Credit unions have multiple strategies available to them to fund their balance sheets, each presenting a different way to meet the challenges posed by today’s changing financial climate. Decision-makers must balance expenses, risk, and reward in determining how to best manage their institution.
The options for balance sheet funding, and tools for advanced liquidity management, were put on display at the ALM First Financial Institute I attended in recently in Dallas, TX.
At the heart of the discussion around funding an institution’s balance sheet was the concept of understanding the marginal expense of different funding sources. The presenters broke this down further into two distinct ways to think of funding: core funding (core and time deposits), and non-core funding (brokered CDs, repo, dollar rolls, derivatives, and borrowings).
When you map out and truly understand the marginal cost of different sources, and their advantages and disadvantages, it becomes more apparent that there isn’t one right answer.
Given the current interest environment and the related impacts to credit unions’ balance sheets and earnings models, a maintained focus on asset liability management will likely be top of mind for credit union executives in the coming quarters and years.
For example, a campaign to raise traditional deposits can appear to be an attractive deposit strategy, but when you take into account the risk of cannibalization associated with certificate specials, potential for non-loyal hot money, and the associated non-interest expense of servicing these types of accounts, the marginal expense of this strategy might not be as cost effective as first thought.
On the non-core funding side of things, the presenters went into great detail to discuss the pros and cons and various circumstances where these products and strategies make sense.
For example, term borrowings from the FHLB are highly flexible, provide an on-demand liquidity source when needed, and are very compatible for asset matching and hedging purposes. However, as the term lengthens for these types of borrowings, generally so do the size of the term premiums which generally makes them more attractive for shorter-term needs.
Other short-term funding alternatives covered were repurchase (repo) transactions and dollar rolls.
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In another session on advanced liquidity management, the presenters offered a top-down approach to understanding liquidity risk and offered several frameworks to manage that risk. Like any sound enterprise risk management policy, institutions need to consider their own contingency funding plans as they relate to the possibility of a liquidity event. Of note, these plans should be twofold technical as well as holistic in their ability to mitigate stress events when they occur.
To measure liquidity, the presenters walked through the liquidity coverage ratio, which calculates the proportion of an institution’s high quality liquid assets (liquid assets net of liquidity needs) to its net cash outflows (sources and uses adequacy of primary and contingent liquidity). This measure attempts to gauge where an institution is today, and ratios are typically greater than 100%.
A common theme throughout this session was the concept of stress testing and models. Whether it’s a traditional up 300 basis point shock, maxing out funding lines, or determining how a haircut to pledged capital would impact an institution’s profile, everyone will be better informed and prepared for the future by using the information gleaned from these tests.
Inherent to risk management is building a sound liquidity management framework that serves as a guide for the testing described above. Frequent (quarterly and semi-annual) testing is recommended to ensure models are accurately capturing the risk profile of the institution and any changes to the broader economic and financial climate.
As the conference came to an end, I left once again with an improved understanding of the nuances of asset liability management, but also with some wonderful tactical insights about implementation and best practices.
Given the current interest environment and the related impacts to credit unions’ balance sheets and earnings models, a maintained focus on asset liability management will likely be top of mind for credit union executives in the coming quarters and years.