Preparing for Rising Interest Rates Webcast Sponsored by the Division of Credit Unions and the Washi

1
Preparing for Rising Interest RatesWebcast
Sponsored by the Division of Credit Unions and
the Washington Credit Union League
Facilitated by James L. This, PhD
The Paragon Consulting Group, LLC
2
Whats the Big Deal?

• Dont rising interest rates mean that credit
  unions will thrive?

3
Echoes of the PastReflections on the S L
Debacle

• SLs found themselves stuck with asset
  portfolios principally invested in long-term
  mortgages whose returns were substantially less
  than the prevailing market interest rates thrifts
  had to pay to maintain depositors. Many weak
  thrifts were unable to manage such interest rate
  exposure.

Source The SL Crisis Putting Things in
Perspective, Walter M. Primoff, December 1989
The CPA Journal Online
4
SL Trends 1980-1984
Source The Savings and Loan Crisis and Its
Relationship to Banking, FDIC.GOV
5
Categories of Risk

• Liquidity
• Loan funding demands and deposit withdrawals
  exceed the availability of liquid assets
  
• Interest rate
• Changes in the market interest rates reduce net
  income

6
Areas of Concern Interest Rates Can Rise Quickly
Fed Funds Rates
7
Areas of ConcernCU Margins Are Already Low
Source CUNA Research and NCUA
8
Areas of ConcernCUs Have Been Relying on Low
Savings Rates to Bolster Spread
9
Areas of ConcernCUs Have Added Long-Term Assets
to Their Loan Portfolios
Especially Mortgages
10
Areas of ConcernSome CUs Are Already Having
Earnings Problems
Percent
Small Credit Unions with Negative Earnings
Source CUNA Economics Statistics
11
Concerns Voiced by DCUSource DCU Bulletin
B-04-06

• Held-to-maturity and available-for-sale
  securities account for half the investment
  portfolio.
  
• Longer term investments (terms over one year)
  increased more than 28 during a falling interest
  rate environment
  
• Liquidity decreased by almost 6

12
Concerns About LiquidityCredit Union Deposit
Portfolios Have a Lot of Rate Sensitive Deposits
13
So What Are the Dangers?Cost of Deposits Rise
Faster Than Loan Income
14
Simplified ExampleCost of Deposits Rise Faster
Than Loan Income

• CU has 50,000,000 in assets (loans) balanced
  with 50,000,000 in liabilities (regular shares)
  
• They increase the rate by 1 on each

15
Look at What HappensCost of Deposits Rise Faster
Than Loan Income
16
So What Are the Dangers?Others Increase Deposit
Rates and You Do NotFunds May Leave

• Possible Scenarios
• You have to sell investments (at a loss) to
  handle cash flows
  
• You have to borrow to cover liquidity needs
• You have to restrict lending due to liquidity
  problems

17
And Just for Fun

• What if the equity markets become attractive
  again?

18
Planning Questions for Leadership

• How much of our deposits are at risk?
• How much are we willing to lose?
• What are we able to pay to stem the flow?
• How will we off-set the higher cost of deposits?

19
So What Do We Do About It?

• Create strong ALM policies and an ALCO Committee
• Assess the risk
• Make decisions and take action using the
  research
  
• Track results
• Make adjustments

20
Basic Principles of Asset-Liability Management
(ALM)

• Diversify the mix of assets and liabilities to
  minimize fluctuations in interest rates
  
• Price assets and liabilities to ensure positive
  net income
  
• Balance assets and liabilities in terms of
  maturities and returns

21
Roles in ALM Management

• DCU and NCUA
• Regulate
• Examine
• But not validate

22
Asset-Liability CommitteeSource DCU Bulletin
B-04-06

• ALCO Committee in Place
• Does your credit union have a Board-appointed
  ALCO?
  
• Qualified People On the Committee
• By position, who sits on the committee and what
  background do they have in managing IRR?

Strong Policies
23
Asset-Liability CommitteeSource DCU Bulletin
B-04-06

• Regular Testing and Reporting
• How often does your ALCO meet and report its
  decisions and discussions to the Board?
  
• Integrity of ALM Models
• Please explain how the ALCOs work is
  periodically audited or the IRR model output
  verified.

Strong Policies
24
Guidelines for MeasurementSource DCU Bulletin
B-04-06

• What methods or model does your credit union use
  to measure IRR?.
  
• What IRR measurements does your credit union use?
  
  
• What are your Board approved policy IRR limits?
  
  
• Who is the primary operator of your IRR system or
  model?
  

Assess the Risk
25
Guidelines for MeasurementSource DCU Bulletin
B-04-06

• Describe the training the operators have been
  provided on your system or model?
  
• What were the results of your most recent model
  or IRR evaluation?
  
• Is your model used for testing various product
  (loans and shares) pricing options before
  implementing the option?

Assess the Risk
26
ALM Procedures for Interest Rate Risk

• DCU Bulletin No. B-04-10
• August 30, 2004
• Topic for discussion after webcast

Assess the Risk
27
Common ALM Models

• Impact of interest rates on net income
• Gap Analysis
• Net Income Simulation
• Impact of interest rates on net worth
• Net Economic Value (NEV)

Assess the Risk
28
Results of ALM Tests
Effect on Net Worth
Net Income At Risk
Assess the Risk
Source CUNA VAP Module V415
29
A Sampling of Models

• Model Management
• CUNA Mutual
• CUPRO
• CUNA Mutual
• IPS Sendero
• Profitstar
• Banc Ware
• CU/ALM-ware
• Brick and Associates
• Mark Smith
• C. Myers
• Palm Software
• NW Corporate CU

Assess the Risk
30
A Model is Only Good If It Is Used in Making
Decisions

• Use ALM process when making decisions
• Pricing
• Terms
• Marketing
• Products and services

31
Set Guidelines on TolerancesExample Only
Scenario A rate increase or decrease of 300
basis points applied to the current quarter end
financial statements.
Strong Policies
32
Possible Actions When Trigger is PulledExample
Only

• Adjust dividends on shares
• Adjust interest rates on loans
• Adjust maturities of share and loan products
• Sell investments and re-invest
• Put variable rates on more products
• Adjust indexes for variable rate share and loan
  products

Strong Policies
33
Possible Actions When Trigger is PulledExample
Only

• Adjust re-pricing intervals for variable rate
  share and loan products
  
• Adjust periodic or lifetime rate caps or floors
  for variable rate share and loan products
  
• Impose early withdrawal options or penalties for
  share certificate products
  
• Charge fees, including but not limited to minimum
  balance fees

Strong Policies
34
Things to Avoid

• Crumbling to conversational pressure

Take Action
35
Things to Avoid

• Pricing only to the marketplace

Take Action
36
Things to Avoid

• Waiting too long to change

Take Action
37
Things to Avoid

• Waiting for the return of the good old days

Take Action
38
Things to Avoid

• Offering a rate that is too good

39
Where to Get Help

• CU facilitators here tonight
• DCU staff here tonight
• WCUL
• Paragon Group
• Jim This

40
Follow-upDCU Website

• FAQs from discussions
• Video copies of studio workshop
• Copy of PowerPoint presentation on the web site
• Link to Paragon Planner

41
And Now.For Something Completely Different
Its all yours, facilitators!!