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Strategic Budgeting/Forecasting Questions: Linking the Appetite for Risk

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The fifth entry in our 6 blog series about Strategic Budgeting/Forecasting Questions addresses the institution’s appetite for risk and how it should connect to the budget or forecast.

Question 5 – How is the budget and forecasting linking to our appetite for risk?

A few short months from now, every credit union will be going through the annual ritual of creating a budget for 2018.  Many leaders and boards not only struggle with this process, but may also consider it a drain on resources and time that take away from more important day-to-day business.  And yet, looked at from a long-term strategic view of the organization, strategic budgeting and forecasting is a key component of a high functioning organization.  Even so, one way boards and credit union leaders can make this coming year’s budget even more effective is to align the budget and forecasting with the credit union’s appetite for risk.

Step back and think through last year’s budgeting process and ask yourself some of the following questions:

  • Did you adequately capture the credit union’s appetite for risk and align the budget to support that appetite?
  • What are your concerns (both internally and externally) and are they being appropriately built into the budget?
  • Are your forecasts aligned with the risks that the credit union is willing to take?

Take, for example, a credit union that goes through a typical “Appetite for Risk” exercise and arrives at the end of the exercise realizing that there are some opportunities to take on additional interest rate and credit risk.  Further, consider that this credit union, like many others, wants to maintain their current earnings.  Given the relevancy concerns noted in the following table, taking on some of this credit risk might well serve some of the needs this credit union has.

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As you put yourself in this credit union’s shoes, consider some specific challenges that will play into their budget as they look to align their risk tolerances with their annual forecasts:

  • Does the budget account for potential increases in lower quality paper and additional losses from bringing on more credit challenges?
  • Do the yields on these loans adequately cover the additional risk the credit union is willing to bring on and are they being built into the budget?
  • If this credit union decides to combine some additional credit risk with some additional interest rate risk, will either of these impact the credit union’s current earnings?

Now, imagine if you have already walked through the multiple steps and questions required to analyze taking on additional credit or interest rate risk and you feel well positioned to move forward and finalize your budget.  Additionally, you feel as though you’ve fully vetted the budget for any potential weaknesses and believe that it’s aligned both with the credit union’s current strategy and appetite for risk.  At that point, the next logical question then becomes:  What’s next?  How do you really know if your budget and the things you are planning for are aligning with the appetite for risk?

Outside of letting the budget play itself out and seeing if it comes to fruition, one effective way of analyzing its potential impact on the organization is to test the budget and its assumptions in your risk model.  To do this, have the starting point of the risk model be the ending targets of the forecast.  This process can help you evaluate whether the forecast is adding too much risk or leaving room for more risk, enabling decision-makers to see and sign off on the potential risk before it is actually added to the structure.  It goes without saying, but it’s a lot easier to say no to a budget ahead of time than it is to unwind risks after they are added to the structure.

In effect, a process of presenting a budget along with the simulated risk, enables you to rehearse tomorrow today.  Doing so will position the credit union to be in a much better strategic position going forward.

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Investment Strategy: Consider Income Volatility vs. Yield

Increase in loan-to-asset ratios along with the potential for higher market interest rates and tighter liquidity heighten the importance of the investment strategy and its role in supporting a credit union’s overall business strategy.

Understanding income volatility versus yield can be valuable in establishing investment strategy. Below we are illustrating the point using two investment strategies with similar yields while exploring volatility in various rate increases. This concept can also be applied to individual investments.

The illustration below complements concepts featured in the February 23rd blog, Don’t Just Focus on Interest Rate Risk – Yield Matters.

Again both investment strategies have essentially the same yield today. Additionally, they have very similar income volatility as a percent of yield in a +300 rate environment.

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At this point, when deciding between the two strategies the credit union would view the decision as a coin flip or slightly tilted to Investment Strategy #1.

But let’s not stop there. Every credit union has a unique appetite for risk and expectation for rates. Beyond evaluating risk in a +300, if a credit union is focused on a +100 bp increase in rates, then they would also want to evaluate the risk/return relationship in a +100 rate environment.

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Considering the risk/return trade-off is similar in a +300, but Investment Strategy #2 has less volatility if rates increase 100 basis points, the credit union would determine that Investment Strategy #2 is a better fit overall.

For many credit unions, looking beyond a +300 rate change is an important part of the risk management process, especially considering that a +400 rate environment today could be the +300 rate environment in the near future. Understanding risk and risk/return relationships beyond +300 is good practice.

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If the credit union is actively managing risk through +400, the risk/return relationship shows Investment Strategy #1 to be the best fit.

Creating a table that provides the risk/return relationships for a wide range of rate scenarios can provide better clarity in connecting the investment strategy with the credit union’s overall strategy and appetite for risk.

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Keep in mind there is no “right” answer. What is important is to help key stakeholders easily see the trade-offs.

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Excerpt: The New IRR Rule – Be Prepared

The National Credit Union Administration recently issued its final rule requiring “federally insured credit unions to develop and adopt a written policy on interest rate risk management and a program to effectively implement that policy, as part of their asset liability management responsibilities.  The interest rate risk policy and implementation program will be among the factors NCUA will consider in determining a credit union’s insurability” (p. 5,155).

“Interest Rate Risk Policy and Program Final Rule” is effective as of Sept. 30.  Credit unions over $50 million in assets are required to have a written interest rate risk policy and an effective IRR program.  Credit unions over $500 million can expect their IRR policies and processes to be put under a microscope.  Credit unions from $10 million to $50 million with first mortgage loans and long-term investments equal to, or exceeding, 100 percent of net worth are subject to these new rules as well.

While we are not proponents of more regulation, this new rule provides a great opportunity – even if it is forced – for credit union managements and boards to ensure they are on the same page with respect to appetite for risk, risk quantification methodology and process.  The timing could not be better as we sit in the lowest rate environment our financial markets have experienced since the 1950s.

To read the full article, please see our c. notes page, available here.