With treasury rates rising recently, credit union managers are feeling pressure to raise rates on their deposits. After a ten year hiatus, credit unions are again face-to-face with an age-old dilemma:
- When should a credit union raise its rates;
- By how much should rates be raised; and
- On which deposit types should rates be raised?
It is important that when credit unions do raise their rates, they do so based on conclusions using empirical methodologies and not on emotion or the competitions’ rates. This article sheds some light on considerations that should go into setting deposit rates.
Many Financial Institutions Have Raised Rates on their Money Market Accounts and CDs
A number of large banks have begun to raise interest rates on their Money Market Accounts and Certificates of Deposit. Are they raising their rates because of increased loan demand? Are they raising deposit rates due to better yields on their investments? Or are they raising rates simply to get the jump on their competitors? These are important questions to ponder before credit union managers and boards buckle to the pressure to raise their rates.
The Financial Markets Are Sending Mixed Signals
Large banks and credit unions may be raising rates on some types of deposits but financial markets are not unanimous in what the future holds for interest rates. In the financial news recently, some Fed officials were advocating a more aggressive stance to tightening rates. On the other hand, we read where the yield curve between 30 year bonds and five year notes is flattening. Typically, this portends expectations of lack-luster growth in the economy and low inflation. Which argument should credit union managers plan around? A lot of future profitability could be at risk if managers bet too heavily on one scenario or the other without using empirical Interest Rate Risk management models.
Boards Need to Resist Setting Deposit Rates Based on Competitors’ Rates or Emotion
Research has led to some interesting conclusions about the effects of rising rates and credit unions’ response to such rises:
- Traditionally, credit unions raise deposit rates faster and at a higher level than they need to to maintain deposits sufficient to meet loan demand (which means they are not maximizing profitability);
- Not all classes of deposits are rate sensitive (price elastic); therefore
- Credit unions should increase rates on the most rate sensitive deposits first and only at a speed necessary to adhere to their Asset/Liability Management (A/LM) plans
Setting rates based on the competition is almost always a bad strategy for the following reasons:
- Few competitors share exactly the same income levels, expense ratios, and economies of scale;
- Few competitors share the same short term and long term profitability goals;
- Few competitors have the same loan-to-deposit ratios;
- Few competitors share the same Interest Rate Risk;
- Setting rates based on competitors’ rates does not assure member satisfaction;
- Setting rates based on the competition does not assure profitability;
- Banks and credit unions could well be watching one another and setting their rates according to their competitors’ rates (everyone is following one another in a high-stakes rate-setting circular dance leading to rates higher than necessary without regards to A/LM strategy and without using empirically based methodologies)
A/LM Policies and Plans Should Be Adhered to When Setting Rates
Credit union boards and managers are responsible for managing many forms of risk. One such risk is Interest Rate Risk (IRR). The task of managing IRR is complicated by the uncertainty of how much and how fast interest rates should be raised. This uncertainty is a central part of IRR. Managing IRR effectively requires designing and following a well-established A/LM policy and plan. This process includes an active A/LM committee that is well trained, monitors reports carefully, has open discussion, and is encouraged to make recommendations to the board and management when deemed useful.
Stochastic Modeling Should be Utilized to Assure Rates are Set Objectively
The process of setting rates is far too important to trust traditional methods such as watching the competition or relying on a “gut feeling”. Proven and “back tested” statistical models need to be used when setting rates. When shopping for a reliable and proven rate-setting modeling tool, credit unions should look for a model that:
- Shows how it can help credit unions achieve their profitability goals;
- Provides methods for control over deposit-interest expenses;
- Provides an objective, non-emotional method for setting rates on different classes of deposits;
- Provides an additional metric for managing IRR;
- Establishes deposit rates considering a credit union’s financial health; and
- Can be used to project cost-of-funds and perform “what if” simulations
Setting Rates Based on Anything Except Empirical Methods Could Sink a Credit Union
The primary determinant of profitability for a credit union is its interest margin. Setting loan and/or deposit rates based on emotions, competitors’ rates or “gut feel” is a recipe for disaster. For assuring profitability and objectively setting interest rates, management needs to be using stochastically derived pricing methodologies.