In comments surrounding the new rule on Interest Rate Risk, the NCUA states that, “net worth is the best measure against which to gauge a credit union’s risk exposure.”  As credit unions are looking to improve earnings and grow net worth dollars in this historically low interest rate environment, yield on assets and cost of funds are only 2 of the 5 strategy levers that credit unions can pull.  In order to have an effective IRR management program, ALL levers that impact earnings and net worth should be evaluated, including operating expense, provision for loan loss and fee/other income.

Bottom-line results can be realized by evaluating operating expenses for operational efficiencies.  However, operational efficiency not only means looking for ways to cut expenses, it also includes evaluating current processes and practices to ensure that no opportunity to generate revenue is left behind.  For example:

• Do your loan processes allow you to effectively capture every loan that you want to fund, or do inefficiencies in the process cause members seeking loans to ultimately go elsewhere?
• Can your front line effectively turn interactions with your membership into educational or cross-sale opportunities, when appropriate, that deepen member relationships and enhance the member experience?
• Does your in-branch advertising reflect the tactical (short-term) and strategic (long-term) objectives of the credit union?  If the credit union is targeting loan growth, are loan rates and promotions more prominently displayed and emphasized than current deposit rates?

Finding ways to revamp processes can improve member interactions and provide employees additional time that can be used to enhance member service or develop other areas of the credit union’s business.  Additionally, ensuring that the credit union is effectively utilizing its sources of revenue is just as important to operational efficiency as cutting un-needed expenses.

The creation of operational efficiencies in your structure can have a positive impact on earnings in all interest rate environments, which is an excellent way to drive increases in net worth without taking on additional risks.

Source:  Interest Rate Risk Policy and Program, NCUA, 2/3/12

As interest rates have been at historic lows for a prolonged period of time, credit unions have had the benefit of lowering their cost of funds (COF) as loan and investment yields decline.  Many seem to have worked through their credit issues and, at least for now, have been able to reduce their provision for loan losses (PLL)—another counter-balance to declining asset yields.

Unfortunately, for many, the COF and PLL have—or will soon—hit a floor while asset yields continue to decline.  Some have turned to longer-term assets, such as mortgages, mortgage investments and callable bonds to help current earnings. However, these options add interest rate risk in a rising rate environment.

To read the full article, please see our c. notes page, available here.

The CFPB is coming online and has begun proposing rules and examining financial institutions.  While questions still abound on the bureau’s stance and operations, credit unions should consider the potential impact of new regulations.  For example, most credit unions weathered overdraft protection regulations fairly well by getting members to opt-in.  However, the CFPB is currently examining the policies and practices of the nine largest banks to see if additional regulation is necessary (Office of Information and Regulatory Affairs and Consumer Financial Protection Bureau).  Depending on the findings, income from overdrafts could be under threat.

Mortgage statements are another example.  The CFPB has stated that it would like to increase transparency in the mortgage servicing industry.  To do this, it is proposing regulations for monthly mortgage statements that would include alerts for delinquent borrowings with information for housing counselors and options to avoid foreclosures.  For adjustable rate mortgages, institutions would have to send warnings of interest rate adjustments and list alternatives consumers can pursue to avoid the adjustment (CFPB Seeks to Enhance Consumer Protections by Targeting the Mortgage Servicing Sector, National Mortgage Professional Magazine, April 2012).  Such changes can increase expenses as a result of changing the statements as well as the possibility of additional paper and postage from warnings depending on how the regulation is worded.

While the CFPB has said it will consider credit unions’ unique needs, the cost of compliance could likely increase as a result of new regulations.

NCUA’s new rule on interest rate risk emphasizes board-approved policy and oversight by the board.  The board is also responsible for setting strategic direction.  With the speed of change the industry has experienced lately, keeping board members apprised of all that’s happening has become more challenging than ever.

Board meetings typically focus on the day-to-day business of the credit union and review of financial results with very little time spent looking forward or learning about industry issues.  Why not take a bit of each board meeting and purposefully devote some time to strategic issues and education?  While formal board education and planning sessions are crucial, regular discussion on these topics can help keep the board moving in the direction that NCUA requires.

Boards share the ultimate fiduciary responsibility for credit unions and equipping them with the tools they need to make informed decisions is critical.  It’s a little bit like sneaking vegetables into the spaghetti sauce, but small, regular doses of education and strategy can go a long way toward healthy boards and credit unions.

Historically, credit unions may have been wary of making material changes to their policies, whether an A/LM policy, Liquidity policy, Investment policy or broader Financial Management policy – for fear of raising regulatory “red flags.”  However, with the adoption of the final rule on interest rate risk (§741.3(b)(5)(i)), and the effective implementation date of September 30, 2012, many credit unions are finding this a great time to revisit their policies.  While reviewing policy, some key questions must be asked:

• How does the policy help promote safety and soundness, while also reflecting the risk appetite of the credit union’s board and senior management?
• Have there been situations in recent history where policy limits or guidelines have “tied hands” with respect to making sound business decisions?
• Conversely, are there limits or guidelines in policy that have aided in the decision-making process, potentially saving the credit union from less than favorable outcomes?
• How can we effectively construct policy limits and/or guidelines to both satisfy regulatory requirements and aid in the decision-making process of the board and senior management?

With heightened industry awareness surrounding interest rate risk, and increasing regulatory pressure to mitigate the risk being taken by some credit unions today, would it possibly raise more regulatory “red flags” if a credit union did not revisit relevant policies prior to the September 30 implementation date?  A good policy has limits and guidelines intended to promote risk management and safety and soundness.  A great policy has limits and guidelines intended to promote risk management and safety and soundness, but most importantly, provisions that drive dialogue to aid in the decision-making process.  While revisiting policy this year, the above questions will help take your existing policy from “good” to great.

Short and long-term market rates have been at—or near—record lows for almost 3.5 years.  This has resulted in credit unions continually replacing higher-yielding assets with lower-yielding assets.  This is creating earnings challenges at many institutions, particularly as the cost of funds is nearing a “floor.”

So, is your NEV analysis reflecting this risk?  The answer for most credit unions is no.  Loan yields have decreased steadily, but offering rates (often used to discount loans in NEV) have decreased much faster.  In many cases this has resulted in loan valuations improving from an NEV perspective, even as the yields and revenue are decreasing.

Consider a credit union auto portfolio that yielded 6% in 2010.  Lower-yielding loans have been booked since then, and have taken the yield down to 5%.  If the NEV discount rate being used is 3.5%, an economic value gain today of ~3% would be produced (a different gain could be generated depending on principal cash flows, prepayment assumptions, etc.).  The credit union might be happy that they are holding autos at a gain, but since they don’t plan to sell them anyway, the reality of lower yields and less revenue is a very unappealing prospect.  NEV does an inadequate job of capturing the risk of declining asset yields (along with ignoring net operating expenses and earnings).  Credit unions should be cautious if NEV is used in the decision-making process, and make sure they are aware of the limitations of NEV.

Many credit unions, rightfully so, are focused on efficiency.  One way to become more efficient is to have the member use the least expensive delivery channels for the credit union.  Those delivery channels usually do not involve personal contact, at least initially.  If your credit union is contemplating an efficiency strategy, part of the implementation plan should include answering the following question:

If we implement a proactive approach to driving members to self-service through remote or electronic channels, what are our marketing and sales strategies as we reduce options for personal contact?

There has been a lot of excitement in the credit union industry as of late about the potential positive impact that proposed legislation on small business lending could have on the industry’s search for new sources of loan growth.  According to a recent Wall Street Journal article, Sen. Mark Udall (D-CO) plans to file legislation that would increase to 25% the amount of assets credit unions can lend to small businesses.  Currently, small business loans by credit unions are limited to the lesser of 12.25% of assets or 1.75x net worth per CUMAA, enacted in 1998.  According to the Credit Union National Association, the higher ceiling could result in an additional $13 billion in small-business loans in the first year alone.

At a time when the credit union industry is searching for sources of loan growth, one would think that this could be a win for all credit unions that are considering small business lending.  Like any decision however, there are risks.  Here are some questions to consider:

• Do you have the expertise in-house?  There are many nuances to underwriting these loans that are unique and require a different level of expertise that most credit unions don’t currently have
• Do you understand the collateral behind the loans and the risks associated with them?  Many small business loans are backed by collateral such as property, machinery or receivables that involve different risks from their consumer-secured brethren
• A typical business loan requires much more attention and member contact than a similar consumer loan.  Can the credit union afford to take this additional time or divert resources from other areas?
• How does making member business loans serve your existing membership?  Is it in line with your strategic vision?

Answering these questions can help boards and managements determine if small business lending is a line of business they want to pursue.

With the OTS having been merged into the OCC, credit unions are looking for alternative sources for loan prepayment information to use when quantifying interest rate risk (IRR).  Unfortunately, there are a limited number of publicly available sources for this information.  The Securities Industry and Financial Markets Association (SIFMA) is one publicly available source that provides a “street consensus” for long-term prepayments based on surveying institutions such as UBS, JP Morgan Chase and Morgan Stanley.

As discussed in our recent post, How Do You Know Your Modeling Assumptions Are Right?, whichever source institutions decide to use, the assumptions should be stress tested and documented in order to understand them better—as well as satisfy the “reasonable and supportable” component of the new NCUA rule on interest rate risk management and policy.

Every day we’re faced with new statistics that may shape our thoughts about where the economy is and where it’s going.  For example, household borrowing grew in 2011 and, as recently as January, was increasing at an annual rate of 8.6%.  GDP has been increasing for the last three quarters and unemployment is decreasing.  But negative trends like rising gas prices and sluggish personal income growth make it unclear where the economy is headed.

How do you wade through the hundreds of statistics to make sense of it?  A better question is:  What would you do differently if you knew? One of the interesting results of a recession is that some companies emerge stronger than they were pre-recession.  In 2009 during the thick of the Great Recession, management author Dr. Donald Sull, a professor at the London Business School, offered several ideas for managing successfully in a downturn including:

• Instill ongoing cost discipline
• Force hard choices
• Seize golden opportunities

Many credit unions would look at the first two bullet points and say that they have been living those tactics for the last few years.  An economic downturn provides the urgency to better manage costs and force hard choices.  Some credit unions found that they could operate more efficiently and reduce some of the expenses that seemed to proliferate during boom times.  Others mustered the organizational will to close a branch that was not performing as hoped.  “The downturn lowers their resistance to change and cuts through complacency,” says Sull.

Is now the time to breathe a sigh of relief and relax?  Identifying opportunities for efficiencies and making hard choices that fit the organization’s strategy are always a good idea, regardless of economic times.  Credit unions that function this way generally find themselves in a better position to weather hard times and seize opportunities when they are presented, such as investing in starting or improving upon a business line.

So what would you do differently if all economic signs pointed to a strong recovery?  Probably lots of things, but the commitment to cost discipline and making difficult choices that has been forged during hard times is worth preserving.

Source:  Seizing the Upside of a Downturn, Donald Sull, Financial Times, 1/22/09