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Optimize Your Budget Business Intelligence

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Given all of the time and rigor that typically go into the annual budget process, it makes sense to consider how that process might be improved and generate greater business intelligence for decision-makers.  Beyond creating a base budget, following these 6 steps can help take the budgeting process to the next level and provide leaders a significantly better understanding of potential outcomes.

Diagram showing steps for optimizing your budget business intelligence

1)  Begin with the Baseline Budget
The baseline budget should provide a solid foundation for understanding how the primary strategy is likely to impact financial results.  Building upon the credit union’s strategic directions, the budget assesses the impacts of expected new business goals, deposit generation, investment strategies, non-interest income, and operating expenses.  The budget establishes the fundamental expectations for the core strategy and how it will impact the financial measures for success such as return on assets (ROA) and net worth ratio.

2)  Use a Long-term View
Looking beyond the next fiscal year acknowledges that the budget is not a destination, but a path to the future.  It can be useful to see the longer trending impacts of decisions made today, even while recognizing that uncertainty increases when projecting further into the future.  Our clients tell us they find long-term financial forecasts showing impacts over the coming 3-5 years provide valuable information and an early warning while not wading too far into the uncertain future.

3)  Understand the Impacts of Changing Rate Environments
Asset/liability management (A/LM) should be an integral part of the budgeting process.  After understanding the baseline budget, assess the sensitivity of the budget to interest rate risk (IRR).

This process begins with choosing the market rate assumptions in the baseline budget.  We recommend credit unions develop baseline budgets assuming market rates remain at current levels.  By so doing, the impacts of the strategic assumptions can be isolated from the potential benefit or detriment of changing market rates.  Otherwise, the market rate changes may hide risks and opportunities driven by the core strategic assumptions.

Once the baseline budget impacts are understood in the current rate environment, play through a variety of likely and potential market rate changes, with rates increasing and decreasing, and where short- and long-term market rates move independently (i.e., twisted yield curves).  How sensitive is the structure to those changes in rates?  And what other decisions might be made today that remain consistent with the overall strategy but may reduce potential net income volatility in changing rate environments?

4)  How is the Credit Union Positioned for IRR if the Budget is Successful?
Regardless of how far forecasts look into the future, targets are typically established for the coming fiscal year for measures such as growth in members/assets/deposits, ROA, net worth, etc.  While assessing the impact of changing rate environments along the way, how well-positioned is the credit union for future IRR in 1 or 2 years if the budget is achieved?

Using the target financial structure implied by the budget, how would the A/LM modeling assess IRR at that point in the future?  Is the credit union better prepared for market rate volatility, or did the credit union increase its risks?  Are IRR policy limits and guidelines still being met?  If not, understanding those risks today and weighing options with the board and management could be critical.

5)  Consider Alternative Scenarios beyond the Base Budget
Most would agree that having a clear picture of the future would be a welcome gift, especially during budget season.  Unfortunately, predicting that future can be a tricky business.  Instead, we often look to recent trends to inform us of likely market directions and pressures.

When trends appear likely to impact the credit union’s business model or strategy, it can be valuable to consider the extent of those impacts and likely responses the credit union may take.  Ask how trends might impact the business model, and develop what-if scenarios to understand the potential financial implications while also testing mitigating strategies.

For example, what if the trend data suggested mortgage volumes may slow, and a growing opportunity for more home equity loans?  What challenges or opportunities might that present?  Similarly, what if some regulators warned about the risks of low-cost funding sources going away, and at a time when long-term assets in the industry have been increasing?  What if funding costs increased more rapidly than anticipated?  If concerns exist for the credit union with regard to long-term assets, what options might exist today (i.e., before more of the industry might face similar pressures) to mitigate the risk in some way?

Considering alternative scenarios can better prepare management and boards for potential impacts, and create more informed strategic dialogues.  Modeling such scenarios early can better prepare the credit union to pivot from current strategies should those trends continue by creating awareness and understanding.

6)  Effectively Summarize the Results
The value and power of this additional business intelligence can be lost if buried in an array of detailed reports.  However, by being clear on the critical measures to evaluate, we have found that the results can be typically summarized in a 1- or 2-page document.  Using a brief description of the budget and what-if options, the measures can be included in table form.  This allows decision-makers to quickly assess the different outcomes of each of the various options and how they compare.

For many credit unions, the investment in the annual budget is significant.  Perhaps because the effort can be monumental, many do not focus on generating the additional value that can come from these steps.  However, with the powerful tools available to credit unions today in budgeting and A/LM software, steps 2-6 should require a fraction of the typical budgeting time while delivering exponentially greater business intelligence to decision-makers.  Tools today can allow for fast-paced what-if scenarios, building on and creating more value from the baseline budget.  Using these tools, credit unions can do more to rehearse many possible tomorrows today.

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Strategic Budgeting/Forecasting Questions: Connecting The Strategy

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This last entry in our 6 blog series about Strategic Budgeting/Forecasting Questions addresses creating a more thorough understanding of the connections between strategies and the budgeting/forecasting process.

Question 6 – What are other questions we should be asking?

While this may at first seem like an open-ended consideration, the goal of this question is to use a very specific approach to create more and deeper dialogue about the strategies and their reflection within the budgets and forecasts.  Very literally, we recommend asking senior management, What other questions should we be asking?  Using this approach can often bring to light those areas where concerns or obstacles may exist, creating a safe and collaborative opportunity to discuss them.

Some variations of this question may also be appropriate, such as, What are the unintended consequences of what we’re asking for?  Or, Is there something in what we’re doing that is creating a barrier to being successful with our strategic initiatives?

Asking such questions may be uncomfortable at first because it invites differing points of view and increased scrutiny of what may be the greatest challenges facing the desired strategy.  However, any initial discomfort is certainly worth the potential rewards—achieving greater buy-in and alignment with strategic directions and creating an opportunity to identify potential obstacles early.

"The point at which you address a problem is directly related to the number of viable options you will have to solve it." —Cliff Myers, 1922-2000

Of course, inviting open dialogue does not equate to an obligation to change the given strategy.  It simply better informs leaders about what may be ahead and allows the group to consider if any course changes might improve the opportunity for success.

For example, what if—through these questions—the board learned that the annual measure of success requiring the credit union to achieve a 1.00% ROA was getting in the way of being successful with the strategic initiative to remain relevant to the membership?  The board may have anticipated that the relevancy initiative would come at some cost to the credit union, but may not have recognized that the previously agreed upon measures of success might hobble that goal.  While a change could be made, it might also be an opportunity for the board to reiterate and clarify the reasons why the existing goals should continue without change.

The stakeholders have the same overall goals—a safe, sustainable, viable, and exciting organization to best serve the membership.  Trusting in that can allow for deep and honest dialogue about the road ahead.  As a final, solidifying step to ensure everyone is on the same page and has a clear vision of the expectations, credit union leadership can ask, What are other questions we should be asking?  By so doing, senior management will be better prepared to follow through and deliver on the strategic initiatives reflected within the budget and financial forecasts.

In this blog series, we explored the critical role of connecting the dots between strategic initiatives and the budgeting/forecasting process.  Specifically, we discussed the following questions:

  1. What is the expected financial direction of each strategic initiative?
  2. How are strategic initiatives represented in the budget and forecast?
  3. What key forces could impact our forecast?
  4. Are our financial measures of success handcuffing the credit union strategically?
  5. How is the budget and forecasting linking to our appetite for risk?
  6. What are other questions we should be asking?
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Strategic Budgeting/Forecasting Questions: Consider Key Forces

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This is the third entry in our 6 blog series about Strategic Budgeting/Forecasting Questions.

Question 3 – What key forces could impact our forecast?

Every good forecast should have a sound rationale and basis for the assumptions. If the current forecasting approach involves simply taking last year’s growth rates and assuming they continue, that will not be good enough going forward. A better approach is to identify key forces that could impact the budget/forecast and use this discussion as the rationale for the forecast assumptions.

It is important to understand that both internal and external forces have the ability to impact the forecast. Internal forces are largely driven by the strategic plan and initiatives set forth by the credit union, as well as the ability to execute (see the first and second blogs in this series for more).

Then there are external forces that have the ability to act as headwinds, which put pressure on the strategy, or tailwinds, which help move the strategy forward. The focus here will be on external forces. What is going on in the world around the credit union that could impact the forecast?

Start by getting decision-makers into a room and brainstorming different external forces that could impact the forecast. The list of forces can be quite extensive, so go through a process of prioritization. Group the ideas into two separate categories, headwinds and tailwinds as seen in the table below.

External Forces

The value is always in the discussion.  Take the top headwinds and tailwinds, study recent trends, and use this business intelligence to inform your forecast assumptions.  Take the potential auto sales headwind as an example.

17-06-q3-v3-dav

Source: macrotrends

Study historical data and discuss as a group. Auto sales have accelerated from 2010 to 2016. More recently, they have slowed. This trend should be incorporated into the forecast, especially on how it might impact the credit union’s strategic initiatives.

What about real estate? Are home values a key force that could impact your real estate lending and ultimately the forecast? Using the S&P CoreLogic Case-Shiller or another market source, decision-makers can understand what property values are doing in the area. If your area has experienced price increases well above national averages and prices are now above previous peaks, maybe that leads the group to assuming a slight decrease in new volume.

The combination of identifying key external forces, studying history, and having a discussion will better inform the forecast. Continue to use the what-if capabilities of your forecasting model to stress test the financial impact of changes in key market forces. Following this process will help decision-makers understand how external forces can impact the financial direction of strategic initiatives.

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Strategic Budgeting/Forecasting Questions: Representation of Strategic Initiatives in the Budget and Forecast

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The second entry in our 6 blog series about Strategic Budgeting/Forecasting Questions builds on an understanding of Question 1. Having identified the financial direction of each strategic initiative, decision-makers are better positioned to look at the budget and see how the initiatives are represented and, of course, ask “why” questions.

Question 2 – How are strategic initiatives represented in the budget and forecast?

Take, for example, a strategic initiative of being the lending machine. One of the first areas decision-makers would look to see how this initiative is represented in the budget is loan growth. Given the initiative, one would expect to see loans increasing compared to previous years. But, what if the loan growth in the budget was the same as previous years? Would that be reasonable? It depends, and what’s key in answering this question is understanding the “why.”

Example 1: Why is loan growth the same as the previous years? Answer 1: There are headwinds the credit union is facing when it comes to loan growth (more on this in the next blog in this series about Question 3 – What key forces could impact our forecast?). Without the lending machine initiative, loan growth would actually decrease in the following years. So the impact of the initiative is actually keeping the loan growth steady. This may be a reasonable answer.

Example 2: Why is loan growth the same as the previous years? Answer 2: The trending from the current year is carried forward into the budget. This is not a reasonable answer and is not representing the strategic initiative. In this case, the budget should be adjusted to reflect the initiative.

What can also be helpful is looking at the budgeting/forecasting trends with and without the impact of the initiatives. Start with a current path where the strategic initiative(s) are not incorporated and it is “business as usual.” Then run a path where the initiative(s) are included and compare the two.

Using the lending machine example, the chart below shows how loan growth and ROA would decline in the current path without implementing the initiative. With the initiative, loan growth stays steady in 2017 and rises in the years after, thus, increasing ROA and net worth. This comparison creates an opportunity to ask and discuss many “why” questions and see how the initiative is represented in the budget/forecast.

Again, the key is understanding the expected financial direction, looking for how that’s represented in the budgeting/forecasting, and then asking why. Even if the representation of the initiative in the budget is reasonable, it’s important to have strategic conversations on the “why” which will help create clarity among decision-makers.

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What Are Some Things to Consider as Part of the Budget Process?

We help a lot of institutions with the creation of their budgets and long-term forecasts. There are many questions that often arise as part of that process. The most common question is, what rate environment should I plan on?

There is no easy answer to this question; the reality is that whichever environment gets incorporated in the budget has a good chance of being wrong.

Fed Chair, Janet Yellen, described this same challenge during a speech in May:

“I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so.” (Source: Janet Yellen just made one of the most surprising admissions you’ll ever hear from an economist, Yahoo Finance, 5/22/15)

The Federal Open Market Committee (FOMC) will meet September 16 and 17 and many anticipate a decision could be made to increase the Federal Funds target rate for the first time in nearly 10 years. However, forecasts have the potential to not come true, which becomes evident when comparing the Federal Funds rate projection from December 2014 versus the most recent projection.

Federal funds rate projection December 2014

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, Federal Reserve, 12/2014

 

The average expected target range for year-end 2015 and 2016 were 1.12% and 2.54%, respectively. The most recent forecast of Federal Reserve Board Members and Bank Presidents from June 2015 reflects a 2015 and 2016 year-end average that is approximately 0.50% and 1.00% lower than the December 2014 projection.

Federal funds rate projection June 2015

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, Federal Reserve, 6/2015

 

The danger in relying on rate forecasts or projections is the potential for not understanding the risk of rates remaining at the same level they are today. As many management teams begin the planning process and budgeting for next year, a key consideration should be testing the impact on the budget of rates not moving as forecast. In fact, a combination of a base prediction along with a range of expectations around that base path can help uncover potential strains to the margin.

Beyond the rate environment, some other common budget questions have to do with growth. Whatever the credit union may plan in the future, it can be valuable to test the potential of those assumptions being wrong. With advanced modeling capabilities, the time it takes to run each of the following tests should be minimal.

Some example tests:

  • Loan growth has been great for many this year, what if it is slower than expectations going forward?
  • What if, in order to get expected growth, the amount paid for dealer reserves or the yield charged for loans is lower than planned?
  • Loan loss has been very good for many recently, what if it increases to a more normal level?
  • What if non-interest income is materially lower than expected, either due to changes in payments systems, regulations, or other demographic reasons?

Note that the unique exposures of your institution might need very different questions. Our recommendation throughout the budgeting process is to not spend so much time trying to prove that you know what will happen in the future, but rather make sure to focus on reasonable expectations and then test the exposure to the institution if those expectations do not come true.