The Interest Rate Shock and the Balance Sheet
A credit union has $500M in assets. Its balance sheet: $350M in fixed-rate 30-year mortgages (average 3.5% yield, average life 7 years), $100M in overnight investments yielding 4.9%, and $50M in cash. Liabilities: $420M in shares, of which $180M is in a promotional 12-month certificate at 4.6% maturing in 90 days. Net interest margin is 2.1%. Rates are expected to stay elevated. The ALCO model shows a 200bp instantaneous increase reduces net interest income by 6% over 12 months. The board is considering extending certificate maturities to lock in funding and adding floating-rate loans.
1. Diagnose the balance sheet's interest-rate risk and explain the 6% NII decline.
Read the worked answer
The balance sheet is liability-sensitive in the short run: $180M of certificates reprice in 90 days, and if rates rise, the credit union must pay more on those shares, while $350M of fixed-rate mortgages yield only 3.5% and do not reprice. The 200bp shock raises funding cost on the $180M promotional CD (roughly 180M × 2% = $3.6M additional annual cost) while asset yields barely move - hence the 6% NII decline. The $100M overnight investment at 4.9% helps on the asset side but is a small share of assets. Core problem: asset-liability mismatch - long-duration fixed assets funded by short-duration liabilities. The 7-year average life on mortgages means the credit union is exposed to extension risk if rates rise and prepayments slow.
2. Evaluate the proposed strategies and recommend an ALCO action plan.
Read the worked answer
Extending certificate maturities: locks in funding and reduces repricing risk, but at current elevated rates it raises cost now; use laddering and callable structures to balance. Floating-rate loans: adds asset sensitivity, improving the mismatch, but credit risk and member demand must be assessed. Additional moves: (1) sell or securitize a portion of the fixed-rate mortgage portfolio to shorten asset duration; (2) grow non-maturity core shares to reduce reliance on rate-sensitive CDs; (3) use derivatives (swaps/caps) if the credit union has the expertise and authority; (4) set ALCO limits on NII sensitivity and economic value of equity (EVE) and report monthly. Recommendation: a phased plan - ladder new CDs, introduce floating-rate home equity products, sell $50–75M of long mortgages, and build core deposits. Monitor NII sensitivity and EVE against board-approved limits; the 6% NII decline should be within tolerance but trending the wrong way.