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.

For years, we have been emphasizing a list of 10 reasons (not in order of priority) risks are not appropriately managed in the financial services industry.  Many of these reasons contributed to the volatile economic environment we find ourselves in today.

1. Mindset—We can take action when bad things happen so things will never be as bad as risk simulations are showing—forgetting that the point at which we address a problem is directly related to the number of viable options we have for solving it
2. Decision-makers don’t agree on appetite for risk
3. Decision-makers agree on appetite for risk but don’t make the tough decisions to manage within their appetite
4. Decision-makers take on more risk than they are truly comfortable taking because “everyone else is doing it”— so it must be right…
5. Lack of effective communication between decision-makers and risk quantifiers
6. Short-term decision making
7. Decision-makers not linking strategy and A/LM (financial structure management)
8. Contingency plans are not tested to determine if they are adequate
9. Using old decision drivers and measures of success in a new environment—following peers
10. Improper risk quantification providing a false sense of security

Click here to view the expanded version…

Recent history has shown us the havoc caused by inadequate risk management, and we are concerned that the havoc will continue or worsen if something doesn’t change.

Many in the financial services industry continue to worry over tightening margins, threats to non-interest income, diminished loan growth—the list goes on.  However, we urge all stakeholders to consider the long-term viability of their credit union rather than rely on short-term decision making (#6).

We are seeing more and more credit unions focus on short-term “Band-Aids” instead of taking a longer-term view of making sustainable changes to the way they do business.  Short-term solutions often come with long-term consequences—some of which could be another cycle of credit losses, assessments or even renewed stabilization efforts.

There are no easy, quick fixes for the financial services industry.  The situation requires a thorough evaluation of the sustainability of current business models and, most likely, redefining measures of success.