Economic Uncertainty Sharpens

Rationale for Asset/Liability Management

 

Change is rampant in the financial industry today, and that’s reason enough for credit unions to renew their interest and efforts in measuring and managing liquidity and interest rate risks. Is your credit union using asset/liability management to its fullest potential? Here are five reasons a sound A/LM process makes sense in today’s economy:

 

1. A/LM is valuable for more than just compliance reasons – Credit unions have been using A/LM to assess their balance sheet risk for years, but taking the next step and incorporating the overall risk exposure into the strategic decision-making process has not yet fully taken hold. Credit unions need to take that leap and begin to evaluate the results of their risk analyses in the context of the credit union’s overall long-term strategy and goals. By integrating the risk position and strategic direction, the credit union will be more adept at adjusting near-term decisions. This will ensure that the credit union’s long-term viability is not jeopardized by unintentionally increased exposures to high risk assets or by becoming overly concentrated in certain positions.

 

Mark DeBree, Southwest Corporate Investment Services’ Manager of A/LM Analysis explains, “Information derived from A/LM reports can be used in a variety of ways. It enables credit unions to manage interest rate risk, assists in strategic planning and budgeting and helps credit unions examine and respond to member deposit behaviors. The A/LM process is a valuable tool for every credit union and should be used for more than just compliance purposes.”

 

2. Credit union balance sheets are becoming more complex as mortgage portfolios grow – Over the past few years, credit unions have been making fewer vehicle loans and more mortgage loans. According to NCUA figures, mortgage loans represented 38 percent of credit unions’ total loan portfolio in 2008, an increase of 6 percent over 2005. Conversely, vehicle loans represented just 21 percent of credit unions’ total loan portfolio in 2008, a decline of 4 percent over the same period.

 

The concern arising from growth in mortgage loans, according to DeBree, comes from the longer average lives and durations typically associated with mortgages. The average life of a vehicle loan is 2-1/2 years, whereas the average life of a mortgage loan is considerably longer, increasing their inherent risk.

 

Furthermore, mortgage loans have greater exposure to extension and contraction risk due to the embedded prepayment option. When interest rates rise, DeBree says, prepayments decrease and the average life tends to extend; when interest rates fall, prepayments increase and the average life tends to contract.  

 

Also, the growth of hybrid mortgage loan products in recent years has added complexity to the loan portfolio that didn’t exist when credit unions were offering only conventional mortgage loans.

 

3. Regulators are pressuring financial institutions to understand and accurately measure interest rate risk – Credit unions are being pressed to gain a more thorough understanding of their A/LM process, from the data and assumption inputs to the reports. Former NCUA Chairman Norman D’Amours kick-started this initiative in Letter to CUs 00-CU-10 when he stated, “Credit unions with real estate loans, complex investments or both should give more attention to A/LM.”

 

Subsequent administrations have upheld this mantra and expanded the A/LM portion of the exam. NCUA contends that credit unions familiar with the tools at their disposal and the information they can provide are better prepared to make wise and timely adjustments when economic events call for change. By properly addressing risk exposure, credit union management can minimize earnings volatility and capital risk.

 

4. Uncertainty prevails in the market – Credit unions have been operating in unprecedented conditions the past two years with interest rates at or near historically low levels, and now the inflation outlook is unclear. With mortgage delinquencies and foreclosures continuing to rise, financial institutions have found it tough to operate profitably. Is the economy headed toward a recovery, or will it remain in a trough for the next 9-12 months? 

 

“Given the Fed’s decision to maintain the short-term target rate in an extremely low range and their recent purchases of securities through Open Market Operations to push down yields on longer term rates, and given talk of adding a second stimulus package, as well as talk of extending the homebuyers’ assistance program to all homebuyers instead of just first-time homebuyers, it is not likely we are headed toward a recovery any time soon,” DeBree says.

 

With all of this economic uncertainty, addressing the risks embedded in credit union balance sheets is more critical than ever. That is the goal of a sound A/LM reporting process.

 

5. The potential for rising interest rates is high – When the economy does turn toward recovery, interest rates are likely to increase. With all the stimulus spending and restructuring of consumer and corporate balance sheets, once the economic recovery begins to gain traction, interest rates are likely to rise rapidly.

 

DeBree says, “A quick rise in rates can be tough on financial institutions. Upward pressure on cost of funds eats into the already narrow net interest margin that has resulted from the fixed rate loans on the books at recent low rates.”

 

A/LM is important for regulatory compliance, but it offers so much more. Southwest Corporate's Asset/Liability Management Department helps credit unions of all complexities establish a sound A/LM process. It offers ancillary services such as core deposit analysis and mortgage servicing rights valuations, as well as standard and comprehensive interest rate risk analysis and income simulation. For more information, contact the A/LM Department at 800.301.6196 or alm@swcorp.org.