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PLL and Managing Expectations

The most recent 2012 NCUA data shows that year-to-date, about 29% of all credit unions have run either a zero or negative provision for loan loss, due primarily to overfunding of the allowance.  The bulk of these credit unions were smaller in terms of asset size. Filtering to credit unions with assets over $500M, the answer is 5%.  Knowing that, it might be easy to infer that the abnormally low provision for loan loss is a small credit union phenomenon, but that is not necessarily the case. While the smaller institutions may have seen the more extreme swings in provision, recent data also shows that about 53% of credit unions over $500M have benefited from a provision for loan loss below 30bps (remember that in the exuberance prior to the credit crisis, PLL averaged 30-35bps).

The drop in PLL expense has helped offset the squeeze in margin that many credit unions are experiencing.  This leads to the question:  Can such a low level of expense be sustained in the future? Looking forward, credit expenses are likely to go back up as many institutions have delinquency and charge-off ratios that materially exceed provision for loan loss.  Managing board expectations in this regard is important.  Boards need to understand the impact of allowance overfunding and how it influences net income.  One simple step to address this would be to compare end-of-year provision for loan loss to actual charge offs.  Another option that could provide more detailed information would be to take your current level of charge offs and run out your budget with charge offs in place of provision for loan loss.  These analyses would help a credit union’s management and board to get a better feel for the sustainability of earnings once the ALL is no longer overfunded and PLL starts to rise.

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Planning For PLL

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Given the economic experience of the past couple of years, many credit unions were forced to beef up their loan loss reserves.  Now, as things appear to be getting better, we are seeing that some credit unions feel they are “overfunded” and are not adding to their reserves.  While this may provide some temporary relief to earnings, credit unions cannot plan their long-term business models on the fact that there is no PLL expense or, in some cases, that the expense is negative.

Credit unions have worked hard in this environment to define their target markets, focus their efforts toward them and have learned to do things more efficiently. They should enjoy this brief reprieve.  However, credit unions should not become complacent.  Rather, they need to continue efforts to position themselves to be better and stronger in the future.

As far as modeling goes, assume that the PLL expense is at the level expected after the allowance for loan loss reaches an adequately funded level.  This will provide a more realistic picture of long-term earnings.  From a risk-management perspective, consider the experiences from the last couple years in making assumptions about worst-case credit risk exposure, not only from loans but also from investments.