As interest rates continue their upward cycle to reduce inflation, credit unions will manage this year-long transition process with multiple tactics and product adjustments.
There is no one operational formula to be universally applied because every credit union’s balance sheet and market standing is different.
But a simple model was the core of NCUA’s response in 2013 and 2014 when Fed Chairman Ben Bernanke announced a policy change to reduce support for the recovery after the Great Recession. The reaction to his June 2013 announcement was an abrupt rise in rates, referred by some writers as a “market tantrum.”
The following is one credit union’s experience as NCUA pursued its own regulatory tantrum as recalled by the current CEO.
A Case Study from a Prior Period of Increasing Rates
Today’s rapidly increasing interest rate environment is very reminiscent of the 2013-2014 period when Federal Reserve Chair Ben Bernanke’s “Taper Tantrum” led to a great deal of market volatility. While Bernanke’s comments in May of 2013 touched off the increase in rates, it really took until the next year for the full effect to be felt.
NCUA’s response to this period of rising rates was nothing short of a panic. Any credit union holding bonds whose value declined due to the increase in market yields was heavily criticized for having too much interest rate risk. This critique was despite the fact that most natural person credit union had more than adequate liquidity to hold the bonds.
The use of static stress tests, which showed dire results from up 300, 400 or 500 basis points, was used as a reason to force credit unions to sell some of their holdings turning unrealized losses, with no operational reason to act, into realized ones. These forced sales unnecessarily depleted capital, the very thing that an insurer/regulator should be trying to preserve.
Things got so heated at our credit union that the Regional Director called a special meeting. Only our Board of Directors could attend; management was forbidden to be there. NCUA lectured them about the evils of excessive interest rate risk. This sent many of them and our CEO into a full-scale panic.
We sought advice from outside experts but finally settled on the dubious strategy of selling bonds at losses as well as borrowing funds from the FHLB that we did not need. These were done to bring the results of these static stress tests in line with the NCUA’s modeled projections. We calculated these actions caused us unnecessary losses of over $10 million before we stopped counting. These came from both the realized losses, the added expense of unneeded borrowings, and the lost revenue on assets sold.
In the aftermath of that debacle, the credit unions senior management and two board members travelled to Alexandria, Virginia to meet a top NCUA regulator to explain our frustration at the loss. After waiting for hours for our scheduled appointment, he heard us out. We never heard back; however, the Regional Director soon departed. Perhaps our message had at least been partially received.
The Problem with Static Tests
Fast forward to today. We find ourselves in the “extreme risk” rating at the end of the first quarter due to the rapid rise in rates. The glaring problem with static stress tests is that non-maturity deposits (which make up a large part of most natural person credit unions’ share liabilities) are limited to a one year average life.
Several third-party studies document our share’s average life to be in excess of ten years. Despite this, the asset side of the balance sheet is written down while the long-standing member relationships, on which most credit unions’ balance sheets are built, doesn’t get much credit at all. For example, if a two-year average life on savings and checking accounts were used, the results of the static test wouldn’t even put us in the high interest rate risk category.
While we have authorization to utilize derivatives (something we didn’t have back in 2014), this could help lower the costs of compliance if we are forced to take action. However, I’m adamant against doing illogical things just to pass a static stress test this time around.
I’ve wondered how it’s OK for the NCUSIF to hold similarly long-term bonds in their portfolios without any concern during periods of volatility like this. We have the strength of our core share relationships and capital positions to withstand periods of rising rates. NCUA just keeps reporting growing unrealized losses transferring their IRR risk to credit unions to make up any operating shortfalls.
I also believe that NCUA should really be much more worried about very low interest rate environments. These periods of very narrow yield curve pickups are actually much worse for financial intermediaries to navigate than periods like the one we’re now in. Overall the industry’s net margin should generally benefit from rising rates, shouldn’t it?
1. One expert’s view of the situation today: As you know, but people often forget, there is no ‘unrealized loss’ if a bond or loan is held to maturity. There is an interest rate risk component that needs to be managed. But if I am holding some 4% mortgages 10 years from now, and the overnight rate is 4%, then I am not upside-down. I just have some of my assets earning the minimum rate of return.
This is why I prefer net income simulation over IRR shock. We don’t live in a static world, it’s a dynamic one.
2. During the November 2021 Board meeting the following interaction took place on the agency’s management of the NCUSIF portfolio and stress tests:
Board Member Hood: Thank you, Myra. And again, I do have another question and this is for the record. Do we all have an interest rate risk shock test to the fund (NCUSIF) like we do for our credit unions under our supervision rule? And also, do we do a cash flow forecast on a regular basis as well?
Eugene Schied: This is Eugene Schied, and I’ll take that question Mr. Hood. Yes, we shock the – we do perform a shock test and perform cash flow analysis for the share insurance fund. These are both reviewed by the investment committee on at least a quarterly basis. The investment committee looks at the monthly cash flow projections for the upcoming 12 months as part of this regular analysis. That concludes my answer, sir.
Board Member Hood: Great. Thank you, Eugene. I would just say that as I consider our investment strategy, we should note that examining portfolios and managing investments in the portfolio are two separate and distinct skillsets. The NCUA today has over $20 billion, with a capital B, in investments under management; so I think we should have an even greater focus on this during our upcoming Share Insurance Fund updates.