Raging Payment Battle Requires Purposeful Strategic Thinking

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Today, July 12, is Amazon’s Prime Day.  As part of the event, they are encouraging their members to apply for their Amazon Prime Store Card, which, among other features, offers 5% back on eligible Amazon purchases.

The raging battle for payments continues to escalate.  Amazon is just one more threat to interchange income.  If you want interchange income to continue to be a primary source of revenue, then you must fight this constant battle with constant strategic thinking.  The right business questions need to be asked – and answered – in order to turn strategic thinking into strategic action.  Specific to Amazon, business questions that can be asked could include:

  • How much interchange income are we earning from members’ transactions with Amazon?
  • What would it cost us if we lost 25% or 50% of the Amazon-related interchange income to Amazon?
  • Which members of ours use our card with Amazon and carry a balance?
  • What actions can we take now to protect, and maybe increase, this interchange income?
  • If payments are a critical component of our strategy, how does our strategic thinking need to change so that we are proactive instead of reactive in this arena?

Regarding the questions above, considerations include:

  • Embrace the brutal fact that providing various payment options to your members increases costs and does not guarantee member usage and engagement.  You must be deliberate about creating and monitoring initiatives that promote valuable member engagement
  • Decide if interchange income is going to be a major and/or permanent source of income for you.  If it is, you can’t always be reacting to what traditional and non-traditional competitors do.  You may consider creating a position of CPO (Chief Payments Officer), who has the mandate to increase member usage of credit, debit, and prepaid cards
  • Take a critical look at your business model, with the intention of removing non-value add products, services, and back office processes, to free up resources for those things that do add value for your membership and potential members

You can read more about Amazon Prime and their credit card here.

In an upcoming blog, we’ll discuss the broader payments battlefield, and how purposeful strategic thinking can keep you in the battle.

NCUA – Rethinking NEV

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It’s no secret that the NCUA is planning to implement new guidance for net economic value (NEV) testing this year.

From NCUA’s recent open meeting, some key elements of the new guidance include:

  • Non-maturity deposit (NMD) values will be capped at a premium, not to exceed 1% in the current rate environment.
  • NMD benefit will not exceed 4% in a +300 bp rate environment.
  • NMD guidelines may need to be re-calibrated over time.
  • Risk thresholds:

NEV Supervisory Test - Risk Thresholds Source: NCUA Board Briefing

The new test is being designed to support the NCUA’s responsibility with respect to understanding risks to the insurance fund, and is intended to create greater comparability between credit unions. Credit unions will still be expected to run their own A/LM analyses, to understand risks to earnings and net worth, and support their internal risk management and decision-making.

Having modeled thousands of NEV simulations, NMD values are arguably the most significant wildcard.  For most of our clients, we already model at least two views of NEV: one using their base case assumptions for NMDs and another showing shares at par. Historically, NEV with shares at par was used by examiners to get the same comparability concept, and to limit the variety of deposit assumptions.

Shares at par ascribes no market value to the shares, thereby removing any benefit of low cost deposits from the analysis. The new guidance then, at least with respect to shares at par, would be some improvement. Keep in mind, though, that any standardization of deposit values would hide any material differences in deposit pricing between credit unions.

However, no matter how much rethinking of NEV occurs…

…NEV, even with standardized assumptions, is still not going to address fundamental business issues. For example:

  • NEV doesn’t recognize the different earnings contributions and the risk/return trade-offs that exist between assets.
    • Overnight investments earning 0.50% devalue less and perform better in NEV than a fixed-rate loan yielding 4.00%. It’s important to note that the loan contributes greater revenue in the current rate environment, as well as in a +300 bp rate environment.
    • A $10 million purchase of a new headquarters would not show any hurt to NEV results because the asset would not devalue as rates increase, but it would have an impact on earnings over a very long-term horizon.
    • Moving from mortgages to autos would reduce NEV volatility in a rising rate environment, but NEV would not show you the possible reduction in earnings power.
  • The standardized assumptions still do not distinguish between pricing for share drafts, regular shares, and money markets. Therefore, a credit union could pay 1 bp on all NMDs or 100 bps, and the NEV results would not be different. But of course, the earnings would be drastically different.
  • NEV won’t tell you if you’re making or losing money. The previous bullet is a great example of this fact. For this reason and many more, NEV won’t show you risks to profitability and if the decisions you’ve made, or are considering will cause your net worth to fall below Well Capitalized.

To sum it up, NCUA has a new test. Passing NCUA’s test does not replace the need to understand short- and long-term profitability, risks to profitability, and risks to net worth. Understanding and managing these risks are directly related to creating a relevant and sustainable business model.

Brexit’s Effect On Your Business Model

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Except for those that have been on vacation in a very remote location, all of us have heard or read countless reports about how voters in The United Kingdom (UK) decided to leave the European Union (Brexit), and predictions about the impact to the global economy (Source). This decision will have long-term implications, as UK is the fifth largest economy in the world (Source), and the second largest in the European Union. Thinking strategically about how Brexit and other events that create uncertainty can impact the business model of their credit union is key. Below are brutal facts and a strategic scenario to consider.

Brutal Facts
Margins are squeezed and Brexit can cause more squeezing. On June 1, 2016, the US 10-year Treasury yield was about 1.85%, already very low by historical standards. On the day following the Brexit vote, due to a spike in uncertainty that Brexit created, the yield was down to 1.57%, a decline of 28 basis points (bps) from earlier in the month and nearly 17 bps from the day before. The 10-year Treasury influences the interest rate charged for longer-term loans, such as mortgages.

Germany is the fourth largest economy in the world, followed by UK as the fifth, as noted earlier. As 2014 got underway, Germany’s 10-year government bonds were trading at 1.94% and UK’s were trading at 3.03%. Both rates have been trending downward in order to “jolt lending, spur inflation, and reinvigorate the economy after other options have been exhausted” (Bloomberg, Negative Interest Rates, June 6, 2016). Of particular note, the day following the Brexit vote, Germany’s 10-year bond was trading at a negative interest rate of (0.05%) and UK’s at 1.09%. At that time, Japan, the world’s third largest economy, had a negative yield on its 10-year government bonds.

Strategic Thinking: Rehearse Tomorrow Today
Consider a process which you have regularly scheduled meetings with a team of key players, such as monthly or quarterly, during which the only thing on the agenda is rehearsing tomorrow today, discussed in a previous blog about strategic planning (http://www.cmyers.com/preparing-for-strategic-planning/).

Identify a trend that is happening, such as negative interest rates in other large economies. Create a future scenario in which those trends continue or expand. Ask your team to discuss what that future could look like and list out all areas of the credit union that could be impacted, and be sure to estimate and simulate the financial implications of the scenario, as well as actions the team would consider. Remember, nothing happens in isolation, so combine events.

An example of a scenario about negative interest rates follows. Imagine it is 2018 and the US has slipped into a modest recession, which was triggered, in part, by the uncertainty created in Europe from the passage of Brexit. Loan demand declines and delinquencies increase. The value of the dollar continued to rise as the value of the Euro and British Pound dropped, making US products even more expensive to the rest of the world. Also, increasing uncertainty caused a flight to safety worldwide. The safest investment is US Treasury debt. As a result, the US 10-year Treasury yield is 0.75%, half of what it was at in June 2016, and shorter-term rates, such as the 3-month and 1-year Treasury bills, are paying negative yields. Current 30-year mortgage rates are 2.50% and competitive rates for auto loans to quality borrowers hover around 0.40%. You are being charged 0.10% to hold cash in an overnight account.

  • What is happening with home sales in your area?
  • What is happening with auto sales?
  • Are your savers saving more or less money?
  • How are you pricing your loans?
  • How are you pricing deposits?
  • Are you charging fees on some deposit accounts?
  • Is there an impact to non-interest income?
  • Because the margin is squeezed further, what are alternative sources of income you can leverage?

Resilient organizations are that way for a number of reasons. One is because they rehearse tomorrow today. Leaders of these organizations are deliberate about preparing their organizations for thriving during disruptions. Negative interest rates may not be the next big disruption, but your preparation for it may help you to thrive during other disruptions.

Don’t Hit Cruise Control on Auto Loans

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Auto sales, which have been at record levels and hit a peak of 17.8 million units last year according to CU Times, may be reaching a plateau. If your earnings are heavily reliant on sustained and significant production in auto loans, think strategically about the following:

  • There are indications of changing behaviors affecting market demand. Licensed drivers as a percentage of their age-group population
    • In 2008, 65.4% of 18 year-olds had a driver’s license. Now, that is down to 60.1% (Source: Yahoo! News).
    • In all age groups from 16-69, the percent of Americans with a license has fallen since 2008 (Source: Yahoo! News).
  • It is important for decision-makers to think through potential implications if these trends continue. Not only could it impact loan demand, but consider possible reduction in non-interest income as a result of reduced sales of related insurance products, as well as the impact on membership growth, particularly for those credit unions that are heavily reliant on indirect lending.
  • Credit risk appears to be on the rise. Some of the increase could be by design as more credit unions have strategically taken on more credit risk.
    • According to TransUnion, the national auto loan delinquency rate increased from 1.16% in Q4 2014 to 1.24% in Q4 2015 – the highest level since Q4 2010 when auto delinquency hit 1.22% (Source: CU Today).
    • According to Callahan & Associates, since 2013 (when this data for autos first became available for autos), credit union auto loan charge-offs are up from 0.43% to 0.62% in 2016, a 44% increase.

Callahan & Associates Total Auto Loan Net Charge Offs Graph

  • According to American Banker, industry analysts are communicating expectations for used car values to fall significantly in 2016 and 2017, as a large number of leased vehicles come back into the market and create a glut of inventory.
    • This could also impact credit risk. But consider the impact it could have on loan production. If the average prices are lower, how many more auto loans would you need to make to have the same loan volume? If it is materially more, what is the impact on operations?

Many credit unions have enjoyed significant growth in autos.

Callahan & Associates Direct & Indirect Auto Loan Growth Table
As you strategically evaluate your competitive position with respect to auto lending, don’t lose sight of these three basics:

  1. Fierce competition for auto loans is a fact. With credit union net interest margins below 3% on average, pricing effectively for risk and profitability is not optional. And this means taking it to bottom-line profitability. Don’t stop at the margin when analyzing pricing.
  2. Material decline in autos loans can directly impact other strategic initiatives, particularly those that are costly. You have to generate money to spend it!
  3. Markets change, sometimes quickly. Keep aware of the industry and competition in the market. Identify trends. Listen for concerns. Ensure the ALCO and the board are informed and discussing the potential impacts to the credit union’s booked loans as well as new business efforts, especially if the credit union is highly reliant on continued new production of auto loans.

Heartfelt Thoughts for Orlando

We would like to take this time to pause from the constant noise around the financial services industry.  We feel it is important to remember those who died or were injured as a result of the heinous crime in Orlando.  Our heartfelt thoughts go out to the individuals, families, and friends, who were impacted by this unnecessary act of violence.

We recognize that heartfelt thoughts are minimal in light of the amount of healing needed.  In time like this we offer this thought.

There is only one thing that remains to us, that cannot be taken away:  to act with courage and dignity and to stick to the ideals that have given meaning to life.

– Jawaharlal Nehru, First Prime Minister of India