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NEV Does Not Equal NII

Some in the industry say that net economic value (NEV) is an indicator of future earnings. Let’s test this out by modeling a credit union taking $30 million of funds that are currently sitting in overnights earning 0.25% and investing them in mortgage-backed securities earning 1.75%. Even without a model, we know that net interest income (NII) will increase; however, as we model the scenario, we will look at both the earnings and the NEV to see how they have changed from the base case.

The income simulation results below show that the credit union will be poised for higher earnings if it purchases the MBS and will increase its interest rate risk in a rising rate environment.

Income simulation for purchasing MBS

If NEV is an indicator of future earnings then one would likewise expect to see an increase in NEV in the current rate environment.  NEV results are shown below:

NEV unchanged by MBS purchase

Notice that the current NEV is unchanged. The credit union would be poised for higher earnings in the current environment if it purchased the MBS, so why didn’t the NEV increase?

Funds sitting in overnights are at par and, on the day the MBS is purchased, its purchase price is its value. In other words, $30 million sitting in overnights is worth $30 million and $30 million of MBS is worth $30 million. Therefore, the current NEV will not change.

The theory that the NEV will represent the future earnings is hard to defend and it misses key aspects of decision-making.

Some have tried to defend this concept by saying that the forward curve will predict future rates; the problem is that it has never done this consistently and has not done this at all over the last decade. If the forward curve were to accurately predict the future, the theory would indicate that the earnings of the overnights will equal the earnings of the MBS in the base rate environment. If decision-makers played this concept out, it would tell you that over time there is no reason not to have all of the credit union assets in overnights. Such a strategy doesn’t make sense.

From a business perspective, understanding the timing of earnings is one of the key questions to answer for decision-making. NEV does not help decision-makers see the timing of the earnings, nor does it answer many of the other key business questions (for more on key business questions, please refer to our c. notes titled Comparison of Interest Rate Risk Methodologies).

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Is Your Battlefield Changing Like Blockbuster’s Changed?

Blockbuster

In 2004, with $5.9 billion in revenue and 9,000 stores, Blockbuster enjoyed a dominant position in its market.  In the evenings and on weekends, their stores were busy with people eager to review the latest titles and select their entertainment for the evening.  However, by 2013, Blockbuster was down to just 300 stores earning $120 million in revenue (Source: Blockbuster and the End of Movie Buying, Bloomberg Businessweek, 11/8/13).  What changed?

Consider the following questions:

  • What business was Blockbuster in?
  • Who did Blockbuster see as their competition?
  • What did Blockbuster’s customers want or value in 2004?  Did that change by 2013?

During the turn of the millennium, new players were entering the video market.  In 1999, Netflix began its subscription-based service allowing members to send and receive DVDs by mail.  By 2007, Netflix introduced video streaming over the internet.  In 2002, Redbox began to provide DVDs through its self-service kiosks placed at convenient locations like McDonald’s restaurants, grocery stores, convenience stores, and gas stations.

Blockbuster’s battlefield had changed.  New market entrants, with new approaches and technologies, fundamentally transformed the consumer’s expectations and behaviors.  Blockbuster’s customers began to see store visits as an inconvenience.  Customers had new options and began to choose them.

Today, in financial services, new entrants like Walmart, Apple, and Google are creating disruption.  Changing consumer behaviors are driving new business models and expectations.  To remain relevant and sustainable, it may be critical to consider whether credit unions’ battlefields have changed and, if so, what strategies could be employed to compete.

 

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Get Ready for Successful Execution of Your Strategic Plan

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It takes more than team spirit to successfully execute on the strategic plan.  It takes… well, planning.  And while good planning and management of individual projects is absolutely critical, there is another piece that is often overlooked.  That piece is the process that surrounds strategic planning and is designed to help the organization hit the ground running right out of the strategic planning session.

Credit union management teams know, usually months in advance, when strategic planning will take place.  Those management teams with good project portfolio management practices also have a solid understanding of what projects are already in progress, their statuses, and what resources are required and when.  With this information and a little advance planning, management teams can implement a process that gets them out of their silos in a productive way and kick starts the execution of the plan.

Start by mapping out a process that fits the organization, since there is no one process that makes sense for all.  Some credit unions have project management departments or dedicated project managers.  Others know what some of the initiatives will be in advance of the planning session.  At a minimum the process should include scheduled meetings immediately following strategic planning to take a realistic look at projects already in progress and understand how the new ones fit in.  It may also include planning meetings for the new initiatives.

With a good process in place, you should never have to say, two months after strategic planning, “We haven’t really started on that yet and aren’t sure when we’ll get to it.”  The initiatives that come out of strategic planning usually represent the most important goals for the credit union.  Failing to execute on them in a timely manner could stop the credit union from making progress toward its strategic direction.  This process ensures that if new initiatives are on hold or existing projects have been sidelined, that it was a conscious, strategic choice to do so.

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An Approach to Monitoring Liquidity

Loan growth in the credit union industry was in double-digits as of first quarter 2015.  While this is a welcome change from the flat to negative growth experienced in 2010, it can put a squeeze on liquidity if not monitored appropriately.  Liquidity monitoring and measuring is a big focus for credit unions and for examiners.  Liquidity analysis should include not just the credit union’s expected liquidity path, but also stress events and potential solutions to those events, should they occur.  Some credit unions find this a daunting task.  Here’s a suggested process to help get your credit union going:

  • Start with your plan/forecast
  • Develop a list of liquidity concerns
  • Survey key members of the organization to rank liquidity exposures
  • Create a story that captures the main exposures
  • Walk through the story and quantify potential exposure
  • Role play how the institution could respond
  • Uncover weaknesses/questions
  • Create action items to address weaknesses/questions

By walking through this process, your credit union will undoubtedly begin to think about its unique liquidity position differently.  Many credit unions uncover action items that can be implemented today to better prepare them for an unexpected future threat to liquidity.