By Steve Waddell CPA, Catalyst Strategic Solutions, Senior ALM Consultant
Budget time will be here again soon, which means you have an opportunity to demonstrate your credit union’s preparedness for potential stress events and scenarios.
A Different World
We now find ourselves in a period of historically low interest rates. Core deposit rates have been low for a while, but the cost advantage compared to similar wholesale funding has disappeared. The resultant decrease in deposit premiums has brought credit union Net Economic Values (NEVs) down near their book values.
Credit union earnings projections are reflecting a declining net interest margin, as funding costs are already near the bottom. Asset yields also continue to decline each month from the pay down or downward rate adjustments on higher yielding loans and investments.
Preparing your credit union’s budget in this economic environment presents its own unique set of challenges. As a result, you may want to consider applying effective earnings and liquidity stress tests as part of your preparation process.
Stress Earnings
Even if you build only modest growth into your budget, you should still stress test earnings by re-computing net income projections based on a flat or static balance sheet. Budgeted growth is often assumed to be funded largely with low-cost core deposits. Removing this growth can paint a very different picture – with regard to potentially lower levels of earnings – if growth targets are not achieved.
Earnings can also be stressed by applying scenarios of increased market interest rates. Review the rate responsiveness (beta) you use in the modeling of your core deposit rates in higher rate environments to ensure it is adequate for the retention of balances. You should be cautious in using historical betas as an assumption going forward, as they may not be adequate to maintain deposits in a stress scenario of a rapidly improving economy and higher interest rates.
Stress Liquidity
You may also want to consider applying liquidity stress scenarios to your budget. The best scenarios involve a combination of deposit runoff and the funding of loan commitments and lines.
The average balances in core deposit products have increased rapidly over recent months as depositors have sought safe haven. One effective liquidity stress test component involves determining the potential deposit withdrawal if members were to draw their balances down closer to their historical level. This test maintains the number of member accounts at the current level, but also reduces average account balances to a lower level, similar to when investors were comfortable with more alternative investment options and had less money invested in credit union accounts.
Your credit union’s stress test should give you a feel for the potential magnitude of a liquidity shortfall. It’s important to ensure borrowing lines and other sources of funds are adequate and test them regularly to ensure funds will be available when needed.
Preparation is Key
Demonstrating that you have the policy, plan and means for dealing with stressed earnings and liquidity scenarios can give you peace of mind and go a long way with your Board and the NCUA.
Catalyst Strategic Solutions' ALM Services team understands that balance sheet risk management is an ever-evolving challenge. Their goal is to empower credit unions, regardless of size or complexity, with actionable data to manage their balance sheets effectively in this fluid economic environment. To speak with Catalyst Strategic Solutions’ ALM consultants about earnings and liquidity stress testing for your credit union, or for assistance with finding value in the market for your balance sheet, contact us today.