As you consider establishing concentration limits on loans, it is important to know how the rate of growth could impact risk.

We understand that loan growth is anemic for many financial institutions.  However, at some point, loan demand will increase and the rate of growth is something decision makers will need to consider.  In fact, some credit unions may need to consider their rate of growth now as we are seeing a rapid increase in indirect lending (often called “point of sale” lending).

The following shows the change in loan concentrations as a percent of assets for two credit unions that no longer exist.  Each experienced brutal losses in the portfolios that grew unmanageably.

Aside from absolute concentration limits, factoring in a threshold for change (growth) in concentration can serve as an early warning sign that a business line may threaten the credit union’s safety and soundness.

Taking the two example credit unions above, extraordinary growth was experienced year-over-year-over-year—yet no effective action was taken to understand the risk and/or stop the growth before it was too late.

As the economy improves and lending demand grows, it will be necessary to perform continuous, rigorous analysis as a portfolio is growing.  Management should constantly step back and ask questions such as:

• Why is this portfolio growing so fast?  Are we experiencing “too much of a good thing”?
• What is missing from our current analytics?
• Are our assumptions too optimistic?  What if our assumptions are wrong?
• What forces are out of our control that could cause this business line to go south—and go south fast?
• Are we making more exceptions in our underwriting?  Is there a pattern with a particular loan officer and/or third party?
• Are we relying on this line of revenue to the detriment of our other lines of business?  What can threaten this line of business, and how fast can we recover should it be dramatically reduced?
• Are our internal controls rigorous?  How can we test this to ensure we are adhering to our standards?

When evaluating options for concentration limits, credit unions should also consider establishing guidelines for portfolio growth.  While we have shown only two examples, these situations occur all too often.  The message is that rapid growth in a particular asset class can play a key role in creating unacceptable risk.

At the moment, there aren’t many credit unions that would make this statement.  Net interest margins continue to be squeezed by the extended low rate environment.  Deposit pricing is nearing the bottom, but there’s still plenty of room for loan and investment yields to decline.  It’s no different for big banks.  Just from the first to second quarter, net interest margins fell 26 basis points at JPMorgan, 17 basis points at Citigroup and 16 basis points at Bank of America.  Deutsche Bank analyst Matt O’Connor commented, “There’s no loan demand, and long-term rates have declined so much.  So as you look out over the next few quarters, it’s potentially a very dire situation for the overall industry.”[1]

Many credit unions also are experiencing low loan demand coupled with high deposit growth.  According to NCUA data, the loan-to-share ratio for credit unions has dropped from 80% in March 2008 to 73% in March 2010 and that typically equals growing investment portfolios.  It has been difficult for some to put the brakes on growth, even while lowering rates to previously unheard of levels.  There are others who want to stick with their growth plan or are reluctant to lower deposit rates further.  What those folks are really saying is, “I want to grow our investment portfolio.”

It doesn’t make much sense when you put it that way.  The critical question is, what is the credit union doing to offset the lower yield on assets that an expanding investment portfolio brings? Some credit unions have been nudged into bad business decisions such as:

• Loosening underwriting standards in a desperate attempt to add more loans
• Delving into business lines for which they lack expertise such as business lending
• Adding indirect and participation loans that are outside of the credit union’s core business and for which the credit risk may not be thoroughly understood
• Increasing interest rate risk by adding fixed-rate mortgages
• Increasing interest rate risk by adding longer investments

The current environment is challenging enough without adding the burden of excess deposit growth and expanding investment portfolios.  If this is an issue for your credit union, everyone on the management team needs to understand what steps will need to be taken to compensate.  A non-decision on this issue can lead to small, incremental adjustments that add up to an unintended change in strategy for the credit union.

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.

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.

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.