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What-Ifs Help the Budget Process

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Testing ideas and running what-ifs is a powerful way for decision-makers to understand the impact of decisions under consideration in real-time (for more on this, please refer to our blog, Has your ALM technology Emerged from the Dark Ages?).  The power of what-ifs can also be applied to the budgeting process, and help link decisions made in the budget to the impact on a credit union’s risk by answering three risk-related business questions:

  1. How much could current earnings change if decisions under consideration are implemented?
  2. What are the profitability and risk trade-offs of decisions under consideration if rates change?
  3. What is the break-even point of decisions under consideration?

Budgets help answer the first question and don’t address the next two questions. The answers to these two questions could impact the credit union’s ability to deliver on its strategy.

Credit unions should create a target financial structure by running their budget through their risk model to understand the overall risk of the budget coming true (for more on this, please refer to our blog, Testing the Budget’s Interest Rate Risk). What-ifs help decision-makers evaluate the risk trade-offs of key decisions and forecasts during the budgeting process.

Not all decisions need to be run through the risk model during the budget process – this is how the target financial structure is helpful. Rather, decision-makers can test three or four of the key decisions or expectations that are driving the budget, both for revenue and expenses, and run a what-if to quickly understand the risk impact.

An example might be that the lending department believes they can generate a high amount of growth in mortgages in the coming year. This would be a key driver of revenue for the credit union. Decision-makers can run a what-if on this expectation and determine if they are comfortable with the risk/return trade-off.

Using what-ifs allow decision-makers to be more nimble during the budgeting process, and make changes along the way if they determine the risk/return trade-offs of key initiatives are out of their comfort zone.

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Net Economic Value: 1 Tip on Effective Discount Rates

There are many tools that can be used to perform a model reasonableness check, or a model validation. Below we share a simple “sniff test” to help credit union CFOs and financial analysts assess one key assumption driving net economic value results, the effective discount rate applied to each loan category.

Tip: Compare the effective discount rate in the current interest rate environment to the applicable loan portfolio yield. Understand the reasons for material differences.

You might be thinking – “Why do I need to see the effective discount rate in the current environment if I can see the values?” Well, how do you know if the starting value is reasonable?

Seeing the assumed effective discount rate and comparing it to the loan portfolio yield would help you think in terms you deal with every day. For example, if you could see the weighted-average yield of your auto loan portfolio has been holding steady at about 5.50% yet the assumed effective discount rate in the current environment is 2.75%, you would probably want to understand why there is such a disparity. You begin asking questions.

Are we charging our members above market rates? If not, what might be the reason that our yields are so much higher than market? Do we accept a higher than typical credit risk? Perhaps insufficient credit spreads are being applied to the assumed discount rate.

Are there other unique lending practices that we perform that might account for higher than market yield in our portfolios? For instance, if your mortgage rates are materially higher than the effective discount rate, dig deeper. Maybe your mortgage loans are non-conforming and the discount rate has not been adjusted appropriately. Ask yourself why a purchaser of non-conforming loans would not want to be appropriately compensated for a potentially higher risk and less liquid asset.

Even if your ALM model touts that a unique spread is being applied for every single loan, you should still step back to determine the reasonableness of these assumptions and understand the overall portfolio effective discount rate for the current interest rate environment relative to your portfolio yield.

Performing this quick reasonableness test helps bring a common sense approach to values and ultimately NEV results.

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COMPARISON OF INTEREST RATE RISK METHODOLOGIES

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Interest rate risk was originally viewed as a process that should be done in a back room, resulting in volumes of information that was stored on a shelf to be available when examiners walked in. However, the complexity of the world has changed over time and so must the use of tools to help evaluate the trade-offs of decisions being faced. Institutions need to ensure they are getting answers to the right business questions in order to create a solid foundation that links strategy and desired financial performance. While there are many aspects to creating strong and sustainable financial performance, this article focuses on the abilities of the primary interest rate risk (IRR) methodologies to support decision-making.

This article was originally published as a Financial Flash by the CUNA CFO Council. The full article (Comparison of Interest Rate Risk Methodologies) can be found here.

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Interest Rate Risk and Member CD Early Withdrawals

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An important component of A/LM modeling that some interest rate risk (IRR) models ignore is applying early withdrawal assumptions to Member CDs. This is especially true for credit unions whose members are rate sensitive and/or accustomed to higher rates. If models do not consider early withdrawals, the benefit of longer-term CDs can be materially overstated in a rising rate environment in relation to the relatively high cost today. This is particularly relevant in today’s historically-low interest rate environment.

While some might argue that “members don’t like fees” and that will be enough of a deterrent for members to hang onto their lower-rate CDs, consider the amount of members willing to pay to refinance their mortgages in recent years. Yes, mortgages are often more top-of-mind for members, but the moral of the story here is that, for many credit unions, the recent economic downturn has heightened member awareness of the cost-benefit of their financial decisions. This applies more so to members with higher-balance CDs.

Developing sound assumptions for early withdrawals can be challenging, but keep in mind that it makes sense to have the withdrawal assumptions increase for longer-term member CDs.

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Evaluating Investment Proposals With Enhanced Due Diligence

Understanding the impact that new business decisions can have on a credit union’s risk profile is central to effective asset/liability management, and is even addressed in NCUA’s recently issued Interest Rate Risk Questionnaire.  This is especially appropriate when evaluating proposals from investment brokers seeking to “rebalance” or “strategically realign” a credit union’s investment portfolio.
Many of our clients have received proposals from their brokers to sell investments they currently own for a gain and replace those sold with comparable investments (albeit at lower yields).  Accompanying these proposals are broker-provided due diligence information packets that show the current portfolio price risk compared to the proposed portfolio price risk in a +300, WAM for the current portfolio and proposed portfolio in a +300 and other industry-standard measures of risk.  While many of these proposals can offer an acceptable balance between risk and return given an individual credit union’s unique circumstances and appetite for risk, some proposals can be downright disastrous, resulting in significant interest rate risk with even the slightest change in interest rate environment.
To appropriately safeguard against making a decision that is inconsistent with a credit union’s normal practice, or board-directed appetite for risk, a certain measure of independent due diligence is highly recommended.  For example, ask your broker to provide the same reports with a shock higher than the traditional +300 (+500 is recommended—before rates plummeted to today’s low levels, short-term rates were roughly 5% for a sustained period).  You should also ask your broker to twist the yield curve (non-parallel shock).
Nearly every broker-provided proposal generates an increase in net worth dollars, and a corresponding increase in net worth ratio.  The key in realizing the potential risks of executing on a proposal is understanding how the amount of net worth not at risk changes, and in what interest rate environments this becomes a negative change.  Understanding margin changes today, as well as changes in price risk in a +300, can be valuable tools.  However, testing the potential impact on net worth is critical when evaluating the risk in a business decision, and this level of testing is typically not included with any standard broker-provided due diligence.
Remember, in NCUA’s Final Rule on Interest Rate Risk Management, NCUA states “net worth is the reserve of funds available to absorb the risks of a credit union, and it is therefore the best measure against which to gauge the credit union’s risk exposure.”  Ensuring that decision-makers have the appropriate information to drive effective decision-making is an integral part of ensuring that an interest rate risk program is effective, and is incorporated in the risk management process of high-performing credit unions.