2020 will certainly be remembered as the year Covid-19 changed the world as we know it. Likewise, the associated “Lockdown Recession” is already changing the way many credit union leaders manage their balance sheets. With loan demand dropping in most parts of the country and stimulus deposits adding to already bloated cash positions, proactive strategic planning has never been more crucial. More to the point, proper liquidity management may offer some of the additional margin and income credit unions desperately need.
Cash and cash equivalents as a percentage of total assets reached 6.98% as of year-end 2019. As the chart above illustrates, that level of liquidity was already at or above the average level since 2007. The surge from 5.62% to 6.98%, which occurred 2018 to 2019, very closely mimics the pop in liquidity experienced in 2008 to 2009 (the beginning of the Great Recession). However, it is the three years after 2009 that we are most focused on. Liquidity continued to grow (hitting 9.11% in 2011/2012) as the industry slowly recovered from weakened loan demand and increased deposits from an embattled member base. The zero-bound range on overnights at the time led to significant drops in overall interest income. As we hit the midpoint of 2020, it appears that the industry must once again prepare to navigate similar waters.
Although we still do not fully understand COVID-19 or the longer-term impact it will have on our economy, we are not completely powerless when it comes to making better-informed decisions. In fact, our performance and trends from past times of crisis can actually become quite useful in a time like this. As we stated earlier, the Great Recession had several important impacts on the overall credit union industry. The severe drop in interest rates, mixed with spiking unemployment (sound familiar?), applied extreme pressures on every balance sheet. As we can see below, Loan to Share ratios, Investment Yield, and ROA all fell while Provision for Loan Losses and Cash increased leading to lower Net Worth Ratios. Although there isn’t a lot we can do about credit issues or lack of demand on the loan side of things, we can do a better job of managing liquidity and specifically cash this time around.
The three charts above show the potential outcome for our industry assuming a 75%, 100% and 125% magnitude of the impact from 2007– 2009. While it can be tempting to “sit on the sidelines” and hope for a V-shaped recovery, we must weigh the potential negative implications from that approach if we end up being wrong. The correct strategy here is not to make a one-way bet in either direction. We can remain positioned for a quicker than expected recovery while also improving our hedge against a longer-term low rate environment like 2007–2012. It all comes down to executable ALM management.
As of 12/31/2019 the industry was carrying just over $110 billion in cash and cash equivalents earning roughly 1.50% on average. In just one month (March 2020) the return on that cash balance dropped to 0.05%, which equates to an annual interest income shortfall of $1.595 billion. To put it quite simply, we cannot afford to accept an income loss of that magnitude when we do not know how long the current situation could last. In fact, every day that we continue to receive 5bps instead of investing those funds, the foregone income becomes harder and harder to recover. If we assume that we can invest 50% of our cash balance as of year-end ($55 bill) at a yield of 1.10%, the foregone income from waiting in cash builds quickly. In just 6-12 months we will have already missed out on $290 to almost $600 million in additional interest income. To make matters worse we ran these figures using cash balances as of year-end 2019. We all know the first quarter always tends to bring the largest deposit growth. So, if we take that into account and also apply the growth trend in cash from the last crisis (+31%), the industry could be looking at another $30 to $50 billion in cash balances near-term. That could potentially double the foregone income figures below. This is not sustainable for earnings or net worth.
We fully understand that 1.10% is not the most attractive yield historically; however, income is income in this type of economic environment. If we had the opportunity to add 105bps of additional margin on just about any other asset we would jump on it. So why does the industry choose to keep additional liquid funds at 0.05% when better earning options are available? The response to this question usually revolves around liquidity concerns in the future. Sure, I have way too much cash now but what if loan demand picks back up? What if deposits become more competitive?
It is our opinion that with proper balance sheet management you can have both. We can increase or at least protect margin and earnings through better investment and liquidity management. As for the potential liquidity worries down the road, that is where contingent liquidity comes into play through wholesale liquidity options. Every credit union has access to lines of credit at corporates and/or FHLB. On top of that, in 2020 the NCUA increased the limit on non-member deposits from 20% of member shares to 50%, greatly increasing liquidity potential as shown below. This chart displays the industries Net Contingent Liquidity going back to 2008, meaning they are net of contingent liabilities. This is the liquidity picture after assuming that all credit card and home equity lines get maxed overnight. Clearly the dollars of available liquidity have grown steadily while the net liquidity-to-asset ratio has recently increased above 60%. Also keep in mind this does not include the potential liquidity that could be accessed through the sale of loan participations.
This is exactly why we have these lines of additional liquidity: so that we can put our cash to work at better yields and margins without worrying about funding future loan demand. It’s also important to note that the current costs to access these liquidity avenues are at historic lows as well. If we were to invest funds and then have a surprise jump in loan demand, I’m confident we would still be able to earn a healthy spread, funding it with advances or non-member deposits well below 1%. The rule of thumb is that as long as available investment yields are higher than borrowing costs, you will make more money investing your cash and borrowing to fund other liquidity needs.
The next 12-18 months will likely highlight those who prepared versus those who chose to wait for it to be over. Current cash balances are approaching unsustainable levels with much more likely on the way. There is still time to put together a strategic investment and liquidity management plan based on your specific ALM results. Allowing earnings and net worth to simply be eroded while sitting in cash is not in line with the industries promise to our membership.
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