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Concentration Risk in Non-Interest Income?

July 10, 2014

NCUA cited the Basel Committee on Banking Supervision when defining concentration risk in NCUA Supervisory Letter – Concentration Risk:

“A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution’s health or ability to maintain its core operations.”

In evaluating the level of concentration risk present in a credit union’s financial structure, many approaches – including the current risk-based capital proposal – operate under the assumption that the material risk to net worth resides in the asset structure of the balance sheet. Managing concentration risk by setting limits on only the balance sheet components of a credit union’s structure falls far short of addressing risk concentrations – which is any exposure that could threaten the ability of a credit union to continue “business as usual.” A reliance on non-interest income to generate earnings may expose many credit unions to the potential for large losses.

In our experience working with hundreds of credit unions, a significant portion of non-interest income (often well in excess of 50%) is derived from interchange revenue, overdraft/courtesy pay and mortgage origination/gains on sale. Even though some battles over interchange income have settled, the risk of non-interest income dropping materially in the future still remains. Consider the impact to earnings and net worth if courtesy pay/overdraft income is considerably altered in the name of consumer protection or if mortgage originations continue their sharp decline.

While the most recent economic downturn was certainly driven by asset-based credit risk exposures, an effective concentration risk management process, and (even more importantly) an effective aggregate risk management process, should include an evaluation of any material exposure that could threaten net worth. Because the ability of a credit union to raise and maintain capital levels is directly related to its ability to generate earnings, any exposure that materially impacts earnings could adversely impact capital levels. Concentration risk policies and procedures that overlook the impact of threats to non-interest income sources may lack a key component to addressing all material threats to net worth.

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