We all have a general idea of how a credit union or a bank functions. They accept deposits, and they turn around and lend those deposits out. It is a great model that transfers money from people who have extra funds to people who have a need for funds. But, this process has some unique risks associated with it. There are some common ways this process can go wrong, so credit union leaders should be aware of three key ways this can lead to total failure of an institution.
Probably the most common way banking institutions are known to fail is through a liquidity failure. History and old movies have depicted this problem as run on deposits. In other words, the institution has lent out deposits so people can buy cars and homes. But now, the depositors want to withdraw all their money, but all the money can’t be returned because all the loans haven’t been paid back yet. In this case, the institution is forced to close because it cannot return everyone’s money.
Various measures have been put in place to try and reduce liquidity failures. Now many deposits are insured up to the $250,000 level, so people feel assured that they don’t need to withdraw their funds hastily. There are also “reserve requirements,” which means each institution must carry a bare minimum amount of cash. Most institutions should also have lines of credit now with the Federal Reserve, FHLB, or some other correspondent, which mitigates any liquidity concerns.
The second major way banking failures happen is losses from bad loans. If too many bad loans are made which can’t be repaid, then depositor money cannot be paid back. This was what led to the banking crises of 2008-2009, and has repeatedly caused banking crises throughout history. Banks and credit unions are mostly made of deposits, with only about 10% of the money owned by the institution. When a loan loss occurs, the loss is charged against the 10% capital, not the 90% deposits. Once that 10% capital is gone, a banking failure has occurred. As you can imagine, it doesn’t take many bad loans to torpedo 10% of an institution. This continues to be the most common modern cause of failures.
The last major way an institution can fail has to do with interest rate mismatching. A credit union funds its operations by charging a higher rate on loans than the rate it charges on its deposits. If it has to charge more for deposits than it charges for loans, it will lose money and a failure will occur. In fact, deposit rates don’t need to be higher than loan rates. Even if deposit rates are 1-2% cheaper than loans, a failure can still occur, because the institution cannot earn enough money to fund operations. This is what happened in the Savings & Loan crises in the 1990s. Thrift-savings institutions made many long-term loans with short-term deposits. When interest rates moved up, the deposits became more expensive but the loan rates remained the same. As a result, many thrift-savings institutions couldn’t make enough money and failed.
These three ways to fail can easily be avoided through prudent management. This means keeping lines of credit at your disposal, having sound loan policy, and good credit union managers that understand asset-liability management. Some observers, which includes me, feel the greatest chance of failure in the near-term will be due to interest rate mismatching as the Federal Reserve starts to increase rates.