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Managing Liquidity: Exploring Options for Loan Demand and Deposit Run-Off through External Funding

By Phil Lucas

Credit unions are currently facing liquidity challenges as loan demand remains steady and deposits decline. Typically, loan demand remains high during the summer months, while members withdraw some of their deposits to fund vacations. In this article, we will provide an overview of strategic considerations when evaluating liquidity options, given the uncertainty of future interest rates.

Where to Start

Your starting point should be to assess the size and scope of your liquidity needs.

Identify the areas of your balance sheet that are impacting your liquidity. For instance, you may be experiencing increased indirect vehicle loan volume as other financial institutions tighten their lending due to their own liquidity concerns. Alternatively, checking and savings deposits may be leaving your institution because of attractive money-market or CD specials offered by local competitors. As a credit union, it can be challenging to turn away potential loan demand, especially after experiencing a few years of subdued demand. In such cases, you might consider supplementing the balance sheet with non-member funding or borrowings. However, be aware that it may take several years for liquidity to fully normalize as credit unions often experience loan growth equivalent to a couple of years' worth in just a few months.

Time Horizon Considerations

Once you have determined your liquidity requirements, consider the time horizon.

Traditionally, credit unions have relied on the investment portfolio as a source of backup liquidity. You may be familiar with the traditional CD ladder strategy, with monthly maturities spread over the next couple of years. However, many credit unions are witnessing their investment portfolios dwindle due to tighter liquidity conditions in the past year. If you have outstanding longer-term maturities, you could explore matching non-member funding with those investments as a potential exit point to repay the liability. It is essential to remember that the investment portfolio also serves as an income hedge against broader credit-risk events in the economy. With the possibility of a recession on the horizon, holding income streams that are not susceptible to losses may be more appealing. These safe income streams help build capital to meet member loan demands during challenging economic conditions when the need is greater.

Asset and Liability Management (ALM) Modeling

Choose the attributes to incorporate into your balance sheet to impact your ALM results.

By selecting shorter- or longer-term funding options, you can significantly alter your interest rate risk profile. As many credit unions learned during the recent period of zero interest rates, ensuring sufficient asset income is crucial for ongoing operations. Therefore, it would be prudent to leverage insights from your ALM report to match the average lives of your assets and liabilities. For most credit unions, this usually falls within the range of 2-4 years on the asset side, given their consumer loan-focused balance sheets.

Short-Term Funding

Short-term funding has become more expensive due to the inverted yield curve and expectations for rate cuts within the next year or so. Even if you anticipate needing funding for several years, a short-term funding strategy might be attractive if there are realistic prospects for early repayment. If you end up requiring the funds for a longer period and rates do decline, there may be an opportunity to renew the funds at lower rates. However, bear in mind that rate declines are not guaranteed, and the Federal Reserve is posturing that rate cuts are not even being considered. Also, for privately insured credit unions, short term borrowings are typically deducted from the credit union’s liquidity ratio, so it is important to model out the impact to these metrics.

Medium-Term Funding

In certain cases, opportunities arise to secure moderate and longer-term liabilities at rates lower than what can be earned from overnight deposits. This option may be appealing to credit unions looking to strengthen their cash position. However, it is important to note that longer-term funding is cheaper because we anticipate overnight deposit rates to decline at some point. Another advantage of medium-term borrowings is the potential reduction in upward interest rate risk on the ALM report, achieved by extending the average life of liabilities. This may be particularly compelling for credit unions that have seen these metrics increase due to the extension of prepayable assets.

While there is no one-size-fits-all solution for funding needs, utilizing this framework can potentially benefit your cost of funds and risk profile. Similar to maintaining an investment ladder, diversifying the maturities of retail funding provides options for future renewal or repayment, while also mitigating the repricing risk associated with changing rate environments.

Accolade can support your credit union through these decisions with ALM modeling, liquidity stress testing, and comprehensive balance sheet advice.

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