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Strategic Budgeting/Forecasting Questions: Connect Strategic Initiatives with Financial Direction

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Strategic initiatives impact results – members may be better served and membership may grow, assets may grow, and earnings and net worth may increase. Some strategies may cause temporary or long-term reductions in membership, assets, earnings, or net worth. Budgets and forecasts should incorporate the anticipated impacts of strategic initiatives and establish common expectations for results. Connecting the dots to better understand the financial implications of strategic initiatives can lead to greater success.

In this and subsequent blogs, we will review 6 questions strategic boards can discuss during the budgeting and forecasting process to better connect the dots. These 6 questions are merely a starting point and will undoubtedly lead to more questions during the process, creating more thorough communication and a greater understanding of strategic plans.

Question 1 – What is the expected financial direction of each strategic initiative?

Begin with a simple, high-level assessment of strategic initiatives. Identify each strategic initiative with a short description. Then, consider what you believe will be the earnings impact next year and in the following years. For this exercise don’t focus on the numbers, just consider the direction of the impact. Draw a quick table or use a spreadsheet as follows:

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Consider that not all strategic initiatives will generate increases to earnings. The important point is to understand why. Some initiatives may hurt earnings in the short term to achieve longer-term improvements, while others might only reduce earnings. For example, a strategy might be to increase member giveback through reduced overdraft fees or installing additional ATMs for improved member access.

In this example, initiative #1 is to become the lending machine – perhaps to make the process more efficient and create capacity – or to generate more loans for the credit union. This initiative may include a project to implement new technology or acquire talent. In Year 1, the project is expected to incur costs that would reduce earnings, or the ROA. We indicate that in the chart with a downward arrow. By Year 2, however, we expect to see some additional loans or experience cost savings that would improve ROA. We show that with an upward arrow.

Continue to complete the chart.

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In Year 3 and beyond, the impact to ROA of the lending machine strategic initiative is expected to continuously increase.  We can use multiple arrows to show the additional impact expected.

For strategic initiative #2, to decrease account opening time, there’s no hard dollar costs in Year 1 as the credit union conducts an internal review and designs process improvements.  In Year 2 and beyond, the efficiencies are expected to lower costs and drive some additional new accounts, thereby increasing ROA.

Beyond looking at each strategic initiative, notice that now the aggregate expected impact of all initiatives can begin to be understood.  If all or a significant number of initiatives have negative ROA impacts, that can be an indication of needing to consider other, offsetting strategies to generate additional revenue.  Or, it may make sense to accept lower earnings for some period.  That would be important to recognize and to make sure that everyone, including the board and management, is on the same page with the expectation so there are no surprises.

After completing this exercise, board members and management can be better prepared to review the budget with a high-level expectation for how it may look.  If projections don’t align with expectations, more “why” questions can be asked and differences understood.  As financial results occur and new budgets are created, this can be a great tool to keep as a reference.  Strategic initiatives can be reassessed for what was originally expected versus what actually happened, and to determine what changed and why.

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All Sources Of Liquidity Cost Something – But Which Impacts Net Worth Ratios The Least?

As credit unions develop contingent funding scenarios to test against contingency funding plans, the solution to a liquidity event is perhaps as important as ensuring the scenario is both realistic and rigorous.

In working with various credit unions, solutions to liquidity scenarios range from CD promotions to brokered (non-member) deposits to borrowings and lastly, to selling investments. If a contingent scenario also includes a change in interest rates, selling investments may seem unpalatable due to the loss. However, what is the decision driver that is being considered when evaluating alternatives? Is it focused on earnings or focused on net worth?

Take the example of two potential solutions below. Option A solves $10M of deposit run-off from the liability side of the balance sheet replacing the deposits with another liability – Promotional CDs. Option B solves the deposit run-off from the asset side of the balance sheet selling term investments at a loss.


Above, Option A impacts 1-year earnings ($175), all else being equal. Option B impacts 1-year earnings ($500). However, compare the resulting net worth ratios. Option A results in a ratio of 9.89%, which decreases from the beginning net worth ratio, but Option B results in a ratio of 10.39%, which increases from the beginning net worth ratio.

If the liquidity scenario cannot resolve itself through normal balance sheet runoff, which could be the case if the runoff occurred over a very short time horizon, any potential solution should consider not only earnings for the current period, but more importantly the impact to net worth. This is especially important if the loss of liquidity occurs as rates rise – “normal” balance sheet runoff may slow materially as rates rise and existing assets extend.

Remember, the NCUA has recently commented “Net worth is the reserve of funds available to absorb the risks of the credit union, and it is therefore the best measure against which to gauge the credit union’s risk.”

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What If The Fed Rate Projection Is Right?

This is a question credit unions should try to answer as part of their ongoing long-term forecasting process.  The FOMC reaffirmed on Wednesday (December 12) that they do not anticipate raising rates until 2015.

Source:  Federal Reserve

So what happens to earnings and net worth if rates stay at historic lows for two more years, and then start to rise? Instinctively, the net interest margin should be squeezed over the next two years as assets continue to reprice down without a corresponding reduction in the cost of funds. The big unknown is: how much and how fast will rates rise?

Credit unions may need to run a series of “what-ifs” to understand the impact. “What-ifs” should include rates rising over different time periods (i.e., 12 months, 24 months, etc.) and increase to different levels (i.e., 100bps, 200bps, 300bps).  It would also be prudent to test changes in balance sheet mix, as rates may rise for different reasons.  If the economy is booming, then the credit union may be able to originate more loans.  This would help the bottom line and possibly mitigate the impact of the lower-yielding assets brought on in 2013 and 2014.  However, if the economy is stagnant, loan growth could be an issue—which would hurt earnings and net worth.

Decision-makers should review the series of “what-ifs” and discuss any areas of concern.  Credit unions should run additional “what-ifs” that address their concerns—particularly in cases where success measures would not be met or the credit union’s ability to deliver on its strategic objectives is threatened.

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Strategic Plans And Quantifying Risk

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In the recently issued Interest Rate Risk Questionnaire, the NCUA devoted an entire section to evaluating if decision-making is informed by interest rate risk measurement systems.  The guidance specifically references interest rate risk “what-if” testing in conjunction with strategic plans and operational decisions—and that “what-if” analysis outcomes should be documented within the strategic plan to either support or reject a decision.

The NCUA further states, “Whenever material changes in assets or liabilities are proposed, NCUA expects management to be proactive and perform what-if analysis before a new strategy is implemented.”  Understanding the potential impact that a strategic plan may have on the credit union’s risk exposures is key to effective asset/liability management.

In order to link strategic planning and desired long-term financial performance, decision-makers should ask themselves the following questions:

  1. How does this plan align with our long-term goals for financial performance?
  2. Is there a possibility that we will sacrifice financial performance in the short- or medium-term to fulfill long-term strategic and/or financial objectives?
  3. If everything goes according to our strategic plan, what will be the impact to the interest rate risk and credit risk exposure of the credit union?  Are there any other risks that may be present in the strategy that we don’t have today?  Specifically, how will those risks impact earnings and net worth levels?
  4. If external forces cause a deviation from our strategic plan, what contingencies are in place or what options do we have to get back on track?

A comprehensive strategic planning process incorporates the evaluation of interest rate risk.  Modeling the impact of strategic decisions beyond the traditional 1-year simulation is a must.

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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.