LOMBARD, Ill.—The extended low-rate environment, which has been lingering even longer thanks to the U.K.’s Brexit, is creating a challenging operating environment for CUs—particularly small ones—according to one analyst who believes now is the time for the smallest CUs to focus on their business model.
“The critical thing is to create a business model that can be successful in a more difficult operating environment, one that focuses on deep member relationships and diversified income sources,” said Bill Handel.
Handel, VP of research at Raddon Financial Group, emphasized why a new business model is essential for many small credit unions, noting that simply sitting on a capital cushion and waiting it out until rates rise is not a sound strategy.
“Without a doubt, many small credit unions are seeing their capital ratios degrade as a result of a subpar earnings environment,” explained Handel. “The good news is that many of these organizations have very strong capital levels that allow them to afford this. The lesson, however, is that they cannot simply wait for a change in the rate environment for earnings to improve. Even when rates do begin to move upward, factors will counter some of the benefits of rising rates, such as increased competition in both deposit and lending markets. Moreover, credit unions are likely to see earnings pressure continue in other areas, such as overdraft and interchange.”
Deeper Relationships
Bill Handel, Raddon
Elaborating on the importance of deepening member relationships and diversifying income sources at small credit unions, Handel said, “Deeper member relationships tend to result in overall greater efficiency for a credit union, and improved efficiency ratios can help small credit unions to weather a tough operating environment. Focus on core competencies and maximize performance in those areas, but be careful not to put all your eggs in one basket.”
Handel concedes that tight margins, which will not be easing until rates rise, are more difficult to address for small credit unions.
“Tighter margins will be impactful for all credit unions but could be especially concerning for small credit unions that tend to have fewer ‘levers’ to pull to ameliorate the situation,” said Handel. “Large credit unions tend to have more diversification in income sources—for example more non-interest income—and often have more ability to manage down operating expenses. So this environment does put a little more pressure on small credit unions.”
Just how long the low-rate environment continues and how much impact Brexit will have on it are uncertain, said Handel.
“Potentially, Brexit could lead to a longer period of low rates,” said Handel. “But the Fed is more likely to pay attention to U.S. economic conditions in its rate decisions. Brexit creates a level of uncertainty in global economics, but its direct impact on the U.S. is not all that significant. More impactful is the GDP report which again showed very disappointing economic gains for the second quarter. This may encourage the Fed to keep rates low into the fourth quarter. It is possible we may see another December rate increase by the Fed as the only rate change in the year.”
Tigther Margins
Meanwhile, credit unions, large and small, should brace for even tighter margins, said Handel, pointing to increased deposit pressures.
“As long as rates remain low margins will continue to tighten for the industry as older, higher yielding assets are replaced with more recently generated assets at lower rates. Additionally, competition in key lending areas such as auto lending is tightening, leading to lower rates in those areas,” said Handel. “And, in many markets, deposit competition is intensifying which is contributing to margin compression as credit unions are forced to pay slightly higher rates to attract new deposits.”