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Testing a Negative Rate Scenario? Consider These Questions First

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There has been a lot of buzz recently about the potential for negative interest rates to hit U.S. financial markets at some point.  Short-term rates have been negative in Europe since June 2014, and the Bank of Japan made the move in January of this year.

European Central Bank rates fall below zero in 2014

Before you test this scenario from an asset/liability management perspective, there are several strategic questions that should be evaluated.  Consider the following:

  • How would loan rates change? Would your credit union’s floor rates on certain loan categories stay the same – meaning even if market rates drop, the loan rates will not decrease further, as the credit union would want to be compensated for liquidity, credit risk, or other concerns?
  • How might loan demand be impacted? This question could be difficult to answer because loan demand is often multifaceted, driven by factors other than just the current level of rates, such as the overall strength of the economy or the direction in which housing values are moving.
  • Could deposit rates drop further, or is there a scenario where the credit union would charge members a fee to hold deposits? If so, how might your members respond? If a “negative rate” comes in the form of fees, and if members have deposits at 3 or 4 different institutions, would they pay fees at multiple institutions or consolidate their balances to minimize the fee impact?  How could this impact liquidity and liquidity planning?
  • If members are charged for their deposit balances, would they be more likely to use those funds to pay down loan balances, resulting in a drop in loan-to-assets?
  • Would important sources of non-interest income be impacted, such as NSF, ODP, or interchange income?
  • What are some changes your biggest competitors might make? How would this impact your credit union’s response to negative rates?

There are many additional questions that could be considered.  The value in discussing these types of scenarios is not that every single question is asked and answered, but that key stakeholders are thinking strategically about events that could materially impact the future of their credit union.  Even if this specific scenario never plays out, thinking through how the credit union might respond and practicing the process can be worthwhile, and can then better inform any asset/liability management modeling you consider.

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What Are Some Things to Consider as Part of the Budget Process?

We help a lot of institutions with the creation of their budgets and long-term forecasts. There are many questions that often arise as part of that process. The most common question is, what rate environment should I plan on?

There is no easy answer to this question; the reality is that whichever environment gets incorporated in the budget has a good chance of being wrong.

Fed Chair, Janet Yellen, described this same challenge during a speech in May:

“I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so.” (Source: Janet Yellen just made one of the most surprising admissions you’ll ever hear from an economist, Yahoo Finance, 5/22/15)

The Federal Open Market Committee (FOMC) will meet September 16 and 17 and many anticipate a decision could be made to increase the Federal Funds target rate for the first time in nearly 10 years. However, forecasts have the potential to not come true, which becomes evident when comparing the Federal Funds rate projection from December 2014 versus the most recent projection.

Federal funds rate projection December 2014

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, Federal Reserve, 12/2014

 

The average expected target range for year-end 2015 and 2016 were 1.12% and 2.54%, respectively. The most recent forecast of Federal Reserve Board Members and Bank Presidents from June 2015 reflects a 2015 and 2016 year-end average that is approximately 0.50% and 1.00% lower than the December 2014 projection.

Federal funds rate projection June 2015

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, Federal Reserve, 6/2015

 

The danger in relying on rate forecasts or projections is the potential for not understanding the risk of rates remaining at the same level they are today. As many management teams begin the planning process and budgeting for next year, a key consideration should be testing the impact on the budget of rates not moving as forecast. In fact, a combination of a base prediction along with a range of expectations around that base path can help uncover potential strains to the margin.

Beyond the rate environment, some other common budget questions have to do with growth. Whatever the credit union may plan in the future, it can be valuable to test the potential of those assumptions being wrong. With advanced modeling capabilities, the time it takes to run each of the following tests should be minimal.

Some example tests:

  • Loan growth has been great for many this year, what if it is slower than expectations going forward?
  • What if, in order to get expected growth, the amount paid for dealer reserves or the yield charged for loans is lower than planned?
  • Loan loss has been very good for many recently, what if it increases to a more normal level?
  • What if non-interest income is materially lower than expected, either due to changes in payments systems, regulations, or other demographic reasons?

Note that the unique exposures of your institution might need very different questions. Our recommendation throughout the budgeting process is to not spend so much time trying to prove that you know what will happen in the future, but rather make sure to focus on reasonable expectations and then test the exposure to the institution if those expectations do not come true.

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Is a Fight for Deposits Heating Up?

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We are seeing some financial institutions in pockets of the country raise money market and CD rates.  If you have not done so already, now may be a good time to proactively test the financial, liquidity and strategic impact of a fight for deposits, assuming rates don’t change.

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NEV: Things to Remember

Net economic value (NEV) will not show you the effect on current earnings when testing risk-mitigating strategies.

To illustrate, assume a credit union concerned about its interest rate risk is considering selling all of its 30-year, fixed-rate, 1st mortgages. The credit union plans to put the proceeds into overnights to give themselves the best hedge against rising rates. As part of the credit union’s decision-making process, a “what if” is run off the most recent NEV analysis. After reviewing the results of the “what if,” the decision is made to sell the mortgages. Why?

As indicated in the table above, the “what if” shows that selling the mortgages today does not hurt the starting NEV, but it does help NEV if rates increase 300 basis points (bps). The decision was a “no-brainer” for the credit union.

The reason the results look like this is that NEV is the fair value of assets less the fair value of liabilities. In the current rate environment, the base case NEV results already included the small loss the credit union expected to take upon sale of the mortgages. That total sale price would be invested into overnights (at par). In a +300 bp rate change, the base case NEV results included the devaluation of the mortgages. However, in a +300 bp environment, overnights are still valued at par. So the “what if” results showed that there was no change to the current NEV, and in a +300 bp rate change, it showed less risk.

What about the earnings trade-off? Selling all of the credit union’s mortgages and putting the proceeds into overnights does help its risk in a rising rate environment, but at the cost of over 100 bps in ROA today. Using NEV as the primary decision-making tool did nothing to show the credit union the “risk-return trade-off.” NEV also will not help the credit union answer the question: “after selling the mortgages, how high would rates have to go before reaching a breakeven point from an earnings perspective?”

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Budgeting For Loan Growth

In this uncertain economy, many credit unions are seeing loan growth come in below budget.  Others are experiencing loan growth that meets their budgets; however, they are still below budget on loan interest income.  Why?  Interest rates have fallen since their budgets were created and competition for loans has resulted in the credit union getting the loans at a lower rate than budgeted.

Example 1:

 

Can the credit union make up this revenue variance by making more loans?  Maybe, but as the example below indicates, the credit union would need to grow loans 25% over the budgeted amount to breakeven on loan interest income.  Many credit unions would feel this is not achievable in today’s environment.

Example 2:

If the credit union is not able to increase loan growth, then, all else equal, net income will fall short of budget.  However, all else doesn’t have to stay equal.  While cost of funds may be hitting a floor for some places, other credit unions still have room to move lower.  And operating efficiencies are key for surviving today and being successful in the future.  Remember, the point at which you address a problem is directly related to the number of viable options you have to solve it.  If you are in this situation, begin laying out alternative plans now to help achieve your desired level of income.

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