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Non-Value Add Activities: Where Are They?

Sometimes we are our own worst enemy—and it’s not intentional. Credit unions have spent the past few decades growing from tight-knit, job-related hubs to financial institutions prevalent in the whole community. Credit union staff are finding that some of the activities and roles that once made sense have become outdated and no longer add value. They are creating roadblocks to the credit union’s success by holding on to traditions because “this is how it’s always been done.”

The hard part is being able to recognize the non-value add (NVA) activities that have developed over the years, and figure out a way to overcome them. For instance, some credit unions still keep paper copies of loan files even though everything is replicated electronically – essentially duplicating effort. This NVA time could be better spent on other income-generating activities for the credit union.

So the question is: What activities are not adding value to the credit union?

A key objective of process improvement is the elimination of waste by identifying and removing NVA and/or improving the product and/or the processing time of value-added activities. Think of NVA as an activity that has no customers, internal or external, or members would not be willing to pay for it if they knew you were performing the activity.

For instance what, and how many, NVA activities are created when the member leaves the branch or hangs up the phone without having a decision on their request for a loan?

Credit unions have seen material improvements in their lending processes by removing NVA activities and focusing on the key parts of the process that do add value. A result of this focus has led to faster decision making and a higher percentage of approved loans getting booked.

The hardest part of reviewing processes for NVA activities can be taking the time required to ask the right questions. During this budget season, challenge all staff to look for NVAs that will add capacity. With a commitment to finding NVA activities and eliminating them, credit unions may find that that time was not spent, it was invested in members, employees and bottom-line earnings.

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Isolating Interest Rate Risk with a Static Balance Sheet

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Some will say that a static balance sheet income simulation achieves its objective of isolating interest rate risk by reducing the variables in the simulation. The question then is: What risk should be isolated?

  • Interest rates change and cash flows do not change
  • Interest rates change and cash flows change in response

If the answer is A:

  • Callable bonds would still be called as rates increase
  • CMO/MBS cash flow assumptions wouldn’t extend
  • Prepayment assumptions wouldn’t slow as rates increase
  • Deposit balances wouldn’t migrate to higher cost deposits (such as CDs) or reverse their flight to safety

Note that holding these assumptions constant would result in less “moving pieces” but would disregard material features of interest rate risk. The answer must be B.

Regulators state that assumptions in modeling should be “reasonable and supportable.” History has demonstrated that ignoring the extension of asset cash flows is neither reasonable nor supportable.

If it is obvious that asset behavior must change, why then isn’t it obvious that the risk of changing deposit behaviors must also be included? Does history support the assumption that the deposit mix will not change as rates change?

Below is the distribution of regular shares and share drafts for NCUA’s largest peer group (credit unions >$500M in assets).

History proves that assuming low-cost deposits will not change as rates change is neither reasonable nor supportable.

There has been a lot of discussion on the need to analyze non-maturity deposit behavior and to understand the threat of surge deposits. Assuming that deposit behavior remains constant (static) while interest rates are changing does not capture the threat of surge deposits leaving. Why analyze this exposure and then ignore this risk in an income simulation?

Sometimes the reason given for ignoring this risk is for simplicity or comparability. However, if A/LM models were not sophisticated enough to factor in prepayment assumptions, in the name of simplicity and comparability, they would be considered unacceptable. In order to incorporate the exposure on the liability side of the balance sheet, the sophistication of modeling needs to be increased.

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Forecasting Considerations

Many credit unions have started their budget and, similar to prior years, stress testing key assumptions should be an important part of the budget process.

Last year, we emphasized the importance of testing out different rates of loan growth. While that continues to be an important stress test to perform, provision for loan loss (PLL) and potential pressure on the cost of funds may need special attention this budget season.

The past few years of historically low PLL could be coming to an end as many credit unions have used up excess reserves or taken on more credit risk. Credit unions should understand the sensitivity of earnings and net worth when testing different levels of PLL.

Another recent trend that could change going forward is a continued reliance on cheap non-maturity deposits to fund future loan growth. There is danger from both an earnings and liquidity perspective in budgeting for the same checking and regular share growth experienced over the past several years. More credit unions have started increasing deposit rates of late as share growth has slowed while loan growth has increased. We encourage credit unions to stress test their ability to handle an increase in deposit rates or pressure from the cost of funds mix changing to more certificates and money markets.

Stress testing continues to be a cornerstone in effective planning. The results of such stress tests can help ALCOs and boards better understand the sensitivity of the earnings and inform the credit union what it may want to do going forward.

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Why Are My Income Simulation Results so Strong in a Shock?

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In performing model validations for credit unions, we often see income simulation results that show significant improvement in net interest income (NII) and net income (NI) as rates rise, even for credit unions that have material positions in long-term, fixed-rate assets.  Why does this happen, and is it reasonable?

Income simulations are commonly run with a static balance sheet, in which the asset and liability mix remains constant regardless of the rate environment, and loan yields are often assumed to move in lock step with market rates.  However, this approach can lead to simulations calculating material returns on new business and increases in margins as rates rise.
The example below illustrates why this often happens.  The calculations assume an average industry loan-to-asset ratio; yield on loans, yield on investments, cost of funds and net operating expense continues into the future, shown for both the base rate environment and the up 300:
In the base rate environment, the new business calculation above is producing an ROA of 0.80%, roughly in line with the current ROA for the industry.  Said differently, if rates do not change the new business would be neither helping nor hurting NII or NI.  However, if you incorporate typical new business assumptions in an income simulation utilizing a static balance sheet, the new business ROA for the up 300 rate environment is 2.30%, a 150 basis point (bp) increase over the new business ROA for the base rate environment.
Combining a 2.30% new business ROA with the earnings on existing business helps explain why NII and NI results often improve as rates rise, even if the ROA on existing business is decreasing.  However, does a 2.30% new business ROA in a +300 bp rate environment pass the reasonableness test?
Consider the implication; this infers that if rates go up 300 bps, over time the entire industry would earn over 200 bps, more than double any peak the industry has experienced.  Following this logic, a +500 bp rate change would show an ROA exceeding 3.00%.
The purpose of ALM/interest rate risk analysis is to understand risks, not ideal situations.  What are risks that could cause earnings to not be this good?
  • What if our deposit mix becomes more heavily weighted toward member CDs as rates rise? In the largest credit union peer group, the last time rates went up, Reg Shares+Share Drafts dropped from 43% of funds to 33%; currently the ratio is 45%. When rates were higher, CDs were the largest deposit type, costing credit unions much more than non-maturity deposits. Does your base analysis incorporate members shifting funds like they did in the past?
  • What if loan yields don’t move at 100% of the market? Competition to generate loans can often lead to irrational pricing.  It is reasonable to expect that competition for loans may restrict the ability for institutions to move loan rates up 100% of the rate change.
  • What if our loan-to-asset ratio is pressured as rates rise?  Rates don’t only go up due to a thriving economy; the material drop in loan-to-asset ratios over the last five years has squeezed margins.  Lending has picked up over the last year, but there is no guarantee that loan-to-asset ratios can’t drop again.
The earnings on the new business would most likely still be positive in the 300 bps shock, but would be significantly lower than the default assumption.  These are real risks that can greatly impact earnings and need to be incorporated in the base risk analysis.  The exposure to risk should then be compared against policy limits for ALCO to understand the risks being taken.  Beyond the base case the stress of additional pressure should also be tested.
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One Tip for Evaluating the Reasonableness of Non-Maturity Deposit Assumptions Used in Net Economic Value

Should decay assumptions change as rates are changing? Absolutely!

When we complete model validations of credit union or vendor-supplied interest rate risk results, we see all too often that decay assumptions don’t change as rates are changing. This assumption is like saying non-maturity deposit cash flows will remain constant and unchanging regardless of what rates do. History shows that this is not a valid assumption and, if used, can provide a false sense of security regarding NEV results.

It can be difficult to tell if the decay rates are changing as rates are changing by looking only at results. A good way to check this assumption is to review your model setup to see if decay rates are increasing as rates are assumed to rise. If they are not, it is a good investment of time to discuss options for representing the risk of decay rates changing as the world around us changes. Keep in mind as you do this it is not about getting the “right” assumption, because that is virtually impossible.  It is about reasonably representing changes in consumer behavior in your base-case risk analysis.