Those of us who read Credit Union Financial Performance Reports (FPRs) well into the evening (and I suspect it’s a rather small group), cannot help but wonder whether the loan growth engine that has been powering the entire industry for almost a decade is finally slowing. While not yet a cause for alarm, there is ample evidence that the long-term trend line has broken.
As a general matter, the prolonged loan growth that has accompanied the nation’s recovery and expansion has translated into higher net interest income for credit unions, as they have deployed excess liquidity into higher earning assets. Until very recently, spreads have also increased, as credit unions have been slower to raise share interest rates.
For management teams that have been running their institutions in this one-way market for some time, it is at least worth (1) pausing to consider whether loan growth is indeed slowing, and (2) identifying strategies to be deployed should the market switch from a loan demand machine to a deposit gathering engine.
The Evidence of Slowing Loan Growth
Looking past the most recent trade war noise and the concomitant equity selloff, there have been signs of broader weakness in credit union lending for some time now. Regionally, the Midwest has shown particular fragility, as U.S. farmers have been defaulting and missing payments at alarming rates.
According to a report by First Midwest Bank, past-due agricultural loans have soared 287% in 2018 versus the prior year. Recently, the Federal Reserve Bank of Kansas City observed that conditions that prompted lenders to ask for more collateral were up 2.5% in Q4 2018 alone. Meanwhile, farmers' income has continued to slide and is down 11% since 2010. Over the same period, expenses have risen 31% as a result of crop prices falling and the continued trade war with China. Floods in the Midwest have added significantly to the headwinds.
The slowing does not seem limited to the Midwest. Each quarter, the Federal Reserve publishes the results of its survey of Senior Loan Officials at domestically chartered banks. The respondents' answers provide information critical to the Federal Reserve's monitoring of lending practices and credit markets. The April 2019 Survey reported weaker demand (1) for commercial and industrial (C&I) loans from firms both large and small, (2) in all three major commercial real estate (CRE) loan categories, and (3) for almost all categories of residential real estate (RRE) loans and for credit card loans. Demand for auto loans was basically unchanged.
In the credit union space, March saw loan balances increase by a meager 0.3%, a slight acceleration relative to the 0.1% February increase, but the slowest March increase since 2013. The first quarter’s loan growth was just 0.7%, marking a significant slowing compared to both the 1.9% fourth quarter 2018 increase and the 1.6% growth in the first quarter a year ago.
Four Tactical Responses for Credit Unions
If loan demand is indeed slowing, we suggest that credit unions take a closer look at: (1) their rate setting policies, (2) their investment choices, (3) their accounting choices, and (4) the potential benefits of secondary capital.
1. Smart Rate Setting Policies
When it comes to interest rates, credit unions typically set loan and deposit rates based on the U.S. Treasury’s yield curve. Against such a strategy, today’s lower and flatter curve brings a whole host of challenges. It’s far easier for financial institutions to make money when there is some slope to the yield curve. By contrast, today’s flatter curve strips the credit union of its margin. And, today’s yield curve is just about as flat as it gets.
The cost of funds has continued to tick higher for credit unions, as the Federal Reserve Open Markets Committee has bumped up its Fed Funds Rate nine times since it started hiking in December 2015. This challenge is exacerbated by the fierce competition for deposits, with members expecting a deposit rate bump in step with lifting Fed rates on the short end of the curve.
Unfortunately, for a credit union, the unreliability of the transmission mechanism has caused real challenges. Today, the lack of lift on the long end of the curve presents a real issue. With loan demand showing real signs of softening and the curve lacking steepness, there is little appetite to raise interest rates on the lending side of the house. And, when loan rates are not rising, it is more difficult to afford to push deposit rates higher.
The trifecta of a flat curve, softening loan demand and stiff competition for deposits creates a vicious cycle. And, in this ultra-competitive environment for asset gathering, those institutions that do not move deposit rates risk losing business to those that do.
Against such a backdrop, we suggest that credit union clients pay careful attention to rate setting on both the loan and deposit side. With a lower and flatter curve, every basis point counts!
2. Investment Management
Because loans are expected to produce a greater return than a credit union investment portfolio in almost all interest rate cases, the slowing demand for loans can put additional pressure on the overall returns available to credit unions. Today, for example, the average credit union yields 4.78% on its loan portfolio and less than half that (2.35%) on investments.
While credit unions are limited in their permissible investments and their investment books have been drawn down in recent years, the ability to manage the investment portfolio smartly is likely to take on added importance if loans are harder to come by.
Today, 69% of the average credit unions assets are in loans, with only 17% in investments. A decade ago, however, loans and investments were 65% and 22% of assets, respectively. And, twenty years ago, those same splits were 62% and 32%. If investments once again take on an added portion of the assets side of the balance sheet, a top to bottom review of the investments book could be in order.
3. Accounting Choices
Credit unions would also be wise to keep an eye on net worth ratios. Of course, net worth measures the capital strength of a credit union. And, the formula is:
(Regular Reserves + Undivided Earnings) / Total Assets
Slowing loan growth can quickly be accompanied by a pickup in deposits. Often, as the economic horizon becomes hazy, consumers retreat to safety. Credit unions which take in new deposits and at the same time fail to simultaneously increase their retained earnings, will see a drop in net worth. And, pressure on net worth can often sneak up quickly on a distracted credit union.
One potential cosmetic defense to a deterioration in net worth caused by unexpected deposit inflows is an accounting adjustment. While net worth ratio is typically calculated by adding the regular reserve and undivided earnings balances and dividing the sum by total assets on the last day of the accounting period (net worth/assets), regulators are aware that dramatic deposit inflows can have an extraordinary impact on a credit union’s financial results. As such, the NCUA allows credit unions to choose an alternate calculation when they complete the Call Report at the end of each quarter.
Specifically, the PCA Net Worth Calculation Worksheet offers credit unions the option to adjust the asset election denominator and reduce the impact on their net worth position. Credit unions can choose (1) the average of daily assets over the calendar quarter (Line 10), (2) the average of the three month-end balances over the calendar quarter (Line 11), or (3) the average of the current and three preceding calendar quarter-end balances (Line 12).
Faced with unexpected increases in deposits, credit unions are wise to calculate all three of the above options to determine the presentation that places the credit union’s safety and soundness in the most favorable light. In most cases of rapid deposit growth, any of these alternate asset choices of denominator would likely produce a more favorable net worth ratio result than mindlessly applying assets at the end of the accounting period. Of course, any such adjustment is a cosmetic fix that doesn’t address the underlying shift in the business prospects for the credit union.
4. Secondary Capital
Aside from a holistic review of rate setting policy and investments, and opportunistic accounting adjustments, we spend a great deal of time speaking with our low income designated credit union (LICU) clients about the potential benefits of secondary capital. The NCUA’s Secondary Capital Best Practices Guide describes secondary capital as “an important regulatory benefit for federally insured credit unions with a low-income designation [that] allows these credit unions to build temporary capital from external sources.” This capital can provide a boost to a credit union’s business model. It can enable additional growth or be available to absorb potential losses.
With the potential for a change in the business cycle to bring pressure on retained earnings and, therefore, pressure on net worth, we believe that now is an opportune time for LICUs to take a closer look at the potential for secondary capital.
Whether bullish or bearish on loan growth, a thoughtful and deliberate approach requires an honest assessment of your credit union’s lending picture. In our experience, too many credit union leaders lack the imagination to avoid a static mindset that suggests (1) explosive growth will never recede, or (2) reduced expectations with never outperform. The majority of Strategic Plans that we review have conservative estimates on loan growth. Of course, being conservative in growth expectations is prudent. But, it does not relieve responsible leaders from having a plan should loan demand far exceed expectations and cause pressure on net worth. On the flipside of the coin, being too rosy in your projections is also not wise. This late in the cycle and against a difficult interest rate picture, a sober consideration of the strategies outlined above is certainly in order.