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Shrinking Margins Yet Higher ROAs? The Sustainability Question…

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Unsurprisingly, many credit union leaders continue to watch their net interest margins erode in this continued, low rate environment. In fact, net interest margins have dropped to levels not experienced in over 20 years, dropping below 3% throughout all of 2012 trending down to 2.93% as of December 31, 2012 according to NCUA aggregate data.

What can be surprising is the improvement in ROA reflected in NCUA’s aggregate data. Let’s examine how much better ROA actually is compared to December 2011. While many will point to the overall ROA, it’s interesting to examine the difference if you ignored the impact of stabilization expense and NCUSIF premium. The improvement in ROA year-over-year as of December 31, 2012 is only 7 bps compared to an almost 20 bp improvement if you factor in the decrease in these expenses.


Regardless, with margins continuing to decline, how sustainable are current levels and trends of increased ROA? As you review financials within your ALCO, consider the following objective:

Communicate the impact of components of earnings that have experienced aberrations. Adjustments demonstrate the difference between the earnings reported on financials and the earnings that can be considered core to the institution.

Following are a few examples of aberrations that may be inflating ROAs unsustainably:

  • Record levels of mortgage originations/sales
  • Unsustainably-low PLL
  • Gains from the sale of investments?

2013 budgets may plan on some or all of these things continuing. Consider stress testing the budget to see the effect if these items do not continue. Furthermore, go beyond one year and stretch out the budget where 2014 and beyond does not count on these items continuing; this can help uncover a potential squeeze to earnings. Then test the impact to the risk profile of this future position.

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Yield on Assets—How Low Can it Go?

How does net income look for 2013?  Even if your budget is showing satisfactory earnings you might not be out of the woods yet.
Earnings could be temporarily propped up by higher yielding loans and investments put on the books in years past.  Unsustainably low provision for loan losses could also be skewing the picture.
Consider doing a long-term forecast to see how the business model performs after higher yielding loans and investments mature.  We would recommend a forecast of at least three years.  This does not need to be a three year budget; simply use high level operating expense assumptions in years 2 and beyond.
If you are not sure you want to invest the time to create a long-term forecast, minimally invest 15 minutes in your next ALCO meeting working through an estimate of new business profitability using the New Business Calculator.  Populate this with rates on loans and investments that are currently being booked (not year-to-date yields) for a preview of where earnings could be headed once higher yielding loans and investments mature.  The earlier you can spot trouble ahead, the sooner you can act to head it off.
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Are You Feeling Liquid?

It may be the last thing you think you need to worry about—needing liquidity.

However, the things furthest from your mind could be the most important to think about in the risk management process.  Risk management is, in part, an exercise of thinking about and preparing for the unexpected.  When was the last time threats to liquidity were discussed in your ALCO?  What could lead to a bad liquidity scenario?  What could be the impact to earnings and net worth in this bad liquidity scenario?  When was the last time contingency liquidity sources were tested—not just for availability but operationally?  It is no different than having a backup generator for power.  Having it is good but making sure it works is the critical part.

While low loan growth and too much liquidity are more common topics right now, it is important, at least annually, that the ALCO discusses contingent liquidity and the results from testing contingency liquidity sources.

In liquidity modeling and discussions it is important to consider the impact of the investment portfolio.  Some credit unions are purchasing longer investments, many of which are not amortizing and/or have optionality (prepayments, call features, etc.).  The risk management process should consider the cash flow and earnings implications, including:

  • What if these bonds do not get called (or prepay) as expected?
  • What is the potential impact on liquidity?

It is common for credit unions to assume they will be able to liquidate their bonds if needed.  It is important to consider the implications of not being able to sell them in a timely fashion or the financial impact of selling them at a loss, such as after a rate increase.