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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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c. notes – Aggregating Risks to Inform Strategy

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To remain successful as the world changes and becomes more complex, risk management processes must keep pace.

Risk management begins with identifying and quantifying strategic risks. An effective process also recognizes that it is not adequate to only quantify and understand risks in silos. Risks should also be quantified and understood in aggregate. As history repeatedly taught us, bad things don’t usually happen in isolation.

Understanding and communicating risks in aggregate allows decision-makers to evaluate if the credit union is taking on too much risk, or if the credit union may be poised to strategically accept more risk. Also note that understanding risks in aggregate permits management to consider the credit union’s capacity for strategic opportunities; strategic risks and opportunities are two sides of the same coin.

To continue reading, please visit the article here.

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Aggregating Risks To Net Worth—The Credit Risk Component

During a recent education course, we fielded the following question:  “How do you develop a proxy for a worst-case loan loss assumption when aggregating risks to net worth?”

This is a great question and it stimulated lively discussion.  While there is not one right way, the following method has been valuable in developing concentration risk limits designed to address credit risk.  This method looks back over a specified timeframe (a common, initial look-back is 5 years) and identifies the 6- or 12-month period that experienced the highest annualized loss rate for each loan category.  Each rate is then applied to the current balance of each respective loan category and totaled to come up with the dollars for the total worst-case loan loss assumption.  Frequently, a factor is added to answer, “what if we had to absorb losses beyond our worst historical experience?”  Common factors include increases of 33%, 50%, or even 100% above the worst historical experience.

With many credit unions having just come out of their worst credit loss experiences in memory, this method captures and utilizes the information gained during that environment.  This method is easily reproducible on a periodic basis and can be re-evaluated annually to ensure that the risks are sufficiently captured.  As time progresses, and as loss histories for various loan categories continue, the loss rates may need to be adjusted to account for new loss experiences in order to keep the spirit of capturing a “worst-case” environment.  This process will help to ensure that a credit union’s management and board do not lose sight of the credit union’s worst credit loss experiences.

Whether or not the above methodology is utilized, one thing is abundantly clear—documenting the rationale behind a worst-case loan loss assumption is an absolute must!