Credit unions looking to improve their Return On Assets (ROA) ratio may have to radically reshape their loan portfolios, according to one financial consultant who demonstrated six tools credit unions can use to boost ROA.
The six tools: average life of products, effective yield calculations, product profitability, MCIF, product pricing and forecasting.
Part of the problem, according to CUNA Mutual's Tim Gardner, is that typically these tools are used by and/or overseen by different departments, so the challenge is finding a way to use them together.
The first step, however, is understanding why the loan portfolio looks the way it does today. Hint: it's not just the interest rate roller coaster, he said.
"Credit unions have moved away from certain loans, like signature loans and credit cards, because they're riskier," said Gardner during his presentation at CUNA Mutual's Discovery conference. "Credit unions want to stay with secured lending, but the problem is, everyone wants to do secured loans. So, it's not just the interest rate environment we're in. The fact is there just is more competition for the same kinds of loans right now."
Concentration Risk
So popular are secured loans that credit unions need to beware of the interest rate risk-as well as the churn and burn mentality of refinancing-that some of these loan products bring to the table.
"As credit unions are moving toward longer-duration loans (typical of real estate-related financing), the risk of concentration can be a major concern," Gardner suggested. "That's fine as long as credit unions manage the risk. Just remember, examiners give credit unions a hard time on real estate loans because of the interest rate risk. If you look at a lot of portfolios right now, you'll see we're doing a lot of work. But a lot of that work is refinancing, and at the end of the day that's not growing the loan portfolio, that's keeping it steady."
Credit unions need to be making unsecured loans as well as secured loans in order to keep the portfolio diversified, he suggested, adding that at some point, members will not be able to and/or won't want to refinance the first mortgage. But they likely will still need loans, and that means unsecured lending.
Besides, taking one of the six tools into consideration-product pricing-unsecured lending tends to have the highest rates in the portfolio. Of course, they also tend to have more delinquencies and charge-offs, and that brings product profitability into play, as well.
But, if the product is priced correctly, that increased risk is worth it, Gardner said. Say the rate paid on a typical unsecured loan is 11%, and the annualized delinquencies and charge-offs is at about 4%-that means the effective yield is seven percentage points, he said, and that is still a healthy number, he suggested.
The average life of a given loan is also important and can be calculated by looking at the average daily balances and the total credits for a month, he said, noting these numbers can be used to price products. "Maybe an auto loan at 4% is not so bad if it will come off the books in 24 months," he said, noting that 24 months is the typical life of an auto loan. "This can also be used in conjunction with the MCIF system to find out which members to target with which marketing message. A credit union could look at which members have an auto loan that's nearing the 24- or 25-month mark and then contact all those members about its most recent auto loan rates."
The Next Frontier
Calling it the "next frontier" for credit unions, Gardner suggested that most credit unions are new to using product profitability as an ROA tool. The first step is looking at the acquisition and maintenance cost of each product so that a credit union can maximize the products that are the least costly.
Product profitability analysis is also a good gauge of how much each product contributes to the net income, he added, noting there is a caveat.
"How do most of us price our loans now? We look at the competition," Gardner counseled. "But that's putting the cart before the horse. First, you figure out what the rates need to be for your credit union in order for it to be profitable, then you can look at what the competition is doing."
