In November 2008, the Federal Reserve lowered the Fed fundstarget to zero. More than six years later,  perhaps thetwo most common phrases in ALCO meetings have likely been, “whenthe Fed raises rates…” followed by multiple variations of “… all (heck) will break loose.”

Though historical evidence does not support doom and gloomprognostications, the widespread anticipation of disaster combineswith the  focus of credit union regulation (managinginterest rate risk-IRR), and results in ALCOs adopting overlyconservative strategies that have caused their institutions toforgo significant income opportunities. 

Given the downward trend in earnings, credit unions andregulators should revisit the realities (and focus) of IRR modelingand the resulting balance sheet strategies.

The Best Guess Practice of ALM

Asset liability management attempts to simulate what will occurto net interest margin, income and capital when rates change. Thesimulation is reliant on assumptions of how fast and how muchdeposit account balances and costs will change and the speed atwhich loans and investments pay down.

Has the practice of ALM morphed into treating the worst possibleoutcome as a reality?

Many credit unions feel compelled to shock the balance sheet to“keep the regulator off my back.”  A balance sheet shockassumes dramatic rate increases that are instantaneous, large,parallel and sustained. Historically, large increases have occurredbut they were never instantaneous or parallel and hardly sustained.Understanding the impact of a shock on the balance sheet is anexercise given enormous significance in spite of the nearimpossibility of actual occurrence. 

Investment decisions at many credit unions seem to be driven bythe unlikely shock mentality (we will describe this in relation tobanks below).

Ironically, the perceived risk to income and capital from risingrates has resulted in less credit union income and capital in thedeclining and flat rate scenarios.

What Has Occurred in the Past?

The two largest rate spikes in the last 25 years (and among thelargest in history) are summarized in the accompanying table.(click to expand) For perspective, also review the graphs depictingcredit union and bank industry cost of funds as Fed Funds change. Note the number of months from trough to peak: 24 months and 15 months – hardly instantaneous!

In the first 12 months of Fed rate increases beginning 2004,bank and credit union deposit costs changed just 9% and 6% of theFed funds rate change respectively.  Trough-to-peak, thechange in cost of deposits is 45% and 31% respectively of the totalfed fund movement, but that took two years which allowed financialinstitutions to receive some benefit from adjusting asset pricingas well.

Banks and credit unions bothsignificantly lag the adjustment of their deposit costs versusmovement in the fed funds rate. As you note the actual 1993-1995percentage changes (Implied Beta, see table above), consider whatchange in deposit costs are being calculated in your credit union'sALM simulation.

In discussions with creditunions, we are hearing expectations of deposit cost changes ranging35%-50% of Fed funds in the first year.  To expect suchchange is to imply that margins are more at risk than what has beenthe case historically (see table), the expectation leads to ashorter target for asset duration than necessary, which in turn,leads to foregone income.

Banks and Credit Unions Behave In UnspokenUnison

Net interest margin at financial institutions has been erodingsince the early 1990s. The erosion is due primarily to anoversupply of lenders combined with technology that makes rateshopping easy for consumers, which have led to the commoditizationof product offerings. Will the managers universally struggling withmargin erosion for years take action that erodes margin furthersimply to be in concert with Fed action? 

Depositors with large balances tend to be older and more riskaverse. Those depositors are 10 years closer to retirement (orretired) since the last rate spike (2004). Will depositors suddenlychase yield by leaving insured deposits for the stock market(currently at 17,800) or the bond market?

Did the consumer move funds in the above two rate spikes?Barely. In the first year of Fed action, core deposits as apercentage of total deposits for credit unions went from 49.4% to49.5% in 2005 and from 56.3% to 54.4% in 1994 (core deposits areregular shares and drafts). Interestingly, total shares grew inboth time periods.

With compliance costs accelerating at breakneck pace, marginsare not expected to support a shift from previous pricing behaviorand while consumers' behavior indicates acceptance.

IRR (Mis)Treatment Is Another Good Reason for RegulatoryStandardization

The proposed risk-based capital rule, the creation of a separateoffice of supervision for the five largest credit unions, and therecently finalized liquidity rule are examples of the trendstandardizing regulatory treatment of banks and credit unions.Unlike bank capital regulation (based on managing credit risk),credit union regulation is based on avoiding IRR when rates rise.This focus ignores the fact that bank and credit union balancesheets have evolved to become substantially similar as they pursuethe same households with the same financial products and creates acompetitive disadvantage for credit unions. This is because the“rate shock” mentality has spilled over to asset decisions in thecredit union's effort to conform to regulatory focus on IRR. Howmuch this affects balance sheet strategy is debatable and distinctto each credit union, but it's clear credit unions have targeted anunnecessarily short duration in the investment portfolio and leftsignificant income on the table.

The graph to the left (clickto expand) shows the differences in investment portfolio yields forcredit unions and banks with assets exceeding $100 million over thepast 11 years.   If credit unions matched banksin investment yield, the additional income represents $22.9billion, according to NCUA and FDIC call reports using yielddifference and year ending credit union investment portfoliobalances for the 11 years. Although some credit unions alreadymatch banks' investment yield, the difference in aggregate ismaterial and implies a systemic cause. 

We Become What We Measure

There are four main reasons for this performance difference. Allfour reasons can be tied to regulatory perception of IRR, whichlarge credit unions increasingly struggle to balance with the needfor more income.

First, banks leave less funds in overnights, and instead more“fully invest” the balance sheet. Banks manage to longer investmentportfolio duration, rely more on mortgage-backed securities andless on callable agency securities, and more actively manage theportfolio. In countless discussions with credit unions, we are toldthat regulatory scrutiny on mortgages and long term assets has ledto overweighting on callable agency securities (whosecharacteristics can mean worse extension risk than MBS and nomonthly cash flow).  Banks and their regulators seem tohave struck a balance between earnings generation and IRRmanagement.

Credit unions need a level playing field on regulation. The NCUAhas already authorized the investments that allow for competitiveinvestment performance and should complete the regulatory parity tobanks in regard to IRR. If retained, $22.9 billion incrementalinvestment income over the 11 years would have raised the net worthratio by 225 basis points, to 13.08% for credit unions greater than$100 million in assets.

What's Next?

The NCUA announced that a new IRR regulation will be releasedsoon. Additionally, a key “agency priority” in the 2015 PerformancePlan is “to develop a proposal for a separate interest rate riskcomponent for complex credit unions' risk based net worthrequirement.” This performance goal appears to reintroduce IRR intoRBC after the final rule is approved.

NCUA should strongly consider the above data regarding foregoneincome and capital and the historical evidence that financials werereluctant, in unison, to raise their cost of funds until absolutelynecessary.  

IRR regulation and supervision should focus on outliers thatfeature multiple balance sheet characteristics of concern (not justone). Supervision should not include treating all credit unions asif they are outliers.

Perhaps there are other risks requiring more attention giventhat no credit union failure has been attributed to interest raterisk and while recognizing the impact of IRR regulation on incomeand capital accumulation. 

Peter Duffy is managing director with Sandler O'Neill &Partners LP in New York City. He can be reachedat [email protected] or646-427-1490.