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Are Unprofitable Loans Creating a Liquidity Challenge?

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Liquidity remains a relevant topic, and we have written several blogs recently dealing with this important issue:  Deposit and Liquidity Concerns and Is Your Certificate Promotion Doing What You Want?.  Some places are seeing liquidity tighten due to outflows in deposits, though for many credit unions liquidity pressures are being driven primarily by growth in loans.  However, is that loan growth helping the credit union achieve its desired goals?  Consider the following, is the loan growth allowing the credit union to reach into new markets that will help accomplish longer-term strategic objectives?  Is it allowing the credit union to serve a larger segment of the existing membership?  Are the loans profitable?

As we review that last question of profitability with our clients, the answers can be surprising.  A lot of time and effort goes into originating loans, so no one wants to hear that their credit union may be booking unprofitable loans, especially if adding those loans is creating additional stress and expense by magnifying a liquidity challenge.

The credit union in the analysis below has tight liquidity, and the pressure is increasing.  In the last 12 months the loan-to-asset ratio increased from 86% to 90% as loan growth continued to outpace the growth in deposits.  The profitability analysis includes just a handful of the credit union’s specific loan types.  The ROAs noted below cover a 4-year time frame in the current market interest rate environment.  Note that this report can be produced for dozens of other market rate environments.  Of particular concern to this credit union is the performance of their auto and RV portfolios.  These are large categories for the credit union at about 32% of total assets combined and represent the bulk of the credit union’s growth in recent years.

A challenge for this credit union is that this issue is not going to resolve itself quickly through the normal course of business.  This is because the average rate on new consumer loans (based on recent production) is only marginally higher than the current yields that are resulting in negative income.  So 6 months from now, the picture is unlikely to have changed materially unless the credit union takes action.

So what should they do?  There are several potential alternatives.  One strategy could be to adjust loan rates more aggressively with the goal of slowing growth over time to help the credit union roughly maintain its current loan-to-asset ratio (as opposed to it continuing to increase).  In the scenario below, the auto and RV rates were increased 50 basis points (bps).  All other loan rates were unchanged.  From a big picture risk perspective, the results dashboard below shows what this could look like compared to the current base analysis.  Note that every metric is improved over the base simulation.

This would also move most of the auto and RV categories into a positive earnings position.  Increasing rates could still result in some loan categories remaining unprofitable, but if growth slows, liquidity should improve.

Another alternative could be to continue aggressively booking auto and RV loans, and buy time from a liquidity perspective by leveraging the credit union’s balance sheet and net worth by adding borrowings.  In the scenario below, a total of $50M in autos and RVs was added at a yield 10 bps higher than the base case, funded with $50M in 2-yr borrowings.  The results show that some of the key metrics are weaker compared to the base case, and the credit union has used $50M of its available borrowing capacity.

So what steps should this credit union take?  While the results may seem clear, it is complicated as there are many nuances with these kinds of decisions.  Having the appropriate analytics to help answer questions like these is a great place to start.  However, engaging in strategic conversations with the key decision-makers is just as important.  Potential questions could be:

  • What are the risks of each path?
  • How could each path impact members, employees, dealer relationships, or overall financial position?
  • How could each answer be impacted if things don’t go as planned?

These are just a few of the questions that should be considered, among others.  Whether or not your credit union has liquidity pressure, understanding profitability is important business intelligence.  When liquidity is challenged, having and using that information is even more critical.

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Transforming from Operational ALCO to Strategic ALCO – Let’s Get Started!

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Being an Asset/Liability Committee (ALCO) member is one of the most exciting roles in the credit union.  If you have the urge to roll your eyes right now, read on.  Asset/liability management (A/LM) touches almost every area of the credit union and connecting all those dots is not only exciting, it can be hugely impactful.

The main reason ALCO meetings have a reputation for being boring is that more time is spent looking back at what has already happened than looking forward; data is reported and boxes are checked.  Sometimes the data is difficult to connect to the real world.  What’s needed are better methods of discussing decision information and more forward-looking strategic focus.

The ALCO absolutely needs to handle operational and reporting tasks, but minimizing time spent on the operational tasks will free up time to consciously attend to strategy and the future.  Chances are that the ALCO is already looking forward to some degree, but purposefully choosing the most relevant questions and spending quality time can boost the depth and effectiveness of those discussions.

There are countless potential strategic questions for ALCOs to consider.  Here are a few that can better link information from various areas for a more holistic decision-making view.  Remember to continuously connect the credit union’s strategy to the discussions at hand:

  • Are potential future changes in the environment actively considered and are decisions made to prepare for, react to, or monitor them? For example, should we adjust our balance sheet structure to prepare for a recession?  What are our next steps if the liquidity crunch worsens?
  • Do we know where the strategic plan leads from a financial perspective, not just for the next year, but over the longer-term time frame of the strategic plan? Is the resulting balance sheet structure, risk profile, expense structure, etc. consistent with where we want to go?
  • Do we consciously ensure that strategy drives our A/LM decisions? For example, if our target market is working families and we don’t want to take on additional interest rate risk, should we slow mortgage production or should we consider selling mortgages or offsetting risk elsewhere in the structure so we can continue to make mortgages?
  • Are we linking data from other areas to A/LM? Do we understand the demographics of our different types of depositors and borrowers?
  • Are we actively considering rapid changes in the payments arena and anticipating how to retain and/or replace payments revenue? What does our data show in regards to the shift to mobile payments, changing behaviors in members’ credit card and debit card usage, and usage trends by demographic groups?
  • Do we know how delivery channel utilization is changing and have we considered how that is impacting our financial structure? For example, are we clear on how expansion of the indirect channel impacts average deposit balances and metrics such as products per household?
  • Have we quantified our aggregate risks and strategic opportunities to fine tune our strategic net worth requirements?
  • Do we understand, not only where risks lie, but how to balance risks with rewards? For example, do we know how high rates need to go before our mortgages or autos will become unprofitable?

Even people who dread the numbers can bring purpose, effectiveness, and impact to the ALCO.  As the mindset shifts from operational to strategic, ALCO meetings will become more exciting, but the biggest rewards are reserved for the credit union as a whole and its members.

We’re so excited about building more strategic ALCOs that we’ve actually created an education course for just that purpose.  Click here for more information.

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Navigating a Flat Yield Curve

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As the New Year gets underway, management teams and CFOs have already started thinking through the various x-factors that could impact earnings in 2019.  At the top of the list for many decision-makers is a flat yield curve.

The potential of a flat Treasury yield curve has been looming for quite some time.  In February 2018, one of our blog posts addressed how credit unions were finding opportunities in a narrowing yield curve.  Since then, short-term rates have continued to increase, while long-term rates have decreased, resulting in a nearly flat Treasury yield curve.

While a flat Treasury yield curve can put pressure on earnings, credit unions are still proactively searching for opportunities within this rate environment.  In particular, some institutions are viewing a flat yield curve as a great opportunity to restructure or tilt the balance sheet based on their interest rate risk profile.  Below are a few examples.

Consider a credit union that feels it is positioned well for the current and down rate environments, but is concerned about its risk if the rate environment were to increase materially.  The credit union focuses on the investment portfolio in which it could reinvest excess liquidity into longer-term agencies, as it has done for years, or keep the funds in overnights to offset the risk of rates rising.

Years ago, the credit union would have been giving up a lot of earnings by not reaching out on the yield curve.  The yield curve and rate environment reflect a different picture today.

Assuming the credit union is comfortable with the risk/return trade-off should rates head back down, current rates provide a unique opportunity to shift the balance sheet, lowering risk in higher rate environments without giving up much in earnings today.

Credit unions are also closely evaluating their lending strategy in this unique yield curve.  Similar to the investment example above, years ago some credit unions gave up a lot of revenue focusing only on auto loans, ignoring mortgages.  However, this is a new rate environment and yield curve.  Mortgage rates have decreased over the past few months and some credit unions are discovering their auto new volume yields are actually higher than mortgage yields.  After incorporating credit risk, it could be a situation where the net yield (yield – credit risk) is roughly the same between the two products.

Given the +300 basis point value change and interest rate risk that often comes with mortgage loans, the table below helps show how autos can have a materially better risk versus return trade-off in today’s economic environment.

Regardless of the rate environment, decision-makers need to understand environments where they are positioned well and the potential weak spots.  Opportunities can be found with a good understanding of the risk profile.

The following blog post was written by c. myers and later published by CUES on February 14, 2019. 

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Moving Forward with Strategic Implementation

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Now that the beginning of the year is upon us, many of the key projects that came out of strategic planning in 2018 are kicking off.  It’s an exciting time!  Unfortunately, not all of those key projects will be completed successfully, many will result in schedule and budget overruns, and some will extract significant pain and suffering from project teams.

Most leaders would say that strategic planning is key to moving their organizations forward.  They also understand the importance of implementing the projects that will transform the strategic direction into reality.  So why isn’t it easier?

Some common reasons that are cited:

  • Other unexpected things came up
  • Not enough resources
  • The day-to-day got in the way
  • The project was bigger than realized
  • Off-track due to vendor schedules

If any of this sounds familiar or if you feel your organization needs a tune-up in the strategic implementation area, here are a few key principles to focus on:

  • A strong project portfolio management process – A clear process for how strategic projects are initiated, vetted, prioritized, monitored, and closed out is a recipe for success. This also helps with resource capacity by providing a big-picture view that can highlight resource shortages
  • Scheduling time to initiate implementation as a part of strategic planning – Strategic planning does not occur in a bubble. It is known that strategic implementation follows on the heels of planning, so schedule time right afterward to begin hashing out high level plans.  The planning session will still be fresh in everyone’s mind and it’s early enough to make adjustments if needed.  This is also the time to research how vendor schedules could impact your plans
  • Front-load project planning – Resist the temptation to skimp on project planning in favor of jumping in to get started on big projects. Time spent up front on detailed planning results in more realistic scheduling and helps uncover snags early, paying big dividends in the end
  • Prioritize – Often there are more projects than there is time or resources to accomplish them. Prioritization is the key to getting the project list under control, along with a willingness to say no or not now to some projects
  • Remain nimble with conscious decision-making – No matter how much project planning is done, the world will throw in some curve balls or unexpected opportunities. With a strong project portfolio management process, good project plans, and clear priorities, adjusting to changed circumstances is easier.  The effects on resources and timelines is clearer and conscious decisions can be made on how to shift or reprioritize projects

Strategic implementation goes hand-in-hand with strategic planning, is integral to the success of the strategy, and should receive as much thought and attention as the strategic plan.  Strong organizational focus on strategic implementation will go a long way toward making your strategic plan a reality.