very rate sensitive, i.e., “hot money”.
Contingency and Alternative Funding Sources:
Loans from the Corporates — The corporate credit union is still the lender of first choice for a majority of credit unions. Loans fall into two major categories: A line of credit and a term loan.
- A Line of Credit — These come in two varieties: committed and uncommitted. A committed line, most common, the credit union pays a fee based on the size of the line and its duration. There is a contractual assurance that the funds will be available to the credit union when those funds are needed. An uncommitted line of credit, funds may be available based on the lender’s — the corporate — ability and willingness to fund. Generally, there is no charge for an uncommitted line of credit, but the certainty of obtaining the funds when you need them could be in doubt.
- Term Loans — These involve a specific amount borrowed for a specific period of time. It may be a bullet loan with the principal due in full at maturity, or an amortizing loan similar to an installment loan. Rates can be fixed or variable.
Wholesale funding — These borrowing sources may be used to complement routine cash management activities or in the early stages of an emerging liquidity problem. However, be aware that funding a liquidity crisis with large amounts of short-term borrowings on a sustained basis increases interest rate risk as such borrowings re-price on short notice, often daily. Consider longer-term funding sources and diversify the borrowings over time when borrowings are expected to be sizable and sustained.
A wholesale funding source that has become more popular in recent years with credit unions is the FHLB. The application process is involved, however, with that said, an excellent exercise. There are also requirements for becoming a member. The FHLB is a quasi-government organization with the objective of supporting and providing loans to financial institutions that make first mortgage real estate loans or that purchase and hold mortgage-backed securities.
These organizations offer a diverse line of lending services to qualifying credit unions. Much like the corporate system, liquidity from the FHLB involves lines of credit and/or term loans at fixed or adjustable rates often at more favorable rates than the corporates.
While the aforementioned examples to manage liquidity are not mutually exclusive they do represent avenues prior to the start of the next economic cycle. Interest rates have for all practical purposes have bottomed out. It may be an opportune time to review your credit union’s policy and contingency plans beforehand.
Edward Lis is vice president of finance at Fulton County Federal Credit Union in Gloversville, N.Y.