Are you reaching too far for yield?
by. Henry Meier
For years, NCUA and other regulators have been warning of impending interest rate risk on the mistaken assumption that a spike in economic activity with a resulting spike in short term interest rates was right around the corner. However, the Fed’s decision to reduce its long term bond buying program by $10 billion a month underscores that now we are actually entering a period where examiners will be justified in taking a particularly close look at your credit union’s approach to interest rate risk. Here’s why.
As explained in his December overview of credit union economic activity, NCUA’s chief economist John Worth points out that over the last year the percentage of credit union assets dedicated to investments and loans has remained constant at about 28%. However, the composition of those assets has changed with credit unions committing to longer term investments. For example, investments with a maturity of less than three years declined 11% last year while those with longer maturities increased over 30%..
Although this might make examiners uncomfortable, I’ve argued for a while that the approach makes sense in light of an anemic economy where a sudden burst of economic activity is not around the corner and Fed policies are specifically designed to keep interest rates artificially low.
But with the Fed’s announcement that it is beginning to taper, things will get a little tricky in the coming months. As Worth explains, as the Fed gets out of the long term bond buying business, credit unions may be tempted to actually increase their purchase of longer term securities. This impulse will be all the more tempting since the Fed remains committed to keeping short term interest rates at or near zero for the foreseeable future. The danger, as explained by Worth, is that when short term interest rates do begin to rise, they will most likely rise faster than the rise in longer term rates creating perfect conditions for a net interest margin squeeze.
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