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Farewell To Borders: No Business Is Immune

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No business is immune to the pressures of external forces and changing consumer behaviors.  At the end of July, after being in business for over 40 years, Borders notified its 1.6M rewards customers that it would be closing its doors for good.

According to Borders’ 2010 annual report, the company had:

  • 642 stores
  • 16,400 employees
  • $2.3B in revenue but a net loss of $299M
  • For comparison, 2009 net loss of $109M and a 2008 net loss of $187M

Following is an excerpt from a letter issued by Borders CEO, Mike Edwards:

We had worked very hard toward a different outcome.  The fact is that Borders has been facing headwinds for quite some time, including a rapidly changing book industry, the eReader revolution, and a turbulent economy.  We put up a great fight, but regrettably, in the end, we weren’t able to overcome these external forces.

Some in the industry are simply preserving the status quo, expecting the environment to eventually subside to pre-Great Recession levels bringing higher loan-to-asset ratios.  A key factor to consider, however, is the blatant un-sustainability of that environment.  Consider the evolution of the personal saving rate at that time:  cycling from a meager 2.4% at year-end 2002 plummeting to negative levels by 2006.

To expect consumers to return to this debt-burdened state after the recent economic collapse is a fallacy.

The lesson here is not that you have to focus your strategy around technology, but that you have to strategically evaluate your business model and evolve as appropriate with the changing landscape. “Appropriate” will be unique to each institution.

Sources:
1.    A Fond Farewell…Thank You For Shopping at Borders, Letter To Borders Rewards Members, 7/21/11
2.    Borders Group, Inc. 2010 Annual Report on Form 10-K

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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.

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Lower Earnings Or Increased Interest Rate Risk?

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If there is one thing to be said infallibly about risk management, it is never black and white.  The historically-low rate environment coupled with mostly-anemic consumer loan demand has put increased pressure on credit union margins across the nation; moreover, many are reaching their floor with regard to lowering deposit rates.  In light of the real threat of rising interest rates, decision makers must strike a delicate balance between the risk of reaching for yield and accepting lower ROA and net worth ratios in favor of managing interest rate risk.  Adding more urgency to the issue is the recent release of NCUA’s proposed rule/guidance amending regulations focused on protecting against interest rate risk.

If you’re feeling the squeeze on your margin like many in the industry, remember that current earnings are not an adequate indicator of success, safety or soundness.  As regulator scrutiny increases, it is critical to identify how your long-term risks to earnings and net worth could change considering your current strategy, potential decisions under consideration and bad-case stress tests.  Too much focus on the margin, and yield specifically, may invite excessive interest rate risk.

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Establishing Concentration Limits

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Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.

The supervisory letter on concentration risk states that examples of concentrations within an asset class include…

“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”

If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.

Let’s assume:

8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in

3,840 total risk limits for the Residential Real Estate Loans

Keep in mind the above example is just for Residential Real Estate.  Imagine applying the same multifactor approach to other asset categories.  The number of limits can become daunting and unmanageable.

We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.

Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management.  However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.

Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications.  Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.

We highly recommend following a deliberate process to establish limits.  Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions.  This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.

This blog addresses only a sliver of the issues regarding concentration limits.  There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.

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When Will This Be Over?

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It’s natural to wonder when things will get back to “normal.”  But week after week, the only thing consistent in the economic indicators is that they are not consistent.  So how do we plan for the future?

Most credit unions are designed to thrive in a different type of economic environment─one we may not see again for a long time.  Yet opportunities exist in every environment.  The key is the ability to alter our mindset and look for ways to take advantage of the current reality.

Try test driving the scenario:  “It is 2015 and we are thriving.  The economy is about the same as it was in 2010.”  What did you do to thrive?  How is your strategy different than it was in 2010?  Instead of looking for a “magic bullet,” consider staying true to your core business and improve areas of expertise.  For example, there may not be much loan demand at the moment, but by truly understanding what your target market needs and values, you can work toward getting more of the loan demand that currently exists.

Also, many institutions are focused on cutting costs; according to NCUA’s aggregate FPR for March 2010, there was a 36% decline in the industry’s average operating expense ratio from March 2009 to March 2010.  However, keep in mind that some cuts are not sustainable, such as pay cuts and leaving critical positions vacant.  While they may be necessary in the short term, work toward sustainable cuts like improvements in processes and strategic changes in product offerings.  Consider the following statistics from the Harvard Business Review’s July-August 2009 readers’ survey, How Bleak is the Landscape?

  • Only 27% of businesses surveyed are streamlining product or service offerings
  • Only 34% are reengineering processes
  • Only 37% are improving current products, services or customer support

Rather than hunkering down and waiting for the storm to pass, meet the storm head-on.  Stay focused on strategy and never stop thinking about ways to improve your business.