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What-If Analysis In The Decision-Making Process – Test Your Hypothesis

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Performing what-if analysis is an integral part of both the A/LM and budget processes. When used correctly, what-if analysis is a powerful way for decision-makers to understand the impact of items under consideration in real-time. The challenge is that often people dive right into modeling and results, producing a less than optimal process. Consider applying a scientific method to the what-if analysis to help strengthen the decision-making process.

The scientific method is essentially a hypothesis-driven methodology. Strong hypotheses lead to expectations either supported or refuted by analysis. What does this all mean? Well, it isn’t as intimidating as it might sound. From a financial modeling perspective, it means don’t just blindly rely on model results.

To help explain this concept further, consider a $1B credit union evaluating a strategy of moving $10M from overnights into 30-year fixed-rate mortgages:

What-If Analysis Test Your Hypothesis as Part of Decision-making Process

 

Before performing a what-if, the scientific method suggests that you first ask what you expect the results to look like, and then create a hypothesis. Start broadly with what you generally expect to happen to earnings in the current rate environment and the risk. In this case, the shift from overnights to mortgages should help earnings in today’s rate environment, adding risk as rates rise.

After identifying the broad expectation, take the next step and do some rough math to estimate the return on assets (ROA) impact of the what-if. Here, a $1B institution testing a strategy of moving 1.00% of its assets could expect a 3-basis-point improvement in the initial ROA (1% of assets multiplied by a 3% increase in yield):

What-If Analysis Testing Your Hypothesis as part of decision-making process

 

On the risk side, you can do the same with the impact to the net economic value (NEV) dollars since understanding the valuation impact is relatively straightforward. Overnights are at par in all rate environments while brand new 30-year mortgages devalue about 20% in a +300 basis points (bps) rate environment. Therefore, you’d expect to see a roughly $2M decrease in your NEV dollars in the +300 bps rate environment:

What-If Analysis as Part of the Decision-making Process Test Your Hypothesis

 

Analysis and observation are the next important steps in the scientific method. Run the what-if through the model and analyze the results in comparison to your expectation and rough math. Do the results of the what-if validate the hypothesis and, if not, why?

Periodically, results may not match up with the hypothesis, which is okay. It doesn’t necessarily mean the model or the hypothesis is incorrect. There could be other factors impacting the what-if. However, it is important to figure out why the results do not match up, especially if the difference is due to an input error.

For the example above, consider some of the following questions that could affect the what-if, causing the hypothesis and results not to match:

  • What was the credit risk assumption?
  • Will additional operating expenses and/or marketing dollars be needed to attract the growth?
  • Did we incorporate any fee income for the closing costs?
  • How long will it take to increase the portfolio $10M?

 

When it comes to the what-if process, shortcuts should not be taken. Always create an expectation internally before relying on model results. Depending exclusively on model results puts the user at risk of input errors and/or an inability to effectively explain what-if results.

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Hidden Cost of Addressing Liquidity Needs

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Loan growth is a good thing, but when it outpaces deposit growth, liquidity pressures start to build. If your credit union is experiencing this situation, there are several liquidity options to consider—each of which comes with its own unique trade-offs. Here we look at two of them.

Third-Party Borrowings

Third-party borrowings are a common source of liquidity. If you choose to address your liquidity needs through borrowing, the structure will depend on your specific needs. Do you take a bullet or amortizing structure? A fixed- or variable-rate borrowing? While a longer-term, fixed-rate borrowing costs more than a short-term variable-rate one, it may make sense depending on your needs and objectives. The same needs and objectives should be applied when considering bullet versus amortizing term borrowings.

Beyond the interest cost of the borrowings, on the day you borrow, your asset size increases and net worth ratio declines. The amount you borrow affects this, so think about the impact to your net worth ratio before pulling the trigger on any borrowings.

Certificate of Deposit Promotions

Another approach some credit unions take is to run certificate of deposit (CD) promotions. In the following example:

Assume a credit union wants to raise $20 million by running a CD promotion at 1.75%. If they are successful and bring in $20 million of new money, the promotion costs them an interest expense of 1.75%.

What may happen, however, is that the credit union achieves their targeted dollar amount in the promotion, when in reality some of this money is cannibalized from their existing deposits. In this next example, let’s assume the credit union gets $20 million, but half of the funds move from regular shares to the promotion.

Marginal Cost of Funds - Existing Deposits Graph

Here is the hidden cost: the credit union achieves $20 million, but brings in only $10 million of new money. The increase in interest expense of the dollars moved from regular shares at 0.10% to the promotion at 1.75% must be factored in—considered part of the cost to acquire $10 million of new money. This is known as the marginal cost of funds. The marginal cost of funds will vary, depending on the amount of cannibalization and the rate the funds were formerly earning, but in this case the credit union should view the CD promotion as costing 3.40% rather than 1.75%. When evaluating the promotion in this light, decision-makers are more informed and understand what the actual costs may be.

Regardless of your liquidity situation and how you chose to address it (whether through borrowing, CD promotions, or any of the many other options available to you), it is critical that you do your analysis, understand the trade-offs, and document your short- and long-term objectives.

For more articles about liquidity, click here.

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Three Practical Ideas For Intentionally Strategic Boards

The following article was written by c. myers and originally published in the CUES Professional Development Library on August 14, 2017.

Board governance is a hot topic, as it should be. Effective boards and board members are essential to the success of the credit union industry. And it’s a fact that boards need to continue to evolve to be more strategic as the environment becomes more complex. In the last 10 years, the average credit union asset size has almost doubled, while the number of credit unions over $500 million has increased 80 percent. The resulting growing pains present organizational challenges for boards, just as they do for employees.

As credit unions continue to grow in an increasingly complex and rapidly evolving environment, it is essential that boards do not skim over strategic opportunities and challenges and do not take deep dives into operations.

Many credit union boards have found the following practical ideas beneficial for being intentional about keeping a strategic view:

1.  Rehearse tomorrow today to stay focused on the future

High performing boards are doing more of this. Changes in the environment, especially competition and technology, are coming so fast that boards need to constantly be thinking ahead. This exercise is deceptively simple, but it can build strategic thinking skills while helping position the credit union for the future. All it involves is creating a future scenario and thinking through how the credit union could respond.

For example, the driverless automobile is likely to set off an avalanche of change over time. To explore this more deeply, create a scenario, such as, “It is the year 20xx and X percent of vehicles on the road are self-driving.”

Hint: Use a percentage that is significant enough to push the group’s thinking but not so big that it will be dismissed as inconceivable. Have some questions ready to guide thinking, but also use some open-ended questions. Then ask, “Is there anything we should be doing today to prepare?”

There are many scenarios that challenge credit union business models and make great candidates for rehearsing tomorrow today. In the example above, an institution that is reliant on auto lending should be asking whether driverless automobiles will reduce auto loan demand and, if they will, how the credit union will shift its business model to make up for lost revenue. It’s also important to ask how driverless automobiles could benefit the business model. Thinking in advance about opportunities is as beneficial as thinking about challenges.

The goal isn’t to come up with the “right” answers, but to think through the possibilities. The only wrong answers are those that assume that the scenario will never happen, or that the credit union will magically be fine without coming up with some specifics on what would need to change.

2.  Establish a common understanding of what is strategic and what is not

As a group, create examples of strategic and operational items. This often results in productive conversation that furthers everyone’s understanding. The list can also become a tool to help with onboarding. Another important step is to create working agreements about how the group will handle operational conversations. For example, a working agreement could state that as soon as conversation becomes operational, anyone in the group can interrupt to bring it back to a strategic level. Another working agreement could be that when there is a good reason to dive into operations, the speaker should explain why.

3.  Determine whether the committee structure is contributing to an overly operational board

In the past, for very small credit unions, it might have been appropriate for the board to be involved in some operations. This is extremely rare now, but these types of legacy committees sometimes persist, even though the purpose is no longer appropriate for the board. Review committees with an eye to whether their functions are too operational and make changes, if needed.

There are only so many hours a board member can devote to the credit union. Every moment spent on operations is time taken away from strategy, which is where the board can bring the most value. Boards need to remain ever-mindful of the road ahead and the far horizon, spend a minimum amount of time looking in the rear-view mirror, and provide guidance to management so they can do what they do best.

C. myers is a Phoenix-based firm that has partnered with credit unions since 1991. The company’s philosophy is based on helping clients ask the right, and often tough, questions in order to create a solid foundation that links strategy and desired financial performance.

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Balancing Credit Union IT Projects Using A Member-Centric Approach

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Technology innovation is exciting!  The newest technologies can change credit union business models, create a new customer experience, improve service, and reduce costs.  Consumers have more choices for ways to conduct their financial transactions than ever before, and we are a culture that values choices.

Leaders face questions about how to best utilize the credit union’s limited resources to keep up with the newest technologies, while having to make educated bets on which ones will survive long term.  In many cases, implementing new technologies does not mean replacing and removing older technologies (e.g., the costs for new technologies are not being offset by retiring old technologies).

For credit unions, navigating today’s digital transformation can be challenging.  Consider payment processing where a wide array of products are available including, among others,  checks, ACH, wire transfer, debit card, credit card, bill pay, interactive voice response (IVR), remote deposit capture (RDC), PayPal™, Apple Pay®, mobile wallets, person-to-person (P2P), Bitcoin, etc.  Many of the newest technologies are growing in acceptance rapidly.  Older payment methods, like paper checks, also continue to have a following even though they’re clearly less efficient for the credit union, the member, and the payee.  In fact, some innovations in recent years have focused on making paper checks more efficient, while other innovations look to supplant paper checks altogether.  As shown below, while declining materially, check volumes continue to be a significant number of payment transactions.

Chart by Bloomberg News shows decline of check usage worldwide in favor of newer technology

Both new and legacy systems require development and infrastructure for ongoing support, as well as integration to work together seamlessly with the member’s account. Front-line staff need training to support every product. As members’ expectations drive new technology, what can credit unions do to prioritize their portfolio of projects and limit their support of legacy services?

A member-centric approach can be the foundation for establishing the long-term technology strategy and making tough technology decisions. As credit unions are compelled to invest in a broader array of products to serve members, a parallel effort to better understand member demographics and behaviors can serve as a navigation beacon. By deepening the understanding of the membership and the target market, credit unions can be better prepared to simplify and narrow their product offerings while maximizing member service. It begins by gathering relevant data.

What are the utilizations of the credit union’s products? Typically, it’s a straightforward exercise to determine the number of transactions that occur for a particular product. Does the credit union have this information for all of the product offerings? Is the number of transactions increasing or decreasing over time? What is the trend of utilization? Are there products today that are minimally used by the membership? If so, what is the cost of that ongoing support (i.e., technology support, front-line support, training, risk, etc.)?

Beyond general utilization metrics, which members are using the products? This information requires more effort, but the value can be significant. By understanding which products and services members use, analytics can be applied to assess each member’s overall participation in the cooperative while identifying opportunities to increase engagement. By associating usage with individual members, data can be further refined by demographic segments, revealing which segments are using products more or using them less.

Armed with a better understanding of their membership along with their preferred products and behaviors, the credit union could then look to its target market strategy. Where will membership growth come from? How does the credit union market to acquire new members? What is the ideal product suite to support the credit union’s target market? By blending a deeper understanding of the credit union’s unique membership and target market, credit unions can better inform their long-term technology strategy.

For some credit unions whose membership is comprised of more early adopters of technology, this analysis will confirm the need for strategy to address quicker implementation of new trends. For others, continued investment in maintaining and integrating legacy systems may need to remain a key focus. In either case, the credit union could begin making decisions today to promote certain technologies in support of their target market, while establishing longer-term objectives to retire other products and services that are waning in use and not aligned with the credit union’s future strategy.

Managing the portfolio of current and potential projects to keep up with technology can seem overwhelming. Technology and member expectations are moving fast, and member expectations are being influenced by experiences in all their consumer activities, not just financial services. The environment today is creating greater challenges for leaders to make effective, timely technology strategy decisions. By remaining member-centric and developing a deeper understanding of member and target market behaviors and expectations, credit union leaders can be better prepared to successfully navigate technology strategy and associated decisions.

 

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Are Today’s Borrowers Finding Your Credit Union?

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Today’s buyers shop differently than in the past. As the first generation of digital natives comes of age and begins to seek loans in earnest, research shows that they go about the buying process differently than previous generations, doing more research and getting more recommendations before interacting with sales people. The Zillow Group Report on Consumer Housing Trends (2016) provides the following insights into the home buying process specifically, but it seems likely that many of the conclusions from the home buying research could be applied to consumer borrowing, as well.

Half of home buyers in the US are under 36 years of age. Half. 42% are Millennials, age 18-34.

In many ways, younger people’s borrowing behaviors don’t vary much from previous generations. They still want to work with agents and value private home tours. But some of the areas where they differ can be useful when rethinking how to reach them. It’s interesting to compare the two biggest generational groups by population—Millennials and Baby Boomers—to highlight how things are changing. When it comes to finding a lender, it’s no surprise that Millennials use online resources more heavily than Baby Boomers, but some of the other areas of resource usage may be more unexpected:

The Zillow Group Report on Consumer Housing Trends

How visible is your credit union to Millennials when they are tapping into these resources?

Millennials use more resources to educate themselves and do more research on agents and lending professionals than any other generation. They make more use of interest rate and affordability tools and mortgage calculators. Are your tools easy to use? Are Millennials finding good content from your credit union as they do their research?

The sheer number of Millennials makes this group hard to ignore, but there are surprising statistics from the study that relate to loyalty—the thing that Millennials “just don’t have” according to some.

Important attributes when selecting a lender:

Important attributes when borrowers select a lender

Before you can build loyalty, you have to be seen. Remember that research is key for Millennials, so making sure that your credit union is visible, provides useful content, and offers easy-to-use tools is important. At the same time, they’ll be looking for positive online reviews as well as referrals from people they know—so fast, friendly, and effective processes are required. Doing an outstanding job for this group might not only help profitability today, but could serve to build member loyalty for years to come.