The recent news about the European bank stress tests has us thinking about when a stress test isn’t a stress test.  By now, you may have heard that out of the banks tested, 7 out of 91 failed the “stress tests”.¹  That is a 92% pass rate, and should earn the European banking system an A grade, right?  As it turns out, there are many critics of these tests.  For example, only trading securities were subject to market devaluations, so all held-to-maturity securities were excluded from the tests.  Further, some of the economic “stresses” were little more stressful than the current environment.

For example, “The worst-case scenario envisioned…the overall euro-zone economy shrinking 0.2% this year and 0.6% the next year.   In some of the 20 countries that conducted the tests, regulators figured that property values would keep rising or hold steady in a worst-case economic scenario…”  In Austria, for example, properties under the stress test were assumed to increase 2% this year and 2.7% next year.²  Try telling a “sand state” credit union that a 2% increase in property values is a stress test.

Why this interest in Europe’s stress tests?  As regulators/governments publish the results, it could provide consumers with a sense of security and hope that may not be justified—ultimately adding more confusion to an already delicate environment.  We often find that appropriately managing expectations is nearly half the battle.

When you decide to conduct stress tests for your organization, don’t shortchange yourself by designing a test that can be easy to pass.  AND, don’t limit your stress tests to what is probable.  Again, nobody thought the cascading events that occurred over the last few years were probable.  It’s the improbable that is currently bringing long-standing organizations to their knees.

¹Cozy Stress Tests Fail Confidence Test, The Source, 07/26/10

²Europe’s Stress Tests Relied On Mild Assumptions, Wall Street Journal, 07/26/10

In our continued efforts to help the credit union industry, we are currently gathering information on how credit union executives view loan concentration limits in light of NCUA Letter to Credit Unions 10-CU-03 on Concentration Risk.

We encourage executives to complete the following short, two-question survey: c. myers loan concentration risk survey

Please note that this survey is completely anonymous unless you provide identifiable information in your response.

Thanks in advance for your participation!  It should only take a few minutes of your time.

Given the flight to safety combined with sustained low loan demand, threats to non-interest income and NCUSIF assessments, many credit unions are reevaluating their investment strategy.

The problem is not enough credit unions are evaluating their investment strategy in light of their entire financial structure and strategic objectives.  They are evaluating one investment at a time. In other words, this investment seems to be a good deal today. But how long will it be a good deal?  And, if/when the decision needs to be unwound, what will be the viable options?  How does it fit with the credit union’s strategic objectives and financial structure?

Let’s take an example using callable bonds.  We are seeing credit unions purchase callable bonds with final maturities of 10 and 15 years.  The reasoning too often is, we need to do something, and they are going to be called anyway, so we may as well get the extra yield today.

Typically, people say they will sell it before rates become unfavorable, therefore they won’t be stuck with it.  The only reliable way that this could happen is if the credit union could accurately forecast rates.  A strategy assuming that you know what will happen in the market, before the market occurs, is fraught with danger and has burned many institutions.

Some say that if rates go up they won’t need to sell low-yielding investments because loan demand will be so good, the yields on new loans will offset the risk of the lower-yielding investments.  This could happen.  However, it is important to keep in mind that rates can go up without economic recovery.

Stating the obvious, there is a tremendous amount of uncertainty—there always has been.  Yet decisions have to be made.  Just make sure your decision framework is sound.  Stick with the basics:

• Make decisions in light of your entire financial structure.
• Agree on how long you are willing to live with your decision if things don’t go as planned.  In the above example, answer:  are we willing to live with this decision for the next 10 or 15 years?  If not, how are we going to know it is time to unwind before it results in unacceptable risk for our credit union? This thought process should be followed when making any decision with potential long-term consequences.
• Don’t assume that the future will be brighter or more forgiving than the present.  Isn’t that part of the mindset that got us here in the first place?
• Document the rationale for major decisions.  Memories are short, so it’s important that key players remember why the decision was made in the first place.  Especially if the changes in the environment result in unfavorable financial performance.
• Test drive your investment strategy before you implement it by using your A/LM model.  Don’t just look up +300 basis points either.  Remember, rates were 500 basis points higher just three years ago.  By rehearsing tomorrow today, you can understand the potential risk of what you are buying and can decide if that risk is worth today’s reward.
• Agree on your appetite for risk for your entire enterprise, stick with it and manage to it.

This writing is not intended to say that callable bonds are bad, we are using them for example purposes only.  Our philosophy is that every decision has a trade-off; it is critical to understand the trade-off before implementing decisions.  It is up to decision makers to understand how each investment they purchase works not only today, but as the environment changes.  Decision makers must also understand how investments complement or compound issues in their entire financial structure and risk profile.

Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.

The supervisory letter on concentration risk states that examples of concentrations within an asset class include…

“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”

If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.

Let’s assume:

8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in

3,840 total risk limits for the Residential Real Estate Loans

Keep in mind the above example is just for Residential Real Estate.  Imagine applying the same multifactor approach to other asset categories.  The number of limits can become daunting and unmanageable.

We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.

Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management.  However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.

Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications.  Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.

We highly recommend following a deliberate process to establish limits.  Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions.  This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.

This blog addresses only a sliver of the issues regarding concentration limits.  There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.

It’s natural to wonder when things will get back to “normal.”  But week after week, the only thing consistent in the economic indicators is that they are not consistent.  So how do we plan for the future?

Most credit unions are designed to thrive in a different type of economic environment─one we may not see again for a long time.  Yet opportunities exist in every environment.  The key is the ability to alter our mindset and look for ways to take advantage of the current reality.

Try test driving the scenario:  “It is 2015 and we are thriving.  The economy is about the same as it was in 2010.”  What did you do to thrive?  How is your strategy different than it was in 2010?  Instead of looking for a “magic bullet,” consider staying true to your core business and improve areas of expertise.  For example, there may not be much loan demand at the moment, but by truly understanding what your target market needs and values, you can work toward getting more of the loan demand that currently exists.

Also, many institutions are focused on cutting costs; according to NCUA’s aggregate FPR for March 2010, there was a 36% decline in the industry’s average operating expense ratio from March 2009 to March 2010.  However, keep in mind that some cuts are not sustainable, such as pay cuts and leaving critical positions vacant.  While they may be necessary in the short term, work toward sustainable cuts like improvements in processes and strategic changes in product offerings.  Consider the following statistics from the Harvard Business Review’s July-August 2009 readers’ survey, How Bleak is the Landscape?

• Only 27% of businesses surveyed are streamlining product or service offerings
• Only 34% are reengineering processes
• Only 37% are improving current products, services or customer support

Rather than hunkering down and waiting for the storm to pass, meet the storm head-on.  Stay focused on strategy and never stop thinking about ways to improve your business.

For months many have been watching and wondering when the inevitable increase in market rates might materialize.  Now, with some economists projecting that rates will stay at historic lows for another 12-18 months, credit unions should evaluate how, or if, they can continue to maintain net interest margin and ROA.

Not all institutions have room to lower deposits enough to mitigate the continued erosion in the yield on assets.  In a sense, deposit pricing is reaching a “floor” for many credit unions.  All else being equal, ROA will continue to erode and interest rate risk profiles will weaken as higher-rate loans and investments roll off, being replaced with lower yielding assets.

So what should credit unions do?  Common strategies include looking beyond the margin and evaluating expenses, as well as potential new sources of non-interest income.  As mentioned in previous posts, some institutions are stretching for yield, either in loans or investments.  If this strategy is employed, institutions need to carefully monitor the impact on the risk profile, and make sure decisions are tested beforehand and fit within the credit union’s philosophy and A/LM policy/guidelines.

Finally, some institutions have chosen to not take any drastic steps at this time, and have instead begun to adjust expectations at both the employee and board level, re-evaluating what success looks like in this environment.  One potential saving grace is that loan losses seem to be stabilizing in many areas, but should not be taken for granted given what institutions have experienced over the last two years.

We have received many calls on the NCUA Concentration Limits Supervisory Letter.  Credit unions are asking us what limits will satisfy NCUA or if there are any standard limits.

The answer is:  there is no standard answer.  This was stated by NCUA in conversation along with NCUA’s statement, there is no magic formula, during a webinar hosted by NAFCU on June 2, 2010.

Before establishing concentration limits for policy, we think there are several key questions that need to be considered.  Following are just a few:

• What types of concentration limits are appropriate for our credit union?
• Should we focus on classes or concentrations within classes?  If concentrations within classes, how much should we drill down?
• How will the newly established limits impact our strategic plans, business decisions, earnings and competitive stance?  Test drive potential scenarios and business decisions your credit union may want to make to see the potential downside of proposed limits.  Keep in mind that the supervisory letter is not limiting the discussion to assets.
• What is our rationale for determining concentration limits?  If we are experiencing unacceptable losses with our current concentrations, will we set concentration limits lower than our current levels?
• How will we respond if we reach a designated limit?  Will we shut down our program?  Will we sell existing holdings to make room for new business?
• Will these new limits prevent our credit union from taking too much risk, or will they result in unintended consequences of taking more risk?  For example, if you reach your limit on typical products, will you begin adding products where there is limited expertise in order to increase earnings?
• Do absolute levels of concentration cause too much risk?  Or, is it the rate of growth in a particular concentration?  Or, is it the rate of growth in concentration during an economic boom?
• How will we aggregate multiple limits to ensure we are not missing the big picture?

Because this decision will directly impact strategy, business decisions, day-to-day operations as well as competitive stance, we encourage decision makers to think through what is best for their credit union rather than take the easier route of using generic limits.

Keep in mind that that in the supervisory letter, NCUA states, “A material red flag is a credit union that simply raises the established limit when it is reached without advanced analysis supporting the rationale for the change in policy.”

If you would like help thinking through what would be best for your credit union, please contact us.

According to NCUA’s first quarter data, shares grew an average of almost 11% (annualized) while loan growth declined 4.76% (annualized)─over a 15% differential.  Funds not loaned out are sitting in investments (generally not earning very much) and are putting a squeeze on the margin.  With loan demand down, many of our clients are requesting what-if scenarios on purchasing longer-term investments with these “excess funds” to pick up a little extra yield.

While running what-if scenarios on the asset side of the balance sheet is a good idea, don’t forget the other half of the equation.  Another common theme we are seeing is an increase in non-maturity shares and a decrease in CDs.  This certainly takes some pressure off the cost of funds today, but it could be costly to mistake a potentially short-term member adjustment to current market conditions for a long-term trend.

At many places today, the rate differential between a money market and a CD is not that big—so it seems that members are willing to give up a few basis points.  But for what? Are your members sending you a signal that they are positioning themselves to move to the stock market as soon as “things turn around?”  Or back to CDs when rates tick up some?  We recommend that you test out these potential scenarios, and more, to help you get a better handle on how things could possibly play out in the future.

The question that many credit union leaders are asking themselves lately is, how far do we reach for yield?  With 10-year Treasury Rates rounding near 3% recently, how far can the balance sheet be pushed to make up for a squeezing margin?

Consumers at large are facing a similar dilemma when it comes to managing their own balance sheet.  How much risk is too much?  And with the world turning on its head, with perceived threats of war on the Korean Peninsula and dark concerns about the financial stability of European markets, that question is becoming harder to answer.  Even as consumer confidence is up on news of positive job forecasts, the Dow has tumbled below 10,000—not crossing that threshold since February 8^th of this year (Dow Falls Under 10000 as Risk Is Shunned, WSJ, 5/25/10).

As the world continues to become more complex, and as ripples from the financial crisis and new developments in world affairs unfold, be mindful of consumers’ tendency toward safety.  While many credit union leaders cannot imagine another influx of low-cost funding, the perceived chaos in the world around the consumer could theoretically cause just that.  Consider stress testing what could happen if you experience another flight to safety of similar (as well as greater) magnitude combined with anemic loan demand to see the impact to your net worth ratio.  If net worth is at high risk of dropping below Well or Adequately Capitalized, identify viable steps you can take to be prepared.

Consumer behavior, specifically spending statistics, is being tracked with much anticipation these days.  Given that consumer spending accounts for 70% of the economy, this is no surprise.  So what is the forecast?

According to a new Associated Press Economy Survey, two-thirds of the 44 economists surveyed believe that the frugality created during the Great Recession will endure beyond the crisis (New Frugality for Many Outlive Recession, MSNBC.com, May 2, 2010).  This prediction comes despite a drop in the national savings rate to 2.7% as of March from its high of 6.4% in 2009 and a recent increase in retail sales (U.S. Bureau of Economic Analysis).  These economists believe that spending will increase as the recovery continues; however, consumers will not run up large amounts of debt to fund spending sprees.  Rather, they’ll continue to save and remain conservative with their money in a Mini Age of Austerity, much like Britain experienced post WWII.

While there are some positive economic signs, we could be in for a slow recovery.  Only time can tell how long this Mini Age of Austerity will last or if it will continue indefinitely.