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Sources of Revenue…Something to Consider

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Many credit unions are examining their business models and dissecting their membership in several ways. One example is by age group. The objective is to understand where business is coming from to help ascertain the age groups that contribute the most to the cooperative. Often the focus is on loans and deposits. However, a key piece of data that needs to be included in such an analysis is the percentage of non-interest income each age group contributes. Without this information, the picture can be incomplete.

Take examples A and B below. Example A looks solely at the loans and deposits held by each age group for a credit union. Example B, on the other hand, includes the non-interest income generated by members. This provides a more complete picture of how each group is generating revenue for the credit union.

Credit unions can learn a lot about their membership with this information, such as which groups generate the most revenue and what the prime borrowing years are for their membership. This type of information can greatly enhance allocation of resources, including marketing efforts.

A couple of logical next steps include evaluating the cost structure of various products and services as well as counting your business every day by delivery channel. Gaining a better understanding how your membership uses key delivery channels also will greatly inform strategic allocation of resources.

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Threats To Interchange—More Than Just An Income Issue

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The financial services industry is still holding its breath awaiting the repercussions of the Durbin Amendment reforming debit interchange.  The initial threat for which many are preparing is a material reduction in non-interest income.  Although the amendment exempts financial institutions with less than $10 billion in assets, opponents argue that merchants will (of course) coerce consumers by any means necessary to use lower-interchange payment forms.  But what operational expenses might be involved?  While many are focused on the direct impact to the bottom line, there is also the challenge of implementation and the associated cost.

A recent statement from William Sheedy, a Group Executive for Visa Inc., noted that:

The Durbin Amendment will be expensive and challenging to implement and will likely require changes by all stakeholders from the point-of-sale through to the issuer.

The statement also mentions that the two separate interchange structures are compounding the issue—noting that the degree of difficulty in implementation will depend upon actions by all stakeholders in the system and, of course, the details of the final regulation.

This is just one more threat facing decision-makers.  Uncertainties that could result in significant financial pain can impact product offerings, service levels and strategic direction.  Our suggestion is to turn these high-level threats into opportunities to reevaluate your business model by test driving how life might be if a particular threat were to become a reality.  If the threats don’t materialize, the worst that happened is decision-makers invested more time to think deeply and strategically about their business.

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Annual Long-Term Financial Planning Process: Include A Deflation Scenario

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We strongly recommend that credit unions annually invest the time to forecast financial performance for at least three future years.  The baseline forecast should compliment the strategic plan and include the cost of major initiatives, as well as expected growth trends.  If the baseline does not produce satisfactory performance, determine what changes could be made.  Once a baseline is established, senior management should identify the issues they feel could have the biggest impact on future financial performance and then test each issue as a what-if.  Typical what-ifs include:

  • Provision for loan loss doubles from the baseline plan for 24 months
  • Non-interest income decreases 50%
  • Lending volume declines significantly
  • NCUSIF assessments are twice the level in the baseline
  • Interest rates increase to the credit union’s self-defined, worst-case scenario

We recommend that a deflation scenario be included as well.  Many management teams have not discussed the possible impact of a sustained period of deflation, and even fewer have taken the time to forecast the possible financial impact of such a scenario.  Following a structured strategic thinking exercise on deflation could be helpful to explore the issue.  Create the what-if forecast by evaluating the impact on all major components of the financial structure and updating assumptions.  Often these forecasts include lower long-term rates including loan rates and investment rates, an increase in loan and investment prepayments, decreased loan demand and an increase in deposits.  While this may sound similar to today’s economic environment, the magnitude of such conditions may be greater.  For example, long-term rates could fall to 2% or lower and loan growth could decrease materially due to accelerated prepayments and consumers postponing purchases.

Management teams are often surprised by the possible significant, negative financial impact of a deflation scenario.

As with all of the what-ifs tested in this process, if the financial performance is not acceptable, determine what actions could be taken and test the impact of these actions.  At the conclusion of the exercise, decide if any of the actions to address the risks in the what-ifs should be implemented in the baseline plan.

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Prolonged Low Rate Environment?

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For months many have been watching and wondering when the inevitable increase in market rates might materialize.  Now, with some economists projecting that rates will stay at historic lows for another 12-18 months, credit unions should evaluate how, or if, they can continue to maintain net interest margin and ROA.

Not all institutions have room to lower deposits enough to mitigate the continued erosion in the yield on assets.  In a sense, deposit pricing is reaching a “floor” for many credit unions.  All else being equal, ROA will continue to erode and interest rate risk profiles will weaken as higher-rate loans and investments roll off, being replaced with lower yielding assets.

So what should credit unions do?  Common strategies include looking beyond the margin and evaluating expenses, as well as potential new sources of non-interest income.  As mentioned in previous posts, some institutions are stretching for yield, either in loans or investments.  If this strategy is employed, institutions need to carefully monitor the impact on the risk profile, and make sure decisions are tested beforehand and fit within the credit union’s philosophy and A/LM policy/guidelines.

Finally, some institutions have chosen to not take any drastic steps at this time, and have instead begun to adjust expectations at both the employee and board level, re-evaluating what success looks like in this environment.  One potential saving grace is that loan losses seem to be stabilizing in many areas, but should not be taken for granted given what institutions have experienced over the last two years.

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Consumer Behavior And Non-Interest Income

Last week, we identified some of the many threats to earnings. With regard to non-interest income, potential changes in regulation were identified to be a major threat. Building on that, here we would like to suggest changes in consumer (i.e., member) behavior as an additional threat to non-interest income. In these trying times, consumer behavior has evolved and people are spending less and saving more. Both of these actions sound like responsible things for consumers to be doing (and they are), but for your credit union, they likely translate into lower earnings. Many places we are working with are reporting decreases in both interchange income and overdraft (or courtesy pay) fees. Members are also working hard to deleverage themselves, leading to lower loan volumes and fewer late payment fees. Whether these are short- or long-term behavioral changes is a topic for debate, but, for the present, credit unions are feeling the impact.

If you aren’t already, make sure you begin to analyze the sources of your income inside and out. Do not merely look at your level of non-interest income as a whole, but understand the components of it and how they are changing. Many credit unions are seeing higher overall levels of non-interest income due to extraordinary mortgage originations. This extra income may be hiding declines in other areas, or increases in operating expense. While higher-than-normal levels of origination income may be helping your earnings today, they most likely are a short-term source of extra income. Sooner or later, interest rates will rise (no predictions here!) and/or the refinance boom will end and mortgage volumes will fall.