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Annual Long-Term Financial Planning Process: Include A Deflation Scenario

September 9, 2010

We strongly recommend that credit unions annually invest the time to forecast financial performance for at least three future years.  The baseline forecast should compliment the strategic plan and include the cost of major initiatives, as well as expected growth trends.  If the baseline does not produce satisfactory performance, determine what changes could be made.  Once a baseline is established, senior management should identify the issues they feel could have the biggest impact on future financial performance and then test each issue as a what-if.  Typical what-ifs include:

  • Provision for loan loss doubles from the baseline plan for 24 months
  • Non-interest income decreases 50%
  • Lending volume declines significantly
  • NCUSIF assessments are twice the level in the baseline
  • Interest rates increase to the credit union’s self-defined, worst-case scenario

We recommend that a deflation scenario be included as well.  Many management teams have not discussed the possible impact of a sustained period of deflation, and even fewer have taken the time to forecast the possible financial impact of such a scenario.  Following a structured strategic thinking exercise on deflation could be helpful to explore the issue.  Create the what-if forecast by evaluating the impact on all major components of the financial structure and updating assumptions.  Often these forecasts include lower long-term rates including loan rates and investment rates, an increase in loan and investment prepayments, decreased loan demand and an increase in deposits.  While this may sound similar to today’s economic environment, the magnitude of such conditions may be greater.  For example, long-term rates could fall to 2% or lower and loan growth could decrease materially due to accelerated prepayments and consumers postponing purchases.

Management teams are often surprised by the possible significant, negative financial impact of a deflation scenario.

As with all of the what-ifs tested in this process, if the financial performance is not acceptable, determine what actions could be taken and test the impact of these actions.  At the conclusion of the exercise, decide if any of the actions to address the risks in the what-ifs should be implemented in the baseline plan.

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