By Ray Birch
PLANO, Texas—Over the coming year credit unions must monitor the mismatch between loan and share growth to protect liquidity and place less pressure on gross margins, says one economist, who adds margins should continue to improve.
Brian Turner, president and chief economist of Meridian Economics, told CUToday.info that slightly higher bond rates are currently driving up interest expense, but given relative short-term funding structures, CUs have largely experienced the majority of their expected higher costs.
“Moreover, asset yields have also experienced the benefit of higher rates as well—so the net cost of any pending higher interest expense is minimal,” said Turner. “For credit unions, liquidity pressure has elevated term certificate rates that have also increased their cost of funds. But they have also enjoyed higher asset revenues that higher rates have brought and have retained gross margins—asset yield versus cost of funds—over the past couple of years.”
Turner pointed out that since 2020, federal funds rates have increased nearly 540 basis points and one-year U.S. Treasuries are up 305 basis points.
‘Lower Cost of Funds’
“But the industry’s gross margin has increased by 16 basis points (2.84% to 3.00%),” he explained. “A pending drop in the fed funds rate will have little to no impact on rates on core deposits, meaning checking and savings. And, as liquidity profiles improve, the use of promotional CDs will decline and average-term CD rates will start to fall. This will lead to lower cost of funds in the near future.”
As CUToday.info has reported, credit union yield on asset ratios rose to 4.84% in the first quarter of 2024, the highest since 2009, according to new analysis released as part of TruStage’s June Trends Report. The 4.84% figure is above the 4.5% long-run average.
What to Do Now?
So, what should credit unions be doing now?
Brian Turner
“Remember that credit union gross margins are based on net spread between asset yield and cost of funds,” reminded Turner. “Therefore, it will be very important to monitor the mismatch between loan and share growth in order to protect liquidity and place less pressure on gross margins. I am not concerned about pending interest rate risk as much as I am concerned over credit risk. Therefore, balance sheet reallocation is important.”
Doubling of Delinquencies
Turner noted that loan delinquency rates across the nation have doubled this year and foreclosure filings are rising.
“So, I suggest at least 88% of new loan originations should be retained in the portfolio, average no lower than A-/B+,” he said. “Most credit unions currently have loss reserves that significantly exceed their implied loss exposure. So, even if there is an upward trend, it should not have an adverse impact on their net worth.”
Turner reminded that many in the financial services industry made mistakes in 2021-2023, when they did not properly manage the mismatch between loan and deposit growth.
“Coming out of post-COVID, there was a burst of loan demand, particularly in consumer loans,” Turner pointed out. “That really got the focus of many credit unions who had experienced a downward trend in loan growth during the pandemic. At the same time, elevated inflation sent consumer prices skyward as inflation exceeded 9%, causing more members to live a paycheck-to-paycheck existence, even dipping into their savings to meet the higher cost on most essentials. Moreover, the loans that credit unions were making were at relatively low rates.”
Negative Cash Flows
That led many credit unions to experience negative cash flows as cash was being reallocated to loans, at the same time, they were experiencing an outflow of core deposits due to elevated inflation, Turner said.
“This depleted surplus liquidity to the extent that many were faced with two options: issue high-rate promotional CDs to rebuild their cash position, or shut down future loan originations while using monthly principal and interest payments to replenish their coffers,” Turner said.
Learning a Lesson
Turner said the lesson credit unions should have learned is loan growth strategies have to coincide with projected deposit outlook or risk the dilution of liquidity.
“Also, growth strategies must take into account the rate environment and how best to reallocate the balance sheet in order to protect future membership capital,” he said, adding his strategic mantra is to “never sacrifice long-term earnings for short-term, gains.”