By Scott Lewis
Many credit unions' mission statements go something like "our members are our first priority," which is what distinguishes CUs from banks. It's not about the money; it's all about helping the community. In fact, banks have focused so much on profit and earnings that they've created a very negative "greed is good" image. Now banks are striving to show a softer side in their advertising to convince the public they care.
Although we agree that members are the priority, we believe that this can only be accomplished for the long term by competitively generating "profit." This is a bold statement but, in the end, focusing on profit is the only way to grow in this landscape and truly keep the member as the first priority.
While banks are viewed as adversaries, and to a certain degree they should be, the new credit union mentality should be "how can we use a bank's profit-enhancing strategies to compete more effectively against them?" That's the single most important question that your management and board should be asking themselves. The reality is, the more profit you generate, the more your members will benefit by your competitiveness.
Why do banks focus on profit? Simple. The more profit that's generated through maximization of the assets on your balance sheet, the more income you will have at your disposal to compete for loans and deposits within your area. If your credit union begins to focus on profit, even though you are a not-for-profit entity, you will increase your competitiveness by increasing your income. The end result will be attaining your objective to make members the first priority.
Leverage: The Art of Growth
Leverage is a fundamental concept in banking that has been used for 200 years. Making a spread on borrowings to obtain higher yields, increase income and maximize growth will be the only way credit unions will survive and thrive going forward.
Having a 10 percent or higher capital ratio means you're not maximizing your ability to grow. Your board needs to understand this. Leveraging the balance sheet and using assets to generate more income will thereby enable you to compete in a proactive way.
You need a two-year game plan for growth and capital. In the short term, your ROA may go lower. However, you will generate more dollars of income to fold back into your balance sheet so you are better positioned going forward.
Banks maintain much lower capital ratios. Why? To generate more profit to compete against you. Your board needs to be shown in black and white that a high capital ratio is just the members' money getting no return. Without a return on that money, they will get lower deposit rates and higher loan rates. How does that benefit members?
Is the Timing Right?
When do credit unions have the most liquidity? When rates go down. Just like the last interest rate cycle and the one before that, you will have substantial excess liquidity to put out in a much lower rate environment.
If we believe this will happen again, and if we know that last time our margins suffered when rates moved lower, now is the best time to leverage the balance sheet, add duration and income, and become more liability sensitive.
There is currently no better time for a financial institution to leverage the balance sheet. You're probably saying to yourself, with this flat yield curve, are you crazy? Think about it; the best time to position your balance sheet is when we are about to enter a new rate cycle, whether it's up or down. We have more clarity now on where rates are going than at any time since the Fed started raising rates in 2004. Chances are, positioning the balance sheet to be more liability sensitive makes as much sense now as it was to become asset sensitive in 2004.
Back in May of 2004, some financial institutions extended their liabilities by giving up spread/margin and invested in three- to five-year CDs at above-market rates. For three to six months, their margins tightened and ROA moved lower, but look at that scenario now, two years later. Those institutions are way ahead of the curve in this extremely competitive deposit market. Giving up spread then has added to their margins now. Don't you wish you had taken on more five-year money below 4 percent?
We are at the same crossroads now. Shortening liabilities, which will probably roll off to be funded at lower rates going forward, makes the most sense if the Fed is done, or almost done. At the same time, extending the duration of your assets to capture the highest yields in almost six years will add margin as we move into the next rate cycle. Borrow now, add spread through duration, and repay those borrowings when that excess liquidity shows up again.
There is Yield in Them There Hills
Simple strategy: Borrow short and invest long. I won't talk about specific assets because for many of you, your policies need to be adjusted to get the best value in the marketplace. I will say, though, that if the curve normalizes as we expect, the belly of the curve (four to seven years) is probably the best place to be as far as average life and duration.
With respect to borrowing, wholesale deposits are extremely expensive right now. The best way an institution can benefit is from organic deposit growth. Get your members to pull their money from other places and bring it into your institution.
A high-yielding checking or money market account is one of the best ways to benefit from this type of strategy. Tiering your deposits to focus more on the larger depositors is the best way to increase deposit growth, without shrinking your margins. We suggest doing a deposit study to see where the tiers should be set, teaching your tellers how to sell these products, then running a special. Many institutions have seen good deposit growth employing this strategy, and have used this relatively cheap funding to enhance their income and position their balance sheet going forward.
In the end, educating your board on these strategies, utilizing your capital to maximize balance sheet assets and positioning yourself today to take advantage of the next interest rate cycle should be the focus of management.
Time is of the essence. We have lost 80 basis points of yield since the June 28th peak. Be proactive, not reactive, and focus on profit-enhancing strategies. Your members will benefit.
Scott Lewis is SVP/fixed income strategies at First Empire Securities Inc., Hauppauge, N.Y.
This commentary is written by the fixed income trading/sales area and is not the product of a research department.The views and opinions are the author's and may differ from those of First Empire Securities or others in the firm. This commentary is provided for information only and is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument. Past performance is not indicative of future results. The information contained herein is as of the date referenced above and First Empire Securities does not undertake any obligation to update such information. All market data and other information are not warranted as to completeness or accuracy and are subject to change without notice. First Empire Securities is a member of the NASD and SIPC.
Read more on deposit strategies in this Credit Union Management magazine archive.
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