Solving the Puzzle: Understanding Short-Term Impact VS. Your Long-Term Business Model

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3 minute read – The list of pressures on revenue and earnings seems to grow by the day.  There are many different drivers of inflation right now, such as food prices, supply chain issues, and wage growth, each of which brings their own unique impacts.  Rising rates, recession concerns, and tightening liquidity bring additional pressures like margin compression and credit risk.  Not to be forgotten in all of this is CECL, which goes into effect at the start of next year.

With the many changes in the environment, it is important for leaders to step back and understand potential short-term impacts to revenue and earnings vs. long-term business model sustainability.    

While in-depth analysis and modeling are helpful, leaders can start high-level and think in terms of the 5 Strategy Levers of ROA. 

Walking through the different pressures and concerns, leaders should discuss and quantify at a high level the potential impact to each lever and the resulting bottom-line impacts.  This will help paint a picture for leaders to evaluate whether the earnings pressure is a shorter-term hiccup, or a longer-term business model issue. 

Below is an example of how that might go.  The columns highlighted in red show the current strategy lever numbers.  The columns highlighted in gray show the results of the discussion of the different pressures.   

In this example, leaders might conclude that the margin compression is painful but short-term while they wait for the existing loans to be replaced, but that slow loan volumes and higher operating expenses are likely to continue, requiring no real change in strategy but a renewed focus on loan growth.  Alternatively, they may decide to revisit their deposit pricing strategy of always being in the top 3 in their market. 

Other pressures that could be explored are the costs of different funding sources to address tightening liquidity, increased credit risk due to a recession, or reductions in non-interest income due to regulation and competition.  The key is having the discussion and understanding the possible impact to ROA. 

Once this is done, leaders can then step back and determine if the ROA impacts indicate a longer-term business model issue.  Questions to think through are: 

  • Is this a timing issue due to environmental changes or a weakness that has been exposed in our financial structure? 
  • Do we need to change our strategy as a result of what we’re seeing? 
  • Are the economic engines driving the business model still viable long-term?

Walking through this process can help leaders have more clarity, especially when there is so much uncertainty in this environment.  This can also help leaders determine where their focus needs to be and what their next course of action should be.

4 Steps Toward Efficiency and Scale Using Effective Software Management

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4 minute read – Why do you want to grow?  Financial institutions have many different reasons, but one of them is almost always for scale.  Digging deeper, they want to get the boost that size can give in terms of making it easier to grow revenue faster than expenses.   

Ironically, one of the most important areas that makes scalability possible is frequently rife with inefficiencies.  Software is an asset that can often be used to support higher volumes of business with little or no increases in cost.  But the explosion in the sheer number of software packages that must be managed has contributed to the inefficient usage of the software and the resources used to obtain it.  This is an area with so much room for creating an efficient foundation for scale that it deserves special focus. 

Here are a few common areas of opportunity: 

  • Purchases – Make sure there is not already similar software in place prior to signing a contract or purchasing to avoid the additional expense, tracking, and maintenance of near-duplicate software.  Preventing this requires a central repository of the software that is in use, a repository owner, and a specific step in the software selection process that comes before signing the contract.  Features that are available, whether in use or not, should be tracked from the initial implementation forward to provide a complete picture of what the existing software can do.   
  • Customization – Weigh this carefully and get clarity on what it means for future upgrades to the software.  A key question is, are we customizing in order to preserve an old, familiar way of doing things when we would be better off changing? 
  • Implementation Phases – With complex software, there is often agreement to implement certain features initially and add more in later phases.   Getting around to those subsequent phases can be a struggle if they are not prioritized, leaving capabilities on the table that are not put to good use.  The features that will be implemented later should be decided on with the initial implementation. 
  • Upgrades and New Features – Each software package needs a clear owner that ensures that upgrades and new features are vetted timely by a subject matter expert and IT.  If implementation requires significant effort, it should be added to projects for prioritization.  

If features, upgrades, and even updates are put off or shelved because there is too much else going on, you might find that “suddenly” a few years later the software is hopelessly out of date and there is a search for new software going on.  It’s like you bought a car and customized it to get the CD player rather than the Bluetooth stereo.  The dealer offered to install upgraded aftermarket speakers and the nicer wheels you wanted, but you never got around to going back to the dealer.  Later, when they asked to apply a fix to the air conditioning to make it work better, you were too busy.  And now you’re driving a car you don’t really like and… it feels like it’s time for a new one. 

Getting the full potential from software investments requires effort over time, not just with initial implementation.  Recognizing this can help with the realistic prioritization of resources.  Intentional focus on the right things is key.  Features and upgrades that are not implemented should be the result of a conscious choice rather than lack of ownership or falling through the cracks.   

It’s possible that some of the shiny new things can wait while you focus on getting the most out of the software investments you’ve already made.  Enhanced management of your software packages can lead to better expense control, improved efficiency, and a foundation for attaining scale.  

For more thoughts on this subject, listen to our podcast Using Scale and Automation to Control Expenses and Grow Revenue.

Update to the NEV Supervisory Test Framework Brings Relief and New Pressures

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6 minute read – The NCUA recently released an update to its Interest Rate Risk Supervisory Framework that specifically addresses the NEV Supervisory Test.  In short, while the update provides some relief for credit unions, it also increases the amount of judgement in the exam process.  This will require credit unions to make sure they have a strong understanding of their ALM results, earnings potential, and sources of risk. 

As a reminder, the test has created a challenge for many institutions, as rates have increased this year.  Their risk classifications increased significantly in the NEV Supervisory Test, which did not always align with the changes in their balance sheets and overall financial structures.  However, the increased risk classifications brought corresponding examiner pressure.  This was especially true for those in the extreme risk category where the NCUA manual would call for a DOR (or other supervisory action).  DORs would then require a de-risking plan.  (See:  https://www.cmyers.com/thought-leadership/ncua-nev-supervisory-test-heads-up-now/).  

In an effort to relieve this pressure, the NCUA removed the extreme risk classification (see below for updated classifications). 

The NCUA’s intention is to relieve pressure on the industry and to give credit unions time to adjust to this new environment.  However, this may cause a different pressure to emerge, as there is now more discretion in the exam process to determine the level of risk and what actions may be needed.  Indeed, many of the subtitled sections in the update speak to the increased discretion in the exam process: 

  • Providing Examiners More Flexibility in Assigning IRR Supervisory Risk Ratings 
  • Considering the Source of High IRR 
  • Assessing Risk Management and Controls 
  • Analyzing Potential Impact on Earnings and Capital 

As always, the heart of the NCUA’s concern is the risk any one institution poses, and even here there is some level of discretion when looking at the examples for when a DOR should be considered: 

  • The credit union’s level of IRR represents an undue risk to the Share Insurance Fund, and the credit union is not taking appropriate and prompt action to address its level of IRR 
  • The credit union has high IRR and has not adequately updated its approach to managing its interest rate, liquidity, and related risks for current market conditions 
  • The credit union has a material governance deficiency (identify, measure, monitor, and control) relative to its level of IRR 

The bottom line is that there is now more burden of proof on the part of the credit union.  This also comes at a time when many in the industry, examiners included, don’t have experience going through a stress event like the one being experienced today with high inflation and rising rates.  It’s easy to imagine how these factors have the potential to create misunderstandings and increased examiner pressure.  This is why it is critical for credit union leaders to understand and be able to explain their IRR position from different angles, as well as the sources of risk and the associated return trade-offs that have been taken. 

This is where there is some silver lining to the new pressures created by the update.  The NCUA has, in many respects, provided a roadmap (and the impetus) for credit unions to be more prepared for their exams and, more importantly, better equipped for this environment.  

As a first step toward becoming better equipped, ALCOs should be highly engaged.  Committee members should be asking more questions and having deeper discussions about the institution’s structure, its sources of profitability and risk, and the risk/return trade-offs of different decisions.   

As part of these conversations, it could be helpful to ask:  Do we need to broaden our view of where rates will go?  Primarily focusing on rising rates can cause the organization to lose out on opportunity if rates go down.  This is where it’s helpful to turn the focus from one rate environment (think +300 bps) to a range of rate environments and think of optimizing for that range.  Expanding conversations in this way will help during the exam, as leaders will have a deeper understanding of IRR and their institution’s approach. 

Ensure that the focus is not limited to NEV, rather, the discussions should focus on understanding the impact to earnings and net worth.  This is especially true if there are concerns around insolvency.  In essence, the key is to show that even with high-risk NEV Supervisory Test results, the institution will remain a going concern, assuming it can demonstrate an ability to generate earnings and build or protect net worth.  Even in cases where an institution has negative earnings, it can often identify ways to protect net worth and remain solvent while it addresses its earnings issues.  A key to this is to have sufficient liquidity, so as to not have to turn unrealized losses into realized losses.  Testing and understanding liquidity strength along with contingent options is critical if the risk profile is tight.  Liquidity risk can change quickly, especially as institutions have seen assets lengthen and some have seen deposits decreasing. 

Internally, institutions may also face questions and pressure from different decision-makers, as there is no ‘right’ answer to appetite for risk.  Some may not like the level of risk indicated in the NEV Supervisory Test and push to de-risk.  It can be easy to request that risk be reduced quickly, but there are always trade-offs. Whether for the examiners or internal pressure, taking steps to de-risk can cost millions of dollars in earnings and net worth.  This is where it is important to have the board and ALCO understand the risk/return trade-offs so they can make informed decisions that help move their strategy and financial structure forward. 

Without understanding the risk/return trade-offs, decisions could be short-sighted, unnecessarily restricting earnings and impacting net worth levels.  This could then interfere with strategic initiatives and moving the business forward.  This is why decision-makers, with different areas of responsibility, will want to take the time to build a solid understanding of ALM, have productive conversations, and connect the decisions to the potential financial and strategic impacts.

6 What-Ifs for Your Financial Reforecast

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5 minute read – The Fed rate increases have been more aggressive than most anticipated back in 2021 when institutions were preparing their financial forecasts.  As a result, you may be looking at a financial reforecast.  In a 3–5-year forward-looking view, these what-ifs can help tell the story of which forces your structure can withstand well, and which might call for mitigation strategies.  Note that if you’re only updating the 2022 budget, these what-ifs won’t have as much impact, which is why a 3–5-year forecast is so beneficial. 

Consider these what-if ideas: 

  1.  Deposits decrease as inflation chews into members’ checking and savings balances 
  2.  Deposits increase in a flight to safety 
  3.  Market area deposit rates increase as competitors vie for deposits 
  4.  Consumer lending drops off along with mortgage lending 
  5.  Credit losses kick in 
  6.  Market rates go back down 

The industry is facing uncertainty on several fronts and the what-ifs are intended to test what could happen if some of the uncertainties materialize.  Team conversations can start with these areas of uncertainty: 

Deposit Balances 

Deposits grew at unprecedented rates after the pandemic, but what will happen next is in question.  Customer deposit balances could dwindle as the result of inflation as people spend more on almost everything.  It’s also possible that a recession could cause deposit balances to grow through a flight to safety, putting more pressure on already-diluted net worth ratios. 

Deposit Rates 

Many organizations do not currently need deposit growth to support lending, so they don’t expect to increase deposit rates much, now that market rates are rising.  But there are some that do need deposits and will likely increase rates to get them.  If a major competitor in your area increases rates, ask yourself if you would increase rates to stay aligned with your value proposition and/or reputational purposes, or let some deposits go.  If you’ll let some go, also ask how much before you’d take action to stop it.   

If you need deposits, consider that competitors that don’t need deposits might raise their rates to stay in line with the market and/or their value proposition, which could mean your organization having to raise rates higher than planned in order to get needed deposit growth. 

Lending 

Mortgage lending predictions have been revised downward as mortgage rates have risen and the market has remained stubbornly low on inventory.  Some could see an increase in home equity products, as people who might have moved stay put in order to keep their low-rate mortgages.  But consumer lending is facing uncertainty as well.  With inflation eating into disposable incomes, many could put off that new car or other purchases.  At the same time, volumes could shift more toward unsecured and credit card lending if people are struggling to make ends meet. 

Credit Losses 

It seems like the industry has been waiting for the other shoe to drop on credit losses since the pandemic hit.  It’s possible that government stimulus postponed that, but inflation could push some people over the edge.  Don’t forget to factor in the impact on CECL. 

Market Rates 

The buzz is all about rates going up, but if recessionary forces begin to take hold, the Fed could pull back on rates.  For a long time, the only direction rates could go was up, so don’t forget the other side of the equation. 

The value in modeling these types of what-ifs is in the team conversation and thought process, as well as the forecast results.  Part of the conversation should revolve around any risks the team thinks need to be addressed, identifying options, and determining timing for implementing the options, if necessary.  

Your situation is unique so be sure to think about other what-ifs that are relevant to your organization.  Also combine the what-ifs you think could happen concurrently to get a view of the aggregate effects.   

One way to meet the uncertainty of the environment is to play out major possibilities through what-ifs.  You won’t be able to anticipate everything that might come along, but looking head-on at various possibilities can bring calm and confidence.  It also helps teams to move into action cohesively to mitigate risks where needed. 

Approach Talent Challenges As If They’re Permanent

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4 minute read The competition for talent has been raging for the past few years.  While it seemed to come to a head after the pandemic, the demographic underpinnings have been at play for decades. 

As teams work to meet today’s talent challenges, approaching the situation as if it’s permanent can recast the thinking, bring new solutions to the surface, and potentially better position the financial institution for future success.   

While there is potential for a recession, which could bring relief on the talent front, the relief may only be temporary, given long-term demographics trends.   

In April, there were 0.5 unemployed workers per job opening, illustrating just how hard it is to find people, let alone the right people.  But this is a continuation of a longer-term trend.  

The question many institutions are faced with is, Where did all the workers go?  Most are aware that the Baby Boomers created a big chunk of the population that are now retiring and some of those retirements were accelerated by the pandemic.  Millennials now make up the largest portion of workers, with Generation Z following closely behind. 

Additionally, the US population has been slowing for years, setting the stage for the current challenges and reinforcing why they may be with us for the long term.  According to the US Census Bureau, the 2021 growth rate was slower than any other year since the founding of the nation.  The trend is the result of women having fewer children and decreasing net international migration, combined with increasing mortality due to an aging population. 

This leaves us with fewer youngsters and more retirees.  Some have theorized that more people have simply decided not to work.  According to the Bureau of Labor Statistics, the labor force participation rate for people 16 and older declined from 2010 to June 2022 (that’s the percentage of the population that is working or actively looking for work).  But when you break it down by age, it tells a more nuanced story.  For ages 25-54, which represents people in their prime working years, the participation rate is about the same.  But that age group now makes up about 3% less of the workforce and people 55 and older make up about 4% more.  When you factor in that older people participate – or work – at much lower rates, it explains how the overall participation rate has decreased. 

The conclusion?  The talent challenges may not be going away soon.  David Kelly, the Chief Global Strategist of JPMorgan’s asset management division, was quoted in a Business Insider article saying that some firms could go out of business.  “It’s very Darwinian – those who can efficiently use labor will succeed and those who cannot adapt to this environment will fail.” 

As Baby Boomers poured into the workplace along with women, there was plenty of ready-made talent to choose from that was educated and trained.  Talent practices formed around this reality.  The question is how to create new practices that will work going forward. 

As an exercise to stretch your thinking, try brainstorming around this scenario:  It’s 2026 and the talent challenges of 2021 and 2022 are still with us.  Knowing this is the case, consider the following questions, how you would answer them differently than today, and how your emphasis on each area would shift: 

  • How should we update the organization’s purpose and strategy to give appropriate focus to the talent we need? 
  • How do we need to elevate our strategic people planning so we can get and stay ahead of our talent needs? 
  • What are potential sources for talent that we’re not taking advantage of? 
  • How might we change our hiring prerequisites? 
  • How can on-the-job training be imagined differently? 
  • Where can technology and automation help? 
  • How can we fulfill the needs and wants of today’s talent in a more meaningful way? 
  • What are the effective keys to retaining more of the talent we need? 
  • What should we be doing today to prepare for this future? 

Chances are that you’ve already been working on talent recruitment, development, and retention.  The challenges won’t be easy to resolve and will likely require foundational change.  Thinking about it as a permanent situation can help your team develop more transformational ideas that could be key to your long-term success.