9 minutes
The job of the asset-liability committee would be a breeze if only it could predict the future path of interest rates, the demand for consumer loans and deposit accounts, and the evolution of the credit union’s balance sheet.
Unfortunately, it’s never been easy to forecast economic conditions and interpret market trends, and that challenge has gotten even more daunting during and following the Great Recession—even for the professionals whose business is understanding the economy. Economists have been predicting with such regularity over the past year that interest rates will begin to rise that credit union executives “kind of take with a grain of salt what we are saying,” says economist and business strategy consultant Bill Conerly of Conerly Consulting, Lake Oswego, Ore. “The economics profession has an imperfect track record of forecasting, and that’s being polite.”
Instead of aiming to predict where the market is going, ALCOs may be better off monitoring market conditions and stepping up their readiness to respond with an array of strategies corresponding to up and down swings and gradations in the middle.
Big-Picture View
If current economic times seem especially volatile, that may be because of the contrast with the previous quarter-century of unusual calm. In fact, the American economy in the years from 1983 to 2007 was so remarkably mild, with only shallow curves upward in boom times and downward in recession, that economists refer to this period as the Great Moderation, Conerly notes.
That era also happens to be the time when many of today’s credit union executives came up through the ranks and developed their management skills and industry perspectives, he adds. As a result, the recent past and current market conditions may seem especially unfathomable.
Volatile might not be the best word to describe the economic environment, but unprecedented certainly fits, says Steve Williams, principal of CUES Supplier member and strategic provider for technology and ERM services Cornerstone Advisors, Scottsdale, Ariz.
“There’s a disconnect between the real economy and what interest rates are doing,” Williams says. “The interest rates are being influenced by the fact that the government is expanding its central bank balance sheet and creating the demand for the bonds themselves, which is keeping rates low. It’s not necessarily the case that the economy is guiding that.
“With the central bank holding rates low for so long, we have no history to tell us what the exit is. That just increases uncertainty because we don’t have history as a guide,” he adds.
The following strategies may be helpful in identifying and monitoring ALM strategies in these uncertain times.
Test Assumptions Regularly
“The future is uncertain in terms of five key factors: economics, technology, social attitudes, government policy and competition,” Conerly explains. “I recommend that managers of credit unions and other organizations be a little bit humble about their ability to predict those things.”
What ALCO members can and should do is to carefully and regularly consider their underlying assumptions about these factors, he says. For example, a credit union’s strategy for pricing loans across credit tiers is likely based, in part, on assumptions about consumer spending. At regular intervals, say quarterly or biannually, the team should be checking in “to see if the world is conforming to their assumptions” by monitoring economic data from federal agencies, trade associations and consulting firms that is available at low or no cost.
“The most important thing is to recognize deviations from your assumptions as quickly as possible so you can make adjustments,” Conerly says. In some organizations, a “visionary leader” may opt to stick with a strategy even when the assumptions underlying that approach are not borne out by reality.
Be Prepared for Down—and Up—Movement
Optimal ALM planning considers drastic shifts in market conditions in both directions. “It’s been common in finance to consider downside scenarios beyond what regulators say they want to see—for instance, what happens if more loans than expected go bad,” Conerly notes.
“But good times bring their own challenges. Successful organizations have thought through questions like, ‘If business booms, do we have the resources to serve those additional members? Do we have the staff? Do we have the systems in place? Do we have the real estate to serve members in new markets?’”
Taking a wide view can help credit unions be prepared for unprecedented economic conditions—as in the launch of new products and services to produce noninterest income to counteract the persistent low-rate environment and in identifying cost-cutting options before an economic downtown begins. A willingness to consider the unlikely—that the mortgage market might collapse, for example, or interest rates might go flat for a decade—can pay dividends, Conerly says. “Sometimes it takes challenging times for managers to consider alternatives.”
Williams agrees on the need to be prepared for the unexpected—but not to attempt to predict it. “While it’s imperative to monitor the interest rate environment, it’s important not to be in the mode of predicting interest rates, because you will fail,” he says. “The goal is not to predict but to dial different scenarios into your planning and ALM model to stress-test based on those differing scenarios.”
Stress testing should occur at either end of the spectrum, Williams says. “We should be aggressive on the types of scenarios we test given the level of uncertainty. We’ve had seven years of low rates already. What happens if it stretches out a decade or more? What does that do to our margins, our ROA, and our capital? Can we execute our strategic plan under each scenario?”
Asking the question, “What if rates go up?” represents classic ALM management, he suggests, but the flip side of “What if rates stay low for another two or more years?” is just as compelling and will help prepare for the full range of eventualities.
Watch the Competition
Credit union executives and financial analysts on the ALCO also need to monitor competitors’ pricing and credit spread, Williams advises. “It’s very important to look at your market share in auto loans, mortgages, credit cards and business loans and talk about, ‘Where are our competitors growing? Who’s gaining market share on us, and who are we gaining on?’”
The next questions become “Do we agree with their risk appetite? And do we need to match that, or do we have a different view of risk?” he adds. “Have a healthy argument around questions like ‘If GMAC (Financial Services) is killing us on rates, do we agree with their assumptions about risk?’”
Ask Not When Rates Will Rise
“It’s often the first question I get: When are interest rates going to start rising? They ask eagerly but often with doubt that they can believe me,” Conerly says. “Most economists have been anticipating interest rates to begin rising for over a year. It’s around the corner, around the corner, around the corner. It’s happening at an agonizingly slow pace.”
Instead of waiting for rates to rise, some credit unions have introduced or expanded business lending with the aim of increasing loan volume and getting a better return on their assets and launching business services that return higher fee income than consumer products.
“This is a period of time when credit union leadership is scanning quite aggressively for these kinds of solutions, which has its pluses and minuses,” he cautions. “Sometimes organizations get desperate and pursue solutions they really shouldn’t. On the up side, there are some good options out there, and credit unions should be taking a look at those.”
Balance Risk and Reward
Balancing credit risk with the yield across credit tiers is another key consideration. A “very healthy exercise” for the asset-liability committee is looking at returns on various types of loans at 60 months, 72 months and 90 months out, for example, Williams suggests.
“If the pricing margins get very thin, it might compel wider explorations about where else the credit union might be investing to enhance the return for members,” he says. “A current example is that some credit unions that have grown extensively through indirect lending are now taking a step back to see that terms are very long, that there’s a little softening on the credit quality, and that they’re paying dealers a fairly generous fee for those loans. They might decide to manage the exposure in indirect lending and expand business lending or even invest in some mortgage securities to diversify the balance sheet.”
Aim for Consistency
“There’s a view that says individual investors shouldn’t follow the market too closely, and the same might be said for credit union managers watching the broader market: Don’t agonize too much about it,” Conerly advises.
Instead of focusing on every market gyration, it might be more productive to identify the factors you believe are most relevant for your credit union and track them on a consistent basis. Human beings have a tendency to look for evidence that confirms their biases, he notes.
Optimists read the paper and see only the good news. Pessimists can read the same paper and come away with only bad news. If the CEO asks a junior analyst for some market information, that analyst will be inclined to support the chief executive’s predilection for viewing the market in the type of data selected for the report.
“Picking the indicators you’re going to track and following them consistently protects you from cherry-picking data that will confirm your biases,” he adds.
Cast a Wide Net
In the quest to manage their balance sheets, monitor demand for loans and deposits, and be ready to respond to interest rate shifts, many CU executives and analysts maintain a “casual curiosity” about what is driving the economy and consumers’ financial decisions, Conerly says.
That curiosity may extend to national politics and the potential impact of the presidential election on the economy. “When people wonder who’s going to win the election, I tell them it’s not going to have a big impact in the short run,” he suggests.
Another form this curiosity takes is in such questions as whether millennials differ from baby boomers in their borrowing habits and how technological advances will affect regional economies. Except for the largest organizations, CUs may not have the internal resources for such analyses, but they may look to external partners and information sources to aid in ALM and strategic planning.
Rather than being diverted by distractions like the current political furor, “it’s important to pay attention to macro trends in economic data that relate to our lending business,” Williams says. “Look for good objective data that helps us understand our risk profile in managing the balance sheet.”
For example, monitoring auto sales, trends in lease vs. purchase, and loan lengths can provide useful information as can trends in home sales and new construction in managing mortgage products, he says. “And the volume of asset purchases is very important in the credit union industry.”
Karen Bankston is a longtime contributor to Credit Union Management and writes about credit unions, membership growth, marketing, operations and technology. She is the proprietor of Precision Prose, Portland, Ore.
