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Recent Uncertainty Highlights The Importance of Evaluating Strategic Net Worth Requirements

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The rapidly changing competitive environment and recent natural disasters are reminders of the importance of evaluating strategic net worth requirements.

Natural disasters, like the recent string of hurricanes that impacted the country, contribute to uncertainty and highlights the need to evaluate strategic net worth requirements.

A key component to understanding strategic net worth requirements is taking a deliberate approach to understanding aggregate risk.  In a previous blog post we outlined an approach to help with this process.

Two types of risks that should be included in any effective aggregate risk process are interest rate risk and credit risk.  While these two key risks need to be addressed, growing concerns on strategic risks to future earnings streams should also be discussed and incorporated into the aggregate risk estimate.

For instance, think about the potential reduction in future earnings as consumer usage of real-time financial management self-service alerts that can curb their spending increases.  And options for how consumers pay for their purchases continue to rapidly expand beyond the traditional financial services industry – Amazon could be the next big player in this space.

The Current Expected Credit Losses (CECL) standard is another example of how the environment is changing.  CECL should not be viewed as just an accounting issue because it has the potential to impact both earnings and net worth.  While 2021 may seem like a lifetime away, it is critical that decision-makers understand their credit union’s capacity to handle the impact of CECL.

Remember that being within individual risk limits does not necessarily indicate that the credit union is safe and sound.  As history repeatedly teaches us, bad things don’t usually happen in isolation.  The few pressures described above can occur while an unforeseen event comes out of left field, such as the Equifax data breach.

Another example of an unforeseen event is the string of natural disasters that have impacted the country in the past few months.  For those affected, it is still too early to understand the fallout from these events.  However, it is an unfortunate reminder that the unexpected can happen, and the net worth needs to be able to handle multiple risks happening simultaneously or bear the brunt of cascading events.

None of the risks above are easy to quantify, but that doesn’t mean risks should not be aggregated to gain an understanding of the aggregate risks relative to net worth.  Starting with a list of your management teams’ top concerns is a great way to get the ball rolling.  Keep in mind that the chance of being “exactly right” on your credit union’s aggregate risks is slim to none.  The value is in the strategic discussions and the allocation of net worth to strategic threats and unforeseen events.

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Strategic Questions around Indirect Auto Lending and Member Growth

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How does your credit union define success when it comes to growth?  For some credit unions it might be asset growth, growth in loans, or growth in membership.  If one of your credit union’s key strategic objectives is growing membership, having the business intelligence to understand where new members are coming from becomes important.  This blog will focus on strategic questions to consider regarding the impact of new member growth through indirect channels.

Couple reviewing car loan information while shopping for a new car at automotive dealership.

For many credit unions, a large percentage of membership growth in recent years has been driven by indirect members. The credit union demographic data noted below shows that between ages 30-70, the years when members do most of their borrowing, more than 50% of the total growth in members in 2016 came through the indirect channel (see the highlighted line in the second table). This information is noteworthy because this credit union has a strategic objective of deepening relationships with members as measured by products per member, and growth in indirect members may be at odds with that objective.

Tables breaking new direct and indirect credit union members by year & age

Growing indirect members is not necessarily a bad thing – in many ways the growth can be positive if the growth in members (and therefore loans) is managed appropriately.  The key is to answer strategic questions and gain clarity on how indirect member growth impacts the credit union and its metrics.

Some strategic questions to consider:

  • How does growth in indirect members impact metrics such as products per member, and is growth from indirect members segregated appropriately when looking at metrics?  Increasing products per member would be significantly impacted by a majority of new member growth coming through the indirect channel.
  • How do new indirect members fit within the description of the credit union’s desired target market(s)?
  • How does indirect member growth support the long-term sustainability and strategy of the credit union?
  • What is the credit union doing to market other products to the indirect members, and has it been effective?
  • How many hours and dollars are spent trying to get those new indirect members to do additional business with the credit union?  Can you quantify if those investments are paying off?
  • How many indirect loans are actually made to current members versus non-members?
  • If the credit union slows indirect growth for strategic reasons, or if auto sales slow, how will that be accounted for with respect to goals of membership growth, products per member, or other metrics?
  • How does fast growth in indirect auto loans impact cross-selling opportunities with indirect members, or with the rest of the membership?
  • Does indirect member growth create a false sense of security in metrics such as membership growth or loan growth?

Test driving some of the asset/liability management implications can be a good exercise as well. For example, if your credit union is heavily reliant on indirect auto lending to sustain the business model, imagine a scenario where market rates for deposits begin to rise. If your credit union has to increase deposit rates in order to maintain liquidity, can rates on indirect autos be increased enough to maintain margins given the competition for indirect lending in your market(s)? If not, how is the lost income replaced?

Having appropriate business intelligence in place can help alleviate some of the strategic challenges that rapid indirect member growth can create.  Be clear in how you count new members and how your credit union could manage through a changing indirect auto environment.  This can help ensure the credit union remains relevant and sustainable over the long term.

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Concentration Risk Limits on Mortgage-related Assets and the Unintended Consequences

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Not all mortgage-related assets are created equal.  Therefore, using a one-size-fits-all approach in establishing concentration risk limits can lead to missed opportunities or a false sense of security.

Concentration risk policies are intended to reduce the impact a risk event could have on a credit union’s balance sheet, financial structure, and/or business model.  The NCUA cites the Basel Committee on Banking Supervision when defining the concept, stating:

A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution’s health or ability to maintain its core operations.

An effective risk management policy and process should incorporate an understanding of the aggregate risk exposure present in a credit union’s financial structure. This is key to ensuring that the overall risk level in the credit union’s financial structure does not exceed the institution’s risk threshold, nor does it place the overall health or viability of the institution at risk.

Concentration risk limits on mortgage-related assets and their unintended consequences on a credit union's balance sheet, business model and/or financial structure.

Supplemental to an effective aggregate risk management process would be limits on certain key areas, or “hot spots,” that fit the definition of a risk concentration, as referenced above from the Basel Committee. Frequently, mortgage-related assets are lumped into a single category and defined as a risk concentration based upon the underlying collateral (mortgages). However, the risk present across all types of mortgage-related assets is not the same. Consider the risks present in:

Some of the above carry liquidity risk, some carry credit risk, others carry interest rate risk (IRR) – and some carry a little of all the listed risks. However, the degree of risk is different for each. The interest rate risk profile of a floating-rate collateralized mortgage obligation (CMO) is materially different than that of a 30-year conventional mortgage. The liquidity risk in a 50% LTV first lien HELOC with a 15% average utilization rate is materially different than the Government National Mortgage Association (GNMA) mortgage-backed security (MBS) pass-through.

Part of an effective overall concentration risk management policy is to document the risk(s) addressed by a particular limit. Instead of setting a single limit on all mortgage-related assets, management teams should invest the time it takes to identify the risk(s) across all types of mortgage-related assets, and set limits where it is determined a concentration exists. As mentioned above, setting a single limit on mortgage-related assets can lead to missed opportunities or lull decision-makers into a false sense of security. Having a robust process to identify and manage the aggregate exposure of risks that could significantly threaten a credit union’s net worth is a critical component of the asset/liability management (A/LM) process.

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Driverless Car Innovation Drives Impact on Financial Services Industry

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It’s not too soon to start thinking about the possible strategic implications of driverless cars and driverless car technology on the financial services industry. Billions of dollars are being invested by numerous companies and sectors to propel the use of driverless technology.

Self-driving or driverless car technology has an impact on the financial services industry.

The impacts can be far reaching. To leverage possible opportunities requires advanced critical and strategic thinking. We thought the article 24 Industries Other Than Auto That Driverless Cars Could Turn Upside Down, by CB Insights, would help jump-start your critical thinking.

Remember, all advancements come with tremendous opportunities. Your job is to find and leverage them!

Read more about the mix of technology and the credit union industry in our blog archive.