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c. notes – Aggregating Risks to Inform Strategy

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To remain successful as the world changes and becomes more complex, risk management processes must keep pace.

Risk management begins with identifying and quantifying strategic risks. An effective process also recognizes that it is not adequate to only quantify and understand risks in silos. Risks should also be quantified and understood in aggregate. As history repeatedly taught us, bad things don’t usually happen in isolation.

Understanding and communicating risks in aggregate allows decision-makers to evaluate if the credit union is taking on too much risk, or if the credit union may be poised to strategically accept more risk. Also note that understanding risks in aggregate permits management to consider the credit union’s capacity for strategic opportunities; strategic risks and opportunities are two sides of the same coin.

To continue reading, please visit the article here.

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Are Your Predictions Limiting Your Strategic Thinking?

I think there is a world market for maybe five computers.

— IBM president Thomas Watson, 1943.

Apple is already dead.

— Nathan Myhrvold, former CTO of Microsoft, 1997.

Neither RedBox nor Netflix are even on the radar screen in terms of competition. It’s more Wal-Mart and Apple.

— Blockbuster CEO Jim Keyes, 2008.

These Google guys, they want to be billionaires and rock stars and go to conferences and all that. Let us see if they still want to run the business in two to three years.

— Bill Gates, founder of Microsoft, 2003.

Predictions are a tricky business.

Leaders assess how the world might or might not change. Whether it’s new non-traditional competition, cutting-edge technologies, evolving business models, or changing member behaviors, developing successful strategies today relies on decision-makers opening their minds to the possibilities and then choosing a path. Are you thinking creatively enough about how the world might change around you and how to ensure your credit union does not get left behind?

Consider the disruptions in financial services today. Like Blockbuster above, should strategy focus on behemoths like Wal-Mart and Apple, or are there greater threats in newer business models like M-Pesa, SoFi, and The Lending Club? Perhaps the greater threats and opportunities are evolving technologies. All of this is happening on top of traditional competition, regulation, and the economy.

Good strategy begins with careful consideration of possible threats and opportunities. Identifying the future you’re planning for is an important first step. With the future uncertain, even the best-laid plans are likely to run into unanticipated challenges. It can be useful, then, to ask, “What if the strategies we pursue are based on expectations that don’t come to pass?”

We recommend going through a process of test driving difficult and hard-to-imagine environments. Creating stories around such environments and discussing how the credit union could respond can be extremely valuable. Institutions are often amazed at the insight this can provide whether the environment actually occurs.

It’s not easy to foresee the future. We’ll leave you with some great historical examples, demonstrating that even the smartest people can misjudge the future.

 

The Americans have need of the telephone, but we do not. We have plenty of messenger boys.

— William Preece, British Post Office, 1876

This ‘telephone’ has too many shortcomings to be seriously considered as a means of communication.

— William Orton, President of Western Union, 1876

Fooling around with alternating current is just a waste of time. Nobody will use it, ever.

— Thomas Edison, 1889

The horse is here to stay but the automobile is only a novelty – a fad.

— President of the Michigan Savings Bank advising Henry Ford’s lawyer, Horace Rackham, not to invest in the Ford Motor Company, 1903

Who the hell wants to hear actors talk?

— Harry M. Warner, co-founder of Warner Brothers, 1926

Stocks have reached what looks like a permanently high plateau.

— Irving Fisher, Professor of Economics, Yale University, 1929

There is not the slightest indication that nuclear energy will ever be obtainable. It would mean that the atom would have to be shattered at will.

— Albert Einstein, 1932

Television won’t be able to hold on to any market it captures after the first six months. People will soon get tired of staring at a plywood box every night.

— Darryl Zanuck, 20th Century Fox, 1946

If excessive smoking actually plays a role in the production of lung cancer, it seems to be a minor one.

— W.C. Heuper, National Cancer Institute, 1954

There is practically no chance communications space satellites will be used to provide better telephone, telegraph, television or radio service inside the United States.

— T.A.M. Craven, Federal Communications Commission commissioner, 1961

With over 50 foreign cars already on sale here, the Japanese auto industry isn’t likely to carve out a big slice of the U.S. market.

— Business Week, 1968

There is no reason for any individual to have a computer in their home.

— Ken Olsen, Chairman and Founder of Digital Equipment Corp., 1977

I predict the Internet will soon go spectacularly supernova and in 1996 catastrophically collapse.

— Robert Metcalfe, founder of 3Com, 1995

Two years from now, spam will be solved.

— Bill Gates, 2004

There’s just not that many videos I want to watch.

— Steve Chen, CTO and co-founder of YouTube expressing concerns about his company’s long term viability, 2005

There’s no chance that the iPhone is going to get any significant market share.

— Steve Ballmer, Microsoft CEO, 2007

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.

— Ben Bernanke, Federal Reserve Chairman, 2007

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OBSERVATIONS FROM ALM MODEL VALIDATIONS: DO DECAY RATES MATTER?

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Yes. Decay rates do matter, but they are often not appropriately applied in the asset/liability management (ALM) process. Decay rates are essential for capturing the risk of evolving member behavior, namely deposit migration, as rates change. This blog will focus on using decay rates when simulating net economic value (NEV).

Model validations typically reveal two common issues as it pertains to the setup and implementation of deposit decay rates.

1) Decay rates are not being incorporated

Model users are often surprised to find out decay rates are not being incorporated. Common reasons for this include the fact that input fields can be hard to locate or reports summarizing key assumptions are not reported effectively (sometimes assumptions reported in a summary are not actually the assumptions in the model). To better illustrate, lack of decay rates from a recent model validation were organized by c. myers in the table below.

Decay Rates (Annual CPR) NOT INCORPORATED

The risk of decay rates not being incorporated in NEV can be dramatic, especially in the various rate shocks. If decay rates are not included, it will result in longer deposit cash flows, an unrealistic market valuation of deposits and, ultimately, an understatement of interest rate risk in a rising rate environment.

Credit unions should check their ALM models to make sure reasonable decay rates are appropriately applied and coincide with key assumption reporting.

2) Decay Rates Do Not Change As Market Rates Change

The issue of decay rates not changing as the world around us changes was discussed during a blog in September 2014. Back then, we pointed out that,

[Assuming decay rates don’t change as market rates change] is like saying non-maturity deposit cash flows will remain constant and unchanging regardless of what rates do. History shows that this is not a valid assumption and, if used, can provide a false sense of security regarding NEV results.

In the table below, c. myers organized decay rates from a recent model validation we performed.

Decay Rates (Annual CPR) STATIC AS MARKET RATES CHANGE

Notice that while decay rates are unique for the three different deposit products, decay rates remain constant regardless of changes in market rates. Said differently, this model assumes members will not consider the evolving advantage they might have to withdraw funds as rates change. However, as demonstrated in the chart below, history does not support the assumption that member behavior does not change as rates change.

The following graph shows when market rates increased from roughly 1% to 5% in 2004 and 2005, the industry experienced a material decrease in the concentration of regular shares and increase in member CDs. However, over the past 8 years, that trend has reversed as member certificates have declined while regular shares have experienced significant growth.

Distribution of Funding as a % of Assets

Keep in mind as you review decay rates, it is not about getting the “right” assumption, because that is virtually impossible. It is about reasonably representing changes in consumer behavior in your base-case risk analysis, then stress testing a range of assumptions to understand the impact.

While the focus of this blog has been on NEV, deposit behavior is a material component of income simulations as well. Ignoring deposit and member behavior will understate the cost of funds in higher rate environments and likewise hide risk. This is an issue that shows up with the static balance sheet approach and has been discussed frequently in previous blogs. To learn more, refer to the links below.

Observations from ALM Model Validations: Cost of Funds Back Testing
Observations from ALM Model Validations: Extremely Profitable New Business ROA in Static Balance Sheet Simulations
Isolating Interest Rate Risk with a Static Balance Sheet

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Are Millennials Finding You Attractive ?

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As time marches on, we find Millennials coming into their most financially productive years, and they need financial services. In 2010, Gen Y made up only 17% of vehicle sales. Five years later, that number has grown to 28% of sales, while Baby Boomers and Gen X have flatlined or fallen back (according to J.D. Power and Associates). Many credit unions are considering process improvement in order to refine their processes to better appeal to Millennials but, believe it or not, easy appeals to any generation!

Consider the lending process from a Millennial’s perspective:

  • How long will I have to wait for an answer? (Most things in my life so far have been instantaneous. I have never had to wait for the annual TV broadcast of “The Wizard of Oz” or for the radio station to play my favorite song, or sit through boring commercials)
  • How many hoops do I have to jump through? (I have to drive somewhere to sign something? On paper? I have to gather a bunch of documents?)
  • How many stipulations are on the deal? (Are all of these questions necessary? Why is this application so long? How does the other online place I found do it without all this? Why can’t this be easy like Amazon?)

Are you getting your fair share of Millennials’ business? Can you be found where they are looking? Are you offering the type of experience they value and expect? Have you considered that making things easy will appeal to other generations – not just Millennials?

Facebook recently published a white paper on Millennials and Money that uncovered some key findings. The Millennials on Facebook are turning out to be financially conservative, with a focus on paying off debt and saving. Unlike previous generations, Millennials talk openly about money matters and they talk about them online, crowdsourcing for their financial advice – the modern-day version of word of mouth. Who better to dispense financial advice than credit unions? The question is, are you part of that online conversation?

Even if you are, is the experience you’re providing relevant to this generation? It’s well known that Millennials “live” on mobile, and while they are often multichannel users, they typically start their journeys on mobile. How do you show up? People expect things to be easy and convenient. If you need inspirational ideas for how fast, easy, and convenient the financial experience can be, look no further than the internet for non-traditional competitors like Lending Club or Quicken’s Rocket Mortgage. How does your experience compare? It is commonly said that this generation isn’t loyal. Why should they be if others are offering a far superior experience?

Have you fully revamped your lending and account opening processes – often the first exposure your potential member has to your credit union – with the Millennial in mind? This takes a hard, honest look, which isn’t easy, but keep in mind that some of your toughest competitors have already done it. Don’t forget this benefits other generations. How many Baby Boomers miss going to Blockbuster to rent a movie?

Process improvement is typically conducted with a goal of eliminating waste, which is critical, but tying in the strategic goal of providing a rewarding experience across generations is key to remaining relevant as a financial institution into the future.