Article

The Rate Tide Is Rising

tide rising to cover stone stairs
By William J. Rissel

4 minutes

As a seafarer, I pay a great deal of attention to tides. Just as tides rise and fall, so does the economy. Both move so gradually that, unless you force yourself, you won’t notice until they become a potential problem.

As a member of the Federal Reserve Bank St. Louis Community Depository Institutions Advisory Council in 2011 and 2012, I know the Fed wants to recover its ability to stimulate the economy by lowering rates. To do so, rates must increase. Last month the Fed raised its benchmark rate to 0.75 to 1.0 percent. What is unknown is how much the rate will increase going forward.

I led a credit union through many interest rate cycles. Here are 10 ideas to take advantage—or mitigate the effects—of higher rates. 

1.  Loan Demand. During an expansion, loan demand increases. Can your CU fund loan growth of 20 percent?

2.  Liquidity. Is it sufficient to fund higher loan growth rates? Is it time to review alternate sources? Suddenly needing to raise liquidity through certificates of deposit is a costly option to avoid. Can your CU sell long-term fixed rate loans?

3.  Cost of Funds. How well is your CU positioned to attract funds? What kinds of funds do you want to attract and what are the associated costs?

4.  Yield on Loans. A good step to recover margins would be to review net loan yields (after losses) by type. Loans that have low yields can be boosted a little as demand increases. As growth rates go up, trade off growth with increased rates. 

5.  Net Interest Margin. In a rising rate environment, the cost of funds commonly increases faster than the yield on assets. Income is slow to increase because a large percentage of loans carry a fixed rate and do not adjust upward. On the expense side, a large percentage of savings carry a rate that adjusts more frequently. A shift in the mix from investments to loans mitigates the effect somewhat. In an increasing rate environment, sensitivity analysis is meaningful. Increase rates 50 basis points and then run a shock for a shock. You will not be pleased with the decline in net economic value!

6.  Limited Resources. Given that your CU can lend a limited amount, emphasize within reason loans with higher net yield. Setting higher rates depresses loan growth in that loan type. Marketing can affect loan demand. Consider raising rates on lesser net yielding loan types and loans in greater demand first. Spend time now determining the vision for its loan portfolio.

7.  Certificates of Deposit. Locking in CDs to longer terms will attenuate the rising cost of funds. Consider offering higher rates on long-term CDs. Also review early withdrawal penalties to ensure they are an effective deterrent to members cashing in CDs early for better rates. 

8.  Loan Losses. In high growth periods, loan delinquency and the loan loss ratio will initially decline. This is a dynamic of the numbers. Loans outstanding (denominator) initially increases faster than loan delinquency and/or losses (numerator). A CU will often fund less into the allowance account as a result—understating future losses and overstating income. Fortunately, the National Credit Union Administration allows some flexibility in loss ratio calculations. Consider extending the average number of years, thereby propping up the current loss ratio. Funding the allowance for loan loss as growth occurs will be less painful than doing it retroactively when growth slows.

9.  Investments. Your CU may be forced to cash in investments to fund loans. If rates have risen, the current investment’s value is likely less than book value. This loss is leveraged higher on longer-term investments. Your CU should consider its position on future book values if rates increase and liquidity is needed. Make adjustments before further rate increases. Is shortening the portfolio now beneficial?

10.  Net Income. NI is nothing more than the sum of the other decisions the CU has made. In a rising rate environment, shifting the mix of assets from lower-yielding investments to higher-yielding loans improves income. Adjustable loans also contribute. Offsetting this improvement is the drag of existing fixed loans and the increasing cost of funds.

Senior executives are inundated with plans and projects requiring their attention. The economy has pretty clearly made a turn—the tide is now rising. Let’s make sure we are paying attention and responding well.

William J. (Bill) Rissel has over 40 years' experience in credit unions and is the former CEO of Fort Knox Federal Credit Union. During his 23-year tenure, the credit union consistently performed in the top 10 percent of peer. When not sailing, he assists credit unions in executive coaching, income improvement and governance.

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