Regulators' Misplaced Focus
Credit union bottom lines are underperforming-and in many cases operating in the red-because regulators continue to misunderstand when earnings are at risk.
That's the argument being made by Peter Duffy, VP with New York-based Sandler O'Neill, who has been taking that message and others on the road before numerous credit union audiences. In this case, Duffy was in Orlando to speak to the Florida league.
According to Duffy, the key success factors for credit unions is to build marketshare and to make marketshare the key ratio, and not the traditional measuring stick, the loan-to-share ratio.
"I can tell you that the years you have spent listening to regulators about earnings being at risk when rates go up are over," Duffy stated. "That cat is out of the bag. Earnings are at risk when rates go down, and you need to start managing your balance sheet that way. You need to be measuring performance on ROE."
Duffy said that any credit union can conduct peer analysis, and that will indeed tell it how it is doing compared to its peers. But that information often says little about how the credit union is doing in is respective marketplace, he said.
"The members who know you, love you," Duffy observed. "The issue here is in focusing on loan-to-share rather than marketshare, and in not turning service into more business. We're nowhere near the marketshare we should have because there are so many unsold members who don't know what the sold member knows. Take every dime and put it into marketing and sales."
ALM, said Duffy, is really just one part of balance sheet management. The objective of balance sheet management is to enhance or protect the competitive posture of the credit union's offerings in the marketplace, he said. "There is a major opportunity for improvement and enhanced earnings," said Duffy. "The good news is it's easy to fix. You have to consider the competitive ramifications of emphasizing ALM in an out-of-focus manner."
Traditionally, noted Duffy, credit union risk-weighting is based on duration of assets. For instance, mortgages up to 25% of assets are risk-weighted at 6%. When the ratio rises above 25%, those mortgages are risk-weighted at 14%, with the assumption being the longer term means greater risk, according to regulators.
Yet Duffy noted that thrifts often have up to 60% of their loans in mortgages and yet consistently out-earn the local credit union.
"The issue is that this risk-weighting difference is costing you money," he said. "The effect has been that you are discouraged from doing mortgages after a certain point. The problem for the marketer is that if you want to increase relationships, you really want that mortgage."
Duffy noted that NCUA has proposed that credit unions be able to use the same risk weighting model employed by the FDIC, where risk is based on credit risk. "The FDIC, OTS, FRB and OCC know that all the money lost over the years was due to bad loans, not the term structure of assets," he said. "The perception of the NCUA has been that the thrift debacle was all about asset-liability management, and it wasn't."
Duffy emphasized his point that the real risk comes in a "rate-down" market.
For example, he noted there is in the U.S. clearly more supply of lenders than there is demand by consumers. The result, he said, has been the ongoing decline in loan yield, even in markets where rates were on the increase, with net interest margin declining even faster than ROA. "The issue here isn't rates, it's competition. There's so much supply of lenders that nobody has pricing power on lending anymore."
What that has created, he said, is a scenario at credit unions where there is zero spread between net interest margin and operating expenses.
As for fees, Duffy cited CUES research showing fee-income-to-average-assets ratios at banks and credit unions, with banks, not surprisingly, seeing higher fee-income ratios. For credit unions that have operating expenses above the net income ratio and also a policy of not charging fees, "they're losing money every day," noted Duffy.
Competition, emphasized Duffy, is what's driving margins tighter, "not a draconian interest rate 'shock.' The way credit unions deal with investments, ALM and marketing will determine their ability to thrive going forward."
Duffy pointed to the period from Oct. 15, 1993 to Dec. 28, 1994, the sharpest increase in rates in history. As regulators regulate in fear of rising rates, Duffy said credit union margins should have shrunk during that period. Yet they rose slightly. "What you need is more duration," he emphasized, noting that loan payments come in every month and reprice every month. But pricing on shares, he noted, often lag, with the cost of funds lagging six to 12 months."
What is missing in the ALM discussion, said Duffy, is that credit unions and banks all move in unison with pricing. And no institution wants to raise deposit rates unless a competitor forces them to.
The ALM vendors, suggested Duffy, are a business model that is at risk. "The only reason we run ALM the way we run it is a perception of the regulator's perception of interest rate risk. The vendors sell it as saying we'll get the regulator off your back."
"Duration isn't the risk," he continued. "The wrong duration is the risk. When regulations measure credit risk as the key criterion to safety and soundness, the well-run institution is free to grow and grow earnings."
The ability of a credit union's board to show why it has bought into extended duration, management's ability to articulate the position, having a well-executed policy in place, should all mean that a credit union gets no argument from the examiner, said Duffy.