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Aggregating Risks To Net Worth—The Credit Risk Component

During a recent education course, we fielded the following question:  “How do you develop a proxy for a worst-case loan loss assumption when aggregating risks to net worth?”

This is a great question and it stimulated lively discussion.  While there is not one right way, the following method has been valuable in developing concentration risk limits designed to address credit risk.  This method looks back over a specified timeframe (a common, initial look-back is 5 years) and identifies the 6- or 12-month period that experienced the highest annualized loss rate for each loan category.  Each rate is then applied to the current balance of each respective loan category and totaled to come up with the dollars for the total worst-case loan loss assumption.  Frequently, a factor is added to answer, “what if we had to absorb losses beyond our worst historical experience?”  Common factors include increases of 33%, 50%, or even 100% above the worst historical experience.

With many credit unions having just come out of their worst credit loss experiences in memory, this method captures and utilizes the information gained during that environment.  This method is easily reproducible on a periodic basis and can be re-evaluated annually to ensure that the risks are sufficiently captured.  As time progresses, and as loss histories for various loan categories continue, the loss rates may need to be adjusted to account for new loss experiences in order to keep the spirit of capturing a “worst-case” environment.  This process will help to ensure that a credit union’s management and board do not lose sight of the credit union’s worst credit loss experiences.

Whether or not the above methodology is utilized, one thing is abundantly clear—documenting the rationale behind a worst-case loan loss assumption is an absolute must!

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Do You Have A Clear Philosophy On Fees?

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With fee income under fire, it is becoming more important than ever for credit union boards and managements to be able to articulate their philosophies on fees.  Simply saying, “We don’t like to fee our members” is not enough.  Most credit unions are already considering, if not implementing, new fees and fee increases—not because they want to fee their membership, but because they feel that replacing lost fee income and/or offsetting increasing expenses is a financial necessity.

Consider the following when discussing fees and fee pricing:

  • Cover Costs—Fees can be implemented to put the burden on the party that is incurring the costs rather than making the entire membership carry the costs.  Take the example of check-cashers.  Check-cashers typically are not contributing members but use a lot of credit union resources.  One answer to this dilemma is to decide that it’s okay to cash checks as long as the costs are covered with a fee.  In this case, it must also be okay to have the check-cashers go elsewhere if they decide that they don’t want to pay the fee
  • Strategy—The fee structure and pricing must support the credit union’s strategy.  A credit union that is building its mortgage business may choose to charge mortgage fees that do not cover all costs.  The rationale could be that the costs will be covered with future interest income while charging more fees today could drive potential borrowers away.  The important thing is that the fees align, and are not in conflict, with the strategy
  • Member Behavior—Some fees are intended to change member behavior.  An example is paper statement fees.  The purpose of these fees is to encourage members to get statements online, enabling the credit union to reduce expenses directly attributable to paper statements.  In addition, the credit union may hope members will shift to using more electronic services, reducing branch and phone transactions
  • The Bottom Line—Fees are sometimes instituted to improve the bottom line, although this is often only part of the reason.  Improving the bottom line often goes hand-in-hand with covering costs and altering member behavior
  • What the Market Will Bear—As a practical matter, fees that most institutions charge are included on many credit unions’ fee schedules simply because the market expects to pay them.  This approach is also used in deciding fee pricing as opposed to pricing to cover costs.  However, it is important to understand the hard costs.  It should be a conscious decision to charge a fee that does not cover the cost

This is the perfect time to discuss and clarify the credit union’s fee income philosophy.  Having decision-makers on the same page will help align upcoming fee structure changes with the credit union’s philosophy and strategy.