Posts

/by

Interest Rate Risk Management: Timing of Earnings Matters

,

Would it surprise you that some interest rate risk mitigation strategies actually add risk for a period of time?  In the end, these strategies may be effective at mitigating interest rate risk but it may take years for the effectiveness to be felt.  The challenge is that many methods used to test mitigation options, like NEV, don’t show decision-makers the full picture.  The reality is that earnings and the timing of earnings matter when understanding the impact of different decisions.

Take for example, a credit union that decides to sell $90.0 million of its 30-year fixed rate mortgages earning 3.61% and reinvest in auto participations earning 1.90% to mitigate interest rate risk.  No surprise that such a move hurts earnings today.  In fact, it would hurt earnings by 23 bps.

What is not obvious, though, is that in a +300 bp interest rate environment they would give up more cumulative revenue with a strategy to hold auto participations than with a strategy to hold fixed-rate mortgages over a four-year time horizon.  Year-by-year and cumulative revenues for both strategies are summarized below:

The credit union would earn more revenue holding fixed-rate mortgages than holding auto participations for each of the next three years.  It is not until Year 4 that the strategy change pays off and they earn more holding auto participations.  Over the four-year period, the credit union would earn a cumulative $15.0 million with mortgages versus $13.5 million with auto participations in the +300 bp increase.  Timing of earnings matters.

Using only NEV to evaluate this strategy might lead the credit union to pull the trigger on it.  In this case, the credit union is using NCUA’s NMS values from the NEV Supervisory Test.  When comparing the proposed strategy to the base, the NEV in the current rate environment is unchanged at 10.75% – meaning the restructure neither helps nor hurts the current NEV.

However, after selling the mortgages, the volatility decreased in the +300 bp environment leaving a higher NEV ratio (see example above).  An added benefit is that the credit union would now be considered low risk under NCUA’s NEV Supervisory Test thresholds.  Said differently, the NEV results show decision-makers would not have to sacrifice a thing in the current rate environment while significantly reducing risk in a +300 bp interest rate change.

Earnings (see Beginning ROA), on the other hand, show there is sacrifice in the current rate environment and more risk to earnings and net worth in a +300 bp rate environment over a four-year time frame.

The moral of this story is not that all credit unions should always hold mortgages because they will earn more than other alternatives.  Certainly, not.  It should be clear, though, that NEV provides credit union decision-makers with a limited picture.  Earnings and the timing of earnings matter.  In this particular example, the credit union may decide to execute the strategy, but decision-makers understand, in advance, that even if interest rates rise quickly, it could take about four years before the alternative strategy will contribute positive earnings and start to reduce interest rate risk.

For more in-depth ways to use ALM as actionable business intelligence, please click here for our c. notes.

/by

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

, ,

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.

/by

Some Things to Consider About a Rising Rate Environment

, ,

The Federal Reserve increased the federal funds target rate to a range of 50-75 bps at its mid-December meeting.  In its forecast (the “dot plot” shown below), the Fed indicates further tightening in 2017.

010517-dot-plot-buz

While credit unions have certainly lived through rising rate environments in the past, few have managed a credit union through a rising rate environment coming from the lowest interest rates our markets have ever experienced.  Combine this with how dramatically the world has changed since the last time rates went up (setting aside the 25 bps increase in December 2015, the last rising rate environment experienced came during 2004 to 2006) and the future is nearly unprecedented.  Can you believe that Apple’s first iPhone came out in 2007 (Source: Time)?

Now that smartphones are ubiquitous and members have access to every financial services “app” in the known universe right in the palm of their hands, what might a rising rate environment mean for your credit union?  Will your members behave differently now than they did in the past?

Using your asset/liability model proactively will allow you to see a range of potential outcomes before they happen.  This will better prepare management and board for both the risks and the opportunities that are out there.

Some questions to consider and then turn into scenarios to model include:

  • Will we be able to increase loan rates?  Or will competition for loans from FinTechs or traditional competition, or the level of long-term rates, keep loan rates stable?
  • When, and by how much, will deposit rates need to increase?  How might this impact our deposit mix?
  • What things are outside of our control – such as a competitor’s liquidity position and the potential impact to us if they have to raise deposit rates dramatically to attract funds?  Or new competition, possibly from non-traditional sources?
  • If deposit rates increase, but loan rates do not, what additional efficiency can the credit union create to have sustainable earnings with a tighter margin?
  • Given the ease of moving money across institutions, are we at risk of seeing members move funds from our credit union?  Or, what if consumers move funds to our credit union that we may not be able to lend out?
  • There are always opportunities.  What opportunities lie ahead for our credit union in this environment?

This list of questions is not meant to be all inclusive, but answering these questions is a great place to start. There are many more questions to be answered.

 

/by

Happy Holidays!

From all of us here at c. myers, enjoy the holidays! We look forward to continuing our thought leadership in the new year.

/by

Best Laid Plans

Over the next few months, credit unions will be going through their strategic planning process to discuss the direction and goals for the credit union going forward. Often, we see actionable game plans with the best intentions to stay focused on implementation, which is when the real tough work begins.

Following are just a few tips to not allow the whirlwind of operations (or of life) to get in the way of strategic implementation (and the best laid plans):

  • Agree on how often progress will be reviewed
  • Keep the plan top of mind and connect it with day-to-day activities
  • Facilitate access to the right people who can make decisions on priorities

Each organization should set working agreements on how to maintain focus that suits the culture and ensures the success of the strategic plan. Ultimately, the key is to make sure the working agreements don’t let the whirlwind of real life take priority over strategic implementation.