Zero Interest Rate Risk

Here's something I expect to write a few times in this blog. There are two kinds of interest rate risk - Earnings at Risk (EAR) and Economic Value at Risk (EVR). Both are important and both should be measured and monitored by all credit unions.

(For some reason, the regulators seem more concerned about EAR interest rate risk than they are about EVR. In Ontario for instance, credit unions don't even report EVR to the regulators. So, they have no idea what risks lurk in the long end of their credit unions' portfolios. Sorry - one of my pet peeves.)

Having stated that EVR is important, this blog is only about EAR. There is something you can do to completely eliminate this interest rate risk at your credit union. Well, you can if you are exposed to falling interest rates - and 90% of credit unions are.

It's pretty simple. One, have your variable asset rates tied to the credit union prime rate not the prime rate at the major banks. And two, do not drop your prime rate when the major banks do. Voila, your EAR is now zero. Now when interest rates fall, your asset rates stay constant but your variable liability rates will still fall. That's why EAR is zero.

Won't the members scream? I am told they do not and that has been true for years, not just this crazy interest rate cycle.

For these loans, a member can refinance without penalty. Won't your credit union become uncompetitive? Yes, the major banks have been dropping prime in lock-step (pretty much) with the Bank of Canada, so their prime will be lower than yours. But they have also been increasing spreads as quickly as they can. Retail line of credit spreads have jumped. Remember those prime minus 0.75% variable closed mortgage rates from a few years ago. Now they are more like prime plus 0.75%. So, no - you likely will not be uncompetitive. Should a member check your rate against the competition, chances are good that you are OK.

I should have written this blog about 6 months ago because now it is too late. We are now sitting at the bottom of the interest rate cycle. (In fact, the all time bottom. In fact, the absolute bottom.) If you freeze your variable rates now, it won't matter because the Bank of Canada is now done. They've reached their 'lower effective bound'. Still, there is always next time. And, if you are really hurting, conceivably you could raise variable asset rates and then freeze them. Or, perhaps more palatable, you could increase spreads instead of increasing your prime.

Here's an interesting thought. Given that the Bank of Canada has (more or less) stated that they will not drop rates any further, every credit union in Canada has had its falling rate exposure eliminated.

And, many credit unions did freeze the rates on their variable loans. They did it to protect income, but they also achieved zero EAR interest rate risk. Now there are some big ramifications. More on that next time.

Oh, and by the way - this 'freezing your variable asset rates' strategy has no effect on EVR.