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Software is Not the Answer (It’s Just a Piece of it)

When it comes to big software installations, it’s easy to lose sight of the real objective. It’s common for projects to be focused on implementing software when that’s not the real goal. These projects spring from business needs, such as reducing the time it takes to open accounts or process loans.

While a piece of the solution is software, it’s only a piece. The real need is met by the software in combination with the processes and behaviors that surround it.

  • The project objectives should be spelled out and understood by everyone involved. If the goal is to be able to add new members faster and cross-sell more efficiently, state the goal for speed and cross-selling rather than making it about implementing a new account opening system.
  • Examine the processes that are related to the goal and make modifications. Don’t limit your process improvements to the parts of the process that touch the software. There are typically opportunities throughout the process for improvements that will help achieve the goals.
  • Get baseline reports for the measures that will be tracked (if possible) and establish regular reporting.

Once the system is in place and everyone is using it correctly, celebrate, but don’t stop there.

  • After the new system and improved processes have been in use, revisit how they are working. This opportunity for easy adjustments is often missed, limiting the effectiveness of the project.
  • Continue to report on the goals regularly. That way you’ll know if something in the process stops working.
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Evaluating Derivatives—Part I: Earnings

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While derivatives can be a good tool for mitigating interest rate risk, it is important for credit unions to understand the cost of the protection they are purchasing. This example uses an interest rate swap with the following terms to illustrate:

  • 7-year term
  • Notional amount: $100 million
  • Credit union pays fixed rate of 2.00%
  • Credit union receives 3-month LIBOR (~0.25%)

The basic workings of the swap are pretty straightforward. If rates do not change, the swap will be a hit to earnings because the credit union will pay a higher fixed rate than the variable rate it will receive; however, if rates increase, the credit union could benefit and this can help to mitigate interest rate risk. In evaluating the decision, it is critical that the credit union understand just how much the swap could cost over its life if rates do not change and how high rates would have to increase before the swap helps.

As shown in the table below, if interest rates do not change the credit union will pay out $1,760K per year, or $12,320K over the term of the swap. For some credit unions, this can be expensive insurance. Note that it takes rates increasing more than 300 bps – assuming an instantaneous rate change, which is an optimistic assumption when evaluating a derivative – before the net benefit to the credit union would offset the potential cost, if rates do not change.

Cumulative Swap Cash Flow table
Note: $s in 000s

Again, derivatives can be an effective tool for mitigating interest rate risk, but the credit union should do a thorough analysis of the financial impact and compare it to other risk-mitigating actions to determine the best route.

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Process Improvement: Did the New Process Become Second Nature?

Definition of Second Nature

Source: Google

Many credit unions are focusing on process improvement to improve scalability, enhance member and staff experience and to control operating expenses. It can be invigorating for many people to shed practices that are non-value add. However, it can also be scary for some to change habits.

A key success factor in the process improvement process is to consistently audit new processes until they become second nature. Consistent process audits are great for helping people understand that the new process is here to stay, which often results in faster improvements.

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If Your Loans are Growing Faster…

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If you are planning for your loans to grow faster than your deposits, helpful blogs to review include:

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Selling Investments for Liquidity

A few weeks ago, we discussed increasing loan-to-share ratios resulting from loan growth outpacing share growth.  The blog went on to discuss the potential liquidity pressures some could experience, today or in the future, if this trend continues.

To keep the lending machine going, many decision-makers maintain that to fund future loan growth they will sell investments in the future.  While this may be an option worth considering, market rates in the future are uncertain and it can take a considerable amount of time to offset losses you may take on the sale of investments.  Let’s walk through an example:

Assume a credit union is experiencing continued loan growth and it also holds a $100M agency bullet, with three years remaining until maturity, earning 0.75%.  Their liquidity analysis is projecting they may need to sell this investment in 12 months to help fund loan opportunities.

Rates could go in any direction but what if rates increase 1% in the next 12 months?  The credit union sells the $100M investment, now with two years remaining until maturity, at a $1.6M loss.  If rates increase 3% in the next 12 months, the loss is $5.4M.

Sell Asset in 12 Months

Beyond asking if the credit union is willing to take the loss, the next question should be, How long it will take new lending opportunities to offset the loss? Assuming loans will yield more as rates go up, it could take up to six months to recoup the loss on the sale in a +100 basis point (bp) increase in rates and 17 months in a +300 bp increase in rates.

Months to Breakeven

The objective here is not to advocate a particular strategy, rather to encourage thorough analysis and provide a different perspective for credit union boards and managements to understand the trade-offs of difficult decisions.