By Todd Benson, Catalyst Strategic Solutions, Senior ALM Consultant
As the COVID-19 pandemic stretches on, we are slowly getting used to our “new normal” and the description of this chapter in history as “unprecedented.” While this year has indeed been unlike any other, an important new economic “truth” has also emerged from the ongoing global health crisis – one credit unions can’t ignore.
Only twice in the 2000s has the Federal Reserve moved the target rate for overnight funds by more than 25 basis points – at the onset of the Great Recession in 2008 and in March 2020 when the pandemic lockdowns began. So, while instantaneous shocks to balance sheets are helpful for revealing underlying risk from options embedded in credit union portfolios, they are a less than realistic forecasting tool when making management decisions.
Though rates are expected to stay at current historic lows for at least the next several quarters, at some point, rates will rise again. And when they do, they will likely move in 25-basis-point increments. Given the typical progression of interest rates at the start of an economic recovery period, it is wise to examine rate environments beyond the parallel shocks to better prepare for what may happen to earnings when rates eventually rise. Conducting ramped rate scenarios, with incremental moves up and down, is an effective method for identifying the potential impact of upcoming rate changes on a credit union portfolio.
Normally, as rates decline, prepayments on loan portfolios are expected to increase. Furthermore, with a large cloud of economic uncertainty hovering over the nation, credit unions are finding themselves inundated with extra liquidity and fewer loan origination opportunities. As the pandemic presses on, what happens to a credit union’s risk profile if members decide to keep their cars a little longer…or hold off on upsizing to a new home due to the uncertainty? A prepayment shock scenario with reduced speeds will show the changes to both net economic value (NEV) and projected earnings in the event of a drastic reduction in prepayments. Similarly, a prepayment shock demonstrating an increase in prepay speeds will help identify the impact of a reinvigorated lending program once the economy begins to recover. If the period leading up to the Fed’s somewhat surprising decreases to the overnight borrowing rate of 50 and 100 basis points in March 2020 showed us anything, it’s that the yield curve is not always upward sloping. Reviewing your credit union’s risk position relative to a variety of different yield curve shapes can shed light on NEV, as well as earnings risk. An inverted yield curve brings forth a different set of management challenges than a steepening yield curve when attempting to manage funding costs that may now exceed those of the loans they are funding.
Catalyst Strategic Solutions’ team of experienced ALM experts can provide in-depth reporting and analysis of your credit union’s balance sheet to evaluate such scenarios. When reviewing these results, be sure to focus on more than just those ratios reported to NCUA. Though none of us has a crystal ball, these alternate scenarios can be a great supplement that aids solid decision making in unprecedented times.
Industry resources, like Catalyst’s Market Overview & Data Report, or weekly publication, Behind the Numbers, offer additional economic insights to help credit unions keep a pulse on the markets and what lies ahead. Additionally, state-by-state peer statistics and industry rate comparison data can be used to further assess deposit rates and balance sheet allocations nationwide.
For a customized peer report for your credit union, or to discuss a tailored strategy for the road ahead, contact us today.