“An investment in knowledge pays the best interest.” So said Benjamin Franklin, a guy with good judgment, common sense and who also knew a thing or two about human nature and the world in general. Knowledge about skillfully managing your credit union’s investment portfolio can not only optimize the portfolio’s return, it can help you mange your credit union’s overall interest rate risk, credit risk and liquidity risk too. And you don’t have to be Ben Franklin to do it.
In this first article in an exclusive series for CU Insight on managing CU investment portfolios, I’ll summarize both the benefits and the basic steps of skillfully managing your credit union’s investment portfolio, which can limit risk and optimize the portfolio’s return so that you can better serve your members. You can likely do better than simply packing your CU’s investment portfolio with relatively low-yielding CDs and yet still limit your risk to a reasonable level. And although CDs are widely regarded as safe and insured investments, they do come with some liquidity risk. Why? Because they are intended to be held to maturity and they may carry penalties for early withdrawal. In any event, your market haircut can be significant. Holders of CDs who wish to sell them may be required to do so at a discount, particularly in a rising interest rate environment where other, higher-yielding, CDs are available to buyers.
Properly managing your CU’s investment portfolio can also help with regulators. The NCUA is concerned about rising interest rates and the effect it will have on CU investment portfolios. In fact, the NCUA expressed this concern in their Economic Update video released on October 1, 2014. In it, the NCUA’s Chief Economist, John Worth, concluded by saying this about rising short-term interest rates and the resulting possibility of narrowing net interest margins for CUs:
Here at NCUA, our chief concern is that credit unions are aware and prepare for this possibility. Credit unions should have a firm idea of how their income statements and balance sheets are affected by a rapid rise in short-term rates and they should have a plan for dealing with the potential consequences.
As experienced CU executives know, when interest rates rise, the price of bonds fall – including bonds in CU investment portfolios. As a result, the NCUA is concerned that when rates rise, the bonds in CU investment portfolios will lose value and maybe even go underwater. If it’s any consolation, the NCUA is not the only government regulator with these concerns. According to our friends at Invictus Consulting, regulators at two recent banking conferences in California and Nebraska offered insights into the problems they are seeing at community banks. Although we all know that CU’s are regulated by the NCUA, not the OCC or FDIC as banks are, history demonstrates that regulators of CUs and banks frequently share similar concerns and focus during their respective examinations. For example, the Federal Reserve and the OCC, like the NCUA, see interest rate risk as a central issue, though credit risk is also now appearing on their radar screens. The OCC expressed some surprise at these conferences that not all community banks have chief risk officers. And in addition to interest rate risk, the FDIC said it was seeing many banks buying securities for the banks’ investment portfolios that the bankers didn’t fully understand. Many banks should perform better securities due diligence and monitor their unrealized losses, even if they are not required to hold capital against those losses. The FDIC also indicated that banks with increased interest rate risk would be more closely scrutinized. The lesson here? Properly managing your CU’s investment portfolio for optimal return with an eye to managing interest rate risk, credit risk and liquidity risk can help convince regulators (and your board members) that your CU’s balance sheet is in good hands.
The basic steps for successfully managing a credit union investment portfolio are simple on the surface. Here they are:
- Create a plan (e.g., draft a good investment policy);
- Execute the plan (e.g., buy the right securities at the right price and sell the wrong securities at the right price);
- Monitor the portfolio on an ongoing basis (e.g., keep an eye on the credit, liquidity and interest rate risk of the securities in the portfolio);
- Graciously accept accolades for doing a good job (optional, but recommended).
As I’ll discuss further in future articles, examiners often look to determine whether your credit union really follows its own investment policy. If you don’t follow the provisions of the policy, whether in the purchase of securities, monitoring of them or any other provision, expect to receive a request for an explanation for it from the examiners regardless of whether your credit union is legally obligated to do it. In other words, if you put it in the policy, you’re expected to comply with it. Incidentally, this applies to all policies – not just investment policies.
In my next CU Insight article, I’ll explain step 1, the basics of writing an investment policy, which will be followed a third article about step 2, executing the investment policy by selecting the proper securities for your credit union’s investment portfolio – without paying an arm and a leg for them. The fourth and last article in the series will cover step 3, monitoring your CU’s investments (step 4 is up to you). In the meantime, here’s some food for thought from Warren Buffett (another guy who knows a thing or two about investing and human nature) “Investing is putting out money to be sure of getting more money back later at an appropriate rate.” Simple, right?