Maintaining Your Credit Union's Fiscal Fitness
Introduction:
In my last two blog entries, I talked about the importance of ratio analysis is diagnosing potential problems in a credit union. NCUA’s forty ratios were presented that are meant to capture the health of the institution were presented. These were compared to having a check-up (which is what NCUA examinations are supposed to be). These ratios, therefore, are meant to be measures of safety and security.
In today’s entry we will move to what would delight our members. Instead of a check-up (where the point is to make sure we are not seriously ill), this ratio examination is meant to be a prescriptive aid in helping us determine a strategy for improving the performance of the institution for our owners/managers. In this process, we cannot lose sight of the fact (and we won’t) that for the long-term viability of the credit union, the NCUA must be happy. However, the objective in our focus today is giving the member more of what they want.
Delighting Members:
Which leads to modern credit union theory. Credit unions are seen as credit cooperatives. Nowhere else in the world is that more true than it is in the United States. For most American credit unions, their only sources of deposits are members in the form of shares. For virtually all American credit unions, the only borrowers are members. Even among the largest of credit unions, one set of members’ deposits essentially fund the other set of members’ loans. Because both sets of members want the best possible rates (depositors want the highest possible rates, and borrowers want the lowest), the only way the institution can please its members is by squeezing its margins.
But a margin squeeze is fine to members, since it is one of few ways they can get remuneration for their ownership in the institution. However, taken to extreme would mean that the institution does not have sufficient capital to survive. For practical reasons, therefore, the institution must widen its margins and provide for retaining some earnings. These earnings are retained for two reasons. First, a buffer is needed against bad loans. When loans go bad, they need to be written off the books. As the loan amount comes off the asset side of the balance sheet, a corresponding amount must come off the liabilities and undistributed earnings side of the balance sheet. If the credit union did not have a buffer the loan write-off could put the institution into immediate receivership at the NCUA.
The second reason earnings need to be retained is to grow the institution. If a bank needs to grow, they can simply raise more equity capital in the market. If they are privately held, either the owners can inject more capital or expand the circle of owners to include others with the necessary capital. If they are publicly traded they can simply issue more stock into the market through a new offering. Credit unions do not have that option. To grow their capital they must retain it.
Growth can, and usually does, benefit members. But it does so over the long-run. The larger the institution, the better the better loan/deposit rates can be offered (all else equal), the wider the services offered, and the more accessible those services are to members. However, since it takes so long to grow the institution to get those benefits, the members who sacrificed for them, may not be those reaping the benefits[i].
In short, members want better rates. They also want better service at lower costs. Both of these demands narrow the “profit margin” of the institution. The limit to this margin squeeze is the capital requirements and (strategically) projected capital requirements of the institution. As they are successful at delighting their members with great rates and low cost services, their members will demand more of them, and bring their friends – which causes the assets/liabilities of the institution to grow. The capital constraints then kick in to moderate the margin. The successful credit union leader understands this tug-of-war and her institutions position in it. One way to measure it is through the following model, made up completely of financial ratios.
The Model:
The model simply shows how certain measures (financial ratios) are mathematically related to other measures. In understanding how they relate to one another, we can understand how we can the trade-offs that come from trying to improve the key ratios. So to understand the model, let’s first introduce those key ratios – note unlike the NCUA who is looking at safety and security, using 40 ratios, we will be able to do this analysis with 10 ratios and 3 weights (13 measures in all):
1) Loan Interest Yield (LIY): This ratio seeks to measure the average interest charged on loans. Members would want this number to be as small as possible.
2) Deposit Yield (DPY): This ratio seeks to measure the average interest earned on shares and deposits. Members would like this number to be as large as possible.
3) Sustainable Equity Growth (SEG): This ratio is how fast our equity capital grew in the past year from retaining earnings. This figure should be compared to the asset growth for the same period and should be greater than or equal to that rate, to maintain your capital ratios. If it is smaller, then adjustments must be made. Most of those adjustments must be made in the above two ratios, and will involve widening their difference (to the chagrin of members). Financially savvy readers will note that in most contexts, this ratio is called ROE (return on equity). But in a credit union, the only way members earn a return is by higher deposit rates, lower loan rates, or superior service at a lower cost.
Now how do they all fit together? Well the model has two parts. The first part relates the first two ratios from above with retained asset growth (RAG). The second part relates RAG to SEG, to show how decisions that affect margins (including LIY and DPY), in turn affect the maximum rate at which the credit union can grow (SEG)[ii].
RAG = wL(LIY – LLY) + wIIY – wDDPY + (NII – NIE) – OE Model Part 1
SEG = RAG × LEV Model Part 2
To introduce each of these ratios, see the brief descriptions below. Note that if we want growth to be as high as possible (which we do) while maintaining low loan rates and high deposit rates, all other ratios must be aimed at making RAG as large as possible.
4) Retained Asset Growth (RAG): This measure shows how much of asset growth this period (usually year) is funded through retained earnings. Again the financially savvy reader will quickly recognize this measure as return on assets (ROA). But the name doesn’t fit in a cooperative, where important components of return to members are taken out before net income (and have an adverse effect on reported net income), so I have taken the liberty to rename it.
5) Loan Loss Yield (LLY): This ratio measures how much loan losses will cost realized loan yield. Because it has a negative sign, credit unions should strive to make this measure as small as possible.
6) Investment Yield (IY): This ratio measures the average return on investments. Because it is added to RAG, the higher this is the better. But the only way it can be increased is by taking on more risk, and as a fiduciary for members’ money they are restricted on how much risk they can take on. This yield is usually (almost always) below the loan yield (LIY), so credit unions typically want to invest more in loans than “investments”.
7) Non-Interest Income (NII): This ratio measures how much RAG is affected by the non-interest income. Non-interest income includes fees for services rendered to members. With this and the non-interest expense (which is next), we must be careful. Higher NIIs would improve the RAG and help grow the credit union. But it would not make members as happy as not charging so much for services. The best way to judge this figure is service by service. Try to figure what the member would pay if they got this service somewhere else. Also important is whether the institution is making a “profit” off of the service. If so, that will increase RAG, but members may want more of their “return” in lower fees.
8) Non-Interest Expense (NIE): This ratio measures how much RAG is affected by the non-interest expense. These expenses are more than just the cost of the services mentioned in NII above; they also include such things as occupancy (if property is leased), salaries, and other expenses. NII – NIE is almost always negative, but it would be better the smaller it is.
9) Other Interest Expense (OE): This ratio measures the contribution to RAG of borrowings. If you look at the industry averages provided with this blog entry, you will note that OE isn’t even used by the typical institution (look at the UQ, Median an LQ rows) until the credit union is larger. As institutions grow their assets, they try also to grow liabilities (not just equity – which is hard enough). If members do not contribute enough as shares, the institution will have to fund the assets somehow. Typically they do that through borrowings. These borrowings could be loans, bonds or negotiable CDs. All of these sources are yields outside the membership of the institution. They are also usually higher than those to members. This figure may look small, but that is because it is scaled by assets, not borrowing. If you wanted to compare yields, you would have to divide other interest expense with the average borrowing. I have found that figure to be horribly misleading, since some institutions only use borrowings during part of the year, and the denominator used by outside analysts is usually biased.
10) Leverage (LEV): This figure measures how highly leveraged the firm is. It is similar to the leverage ratios discussed in earlier blog entries. This is essentially the inverse of the net worth to total assets ratio. That means that NCUA requires this ratio to remain below 14.28 to be well capitalized. Again note that there are some size categories at the end of 2011 where the UQ was higher than that (meaning more than 25% of all institutions of that size were under NCUA scrutiny).
11) Weights (wL, wI, wD): The first two weights measure what proportion of total assets are made up of loans, or investments. The last measures what proportion of total assets are funded by member deposits. These measures also differ by institution size.
The first stage in using this model would be to calculate the ratios and weights for your institution. For help in do that, access this document stored on the CUES website. If you calculated it correctly, then the model 1 and model 2 equations will in fact hold (i.e. RAG calculated as in the formula above will equal the equation).
Second, you could compare your institution to the norms for your industry. Remember, that you should compare yourself to the total normal range (within the LQ to UQ range), not just the median. The 2010 figures are found along the sides[iii].
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| 2010 Industry Norms |
Third, be aware that some credit unions at all size levels have different cost structures depending on their sponsoring organization. The largest credit union in the U.S. is Navy Federal Credit Union. It is much more likely to get subsidized occupancy expense than a community credit union in the same size category. Try to remain open-minded as to what is causing the differences.
Fourth, use models 1 and 2 to explore how RAG could be improved by changing some inputs. This should start as a brainstorming session, where little criticism is used when suggestions are made. After brainstorming what inputs (ratios or weights) could be adjusted to get the RAG to move where you want, then focus on specifics. Try to find a strategy that would move it higher while still maintaining loan and deposit rates that will delight members.
Conclusion:
In the past two blog entries, I compared ratio analysis to going to the doctor for a check-up. I suggested that you probably want to perform a self check-up, since the NCUA will do their own. We don’t want any surprises from them. In this entry, we have used a model aimed at improving our performance as perceived by members. Because this effort is ongoing, this effort is more like going to the gym to work on burning calories and getting our heart rate (and blood pressure) down. Next blog entry I hope to examine the use of a personal trainer in that effort. In particular, I will introduce a measure of improved performance and show how all these measures can be used to help understand how the institution improved their performance. So stay tuned.
[i] This is another difference between banks and credit unions pointed out by Bauer, Miles and Nishikawa (2009). Taken to the extreme this observation makes credit unions less risk seeking. New projects would have to be more certain for current members to risk current improved rates for future improved rates. It also makes credit unions seek faster return on new projects (which might be saying the same thing). This article is an academic article accessible as a conference presentation, or as published in a peer reviewed journal (Journal of Banking and Finance).
[ii] Note this model is identical to the model I presented in Credit Union Management magazine in 2010. The introduction here is somewhat different.
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