The Cost Of Liquidity
July 28, 2023
Tight liquidity conditions are a pendulum swing of challenges for many credit unions, according to Catalyst. Prior to 2022, credit unions had ample liquidity and liquidity management, which mostly involved deploying the funds to earn a positive return. In 2022, the pendulum swung back the other way. Credit union managers were faced with the opposite challenge: retaining and raising funds to maintain sufficient liquidity at their credit union.
Borrowing, selling securities, and selling loan participations are all valid ways to increase liquidity, but each option has costs a credit union must consider before determining which solution is best.
Borrowings and/or raising non-member deposits are the most common and frequently used methods for accessing liquidity. Every credit union has a line of credit or term borrowing arrangement set up with their corporate credit union, FHLB, Federal Reserve, or other institution. Tapping into borrowings provides virtually immediate balance sheet liquidity, which is the main advantage of accessing funds through this channel. However, borrowing can be expensive.
Another route credit unions pursue is raising money through non-member deposits. This tool has seen a significant increase in usage since 2022 as liquidity grew tighter. However, depending on the amount of funding a credit union needs and the speed at which the funds are required, this avenue may not be the best path. Issuing non-member deposits might take time to reach the desired level, as most funds are raised in individual amounts of $250,000 or less. Adding to the challenge — when your credit union faces economic liquidity trials, other credit unions will be tight on liquidity as well, which could mean paying a premium to attract funds. While not as quick as borrowing from a line of credit, the funding cost for non-member deposits might be the best solution for your credit union.
Borrowing arrangements and non-member deposits are easy and relatively fast tools for credit union managers to use for adding liquidity to the balance sheet. However, the broader impact on the credit union’s balance sheet and ratios should also be considered.
Investment portfolios are important components of credit union balance sheets. They serve several critical functions. Individual securities can be pledged as collateral to support borrowing capacity, and the interest income they generate provides support for earnings. In some situations, investment portfolios serve as a liquidity reserve that credit unions can turn to when they need liquidity quickly. Unfortunately, rising interest rates in 2022 have credit unions sitting on portfolios that are significantly underwater from a valuation perspective, and since selling securities would result in booking a loss, most credit unions have ruled out this option altogether.
While realizing any losses is undesirable, selling securities should not be completely ruled out as an option simply to avoid a loss on the sale. Using a more comprehensive approach, where the loss is evaluated as the “cost” of liquidity, is appropriate. There are often situations where the loss realized, when compared to the total cost of borrowings (or non-member deposits), can be the less expensive path to take.
There are also benefits to selling securities as opposed to assuming borrowings. Security sales to raise liquidity do not inflate the size of your balance sheet like borrowings or the issuance of non-member deposits.
Selling Loans / Loan Participations
Credit union loan participations have experienced an explosion in activity over the past few years. As activity has grown, credit unions of all sizes have become more familiar and involved — to the point that loan participations have become a widely used solution for both buyers and sellers. For buyers, loan participations can offer attractive income-producing assets. For sellers, loan participations have become an important source of liquidity, as well as a balance sheet management tool.
Selling loan participations enables sellers to maintain loan originations, while providing a channel to offload some volume to other credit unions. This offers sellers the opportunity to meet member loan demands, capture loan origination fees, retain member servicing relationships and potentially capture gains from the sales process; that is, until the rate rise in 2022 pushed loan portfolio valuations lower.
In the same vein as with underwater security portfolios, when pricing of a loan participation would result in a loss on the sale, the idea of selling a loan participation as a funding alternative gets almost immediately dismissed as an option. But by summarily dismissing this alternative, you may be omitting a less costly strategy for generating liquidity.
Determining the “right” path for your credit union should always be based on the optimal bottom line benefit to the credit union. Which strategy will produce the required increase in liquidity at the lowest total cost? Contact your GoWest Solutions team if you’d like to learn more about Catalyst’s potential solutions to the challenge of liquidity.
Editor’s note: This article appeared originally on CreditUnions.com and is the intellectual property of CALLAHAN & ASSOCIATES. No part may be reproduced, transmitted, distributed, published, or otherwise communicated without the express written permission of CALLAHAN & ASSOCIATES.