Low market rates have caused credit unions to see their margins compress for the last several years. While credit unions are managing the compression of margins well, it is critical that credit union managers reassess their riskmanagement practices as economic conditions or the credit union's operations change. This is especially true when it comes to managing a credit union's liquidity needs.
Section 741.12 of NCUA's Rules and Regulations details the liquidity management requirements for federally insured credit unions. While all credit unions must comply with these regulatory requirements, each liquidity management program will vary depending on the complexity and risk exposure at each individual credit union.
For example, credit unions with less than $50 million in assets must maintain a written liquidity policy with formal guidance for how the credit union will manage its liquidity, as well as a list of contingent liquidity sources. Credit unions with more than $50 million in assets must also develop a contingency funding plan for addressing emergency liquidity shortfalls.
In a credit union of $100 million or more in assets, which we focus on in this article, a robust liquidity management program will generally include:
- A liquidity policy and contingency funding plan;
- A short-term operational cash flow forecast;
- A long-term strategic cash flow forecast;
- A set of defined stress-testing scenarios; and
- A board tracking report containing risk management limits.
What Goes into a Liquidity and Contingency Funding Plan
A credit union's board of directors is ultimately responsible for establishing a credit union's liquidity-risk tolerances and effectively communicating those strategies and limits to senior management. The liquidity policy should clearly describe its purpose, delegations of authority, risk tolerances, overarching strategies for liquidity management and reporting requirements. This policy document provides a general framework for all of the credit union's liquidity management activities.
In addition, a contingency funding plan is required, and it must detail contingent funding sources and procedures for responding to a liquidity stress event. The plan should outline the methods used to confirm that the contingency funding strategies are adequate for the credit union in a number of adverse scenarios. Credit unions that are greater than $250 million in assets also must establish and document access to at least one federal contingent funding source—the Central Liquidity Facility or Federal Reserve Discount Window satisfy this requirement.
Understanding Cash Flows Is Key
The purpose of cash flow forecasting is to identify cash flow mismatches over an appropriate set of time horizons. Shortterm operational cash flow forecasts may cover time horizons ranging from a week to 30 days. These forecasts contain highly reliable information for managing intraday operations. Long-term strategic cash flow forecasts may cover a time horizon ranging from 6 to 12 months. These forecasts are assumption dependent and provide longer-term projections for strategic planning and stress testing. Credit union management should use both types of cash flow forecasts to measure, monitor and control liquidity-risk exposure.
Stress Tests Can Determine If Plans Are Adequate
Cash flow stress testing is an effective way of testing if a contingency liquidity plan is adequate. Cash flow stress testing requires credit union management to identify a set of plausible scenarios that can adversely affect a credit union's cash flows. The frequency of stress testing should also be commensurate with credit union's risk exposure.
Scenarios will vary depending on the nature of the credit union's operations, but will typically include the following variables:
- A material drawdown of unused commitments. Examples of possible scenarios include a 5 percent drawdown over 30 days and a 20 percent drawdown over 6 months.
- A market-rate shock capturing changing loan prepayment speeds and other rate-driven variables. Examples of possible scenarios include a 300 basis point rate increase immediately and increased market rate shocks.
- A material decline in shares. Examples of possible scenarios include a 5 percent runoff over 30 days and 20 percent runoff over six months.
- A decline in the value of collateral or other events limiting the availability of contingent funding sources. Examples of possible scenarios include a market rate shock or a credit deterioration lowering all collateral value.
- A combination of different stress events happening at the same time. Examples include a market rate shock that slows prepayment speeds, and causes members to move funds into higher yield investments or an economic downturn that increases credit draws, share runoff and delinquency rates.
In each of these scenarios, it is important that management consider the unique demographics of the membership, significant share and loan concentrations of the credit union, the rate sensitivity of deposits and the types of collateral pledged to secure credit.
Engaging the Board Is Also a Key Part of Liquidity Management
The credit union's board has an important role to play as well. Credit union management should provide the board of directors timely reports on liquidity management activities and compliance with risk limits. A risk-limit tracking report illustrating exposure in relation to limits allows board members to quickly assess a credit union's compliance and determine if corrective action is necessary.
The board should also document discussions on the credit union's liquidity management in meeting minutes. This documentation should clearly describe any corrective action taken to resolve any risk-limit violation, as well as why the board would deem a violation of its own policies as acceptable and for how long.
Margin compression will likely remain a challenge for credit unions until market rates normalize. A credit union's management has flexibility when addressing this threat to earnings, but it must continually reassess the credit union's risk-management processes as operations or the economic outlook change.