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.