TCT Risk Solutions Newsletter November 2015
Deposit Pricing in a Rising Rate Environment
By Dennis Child, Marketing Director, TCT Risk Solutions, LLC
Finally, after seven years of speculation, there is now a greater chance than in that seven year period that the Fed will raise rates by about 25 basis points before the end of 2015.
Boards and CEOs should be prepared to address an increase in rates even though that increase may be modest for the time being and may be modest even into the foreseeable future. For the benefit of those who missed my article in this newsletter last month, let’s review what factors drive interest rates. Then we’ll look at how boards and CEOs should manage their interest margins once rates do begin to increase.
The Fed drives interest rates upward primarily in response to rising inflation through its monetary policies. Measures of inflation include: Gross Domestic Product, employment/wage growth, increasing consumer spending/prices, and rapid increases in real estate values. There are mixed signals right now in these measures. Overall, inflation is presently far below what the Fed sees as indicative of a healthy, expanding economy. The Fed controls rates through monetary policies. Monetary policy actions include “quantitative easing”, Fed Funds rate manipulation, and so forth.
Complicating the Fed’s control over rate increases and its monetary policies are the federal government’s fiscal policies. Fiscal policies impact increases or decreases in: taxes, government spending, deficits, and regulations. The government has been quite aggressive the past several years and the country has seen increases in: taxes, spending, deficits, and regulations. Some contend these actions by the government have stymied economic growth. Fiscal policies usually trump monetary policies.
But, even though the traditional indicators of economic health are anemic, there is pressure on the Fed to raise rates.
So, the big question is: when will the Fed move to increase interest rates and how often and in what increments? The answer of course is: it depends. Eventually, rates will rise. Most likely (the way things look right now), at least in the short term, rate increases will be slow and modest.
At some point in the not too distant future, credit union boards and CEOs will be facing the need to raise their rates on deposits. They need to prepare now for the impact rate increases will have on their cost of deposits, their interest margins, and their profitability. Wise management teams have already prepared and planned for rising rates.
TCT’s interest-margin optimization tools aid the A/LM committee, CEOs, CFOs and boards in carrying out their risk management responsibilities.
For the past 30 years or so, we at TCT Risk Solutions, LLC have been studying the effects rising rates have on credit unions as well as how credit unions respond when rates do rise. Our findings point to some interesting conclusions:
- traditionally, in a rising rate environment, credit unions raise their deposit rates faster and at a higher level than they need to to maintain deposit bases sufficient to meet loan demand (which means they are not maximizing profitability);
- not all classes of deposits are rate sensitive (price elastic) to the same extent and this affects how different classes of deposits should be priced and shock tests administered;
- credit unions should increase rates on the most rate sensitive deposits first and only at the speed necessary to adhere to their Asset/Liability Management plans;
- credit unions should use a disciplined approach to deposit pricing utilizing stochastically-derived pricing tools (they should resist the temptation to price their deposits primarily on how the competition prices theirs); and
- CEOs and boards have better control over deposit costs and rate shocks when they follow a well-designed A/LM policy.
TCT has developed empirical processes to help credit union boards and managers maximize their interest margins. These processes include stochastically-derived management tools including:
- Asset/Liability Management Modeling
- Margin-Optimizing Deposit and Loan Pricing Tools
- Deposit Pricing (including Dr. Thompson’s unique “Dividend Payout Ratio”)
- Loan Pricing (Risk Based Loan Pricing)
- Margin Management Tool (an interactive system for predicting interest rate margins and performing “what if” scenarios)
TCT’s Margin Management Tool (MMT) is particularly effective when integrated with TCT’s A/LM model. TCT’s A/LM process aids in determining the price elasticity of share classes.
Using the MMT, credit union managers are able to:
- Predict Net Interest Income broken out by deposit classes over a specified timeline (applying different rates to deposit classes according to their price elasticity)
- Perform “what if” scenarios, i.e. outcomes of (1) increasing/decreasing balances by deposit class; and/or (2) raising/decreasing rates by deposit class; and (3) applying various timelines to those changes. Note: MMT takes into account existing deposit balances, CD maturities, repricing opportunities, etc.
Effectively pricing deposits is just one of many risk management challenges credit union CEOs face. Complicating the task is the uncertainty of how much and how fast interest rates will change. This uncertainty is the central part of Interest Rate Risk (IRR). The key to managing IRR effectively requires designing and following a purposeful Asset\Liability Management policy and plan. An effective A/LM process includes an active A/LM committee that is well trained, that monitors A/LM reports carefully, has innovative discussion, and then makes recommendations when appropriate. TCT’s interest-margin optimization tools aid the A/LM committee, CEOs, CFOs and boards in carrying out their risk management responsibilities.
If you would like more information about our products and services please contact us:
Thompson Consulting & Training
Randy Thompson ~ President/CEO Brian Evans ~ Operations Manager
Dennis Child ~ Research Specialist Bruce Moret ~ ALCO Specialist
Dolores Pico ~ Compliance Specialist Donna Jensen ~ Office Manager
Visit us on the web at our NEW website - www.tctrisk.com
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