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contact@cmyers.com
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Is Your Risk Methodology Giving You a False Sense of Security?
ALM, Interest Rate Risk Blog PostsA recent front page article in the Wall Street Journal caused quite a stir by claiming that credit unions are “piling into longer-term assets, exposing the firms to potentially significant losses if interest rates rise…”
The objective of this blog is not to debate whether there is or is not too much interest rate risk (IRR) in the industry. The facts are the facts: credit unions have operated in a historically-low rate environment for the last six years; credit unions have, on average, extended their loan and/or investment portfolios; and there has been a flight-to-safety. The ingredients are there. There is potential IRR built into the system, that, if not managed properly could present issues when rates do rise – depending on what level they rise to and how quickly. The question, then, is “is IRR being managed properly?” or are some decision-makers getting a false sense of security by IRR quantification methodologies that miss risk or allow users to assume away the risk?
In our experience of doing numerous model validations, we have seen many examples of a false sense of security being created either through the methodology or the assumptions needed for the methodology. The most common concerns that may hide risk from decision-makers include:
Traditional income simulation
Net economic value
Risk limits
Are you at risk of being blindsided? Now is the time to evaluate your modeling methodologies and assumptions.
Don’t Take This Wrong: Being Lazy Is Not The Same As Being Efficient
Process Improvement Blog PostsA common process improvement tactic is to take a thorough look at current processes and analyze them for non-value add (NVA) activities. NVA activities usually meet one or more of the following criteria (all other activities are value-add):
What is sometimes lost in this process is looking with an objective eye to see if a process is missing a step that could turn out to be a value-add for the credit union. It is a counter-intuitive thought—why would you add steps to your process when process improvement usually means eliminating or refining steps?
The truth is, process improvement is designed to add value and eliminate waste. It is feasible that adding or reintroducing steps to a process may add value, and therefore would be an important addition to make. Sometimes human nature takes over and people stop doing important things they used to, or skip steps due to familiarity, and a process becomes slack over time because unintentional laziness has set in. What they don’t realize is that making up those steps later usually takes more time than if it was done in the first place, or not doing something at all has cost the credit union opportunities for income.
Examples:
Is it possible that the staff at your credit union has let processes go, or is avoiding them for their own “good” reasons?
Lending Process Improvement: New Processes, New Problems, New Solutions
Process Improvement Blog PostsUnderstanding a baseline for any process you are improving is critical for tracking changes, progress and, ultimately, the success of the endeavor. Further, tracking progress and understanding trends will help ensure a new process is “under control” and that any unintended consequences are recognized and addressed.
In this example, a credit union is improving its lending process with a new lending origination system (LOS) to improve turnaround and, ultimately, member satisfaction—helping to make and fund loans faster and easier. The baseline metrics have been analyzed to give decision makers and project stakeholders an understanding of the process before improvement—which in this case is average time to decision and fund loans:
Fast-forward four months later after the new process and LOS have been implemented. How has the new process affected the average times? Is the process working as expected? Let’s see:
You can observe that the time to decision has been cut roughly in half due to the more efficient process the credit union put into place. But notice the time to fund—it has actually increased. Of course, this begs the question “why?” With an overall objective of bringing the total time down, the credit union researches the increase and finds that the increased speed of approval has caused a slight backlog with funding. Armed with this information, the credit union takes further steps in staffing and funding processes to curtail the upward trend and reviews the progress after another few months have passed:
A striking improvement in each component of the process is realized—with the credit union able to book more loans more efficiently and helping to improve member satisfaction as well as the credit union’s bottom line. Consider, however, that this is not an ending process. Tracking these metrics on an ongoing basis will help ensure that the new process remains stable and continues to add value to the credit union.
We Are Outside of Our A/LM Risk Limits. Should We Change Them?
ALM, Strategic Planning Blog PostsThere is tremendous pressure on earnings from increasing costs due to regulations, compliance, technology and delivery channels to name a few. Margins are also tighter than in the past. To help compensate for reduced profitability, credit unions often take on more risk, such as interest rate risk and credit risk, to protect current earnings. However, this can lead to the credit union being outside of the risk limits they have outlined in policy. When this happens, the question, “Should we change our A/LM risk limits?” frequently gets asked.
Before you decide to change your risk limits and simply accept more risk, it is important to have a healthy debate and discussion focused on what the true line in the sand should be and to make sure that stakeholders fully understand the consequences. Many credit unions have found it valuable to place themselves in a scenario where rates have increased to their risk limit scenario to understand, ahead of time, the viable options they may have to unwind their risk. For some, this exercise has been very comforting – in other words, they have many viable options. Others have discovered that the options they thought they had were not enough to mitigate the additional risk in a timely fashion. Those credit unions may choose not to increase risk and address earnings issues from a different angle.
Net Economic Value and Business Decisions: Do You Understand the Trade-Offs?
ALM, Interest Rate Risk Blog PostsAs a result of running a net economic value shares at par analysis, it appears that some examiners are trying to force credit union CEOs and CFOs to reduce interest rate risk in a rising rate environment by selling assets.
While we won’t argue that some credit unions should consider reducing interest rate risk, using net economic value to make this decision does not give decision-makers and examiners appropriate decision information.
The net economic value analysis will not show the hurt of replacing the asset sold with a lower-yielding, shorter-term asset. It will also not show the hit to earnings and net worth should the assets need to be sold at a loss. Additionally, no one involved in this type of decision will understand the breakeven point of this decision. In other words, decision-makers and examiners should gain an understanding of how high rates would need to go in order to be glad that the credit union took a guaranteed loss and reduced earnings today.
As we said above, it may be a good decision for some credit unions to restructure their interest rate risk profile while rates are still low. However, before taking any action, we encourage decision-makers to work very hard to ensure that they, and their examiners, thoroughly understand the impact of the direct hit to earnings and net worth of selling assets. It would be unfortunate for a credit union to take action based on net economic value analyses and have decision-makers and examiners be surprised by the hit to earnings and net worth.