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PLL and Managing Expectations

The most recent 2012 NCUA data shows that year-to-date, about 29% of all credit unions have run either a zero or negative provision for loan loss, due primarily to overfunding of the allowance.  The bulk of these credit unions were smaller in terms of asset size. Filtering to credit unions with assets over $500M, the answer is 5%.  Knowing that, it might be easy to infer that the abnormally low provision for loan loss is a small credit union phenomenon, but that is not necessarily the case. While the smaller institutions may have seen the more extreme swings in provision, recent data also shows that about 53% of credit unions over $500M have benefited from a provision for loan loss below 30bps (remember that in the exuberance prior to the credit crisis, PLL averaged 30-35bps).

The drop in PLL expense has helped offset the squeeze in margin that many credit unions are experiencing.  This leads to the question:  Can such a low level of expense be sustained in the future? Looking forward, credit expenses are likely to go back up as many institutions have delinquency and charge-off ratios that materially exceed provision for loan loss.  Managing board expectations in this regard is important.  Boards need to understand the impact of allowance overfunding and how it influences net income.  One simple step to address this would be to compare end-of-year provision for loan loss to actual charge offs.  Another option that could provide more detailed information would be to take your current level of charge offs and run out your budget with charge offs in place of provision for loan loss.  These analyses would help a credit union’s management and board to get a better feel for the sustainability of earnings once the ALL is no longer overfunded and PLL starts to rise.

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Yield on Assets—How Low Can it Go?

How does net income look for 2013?  Even if your budget is showing satisfactory earnings you might not be out of the woods yet.
Earnings could be temporarily propped up by higher yielding loans and investments put on the books in years past.  Unsustainably low provision for loan losses could also be skewing the picture.
Consider doing a long-term forecast to see how the business model performs after higher yielding loans and investments mature.  We would recommend a forecast of at least three years.  This does not need to be a three year budget; simply use high level operating expense assumptions in years 2 and beyond.
If you are not sure you want to invest the time to create a long-term forecast, minimally invest 15 minutes in your next ALCO meeting working through an estimate of new business profitability using the New Business Calculator.  Populate this with rates on loans and investments that are currently being booked (not year-to-date yields) for a preview of where earnings could be headed once higher yielding loans and investments mature.  The earlier you can spot trouble ahead, the sooner you can act to head it off.
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Operational Efficiency—Improving Earnings And Member Experiences While Driving Increases In Net Worth Dollars

In comments surrounding the new rule on Interest Rate Risk, the NCUA states that, “net worth is the best measure against which to gauge a credit union’s risk exposure.”  As credit unions are looking to improve earnings and grow net worth dollars in this historically low interest rate environment, yield on assets and cost of funds are only 2 of the 5 strategy levers that credit unions can pull.  In order to have an effective IRR management program, ALL levers that impact earnings and net worth should be evaluated, including operating expense, provision for loan loss and fee/other income.

Bottom-line results can be realized by evaluating operating expenses for operational efficiencies.  However, operational efficiency not only means looking for ways to cut expenses, it also includes evaluating current processes and practices to ensure that no opportunity to generate revenue is left behind.  For example:

  • Do your loan processes allow you to effectively capture every loan that you want to fund, or do inefficiencies in the process cause members seeking loans to ultimately go elsewhere?
  • Can your front line effectively turn interactions with your membership into educational or cross-sale opportunities, when appropriate, that deepen member relationships and enhance the member experience?
  • Does your in-branch advertising reflect the tactical (short-term) and strategic (long-term) objectives of the credit union?  If the credit union is targeting loan growth, are loan rates and promotions more prominently displayed and emphasized than current deposit rates?

Finding ways to revamp processes can improve member interactions and provide employees additional time that can be used to enhance member service or develop other areas of the credit union’s business.  Additionally, ensuring that the credit union is effectively utilizing its sources of revenue is just as important to operational efficiency as cutting un-needed expenses.

The creation of operational efficiencies in your structure can have a positive impact on earnings in all interest rate environments, which is an excellent way to drive increases in net worth without taking on additional risks.

Source:  Interest Rate Risk Policy and Program, NCUA, 2/3/12
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c. notes Excerpt: Thriving In A World of Shrinking Margins

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As interest rates have been at historic lows for a prolonged period of time, credit unions have had the benefit of lowering their cost of funds (COF) as loan and investment yields decline.  Many seem to have worked through their credit issues and, at least for now, have been able to reduce their provision for loan losses (PLL)—another counter-balance to declining asset yields.

Unfortunately, for many, the COF and PLL have—or will soon—hit a floor while asset yields continue to decline.  Some have turned to longer-term assets, such as mortgages, mortgage investments and callable bonds to help current earnings. However, these options add interest rate risk in a rising rate environment.

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

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Setting Board Expectations

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Setting board expectations has always been key.  However, it is increasingly important as many credit unions are seeing their ROA jump—largely due to falling provision ratios.  Over the last two years, the industry average PLL has declined from its peak of just over 1% in 2009 to about 0.50% as of the first quarter in 2011 (see graph A below, Source NCUA, FDIC).  The decrease in PLL has been the single biggest reason that the industry average ROA has increased since its low in 2009 (see graph B).

While this has been great for the industry, the question is, how sustainable is the decline in PLL? In many cases, the decline is not sustainable as credit unions are running a provision that is below “normal” levels or reversing accruals to ALLL that they believe to be excessive (see post Planning for PLL).  This means the current ROA is temporary, as it will decrease once the provision returns to normal levels.

Management teams need to communicate this to their board and set the expectation that their financial position will be different going forward.  This will help prevent misunderstanding between the board and management and ensure that the two groups continue to work together to position their institution to be stronger in the future.

Table A:


Table B: