The balance sheet and strategic benefits of low-cost deposits.
As economic conditions shift, so do the challenges and opportunities for credit unions in achieving their strategic objectives. In the current rate environment, mergers may take on more prominence as opportunities to address liquidity and revenue production challenges.
Let’s say the executive team and board agree on a strategic objective to enhance the CU’s relevance to members by increasing revenue to invest in the services members value. The CU has already established a strong lending presence in its market, but the threat of a liquidity crunch under elevated rate conditions poses a serious obstacle to continued growth. Seeking a merger partner with excess liquidity presents the opportunity to help the CU achieve its strategic aim.
This may become increasingly common as CUs with a high loan-to-share ratio seek a low-cost source of funds, which for many means member deposits. Unlike banks, CUs can’t turn to secondary markets or Wall Street to get capital. If the organization in our example can’t generate deposits organically without significant dividend increases, its board and executive team might decide to look for a merger partner with a lower loan-to-share mix and excess deposits available to fund loan growth.
Another concern is the specter of net interest margin compression if a CU’s cost of funds increases faster than loan rates. It’s a different challenge than being loaned out, but access to low-cost deposits can mitigate both problems.
The merger-as-opportunity scenario will likely arise in managing the loan portfolio as well. Some CUs may need to address higher delinquencies and charge-offs for loans in a higher rate environment. In this event, the possibility of merging into a financially stronger CU offers a way to cover higher credit losses and also deliver on members’ expectations for state-of-the-art digital delivery and access to new products and services.
Increased interest rates may also slow down loan growth as members may no longer be able to afford higher-cost borrowing. Credit unions without a strong loan generation platform will be forced to deal with declining revenue and less money to put back into new capabilities.
This platform is more than just technology; it involves having the right people and processes in place to deliver a differentiated member experience at the “moment of truth” in whatever channels members choose. Without those components in place, some CUs may find themselves in a downward loop, as lower revenues lead to lower earnings, which in turn lead to lower investment in services, leading to lower relevance to members and even lower member growth. At some point, organizations that don’t support a strong loan platform may need to consider a merger with a larger CU that may be more “future-ready” as a survival strategy.
Finding the Best Match
Identifying merger partners with complementary opportunities and challenges can help both CUs better serve their combined membership and improve the continuing organization’s outcomes. All else being equal, a loaned-out CU would prefer a merger partner with excess deposits. If CUs with high loan-to-deposit ratios joined forces, the result might actually exacerbate a liquidity crisis and/or increase concentration risk in indirect loans or mortgages.
The need to seek out a merger partner that offers a good fit is a constant, but the current rate environment with its pressure on cost of funds makes this consideration even more crucial.
Toward that end, a key metric in evaluating potential merger partners is a CU’s “deposit beta,” or how much of an increase in market rates is passed on to members for every 1 percent the Fed raises rates.
The deposit beta has increased significantly across the industry. We’ve begun to see deposit betas in the 0.5 to 0.6 range (and higher in some markets), which means that 50 to 60 percent of Fed interest rate increases are reflected in savings, CD and money market account rates. However, there can be sizable variations in the pace and size of rate increases among institutions, and a wide disparity in deposit betas between two CUs considering merging could signal a disconnect in deposit pricing strategies.
Thus, a key consideration is how the merging CU’s current rates compare with both market rates and the pricing approach of the surviving institution. As an example, if the merging financial cooperative competes on price by offering deposit rates higher than those offered by the surviving institution, the potential draining away of members following the merger will likely be higher than if the rates offered by both CUs are comparable.
Another valuable metric in assessing fit with prospective merger partners is duration of deposits, including checking, savings and money market accounts. Some CUs might have checking account duration close to 10 years; others might be around five. Depending on how those averages are calculated, CUs can measure the relative stickiness of other organizations’ deposit bases as well as its basis (such as competing on price vs. value-added services).
In addition to a duration analysis, due diligence on merger candidates likely encompasses a close look at how much of the merging CU’s loan and deposit portfolio will reprice and when. That view will inform projections about when the risk profile of the underlying portfolios may change, as it will highlight potential margin compression risk and deposit loss/liquidity pressures in the future.
Some ongoing imperatives in managing member relationships, aligning asset-liability strategies and vetting mergers will take on added importance. For one, the charge to build member loyalty using the most cost-effective means is a quandary that transcends rate cycles. Strategists are always looking for ways to balance sticky deposit pricing and other promotional tactics (such as loyalty programs) to gain access to members’ funds long term.
Smaller institutions can’t compete against large banks like Chase that hold on to deposits based on convenience (digital capabilities, physical locations, etc.) versus rates. Given that CUs can’t keep pace, it is even more imperative to find non-price-based mechanisms to sustain and increase member loyalty.
That aim seeks to sidestep the pursuit of “hot money” with high-rate certificates of deposit that members will likely transfer when other financial institutions—the online Ally Bank is a high-profile example—offer a better rate. Maintaining a lower cost of funds matters, but so does the long-term retention of members’ deposits.
Service levels also influence member loyalty—and likely run-off in the wake of a merger. As deposit rates dropped and then bumped along the bottom over the past decade, the expectations of many consumers shifted from rate consciousness to digital services. If the surviving CU is competitive on price, even if it doesn’t compete on price (yes, those are two distinct pricing strategies), its commitment to offer superior service may be enough to keep members.
In today’s hypercompetitive marketplace, value built on high quality digital channels and/or such perks as rewards may close the gap with financial institutions pushing CD rate specials and build long-term loyalty. Following a merger, the combined CU may not win over every member with that approach, but the financial trade-off could make it worthwhile, especially if one CU brings more future readiness to the continuing entity.
Ready, Reset, Grow
Balancing asset/liability management priorities is not the only factor driving merger explorations across the industry. Predictions of an economic downturn in 2020 or 2021 could also ramp up consolidation between CUs already dealing with challenges and those with more solid foundations.
A wild card in this discussion is that some CU leaders have no experience managing in a higher rate environment. The Fed’s decision to raise its target funds rate by a quarter point in December 2015 was the first rate increase since June 2006. The last extended period of rising rates goes back even further into the 1990s. Given the average tenure of CU executive teams and boards, current economic conditions may present a novel challenge in managing both sides of the balance sheet. In addition, the focus on loan growth over the past decade often leaves CUs with good loan generators but more limited experience and skills in deposit gathering. That’s a factor behind a big uptick in financial institutions hiring (and poaching) professionals who have a track record of deposit growth. This situation may also quicken the pace of merger activity.
Returning to our original premise, the bottom line in choosing the right merger partner to support strategic objectives is even more critical in the current environment when the definition of “right” will need to evolve. What constitutes member relevance has changed a great deal over the past decade. Convenient digital delivery and ease of access have supplanted deposit and loan rates as the top priority for many. At the same time, the capacity to innovate on service hinges on strong financial performance. Institutions that don’t have the resources to invest in those channels will continue to lose ground and may look to mergers to offer a more future-ready and compelling member experience.
Even organizations that have been rolling along comfortably need to plan for evolving interest-rate, credit, liquidity and other financial risks. Recent mergers indicate that the most progressive CUs are doing just that. Many mergers now involve thriving partners that don’t need to merge but agree that joining forces is an effective way to stay relevant to their members. With a strong foundation in place to respond to risks, CUs will be better positioned to achieve their strategic objectives through the right merger opportunities. cues icon
Vincent Hui specializes in strategic planning and leads the merger and acquisition and risk management practices for CUES Supplier member and strategic provider Cornerstone Advisors, Scottsdale, Arizona.