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Strategic Budgeting/Forecasting Questions: Establish Appropriate Measures of Success

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The fourth entry in our 6 blog series about Strategic Budgeting/Forecasting Questions addresses measures of success, and how they should connect to the budget or forecast.

Question 4 – Are our financial measures of success handcuffing the credit union strategically?

There are many examples of appropriate and inappropriate measures of success as they relate to the budget and strategy. Some measures even come with unintended consequences. Measures should reflect, as closely as possible, what the credit union is really trying to accomplish, such as more engaged members or a profitable structure. Sometimes, measures that have existed in that past are kept as a matter of habit and simply aren’t updated in accordance with the plan.

Let’s assume that a credit union has a strategy to target members in their mid 20s to 30s to serve as a pipeline for the future. Beyond ROA and net worth, here are examples of some common measures of success:

  • Low delinquency: Choosing to target younger members is likely to come with more credit risk, so a measure of success that keeps delinquency at the same or lower levels may be in conflict with the plan. Not all younger members have higher credit risk, but focusing on low delinquency could lead the credit union to say no to the very members it is trying to attract, damaging its reputation with this group who likes to share their experiences. Setting this measure to realistic levels at the outset also helps stakeholders be more comfortable when higher delinquencies appear. It may be reasonable, in this situation, to budget a higher PLL
  • Products per member (PPM) or products per household (PPH): A strategy that aims to bring in new members is likely to reduce PPM and PPH. New members tend to have fewer products early on. An organization that is trying to increase PPM and PPH will be intent on getting existing members to do more business with the credit union, which could create little motivation to capture the target group. Consider measuring new members or households separately if measuring PPM or PPH
  • Member satisfaction/Net Promoter Score (NPS): A credit union that is successful in attracting younger members could find their overall member satisfaction or NPS dropping. Many credit unions find that, after segmenting by age, scores for younger members are much lower than for older members. Telling the organization to improve member satisfaction or NPS could work against the strategy to attract younger members. Consider measuring score trends segmented by age
  • Asset growth: Younger members usually don’t bring a lot of deposit dollars and deposit growth usually drives asset growth. If the asset growth measure requires special effort to be successful, those efforts will reasonably be focused on older members, pushing the target group to a lower priority
  • Loan growth: Similar to asset growth, younger people usually don’t bring a lot of loans to the credit union. Loan dollars borrowed per member is usually heaviest for people in their 50s. A push for loan growth will also push the target group to a lower priority

Other considerations to keep in mind when setting measures of success:

  • Member growth: When measuring the number of new members, remember that it’s easy to grow $5 member accounts, so consider whether that’s really success when setting measures for this strategy
  • Member growth and indirect lending: Growth in indirect lending could increase membership in the target group, but is that a good thing? Indirect members often have a single product (an indirect loan) and it is commonly acknowledged that it is difficult to convert those members to “real” members who use other credit union products. Including these members in member growth measures could show an uptick while failing the strategy of filling the pipeline. Consider measuring members that come from the indirect lending channel separately from direct members
  • Member growth and PPM/PPH loopholes: By not purging inactive members, growth will look better. At the same time, purging inactive members can make PPM and PPH increase without accomplishing anything. Consider adding caveats to measures that can be easily improved without actually getting any closer to the strategy
  • Member engagement: Don’t just focus on products when evaluating engagement; consider services, especially those from other areas of the credit union, such as insurance or wealth management

Assuming the budget reflects the strategic initiatives, which we discussed in the second blog in this series, stakeholders should view the measures of success through the lens of the budget. If it’s not clear how the budget leads to the measures, or if the measures are in conflict with the budget or the strategy, stakeholders should be asking questions. The goal is for everyone to emerge from the budgeting and strategic planning processes with a realistic view of what success looks like.

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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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Too Much Loan Growth?

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Many credit unions have had the good problem of being so successful in lending that liquidity has become a challenge.  A blog we wrote in December 2016 identified 6 key questions that decision-makers should evaluate on the issue.  This post expands on that topic by looking at several possible liquidity solutions credit unions are considering as they deal with tightening liquidity, and what the A/LM implications of each scenario would be.

So how did we get here?  The average loan-to-share ratio for credit unions has increased by almost 12% over the last 4 years as loan growth has steadily outpaced deposit growth.  The average loan-to-share ratio now stands at almost 80%, while many individual credit unions have seen their loan-to-share ratio increase well above that level.

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As liquidity has tightened, some credit unions have turned to selling or participating out loans as a way to manage short-falls in funding.  However, many of those same credit unions are finding that selling or participating out loans at favorable terms has become increasingly difficult, and that trend could continue.  If the economy strengthens, financial institutions would likely see loan demand remain strong, which could further hamper an ability to sell loans.  Why would another credit union or bank buy loans from your institution, if they can originate loans on their own?

One solution could be to slow down loan growth by raising rates.  However, credit unions are initially reticent about this path if other viable alternatives are available due to fears about getting growth ramped up again, especially for institutions that do a lot of indirect or commercial loan business.

While there are important strategic and budgetary considerations that should be evaluated, the A/LM impact should not be forgotten.  Below are examples of liquidity funding scenarios that credit unions are testing with some frequency.  In each scenario, the credit union is adding $50M in auto loans, while evaluating 3 distinct funding strategies.  Additionally, in these scenarios the credit union has assumed it has the internal capacity to make these loans without the need for increased operating expenses.

Member CD Promo

For many credit unions, the first option to attract liquidity would be to get it from the credit unions’ members.  The first option (see Option 1) looks at the impact of solving the liquidity challenge through an aggressive CD promotion (1-year term at 1.4%).  A challenge with the member CD solution is the likelihood of cannibalizing lower cost deposits as members take advantage of the higher rate.  Additionally, funds acquired through CD promotions could be rate sensitive if opportunities develop for the member to obtain a higher yield.  Both of these risks were factored into the modeling.  The results show that adding autos and funding with short-term CDs (including transfers from lower-cost deposits) would negatively impact ROA today compared to the base case, as well as increase risks to earnings and net worth if rates rise.

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Intermediate-Term Borrowing

The credit union could also evaluate an intermediate-term borrowing strategy (Option 2).  While borrowing at a fixed rate for 3 years is more expensive than short-term borrowings, it can help reduce risks to earnings and net worth if rates rise.

If borrowings are utilized, there are other questions to consider.  For example:

  • What internal borrowing limits might your credit union have in place?
  • Are there any regulatory constraints on your planned borrowing strategy, and how much would you have remaining in available lines of credit in the event of a liquidity emergency?
  • Would your credit union plan to increase available lines of credit in the future? If so, the type of loans being added would matter.  For instance, consumer loans are not as readily collateralized as mortgages.          

Selling Investments

The final strategy (Option 3) looks at selling investments to fund the same $50M in loan growth and assumes the investments are sold at a 1% loss.  Setting aside the slight decrease in the net worth ratio, the results of this scenario look the most favorable with improvements in ROA and the risk measurements.  However, this solution could raise a different set of questions.  For example:

  • Are the investments that were sold being used as borrowing collateral?
  • If they were borrowing collateral, how would this impact future liquidity options and is it a sustainable strategy?
  • What kind of gain/loss would there actually be if investments were sold?

Whatever the solution, it is important to look beyond just the next couple of quarters.  If loan sales remain challenging or loan growth continues to outpace deposit growth, what is your credit union’s long-term liquidity management strategy?  Consider playing this out over the next 12 months, think through the tough strategic questions, consider the impact to your budget/forecast, and make sure you play out the results from an A/LM perspective.

Finally, if it is determined that there are limits to the amount of loans the credit union can book going forward, does the credit union have the tools that allow you to see the complete risk/return picture of your different asset categories to determine which have the most favorable risk/return trade-offs?  Armed with that information, your credit union could work to maximize the growth in the most favorable loan categories, while perhaps reducing emphasis on those categories that are less favorable.  Our clients have reporting that allows them to comprehensively evaluate the risk/return trade-offs of individual loan categories.  We wrote a c. notes on this topic in 2016.

 

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Pay Attention to Liquidity

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As we conclude our budget and forecasting work with many credit unions, we continue to see expectations for loan growth to exceed share growth in 2017. Combining this trend with an assumption for higher interest rates could squeeze liquidity positions in 2017.

Callable bonds may no longer get called and mortgage related assets will extend if rates increase. In addition, deposit growth could slow or shift to more expensive deposits.

While we recently posted a blog on liquidity, we felt it was important to give another reminder to do advance planning in this arena.

Test your liquidity position under various scenarios. If you see pressure beyond your comfort zone, now is the time to have the strategic conversations about how the credit union will be prepared to respond without sacrificing longer-term strategic objectives.

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Focusing on Branch Profitability, Solely, Misses the Mark: 4 Things to Consider

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As consumers’ preferences continue to evolve, it is becoming painfully clear that focusing solely on branch profitability will provide an incomplete or even misleading picture for decision-makers.

Think of it this way.   Traditional branch profitability analyses often reward branches for living off the past. 

Consider a branch that has a large loan portfolio, creating a lot of revenue, ultimately leading to today’s high ROA for that branch.  However after taking a closer look, it may turn out that this branch hasn’t produced many loans over the past year.  In fact, they are one of the lower ranked branches in terms of loan production.  However, the high ROA shown in a traditional branch profitability analysis is the result of living off loan production from years ago.

Evaluation in terms of current ROA alone may result in missed opportunities to realign resources today in order to have intentional focus on strategic objectives and evolving trends.

The following outlines 4 things to consider that is guaranteed to enhance business intelligence with respect to delivery channel effectiveness.

1.  Expand the evaluation to all delivery channels.  Credit unions are investing heavily in self-service options for members.  Effective adoption of these options is key to remaining relevant for many credit unions.  A focus during on-boarding has proven to help with adoption and engagement of new self-service options

2.  Align measures of success for each delivery channel with the credit union’s strategy.  This requires decision-makers to be intentional about the purpose of each branch, the contact center, and digital delivery channels

3.  Take a holistic approach to metrics.  Rank them to align with the credit union’s strategy.  For example:

  • Membership Growth
    • Not all growth is created equal.  This can be evaluated by segments if there is a strategic emphasis on the type of membership growth
    • Assigning indirect autos to the closest branch can significantly skew results.  Consider evaluating and managing the indirect channel as a stand-alone delivery channel
    • The same holds true for membership acquired digitally.  If a branch is credited, decision-makers will not have clarity with respect to the effectiveness of their digital delivery strategy or the physical branch
  • Value-Add vs. Routine Transactions
    • Work with your team to distinguish value-add from routine transactions, then rank delivery channels accordingly.  For example, many are revamping branches to remove routine transactions so that value-add and complex transactions can be effectively and efficiently handled.  In this case, the metric would evolve around reducing routine in-branch transactions and increasing value-add transactions
  • Member Engagement & Feedback
    • Comprehensive delivery channel evaluations should incorporate what the members are saying about their experiences with the different touch-points.  Credit unions are investing heavily in digital delivery.  It is not uncommon to hear that member satisfaction with digital delivery is lower than that provided in branches.  If this is true for your credit union, ask yourself how this can impact member engagement and how the gap in member satisfaction can be narrowed
    • If the credit union has strategic emphasis on particular demographic segments, consider establishing metrics that align with this focus
  • Loan Growth
    • Rank current balance, short-term, intermediate-term, and long-term performance independently.  This addresses a common flaw of profitability studies that can focus too heavily on older loans
    • Rank major segments of lending by balance and recent production.  This provides an early warning if production is falling off
  • Share Growth
    • Consider category evaluations.  Delivery channels that rank high for regular shares or checking may benefit the credit union differently than those with a heavy reliance on money markets or CDs

4.  Weighting Is Key

  • Each of the above can be important to monitor, but not all of them will contribute equally to the credit union’s performance or strategy.  Consider the credit union’s strategic objectives and then use these objectives to help weight the importance of each category.  This intentional view of production and member experience, connected to strategy, creates better business intelligence for decision-makers than a traditional branch profitability analysis

Having a broader understanding of delivery channels in terms of contribution to strategic objectives and the trends exhibited is the first step.  This can then be combined with profitability estimates if desired.

As the financial services industry becomes more complex, it is important for decision-makers to have the right type of business intelligence so they can take action and make necessary course corrections, timely.