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Budgeting For Loan Growth

In this uncertain economy, many credit unions are seeing loan growth come in below budget.  Others are experiencing loan growth that meets their budgets; however, they are still below budget on loan interest income.  Why?  Interest rates have fallen since their budgets were created and competition for loans has resulted in the credit union getting the loans at a lower rate than budgeted.

Example 1:

 

Can the credit union make up this revenue variance by making more loans?  Maybe, but as the example below indicates, the credit union would need to grow loans 25% over the budgeted amount to breakeven on loan interest income.  Many credit unions would feel this is not achievable in today’s environment.

Example 2:

If the credit union is not able to increase loan growth, then, all else equal, net income will fall short of budget.  However, all else doesn’t have to stay equal.  While cost of funds may be hitting a floor for some places, other credit unions still have room to move lower.  And operating efficiencies are key for surviving today and being successful in the future.  Remember, the point at which you address a problem is directly related to the number of viable options you have to solve it.  If you are in this situation, begin laying out alternative plans now to help achieve your desired level of income.

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NCUA Beefs Up Insurance Requirements with New Emergency Liquidity Rule

Approved at NCUA’s July 24th board meeting, the proposed rule on maintaining access to emergency liquidity will require credit unions to create/maintain various levels of liquidity planning based on asset sizes.

Under $10 million in assets:  Maintain a written policy approved by the board with a list of contingent liquidity sources.

$10 million or more in assets: Establish a formal contingency funding plan (CFP) that clearly defines strategies for addressing liquidity shortfalls under adverse circumstances.  The CFP must address, at a minimum, the following:

  1. The sufficiency of the institution’s liquidity sources to meet normal operating requirements as well as contingent events
  2. The identification of contingent liquidity sources
  3. Policies to manage a range of stress environments, identification of some possible stress events and identification of likely liquidity responses to such events
  4. Lines of responsibility within the institution to respond to liquidity events
  5. Management processes that include clear implementation and escalation procedures for liquidity events
  6. The frequency that the institution will test and update the plan

$100 million in assets: In addition to maintaining a CFP as described above, demonstrate access to at least one of the following three sources:  becoming a member of the CLF, becoming a CLF member through a CLF agent, or establishing borrowing access at the Federal Reserve Discount Window.

Required For Federal Insurance
Perhaps more interesting to note is the placement of this proposed rule under Part 741 of the NCUA rules and regulations, which outlines requirements for Federal insurance.  This is the same Part that was revised to require formal IRR programs/policies earlier this year.

Liquidity Contingency Planning
When approaching liquidity planning, c. myers provides its clients with no less than 2 “what-if” scenarios based on an actual liquidity forecast:

  • What-if #1:  What’s our bad-case liquidity environment? Consider heightened loan demand, increased competition for low-cost deposits and potential cuts in lines of credit in order to stress the credit union’s liquidity position
  • What-if #2:  How will we respond to our bad-case liquidity environment? When addressing the bad-case environment, consider triggers the credit union can pull to protect its liquidity position, including slowing down/stopping lending, selling investments, raising rates to attract “hot” money, etc.

Exploring these scenarios on a regular basis can help credit unions be prepared for potential liquidity risks—and in light of the new proposed rule—will also help satisfy regulatory requirements for federal insurance if the rule is realized.

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Callables and Low Rate Environments

Trying to get any kind of yield on investments is tough when rates are this low. Some credit unions are reaching for yield by purchasing longer-term callables with the justification that “we don’t have to worry much about the risk because they are going to get called.” But consider this, if rates move up even a little bit, most callable bonds will not get called, and the credit union could be stuck with material losses. The example table below demonstrates this potential risk.

The example assumes that a $1M 1/5 callable (callable in 1 year, final maturity in 5 years) is purchased today at 80bp. It shows that, compared to Overnights earning 25bp, this investment would yield an additional $6K in revenue over the course of 1 year, at which point it would be called. However, when you layer on industry-average cost of funds, operating expense and fee income, it reveals that from an ROA perspective this investment loses $19K in year 1. If rates go up at all, the bond will stick around for the full 5 years, and in a +300bp rate environment the bond would lose about $147K over its lifetime when the credit union cost of funds, operating expense and fee income are factored in. If rates returned to levels seen in 2007 (5%), this bond would lose $190K over its lifetime.

Note that for simplicity sake it is assumed that rates move immediately.

Some credit unions can afford to take this risk, some cannot. In any case, the decision to buy longer-term callables should NOT be based solely on the expectation that they will be called; the consequences of being wrong could have a very negative impact on a credit union’s risk profile and future earnings.

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Strategic Plans And Quantifying Risk

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In the recently issued Interest Rate Risk Questionnaire, the NCUA devoted an entire section to evaluating if decision-making is informed by interest rate risk measurement systems.  The guidance specifically references interest rate risk “what-if” testing in conjunction with strategic plans and operational decisions—and that “what-if” analysis outcomes should be documented within the strategic plan to either support or reject a decision.

The NCUA further states, “Whenever material changes in assets or liabilities are proposed, NCUA expects management to be proactive and perform what-if analysis before a new strategy is implemented.”  Understanding the potential impact that a strategic plan may have on the credit union’s risk exposures is key to effective asset/liability management.

In order to link strategic planning and desired long-term financial performance, decision-makers should ask themselves the following questions:

  1. How does this plan align with our long-term goals for financial performance?
  2. Is there a possibility that we will sacrifice financial performance in the short- or medium-term to fulfill long-term strategic and/or financial objectives?
  3. If everything goes according to our strategic plan, what will be the impact to the interest rate risk and credit risk exposure of the credit union?  Are there any other risks that may be present in the strategy that we don’t have today?  Specifically, how will those risks impact earnings and net worth levels?
  4. If external forces cause a deviation from our strategic plan, what contingencies are in place or what options do we have to get back on track?

A comprehensive strategic planning process incorporates the evaluation of interest rate risk.  Modeling the impact of strategic decisions beyond the traditional 1-year simulation is a must.

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Preparing For Strategic Planning

As you prepare for strategic planning with your credit union, consider carving out time to go through a structured strategic thinking process.  There are many scenarios to test drive.  Test driving helps you rehearse tomorrow today.  The objective of a structured strategic thinking process is to expand thinking and imagination – not necessarily to make decisions during this process.  Following is just one example scenario many credit unions are test driving.  We have listed a few questions to consider.

Test Drive: It’s 2017 and it is clear that most consumers prefer minimal verbal communication when addressing their banking needs.

Questions:

  • What would be the credit union’s measures of success in this future?
  • What would be the credit union’s value proposition in this future?
  • How has limited verbal interaction impacted the credit union’s ability to create member loyalty?
  • How is the credit union effectively cross selling in this future?
  • How is the credit union acquiring new members from its target market in this future?
  • What is the role of physical locations in this future?
  • How has it changed recruiting, training and retention of employees, management and board?
  • How is the competition taking advantage of this strategy?
  • What verbal communication was considered “sacred cow” and left untouched?
Keep in mind the more you delve into the questions, the more questions you may have.  That’s expected!