Time for your (Credit Union’s) Annual Check-up [Part 1]

                 In Springtime a young person’s fancies turn to thoughts of the institutions’ performance.  Okay, maybe not.  But now is the time that boards of directors are elected, and performance evaluations of CEOs are made.  Financial statements are disclosed.  Members can (and some try to) analyze the results of operations.  In this blog entry I will begin a discussion of how performance should be made on a credit union.  Although many inputs should be taken into account, the next couple of entries here will focus on key measures and financial ratios.

                Measures and ratios may seem boring, but when properly understood, they are the basis for an annual check-up of the institution.  Think for a moment of the last time you went to the doctor for a check-up.  After you dealt with the insurance, paperwork and legal waivers – and after you have spent a sufficient time in inventory in the waiting room – you were probably taken back to be weighed.  Then your temperature and blood pressure were taken.  All of those measures were duly noted in your official record.  These measures are then compared to where these measures have been during past visits to the doctor, as well as the norms for people of your gender, age, and weight.  We will be doing a similar comparison as we look at the health of your organization.

The Power of Ratio Analysis:

                Ratios are what the name implies – a ratio of one measure to another.  For instance, the net worth to total assets ratio is an attempt to measure how much of total assets are financed by the equity investment of members.  Ratios should be relevant to a concept interesting to the financial analyst.  If the analyst is interested in the proportion of assets financed by the members through retained earnings then it is a good measure.  If the analyst wants to measure financial stability, it might not be the best measure by itself.  Or if the financial analyst wants to measure how well capitalized the credit union is, the net worth to total assets ratio is probably insufficient by itself to answer that question.  The reason it may not be sufficient by itself is that it does not take into account how risky the institution's loans are.

For complex problems, good analysts try to use several ratios together to hypothesize the correct diagnosis.  Let me return to a medical example for illustration.  Several years ago, my daughter was lethargic, pale, and running a very slight fever.  My daughter reminded my wife of how she had felt when she (my wife) had been anemic.  So she took my daughter to the pediatrician and told him of her suspicions.  The doctor’s office worked just as described above.  They weighed her, and took her temperature and blood pressure.  She did have a slight temperature – which led the pediatrician to write a prescription for an antibiotic.  But my wife insisted that she “looked anemic”.  So the pediatrician ordered a blood sample.

The results of blood samples come in the form of ratios – virtually all of them.  Like financial ratios they have normal ranges.  And in my daughter's case several of these key blood ratios were way out of whack.  The white cell counts were way too high (consistent with an infection).  Her red cell counts were way low (consistent with anemia).  But even platelets were way too low.  But that could just be an anomaly.  Many novice number “analysts” would have given my daughter antibiotics for the infection, iron for the anemia and run some more tests for the platelets problem.  But our pediatrician was also a pediatric oncologist who recognized early warning signs of childhood leukemia, and thereby saved my daughter’s life.  

Although the story is an interesting one, there are at least a couple of relevant “take-aways”.  First, do not focus on individual ratios as only representing specific concepts.  If the doctor had done what many number analysts tend to do, my daughter would have been treated for an infection, anemia and would have died.  Second, when more than one measure is way out of whack, always look for one consistent root cause.  Although we never thought that leukemia was possible, the doctor was trained to look for it as a root cause.  If one source may be causing all ratios being out of the norms, that cause should be the focus of further investigation. 

Credit Union Vital Signs:

When you go to the doctor, you know what measures they will take to assess your overall health.  A credit union’s health is somewhat more complex.  Over the next few blog entries we will discuss key measures you can use to assess the health of your institution.  The first set, I will call the constraints. These key measures are used by the regulators to assess your institution’s health.  In many instances they are good health measures, but it is important to note how the NCUA understands and uses them.  The NCUA can shut down the institution if it deems it necessary.  Because of this introduction this week, and the number of ratios NCUA considers (they list 40 on their website as key ratios), their portion of this discussion will have to take two blog entries.

After this introduction, I will discuss what members could use to assess whether the institution’s performance is optimal from their perspective, and what board members can and should do to help management to improve performance.  Unlike a for-profit business, or even commercial bank, credit union performance is hard to appropriately capture with just one measure, but we will use some academic tricks to try to assess whether or not performance has improved.

In the last entry, I hope to be able to apply these principles to specific credit unions (with permission of the CEO if at all possible – so be ready for good examples of credit union performance).  If you are a CEO who would be interested in discussing this with me (that means some free consulting with a PhD - I hope that is not considered a bad thing) please e-mail me and let me know.

Safety and Security – NCUA Constraints:

The National Credit Union Administration (NCUA) is the primary regulator for most credit unions in the United States.  Even most state chartered institutions are regulated by NCUA due to deposit insurance.  NCUA is primarily interested in the safety and security of the institution.  Secondarily, they are interested in the long-term viability of the institution.  If the institution does not appear a long-term going concern, the regulator can intervene to find a merger partner.

Although the NCUA has a few favorite ratios, they list 40 key ratios on the website.  Some of these ratios have essentially regulatory standards, others should be assessed the same way vital statistics are assessed:  by trend analysis and industry analysis.  Industry analysis means comparing your institution to industry norms.  An industry norm is not a single number but a normal range.  For instance, if you were told the normal weight for someone of your height, age and gender is 175 pounds you should not feel that you need to diet as soon as your weight reaches 176, nor do you need to fear malnutrition as soon as your weight falls to 174.  A healthier approach would be if your weight reaches 190, you probably want to start watching what you eat, and when your weight gets down to 160, you might start wanting to eat what you watch.

A trend analysis, as the name suggests, analyzes any noticeable trend.  The point of a trend analysis is to see if a measure is going up or down.  When taken together with the industry analysis, the trend analysis can tell analysts whether a trend will put the institution outside the industry norms in the near future.

NCUA, like most financial institution regulators, uses a CAMEL rating system.  CAMEL is an acronym meaning Capital adequacy, Asset quality, Management, Earnings, and asset/Liability management.  To apply the full CAMEL rating system, interested readers (hopefully some among the board of directors) will read the NCUA’s description in this kind of old description.  This description was written for the benefit of boards of directors, and does contain some firm standards, which if they have changed, they wouldn’t have changed by much.

And finally, the vital signs that NCUA lists as “key ratios” are listed in this NCUA document.  The document does give the formulas used to calculate them.  If your credit union is NCUA insured, you can go the NCUA website, and input your credit union number.  Using the call report as reported at NCUA together with the account numbers listed in the formula sheet, you should be able to calculate each of these ratios for your institution.  You should then try to determine whether, over the past, your institution has been increasing or decreasing in these measures.  For some measures they may themselves go up or down with market rates.  In those cases, the industry comparison may be more relevant.   

I have calculated the median, as well as the upper and lower quartiles for each of these measures for the last three reported years (2010, 2009 and 2008).  All ratios falling between the upper and lower quartiles should be seen as normal.  Be aware that what that means is that half the time an institution's ratios should fall outside that range (either above or below).  They are listed in the same order as the NCUA sheet.  I will give a brief description below with what I think this measure actually is trying to measure.  In some instances, I will give you NCUA regulatory standards for these measures if they are listed.

2010 Industry Norms Ratios 1-10

Ratio 1:  Net Worth to Total Assets – This is probably the ratio that can get your institution closed by NCUA the fastest for being below the standard.  It is no accident that it is listed first.  The current (or at least as current as I can find) regulation defines institutions as well capitalized (no regulatory problems in this regard) if this figure is 7% or greater.  The institution is considered adequately capitalized (regulatory pressure) if this figure is 6% to, but not including 7%.  The institution is considered undercapitalized (extreme regulatory pressure or regulatory action including possibly closing the institution) if this figure is 4% to, but not including 6%.  The institution is considered significantly undercapitalized (I don’t know that I have seen many of these listed, so I think regulatory action is swift) if this figure is 2% to, but not including 4%.  And below 2% the institution is considered critically undercapitalized (have the keys ready because regulators will be at the door).  For NCUA this figure should be as high as possible.  However, for members, they would want to stay above NCUA guideline, but at the same time keep this figure as low as practicable so that they can either reduce loan rates, increase deposit rates, or squeeze the non-interest margin (not be charged fees for the same things banks charge fees).

2009 Industry Norms Ratios 1-10

Ratio 2:  Total Delinquent Loans to Net Worth – This ratio measures the amount of loans that could threaten net worth (those currently delinquent) as a proportion of net worth.  In essence it is measure how much of the currently listed net worth could easily disappear.  And that directly impacts how quickly the institution could move toward being taken over by NCUA (see ratio 1).  This number should be a small as possible for both NCUA and for the sake of all members.

Ratio 3:  Solvency Evaluation – This ratio is somewhat hard to describe what it is supposed to measure.  The important point is that it should generally remain above 100% to signal solvency to the regulator.

Ratio 4:  Classified Assets to Net Worth – This ratio measures some risk issues.  The numerator measures loan and lease losses and non-conforming (riskier) investments.  The numerator is net worth (equity in non-cooperative firms).  NCUA wants this to be as small as possible.  The first component, members should unquestionably want lower.  The second portion will almost certainly increase risk, while probably not increasing return to compensate.  Therefore, members will usually want this figure to be lower.

2008 Industry Norms Ratios 1-10

Ratio 5:  Delinquent Loans to Total Loans – This ratio measures the proportion of loans that are non-performing.  This figure does have regulatory standards.  These standards differ slightly by institution size.  See pages 19 and 20 of this publication for the last standards I can find.  Both NCUA and members want this figure to be as low as possible.

Ratio 6:  Net Charge-Offs to Average Loans – This ratio measures actual loan charge-offs to the average level of loans.  It attempts to measure the proportion of loan value that was lost during the year.  Again this measure has regulatory standards.  They are listed on pages 19 and 20 of this publication.  I believe that in the last asset size there is a typographical error, however, in that the last table in code 1 (the highest or best rated category) there is a decimal missing.  It should read less than 0.25%, when it actually appears to say less than 25%.  Again both regulator and members want this ratio to be as small as possible.

Ratio 7:  Fair Value of Held to Maturity Investments to Book Value of Held to Maturity Investments – This ratio is showing what has happened to the market value of the investment portfolio.  Even though the institution is planning to hold these investments to maturity, it is important for the regulators to know if they had to sell, would more net worth be lost or gained by doing so.  If the investments are actually held to maturity, this ratio makes little difference, but if the institution does have to sell early, both regulators and members will want this to be as big as possible (and certainly larger than 100%).

Ratio 8:  Accumulated Net Unrealized Gain/Loss on Assets Held for Sale to Cost of Assets Held for Sale – This is another hard to wrap you mind around ratio from the name.  It is trying to determine how much “available for sale” securities have appreciated over the year.  “Available for sale” securities are securities that have been purchased primarily to provide temporary liquidity and income.  Both regulators and members would want this figure to be as large as possible.

Ratio 9:  Delinquent Loans to Assets – This is self explanatory.  It measures delinquent loans as a percent of all assets.  Both regulators and members would want this measure to be as small as possible.

Ratio 10:  Return on Average Assets (ROA) – This measure is listed by NCUA as an earnings measure.  NCUA does have stated standards for this measure as well.  Those standards differ by size of the institution (although their last listed assets sizes do not represent the current reality in the industry).  For all depository institutions this measure declines as asset size increases.  The fact that NCUA standards stop at institutions of size $50 million is not recognizing current realities in the industry.  The NCUA’s standards are listed on pages 19 and 20 of this publication.  This is the most troubling measure in the list.  In a cooperative, ROA does not measure what it would in a for-profit institution.  ROA is calculated as net income divided by average assets.  Since net income is after interest income on loans (which members would like as low as possible) and also after interest expense on deposits (which members would like to be as high as possible) to make our members happy, we would want this figure to be small.  However, if it is as small as possible, then nothing will be available for growing net worth (which can only grow if we generate net income).  Net income in a credit union is the maximum amount of dollar growth in retained earnings.  Therefore, ROA is the percent growth in assets generated by retaining earnings.  Because of its unique interpretation in the credit union industry, it should be higher as the asset growth in assets is higher, and could be lower if the institution is not growing as fast.  But you should be aware that NCUA still has a standard for this, and assumes that the higher this figure is – the better.