Pricing for Risk in the Loan Portfolio—Why It Is Critical to Start Doing So

By Keri M. Crooks12.17.2018

Discussions throughout the industry remain focused on deposit betas or how rates paid on various deposit products are increasing with each 25bp hike by the FOMC. At the same time, the NCUA and other regulators are shifting gears and allocating resources towards liquidity and contingency planning for deposit outflows. And last, but not least, risk management teams and boards of directors are quite tangled up in discussions around what has become a very flat yield curve and its potential inversion. While these are valid current concerns and items to be strategically managed, there is an overlooked risk that has been growing over the past three years of this rising rate cycle. This is apparent among credit unions and banks of all shapes, sizes and locations.

Loan origination rates have notably lagged increases in market rates—and you will not be able to get away with it for much longer.  

Loan growth together with the benefit of each 25bp FOMC rate increase on floating rate loans have contributed to wider spreads and income for most credit unions. This was possible as long as rising interest rates had not yet pushed the cost of deposits notably higher. After eight increases by the FOMC, credit unions (and banks alike) are starting to feel the pain of rising interest rates as the cost to retain member deposits is climbing and margin compression is beginning to percolate. The last time this trend played out was in the 2004 to 2006 rising rate cycle when the cost of deposits was mostly unchanged through the first half of the cycle. It wasn’t until the second half that institutions absorbed the cost of higher deposit rates as betas increased notably. Currently, we are closing out the third year of this rising rate cycle (recall that the first hike was in December of 2015!) while at the same time the FOMC is telling us the end is near with the Fed Funds rate peaking in 2019. One should expect the cost to retain and grow member deposits to increase more from here, creating pressure on margins for at least the next several quarters and spotlighting lagging loan yields. Funding strategies will remain critical, but this is just one part of the balance sheet to factor into the bottom line.

Many credit unions have been slow to move their loan rates higher and/or have tightened spreads on floating rate production to keep volume elevated and combat intense competition. The most common culprits have been member business loans, adjustable rate mortgages and indirect auto loans where rates (and structure) remain very competitive. How much have rates on loan products increased at your credit union during this rising rate cycle? Note that the Prime and Fed Funds rates are 200bp higher today, the 5-year Treasury yield has increased 130bp and 10-year Treasury yields are 100bp higher (all relative to December 2015 in advance of the first FOMC rate hike). As an exercise, compare rates on loans originated in the 2015 timeframe (prior to the start of this rate cycle) to what your lenders are booking today. How much of an increase have you been able to obtain? Something MUCH less is the common answer.

DCG has been running loan beta stress testing on net interest income projections to identify the potential exposure caused by narrowing loan spreads or the inability to increase loan rates in conjunction with market rate movements.  With a 75% beta applied to assumptions for loan rates in rising rate scenarios, the results are painful—but insightful. The results show how projected rising rate sensitivity and earnings could and will change without action. Also, even if there is no change in sensitivity under this scenario, it clearly quantifies the significance - in dollars - of money being left on the table in the form of lost income from lower loan yields. As a general observation, the 25% reduction in projected higher loan rates may not be enough of a reduction at some credit unions given their pricing. Tighter loan spreads do have an adverse effect on the overall margin and are set to become more apparent and obvious as deposit rates accelerate more notably thru year end and into 2019.

It’s not too late. Take this opportunity to educate your lending staff on the escalating cost of member deposits and wholesale funding (the “raw materials” available to “manufacture” your loan products), as well as the realities of today’s market interest rates. Note that some credit unions have already begun to experience outflows of low-cost non-maturity share deposits. Operational silos can often exist among lenders and deposit operations, making it difficult to reach a common understanding of the credit union’s goals. The Prime swap market today shows term rates from 3 to 15 years at around 5.75%. This is just what you should be paid in the form of interest rate for extending out on the curve today and taking interest rate risk (“locking in” fixed rate). This rate of 5.75% has no pricing component for credit or liquidity risk. 

Keep in mind that even if you are getting higher rates on newly originated loans, the yield on your total loan portfolio (and your margin) will be slower to respond as your portfolio will take time to turn over. This will not be a quick fix for combating rising deposit costs.

The pain associated with higher funding costs does not really kick in until the later stages of the rising rate cycle, and that time is coming. Every basis point of pickup in loan yields will go a long way toward offsetting higher rates paid on member deposits, supporting rising overhead costs and increasing income and therefore net worth. Also, no one has a crystal ball detailing what risks are around the corner or could come in the next cycle. As such, now is a good time to ensure your credit union is paid appropriately for all of the risks being taken.

Keri Crooks is managing director for Darling Consulting Group, a Newburyport, Mass.-based provider of asset liability management (ALM) solutions for financial institutions.