CFO Focus: Maintaining Profitability in a Zero-Bound Rate Environment

Over the past few weeks, the COVID-19 pandemic has brought global and local economies to a screeching halt. In March, the Federal Reserve lowered short-term interest rates by a total of 150 basis points to a target range of 0 to 0.25% through two emergency rate cuts. This unprecedented move is intended to loosen the cost of borrowing and infuse the markets with liquidity. However, it was not effective in easing market concerns and has exasperated the task ahead for financial institutions already dealing with an operational crisis. Credit unions must now adjust their balance sheets to maintain profitability in a zero-bound rate environment.

Credit union leaders must focus on the strategic levers they have available to drive profitability: operational, funding, liquidity, credit, interest rate risk and leverage.

The first step for credit unions is to review the potential impacts of this zero-bound rate environment on their balance sheets. While most asset/liability management models do not have a down 1.5% rate-shock scenario, looking at the down 1% and down 2% scenarios will provide a close approximation. We encourage credit union executives to give special consideration to projected profitability as well as the potential impact on capital. Before the rapid development of this current health and economic crisis, most credit unions only budgeted for one rate cut this year. Credit unions will see pressure on net income in 2020, so we advise credit union executives review their budgets and forecasts for the remainder of the year.  

The recent Fed rate cuts are a real-life rate shock and justify the necessary process of modeling interest rate risk regularly. Unfortunately, many credit unions have been singularly focused on the risk of rates increasingly rapidly (as we saw in the saving & loan crisis of 1980), which would serve to pressure margin as fixed-rate assets would reprice more slowly than the cost to fund them. As a result, many credit unions have maintained excess cash, a relatively low cost of funds, investment and loan portfolios with short duration, and have largely avoided longer duration assets. We think now is an appropriate time to reevaluate strategies and better balance upside and downside interest rate risk. While rates are lower across the board, the yield curve has begun to steepen which means that there is more compensation for the assumption of interest rate risk. It may be worth reconsidering some longer-term assets, while adjusting the interest-rate risk profile through the use of term funding.

Liquidity will be paramount to manage as the opportunity cost of holding excessive cash has increased dramatically now that overnight rates pay virtually zero. In a crisis, there may be a concern that members will run on the credit union. However, we are also at the start of “liquidity season” in which tax returns and bonuses pay out. Moreover, members who are likely to be significantly impacted financially by shutdowns and layoffs are more likely to make greater use of credit cards. As of the time this article is being finalized, the U.S. government has just passed a law that includes sending direct stimulus checks to every American. These funds will likely be held in their checking accounts, at least temporarily. To avoid holding too much cash, credit union leaders must review liquidity targets and consider their liquid investment options.

While cash, investments and loans are likely to price down in a zero-bound rate environment, credit unions may be able to offset some of the impact to margins by lowering cost of funds. This option could prove unpopular with credit union boards, as it could appear averse to the institution’s mission of paying members a good dividend. However, it may need to be considered as a temporary solution for the credit union’s continued success. Pay special attention to certificate pricing, particularly matched or special pricing, and assess if such an arrangement is critical to the member’s relationship with the institution. One of the few bright spots in a low rate environment is the opportunity to lock in lower-cost term funding. Regularly review wholesale funding pricing from the Federal Home Loan Bank or corporate credit unions as an alternative to certificate pricing.

Credit risk will need to be closely monitored as borrowers’ ability to repay loans may become impaired. We often describe borrowers in two camps: financially stable and financially sensitive. Financially sensitive borrowers are likely to utilize credit lines, and the prevalence of delinquencies is likely to increase. At the same time, while the financially stable borrowers are less likely to be personally impacted, the psychological effects of quarantines and economic unrest may prompt some belt-tightening. From a high level, this is one of the worst times to take more exposure to the lower end of the credit spectrum, particularly to chase yield. However, it’s also a critical time to try to support your members, who may be looking to you for temporary assistance through loans, deferred payments, or other arrangements. Communication will be critical in understanding how community, counterparties, and members are impacted by the COVID-19 outbreak.

Finally, when all other levers have been exhausted, it’s time to review operating expenses. There’s not likely to be a lot of room to trim expenses, as credit unions have spent the better part of the last 20 years focusing on operational efficiencies. Credit union leaders should review any capital expenditures for 2020 and consider that these plans may need to be put on hold. Additionally, leaders must make sure to regularly communicate with board members about the projected impacts to profitability.

Remember, a crisis is why financial institutions are required to be well-capitalized. The world has materially changed in the last few weeks, and strategies will need to be adjusted, but with every challenge comes opportunities. Assuring credit union profitability in a zero-bound rate environment will allow credit union leaders to continue the mission of serving members, particularly in a time when they need their credit unions the most.

Phil Lucas is senior balance sheet adviser and JD Pisula is VP/investment advisory for Accolade Investment Advisory LLC, Columbus, Ohio.