The Asset Extension Dilemma
Margin pressure remains one of the industry’s biggest challenges today. The good news is higher rates and a steeper yield curve present opportunity not seen in a long time. The bond market is at a crossroads as long-term yields have entered a bear market amid mounting inflation expectations, while the front end of the curve remains near zero and may stay low for some time. Yet, in working as an independent strategic partner with many credit unions, we often find there is a stigma associated with fixed-rate assets. That stigma is related to traditional ways of looking at interest rate risk.
Herein lies the Asset Extension Dilemma. Should we extend assets today to grow net interest income and protect margins in this low rate environment?
If we do, how does it impact my risk position, and does my balance sheet support extension? If we do not, what gets in the way?
Below are six common impediments that disable asset extension which may increase risk and reduce earnings.
1. Internal Bias
We all have a bias, and we all have our opinion on where rates are going. Our biases are shaped by experiences. Some may have been banking in the 80s when rates were very high. Some may have a bias based on a difficult exam. However, it is important to note that our balance sheet also has a bias. We must listen to what our balance sheet is telling us. If our bias or opinion is wrong, what does that mean to our risk profile and earnings potential? (Interesting to note, results from a recent webinar polling question suggested that internal bias was the number one impediment to extending assets).
2. NEV Supervisory Test
I suspect this may not be on a lot of credit unions’ radars today. After all, the Supervisory Test is designed to assess rising rate risk, with less of a focus on a low rate environment. However, asset extension and lower net worth ratios today will put pressure on Supervisory Test risk levels for credit unions as rates rise. I suspect more credit unions will fall in the risk grading system in the next rate cycle, given net worth ratios have dropped aggressively post-pandemic. Two action items: First, focus on how you will defend your position if your risk rises in the upcoming years (hint: lean on core deposit strength). Second, identify the shortcomings of the NEV Supervisory Test and tell your story.
3. Conservative Deposit Assumptions
Tell me if you have heard this one…“We have completed a core deposit study, which tells us we have a 7-8 year average life on non-maturity shares, but we don’t think the regulators will buy that so we use something shorter for our NEV calculation.” I hear this often, and then find that NEV sensitivity is approaching policy limits, which is affecting strategy (e.g., shortening investment duration). Use your greatest strength (core deposits) in defending your IRR position.
4. Limited IRR Simulations
It is harmful to look at your net interest income simulations primarily through the lens of interest rate shocks, a short-term horizon, and without graphs. Broaden the IRR analysis and run pro-forma simulations to bring clarity to asset extension ideas (e.g., What happens if I hold more fixed-rate mortgages?).
5. Regulatory Limitations
The cash plus short-term investments/assets ratio really gets me. It is a limited assessment of how credit unions manage liquidity and leads to higher cash levels. Unfortunately, this ratio is over 18% today for all credit unions. To overcome this, build a total liquidity solution, which focuses more on collateral instead of primarily cash.
6. Fear of Unrealized Losses
I understand this challenge, especially from the board. It is critical to provide education before unrealized losses appear. For example, what does an environment look like when we have unrealized losses? Generally, it’s a stronger economy with robust loan growth. Just look back to the fourth quarter of 2018. Unrealized losses were elevated, yet NIM (+32 bps) and ROA (+22bps) were higher than the fourth quarter of 2020 when rates were low and unrealized gains were high.
This is not a speculative piece. I am not suggesting asset extension based on a belief of where I think rates are going, nor am I suggesting every credit union is asset sensitive and should load up on fixed-rate assets.
Instead, we must overcome the stigma associated with fixed-rate assets to ensure we have opportunities available to us to protect net interest income levels and take control of our balance sheets.
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ABOUT THE AUTHOR
Joe Kennerson is a Managing Director at Darling Consulting Group. In this capacity, he works directly with financial institutions by providing solutions for their asset liability management process in the areas of interest rate risk, liquidity risk management, ALM modeling, regulatory compliance and executive-level education. He is a frequent speaker and author and directly advises clients in all aspects of ALM.
Contact Joe Kennerson: firstname.lastname@example.org or call at 978-499-8150 if you are interested in sharing strategy ideas in the current rate environment.
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