Investing with Purpose Starts at the Source

Originally published on CUInsight.com.

Defining Risk Through Member Deposits

To be more direct, our focus on making investment decisions is limited by the risk profile of the funding source, our members. This limiting factor is defined when the deposits are made, either expressly with maturity dates of a certificate, or implied by the pricing and availability of savings and money market deposits. These liability characteristics are the driving source of our ability to put funds at risk.

The Lending Layer of Risk Appetite

Our dual function of promoting thrift and providing loans complicates the liability-driven investment concept. Our liability stream defines the risk limits, but our lending function uses some of that risk when we lend to members. Put a simpler way, our liabilities define our risk appetite and our lending fills some of that appetite. What remains after we allocate the risk appetite to the loan portfolio is how we can structure the investment portfolio. For our purposes here, we can refer to this remainder as the net risk in the balance sheet, total risk defined by liabilities less the risk present in the loan portfolio.

Targeting Net Risk in the Balance Sheet

Once we gain comfort with the concept of targeting the net risk of the balance sheet, we can now review some details in how to calculate this target. We focus on the risk of earnings fluctuations due to changes in interest rates. There are several measurements of this risk that are good approximations to help see how much interest rate risk exposure we have on each side of our balance sheet, but these measures are only approximations and have shortcomings through the interest rate cycle changes.

Avoiding Market Noise with Member-Focused Strategy

Traditionally, many credit union investors have focused their efforts on maintaining safety as the primary focus of the investment portfolio. Others have focused their efforts on maximizing returns, attempting to predict market reactions to economic events. Each of these strategies are well meaning but focus on outcomes that are not member-focused and introduce potential adverse outcomes by bringing non-credit union specific elements into the decision-making process. It doesn’t help when the industry that markets investment securities is set up to focus investors on the wrong goals and steers our attention away from our member focus. This is why an approach that is disciplined, member-focused, and accurately measured will keep credit unions on a well thought through strategy.

Trusting the Risk Measurement Process

To employ liability-driven investment decisions, we must trust our risk measurement process. We assume the risk measurement using the asset liability management modeling is accurate and trusted to produce a reliable risk profile. This, after all, is the basis for the measurement needed to employ the liability-driven investment process. If we are producing the information necessary to see how much risk our balance sheet contains on both sides of the balance sheet, we can also see the net risk between the liability and loan sections of the balance sheet and invest accordingly. It is important to note that this must be observed in more than a single interest rate environment. Since risk profiles for many instruments vary as interest rates change, the net risk profile is likely to change as well. When evaluating options, the impact of these decisions should be understood in today’s environment, along with many other rate environment possibilities.

Evolving Tools for Real-Time Decision Making

This process of using liability-driven investment decisions can seem cumbersome. Doing the many calculations required to see the information can take time and effort that is often in short supply. Measuring the impact of each investment decision on the overall risk of the balance sheet adds more time and effort to that challenge. Previously, there were techniques developed to measure the net risk position required to help credit unions see what they can target to balance the net risk and gain comfort that each decision made was beneficial to their specific risk profile. This process was evolutionary in its ability to focus decisions away from the noise of the financial markets and on the credit union and its members.

As with most work in our world, the process of making better decisions continues to evolve and improve. Liability-driven investment decision making is no different. Modeling tools are now available that display real-time impact on net risk for each investment decision. These tools help investors see how the net risk changes as they are being contemplated and can ensure the decisions are meaningful. Most importantly, this information is available before a decision is made.

The Future of Credit Union Investing

If you are wondering what the next large move forward in credit union financial management is, this is it. Seeing the benefit for each credit union’s financial performance and being able to make that benefit happen in the moment is how many have envisioned credit union investing could be. Later this year, credit unions will gain access to a new suite of Balance Sheet Management tools within Beastro. Designed to unify modeling, trading, and reporting into a single, seamless experience, this platform will help institutions make smarter, faster decisions across the entire balance sheet. While details are still emerging, the framework promises to elevate how credit unions manage risk and optimize performance. Keep an eye out for the official release of this suite of products and contact our balance sheet management CUSO, QuantyPhi, to schedule a demo of the new platform. QuantyPhi can demonstrate how the suite of products can link ALM into investment analysis and trading, allowing you to execute trades to optimize their risk position.