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c. notes – Aggregating Risks to Inform Strategy

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To remain successful as the world changes and becomes more complex, risk management processes must keep pace.

Risk management begins with identifying and quantifying strategic risks. An effective process also recognizes that it is not adequate to only quantify and understand risks in silos. Risks should also be quantified and understood in aggregate. As history repeatedly taught us, bad things don’t usually happen in isolation.

Understanding and communicating risks in aggregate allows decision-makers to evaluate if the credit union is taking on too much risk, or if the credit union may be poised to strategically accept more risk. Also note that understanding risks in aggregate permits management to consider the credit union’s capacity for strategic opportunities; strategic risks and opportunities are two sides of the same coin.

To continue reading, please visit the article here.

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Is Your Risk Methodology Giving You a False Sense of Security?

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A recent front page article in the Wall Street Journal caused quite a stir by claiming that credit unions are “piling into longer-term assets, exposing the firms to potentially significant losses if interest rates rise…”

The objective of this blog is not to debate whether there is or is not too much interest rate risk (IRR) in the industry. The facts are the facts: credit unions have operated in a historically-low rate environment for the last six years; credit unions have, on average, extended their loan and/or investment portfolios; and there has been a flight-to-safety. The ingredients are there. There is potential IRR built into the system, that, if not managed properly could present issues when rates do rise – depending on what level they rise to and how quickly. The question, then, is “is IRR being managed properly?” or are some decision-makers getting a false sense of security by IRR quantification methodologies that miss risk or allow users to assume away the risk?

In our experience of doing numerous model validations, we have seen many examples of a false sense of security being created either through the methodology or the assumptions needed for the methodology. The most common concerns that may hide risk from decision-makers include:

Traditional income simulation

  • Optimistic assumptions about growth in new business
  • Optimistic assumptions about new volume yields as rates change
  • Seldom incorporate the risk of non-maturity deposit withdrawals or member CD early withdrawals
  • Time horizon is too short, often only one year

Net economic value

  • Optimistic deposit values in current and shocked rate environments (the never-ending argument about deposit length and valuation)
  • Optimistic loan values showing large gains that ignore the market perspective on both credit concerns and liquidity risk

Risk limits

  • Policy limits that focus only on net interest income and net economic value ignoring the entire financial structure, which may hide the potential of negative net income and resulting decline in net worth

Are you at risk of being blindsided? Now is the time to evaluate your modeling methodologies and assumptions.

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10 Reasons Things Went Wrong… Has Anything Really Changed?

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For years, we have been emphasizing a list of 10 reasons (not in order of priority) risks are not appropriately managed in the financial services industry.  Many of these reasons contributed to the volatile economic environment we find ourselves in today.

  1. Mindset—We can take action when bad things happen so things will never be as bad as risk simulations are showing—forgetting that the point at which we address a problem is directly related to the number of viable options we have for solving it
  2. Decision-makers don’t agree on appetite for risk
  3. Decision-makers agree on appetite for risk but don’t make the tough decisions to manage within their appetite
  4. Decision-makers take on more risk than they are truly comfortable taking because “everyone else is doing it”— so it must be right…
  5. Lack of effective communication between decision-makers and risk quantifiers
  6. Short-term decision making
  7. Decision-makers not linking strategy and A/LM (financial structure management)
  8. Contingency plans are not tested to determine if they are adequate
  9. Using old decision drivers and measures of success in a new environment—following peers
  10. Improper risk quantification providing a false sense of security

Click here to view the expanded version…

Recent history has shown us the havoc caused by inadequate risk management, and we are concerned that the havoc will continue or worsen if something doesn’t change.

Many in the financial services industry continue to worry over tightening margins, threats to non-interest income, diminished loan growth—the list goes on.  However, we urge all stakeholders to consider the long-term viability of their credit union rather than rely on short-term decision making (#6).

We are seeing more and more credit unions focus on short-term “Band-Aids” instead of taking a longer-term view of making sustainable changes to the way they do business.  Short-term solutions often come with long-term consequences—some of which could be another cycle of credit losses, assessments or even renewed stabilization efforts.

There are no easy, quick fixes for the financial services industry.  The situation requires a thorough evaluation of the sustainability of current business models and, most likely, redefining measures of success.