The Importance of IRR Timing– How Credit Unions Are Facing Falling Rates
We’re all familiar with the adage, “timing is everything,” but when it comes to interest rate risk, that saying is especially true. Just like an inevitable scheduling conflict or a missed career training opportunity, think of interest rate risk as a measurement of a timing mismatch.
As credit unions buy and sell money, these timing differences will occur. Thankfully, there are tools available to help navigate IRR, like the Projected Earnings at Risk and Net Economic Value reports, which help us to measure our risk in both short and long intervals. For example, looking back to the rapidly rising rate cycle of 2022-2023, the measurements we used effectively alerted us of the rising risk to earnings and capital, as risk profiles intensified due to the rate environment.
Since then, management has responded to the IRR alerts and has adjusted accordingly to diminish the risk – taking an active approach by balance sheet restructuring and a passive approach by reinvesting cash flows into shorter duration products. In addition, what happened to the high rates? They dropped slightly and the yield curve shifted.
As a result, with all these factors impacting interest rate risk and the amount of time we’ve had to adjust to the rate environment, IRR measurements, on average, have lightened.
Looking Ahead - Credit Union Considerations in 2025
With these recent events in mind, I want to share some important callouts for credit unions to consider as we move forward into 2025 during this higher for longer era, which admittedly sounds like a timespan that Taylor Swift could have included in The Eras Tour.
The Federal Reserve and the market appear to agree that rates are heading down. The most recent Federal Reserve Dot Plot projects declining rates but not ones that return to the zero-bound rates we’ve been used to seeing. With this data, it’s reasonable to assume that credit unions are preparing their balance sheets to position for a lower rate environment adding duration to insulate earnings as rates fall.
While we do see asset extension over the last few quarters, most credit unions remain positioned to recognize less net interest income in falling rate environments. So, why is this the case when both the market and the Federal Reserve believe rates will be falling? Why are asset cash flows not extending?
For one, shifting our assets into high yielding loans is easier said than done.
Additionally, consumer demand is the leading driver of the lackluster loan growth we are currently seeing. As the economy is bracing for a potential decline, consumers are more hesitant to take on additional debt. Current loan rates are pausing purchases because the payments are unaffordable. And on top of everything, record inflation is creating additional strain on consumers’ wallets.
Our Role as Credit Unions
Despite these influences adding pressure to our ability to lend, credit unions are resilient and have multiple avenues available to assist members. During high rate and economic uncertainty, we have seen credit unions successfully implement consolidation loans to ease the financial burden of their members and have success with HELOCs as consumers hang on to low mortgage rates. By offering credit solutions to members, this also provides revenue to the credit union.
This increase in yield is helpful, but another way we see impact to the bottom line is the reduction to the cost of funds. As Share Certificate rates are coming down, credit unions have been able to price these costs lower while retaining the funding. This is a trend that is expected to remain elevated due to the rate incentive to hold these products.
Credit unions continue to move forward with shifting to products that support their members by providing lines of credit and the timing of the changes made on balance sheets today will impact the future risk as markets are expected to decline.
We come from a long history of shifting services to prop up our members and this rate environment is no different. Interestingly enough, in 1909, when credit unions were founded in the United States to provide affordable credit, U.S. news headlines covered the same topics we’re discussing today, such as controversy over the Panama Canal, implementation of high tariff rates and technical disruptions. While the underlying stories were different back then, the topics were the same.
Just like in the early 20th century, a similar model exists today for credit unions. Credit unions are here to provide affordable credit, and success will be built in the same way it was in 1909, by being there for our members. As we move towards a potentially declining rate environment, lending will likely increase, as affordability will come in view for many on the sidelines.
In the meantime, look for opportunities to add yield on the loan and investments as this props up net interest margin, should rates fall. After all, timing is important, and the decisions and actions we make today will shape the earnings and risk profiles of the future.
Melissa Scott serves as Vizo Financial’s vice president of ALM services. In this role, she is responsible for managing and providing ALM reporting, modeling, validation and consulting services to credit unions. She is also responsible for providing ongoing training, support and education for ALM users, management and their board of directors. She also holds the designation of certified public accountant (CPA) and is a member of the North Carolina Association of Certified Public Accountants.