By Phil Lucas, Senior Balance Sheet Advisor
In January, the NCUA circulated an advisory note on Liquidity Risk Management, highlighting the funding pressures that credit unions are experiencing due to high loan demand and slower share growth. A few days later, the NCUA released their supervisory priorities for 2024 which listed Liquidity Risk right after Credit Risk at the top. With the bank failures of 2023 fresh in our collective memories, many credit unions have spent the last year balancing the operational needs to continue funding loan demand while also seeking to proactively expand emergency liquidity sources. In this memo, we will overview the NCUA’s key areas of focus for effective liquidity risk management along with the resources that Accolade is able to provide to support your risk management program.
Managing and Forecasting Cash Flows
The NCUA posits that recent trends in deposit movement should prompt analysis of cash flows and deposit assumptions. As a reminder, deposit assumptions such as average lives and betas are used to approximate member behavior (how long will a dollar remain in an account) and management deposit pricing decisions (how will management price shares in response to changes in the rate environment), specifically on non-maturity shares. These are the most subjective inputs in ALM modeling which ultimately looks to measure the mismatch of repricing cash inflows and outflows. Rather than attempting to perfectly predict non-maturity share behavior, Accolade’s ALM Advisory services can be leveraged to consider multiple scenarios, including changes in prepayment speeds, higher deposit betas, and changes in the shape of the yield curve.
It's also important to consider the context of the extraordinary environment that’s colored the last few years, namely that government stimulus programs and high inflation have materially stressed routine liquidity operations. In the longer term, this should revert to the mean. In other words, we don’t think that this period would be appropriate for long-term business planning but rather serves as a real-life stress period, the study of which can be used to revise operational and contingency funding plans.
Controlling Asset Composition
The credit union industry just experienced one of the strongest periods of loan growth in decades. While there are many reasons to celebrate record growth, in some cases, market share was gained by less-than-vigorous discipline on loan pricing. In due course, credit unions who loaded up on loans in 2022 are starting to see significant pressures on margins as funding costs continue to rise. In some cases, credit unions learned that their entire lending operations, which were set up to capture as many loans as possible, lacked proper controls to navigate high-volume demand.
Management should consider asset composition through multiple risk parameters. Loan-to-assets or loan-to-share targets and limits should be considered to control earnings exposure to credit risk, and overall asset size will need to be limited in the context of complying with capital requirements. Management can also use concentration limits for specific types of lending with unique risk characteristics, such as longer duration loans like mortgages, or to borrowers with lower credit scores. When concentration limits have been reached, management must consider strategies to slow further loan demand. This can be done by hiking offering rates or tightening underwriting standards. Many credit unions have successfully utilized secondary sales channels such as loan participations to relieve excess loan demand. However, such channels have seen far fewer buyers as collective liquidity tightened, which illustrates the need for proactively adjusting lending strategies. Accolade is working on developing a new CUSO to aid credit unions seeking to reach a larger secondary market with loan sales via auto loan securitization.
For many credit unions, the last couple years provided a fresh lesson in liability management, following a long period of easy and inexpensive funding. As we look to continue normalizing our balance sheet composition, the NCUA suggests considering strategies to migrate liability concentrations away from market-sensitive accounts towards stable core funding like share drafts and regular shares. In a higher interest rate environment, the economic value of low-cost share accounts balloons, and we recommend tasking marketing and member experience staff to build relationships that bring in new stable deposits. You might consider offering incentives to do so, bearing in mind the alternatives from the wholesale funding market are expensive. The NCUA also lists uninsured shares as a specific area to monitor. If you had discussions with large depositors in the fallout of Silicon Valley Bank or if you upped your excess share insurance recently, this should help to insure the stability of such funding.
The challenge of the current economic environment is that liquidity is hard to find (and therefore, expensive), and the inverted yield curve incentivizes to widen the gap repricing gap of assets and liabilities. For example, many credit unions are inverting their member (and non-member) certificate yields to push more contractual maturities to the near term, potentially offering an opportunity to start pricing down cost of funds if the Fed starts cutting rates later this year. At the same time, credit unions are considering extending the average life of assets to lock in income. One alternative to consider is laddering out moderate-term time deposits (member certificates, nonmember funds, wholesale borrowings) to match the average life of your loan portfolio (often 2-4 years) more closely. These strategies may also offer immediate reductions in cost of funds due to the inverted yield curve without speculating on Fed policy.
Liquidity governance should be incorporated into the overall ALM process. Rigorous and regular review of risk factors are critical inputs for setting and adjusting strategies, and summaries should be communicated to Boards. Accolade can assist in both generating liquidity and ALM reports, facilitating reviews, and developing strategies to address challenges or achieve objectives. We’re also always happy to facilitate Board education.
The unique challenges of the last couple years have highlighted some opportunities for improvement in these processes. For example, at some credit unions, lending staff are incentivized to continue generating new originations even if the institution lacks funding to ensure profitability. At other institutions, loan and deposit pricing is solely based on local competition rather than unique operational needs of the institution. A robust and supported governance structure can help to connect the many individual pieces of the credit union to align with managements long-term goals.
Diversified Liquidity Sources
Above all other recommendations in the guidance, the most important message from the NCUA is an expectation that credit unions expand their liquidity options. Credit unions with assets above $250 million are required to maintain a credit line at either the Central Liquidity Facility or the Federal Discount Window. Both sources are for emergency funding only. There is also a broader expectation that credit unions develop robust liquidity strategies including asset-based sources (such as holding more cash and short-term assets or developing avenues to sell excess loans), and liability-based sources (share strategies, nonmember deposits, borrowings, or subordinated debt). In addition, we expect there to be an increased expectation to expand borrowing capacity at sources such as the FHLB or corporate credit unions, including proactively pledging collateral as appropriate and ensuring staff has adequate training to utilize and structure such advances. The Federal Reserve’s Bank Term Funding Program (BTFP) is due to expire on schedule in March of this year, and we recommend that credit unions being to develop a plan to transition any borrowings from the facility to other liquidity sources upon maturity. While new advances are still available from the BTFP, in late January the Federal Reserve changed the pricing formula to be no lower than the interest rate on reserve balances, currently about 5.4%, a hefty increase from the previous pricing.
Accolade can assist with each step of the liquidity risk management program, including evaluating the opportunities of different funding sources and modeling the risk implications of different strategies. If you’d like to learn more about our advisory and modeling services, please contact us to start a discussion.