Credit union executives are keeping an eye on anticipated interest rate increases as they make strategic decisions to grow revenue and trim expenses. Decision-makers should be revising strategies involving investments, non-interest income, loans, deposits, branches, and technology, in a direct response to 2013 growth and expected interest rate hikes.
“The last three years have been a period of nurturing for the industry,” says Bill Handel, VP/research at Raddon Financial Group, Lombard, Ill., which provides research data, analysis, and marketing to financial institutions. “The Federal Reserve dropping interest rates so dramatically around the time of the financial crisis allowed organizations to rebuild spread.”
According to the National Credit Union Administration, by the end of 2013, net worth, total assets, memberships, share and deposit accounts, and total loans were up at federally insured credit unions, while net interest margins, annualized net income, and ratios for return on average assets, delinquencies, and net charge-offs were down.
“2013 was a very interesting year in this regard. Profitability of our clients was up, and yet efficiency was down. That’s not something you see very often,” Handel says. “Earnings grew, but the underlying base of performance didn’t improve. That’s something that we have to address going forward.”
Low interest rates drove 2012 and 2013 income largely through mortgage origination and refinancing and, while those earnings were significant to the bottom line, the mortgage market is not expected to be the primary driver of additional growth as interest rates rise. The fact that credit unions increased their long-term investments over the past few years could expose them to risk as interest rates rise.
So what should credit unions be doing now—not six months from now—to address these issues? What do financial advisors recommend for credit unions to stay on the upswing throughout 2014?
“As we think about quick hits, the things that are most directly impactful in the short term are income statement items: fee income, expenses, and changes that can be done to the investment portfolio,” says Brad Dahlman, product manager of profitability, pricing, and dashboard solutions at ProfitStars, Mendota Heights, Minn., a provider of software and IT consulting for financial institutions.
Dahlman says credit union executives should identify investments that can be sold at a gain now and reinvested in short-term instruments until rates go up. As rates fluctuate, the value of fixed-rate bonds also changes. If an investment portfolio includes higher yielding bonds, these could be sold now at a gain and re-invested in another asset, such as loans or short-term bonds (assuming that rates will rise). The downside is that the gain is realized but the higher yielding bonds are no longer in the portfolio. Investment managers must evaluate the trade-offs.
In addition, he says, credit unions need to look at their margin on loans and deposits, as these areas represent two-thirds of overall revenue. With fixed rates on long-term member loans locked in, executives need to price new loans effectively to improve overall performance down the road. Fee income is also important, as it represents about a third of most credit unions’ overall earnings, according to Dahlman.
Sally Myers, CEO/principal of C. Myers Corp. (www.cmyers.com), Phoenix, which provides ALM and process improvement services for credit unions, says that while many credit unions have the ability to grow their loan portfolios, others may be severely restricted by money they need from investments to make those loans.
“They may not be able to unwind the investments at par; they may need to start discussing trade-offs with regard to unwinding investments at a slight loss,” she explains.
Executives need to act now, before interest rates rise, according to Myers: “Before this problem gets big, credit unions need to develop a very clear strategy. If their focus is on lending and providing their members with good solid loans at good pricing, then what they need to do is consider the current structure of their portfolios and how they will be investing in the future.”
Competition is, of course a major factor in lending. Handel suggests that credit union executives look at their loan strategies thinking about whether the marketplace is “red ocean” or a “blue” one. Red oceans are cutthroat marketplaces with intense competition, like auto lending, and blue oceans are less intense.
Credit unions need to include more blue ocean lending in their strategies, such as home equity loans and lines of credit, according to Handel. While these types of loans have been flat to declining for several years because mortgage refinancing act-ivity absorbed demand for them, they will become more viable in a higher rate environment, he says.
Credit unions won’t be able to offer home loan refinancing at lower rates, Handel says, but they can explain the tax advantages of equity loans to long-time members and new members, who may move accounts to the credit unions that finance their equity loans. Credit unions will be more selective about approving loans than they were before the economic downturn, he adds.
Handel admits that some executives might be skeptical: “You’re going to have people reading this say, ‘That’s crazy, we’re not doing more equity lending.’ That’s because people naturally react to the last crisis, and the last crisis was real estate. But the silver lining is that supply and demand for real estate has been brought into better balance.”
Dahlman and Myers both suggest credit unions look for ways to reallocate investment dollars for loans. “Every dollar you can take out of the investment portfolio and put in the loan portfolio is going to give you four times the level of return based on current yields,” Dahlman says. “We want to try to increase that loan-deposit ratio and get more dollars invested in loans because they are much higher in yield — but, as we grow that portfolio, not be foolish and give it away.”
For example, he wonders why a financial institution would offer auto loans at 0.99 percent, considering the costs involved. “By the time you fund the loan and adjust for risk, the spread may be very skinny,” Dahlman says.
Myers, whose firm provides process management and project management consulting, says inefficient lending practices waste time and opportunities. For example, executives need to understand the number of auto loan applications they receive, the number of applications by credit risk, the number they approve by credit risk tiers, and the number they fund. They need to know their funding ratio relative to the number of applications they receive.
“Sometimes we’ll see credit unions that will only fund 25 percent or 30 percent of the applications they touch,” Myers says. “Is it because you’re not approving them? Is it because you’re taking too long to say yes? Or are you saying yes but people have to jump through rings of fire?”
She says credit unions have to ask themselves difficult questions, including, “‘Is my appetite for risk in line with the membership I serve, or is my marketing effort not aligned with my appetite for risk? Is my marketing effort not focused enough on the people I want to make loans to?’”
While Handel suggests that some credit union executives may fail to plan for an uptick in home equity lending, some also may question focusing on deposits right now. “Most institutions will say, we don’t need deposits so we don’t need a deposit strategy,” Handel says. “But this is a good time to think about your deposit strategy—when you don’t need deposits.
“As soon as people see an increase in interest rates, there’s going to be a cry to raise deposit rates,” he explains. Credit unions can put strategies in place now, so they are ready to act when the time comes. One strategy is that as interest rates begin to increase, rather than simply pass along these rate increases to all categories of accounts, the credit union creates new products with higher rates and holds the line on rates for its other accounts.
The new products are made available to “rate sensitive” clients who are looking for a higher return. By creating new products and purposely moving only the rate-sensitive clients into these products (upon their requests for better rates), the credit union can better manage its dividend expense.
The CU can use relationship pricing to introduce a new money market account with higher requirements that earns higher interest. Members have the option of migrating to the new account as long as they meet the requirements.
“Should credit unions focus on how to get core deposit accounts?” Myers asks. “Yes, if that’s their strategy.” They need to consider the costs vs. the benefits of accounts held by newer members who fled to the safety of credit unions when many banks failed during the recession.
Deposit strategies should include costs and benefits from an operational and delivery-channel perspective, she adds.
“They might be low-cost from an interest standpoint, but what about the infrastructure to support those types of accounts?” she says. “You look at everything that’s going on with mobile channels and the way that the consumer is demanding instantaneous attention—that infrastructure is expensive. And fraud, there’s a heavy cost there.”
Non-interest income also deserves significant attention now, these financial advisors say. Just as fee income from mortgage origination has slowed, overdraft income per account has declined, and will continue to do so, Handel says. Account holders now receive electronic alerts about low balances, and they are more inclined to maintain balances to avoid fees.
As non-interest income flattens out, credit unions need to look for new sources and ways to generate income that will not be subject to oversight. Potential areas for growth include wealth management and insurance, according to Handel. Baby Boomers are looking for new ways to make the most of their 401(k) balances, and younger people need wealth management services to help them get started on their path to retirement.
Credit and debit cards also offer some space for non-interest income. Handel explains that credit unions can use rewards and other approaches to encourage credit card and debit card use. “You can use a non-use fee on debit cards to drive more transaction behavior,” he says. “We’ve seen credit unions have great success with this. If a member doesn’t use the card, they’re going to pay a fee.”
Another illustration of driving behavior is in fees for paper statements. These fees don’t necessarily drive income, but they do reduce expenses, Handel says.
Dahlman encourages executives to do annual reviews of fee schedules compared to the competition. “Are there fees that their members are more or less sensitive to?” he says. “Are there fees for convenience, fees for services that members value that they are willing to pay for? Are there fees that you can apply to clients that have stopped using their accounts? Are there additional fees that they should be able to get on loans? Should they be getting more for home equity lines? Should they be getting closing costs? Those are the fees that clients are willing to pay.”
Analyzing branch profitability is a trend, but there are no quick and easy answers about whether to open, close, expand or shrink branches. Financial advisors caution that branch viability should not be based solely on the volume of transactions, as branch profitability analysis is complex and unique to the institution and its market.
“We’ve given people mobile banking, ATM cards, payroll deposits, debit cards, Internet banking, remote deposit capture, Internet bill pay” but we still have lots of branches, Dahlman says. “We have this cost structure and nobody’s visiting branches.”
A credit union can decide to close a branch in the next six months and reduce expenses in a fairly material way, he says, but what about the impact on members? “There are good reasons to go to a branch—to open an account for example,” Dahlman says, or “if you’re growing your member base.”
Handel—who says credit unions are actually competing with the three largest banks, Bank of America, Chase, and Wells Fargo—says executives need to consider advances in branch banking. “Some of the big banks are looking at the branch having an entirely different type of layout,” he says. In the new branch layout, “people can do so much on a self-service basis; your employees can be much more engaged in sales and service. That, over the long haul, will result in some great gains in terms of efficiency. It’s evolutionary, not revolutionary.”
Handel says a recent Raddon survey found that 20 percent of all respondents and 35 percent of Gen Y respondents expected technology to reduce the need to visit branches. Yet, only 20 percent of Gen Y respondents who earned more than $125,000 a year expected technology to reduce the need to visit branches—the same as all respondents.
“So even though we think that these younger households have no need for a branch, it’s a place for them to get advice, open accounts, and talk to somebody about what their needs are,” Handel says. “If that’s how things are indeed moving, we have to think about how we upgrade the competencies of our staff.”
Myers says the question of whether to close or reconfigure branches is tricky, and financial institutions sometimes move too quickly or
too slowly. The trick is there are many variables, and the future is hard to predict with regard to rapidly changing technology and its impact on behavior.
“Sometimes when you add up all the components of the branch profitability and put it together, the sum of the pieces may not necessarily equal the whole,” she says. Many times analyses recommend branch closings, but executives decide to keep branches open for other strategic reasons like visibility, Myers explains. On the other hand, if closing a branch allows money to be reallocated, it may be worth the pain to close the branch, reduce its footprint, and/or change its strategic focus.
“Nobody knows if the physical location will be needed to get further business from the consumer,” Myers adds. “You have to ask, ‘What is it that I really want to accomplish with this branch?’ Can you provide additional products and services to the people who come in and use the branches for transactions?”
Dahlman says that when it comes to realigning expenses, credit unions need to start with an understanding of cost structure and to look at the larger dollar items: people, occupancy, supplies, data processing, and technology. He encourages executives to do zero-based budgeting—in which every expense is addressed—rather than just talk about it.
“Consider whether you need those locations, whether you need ATMs, whether you need that equipment, and justify or demonstrate why you want to do things that you always do,” Dahlman explains. “We have limited resources; are we spending them in the right spot? A lot of things happen because of inertia.”
Technology may be one of the most difficult expenses to reduce because it’s become an expectation on the part of the member, it’s costly, evolving rapidly, and no one can go back in time and cut technology that has become commonplace.
“Bank of America, Chase and Wells Fargo are really competing on the basis of technology,” Handel says. “They have the dollars they can spend on promotion from a technology standpoint. This industry has to make sure we understand that and compete effectively. The flip side of that is that, over time, as the member becomes more and more self-service in terms of doing transactions, we can reallocate our people and move them into much more productive areas of the organization.”
Myers says many credit unions held off on technology upgrades during the downturn and may need to consider them now. Regardless of whether technology is up to date, however, there are ways to manage expenses through process improvement.
“Technology is there to make things better and more efficient,” she says. “To take advantage of that, the credit union needs to look at its processes and change them to gain the enhancements that the technology is designed to provide.”
One of the best values of technology is the ability to analyze risks and make appropriate lending decisions quickly, Myers says.
Handel says there are advantages to economies of scale in technology, compliance, brand development and marketing, and that credit unions can also take a look at sharing costs through credit union service organizations that provide clerical, professional and management services; checking and currency services; record retention; disaster recovery; brokerage services; payroll processing; and other services.
Although the economic environment is changing, the fact that income and expenses are the primary places to look for improvement is not new.
“If I were to say what our thinking is regarding resource allocation in 2014-15 for credit unions to make themselves better as organizations, I would say probably 60 percent to 70 percent would be on the revenue side and 30 percent or so would be on the expense side,” Handel concludes.
“We’re in a good spot in the industry; we’ve weathered the worst of it,” Dahlman adds. “There are opportunities out there. We’re doing a better job of lending out our dollars. We need to be very careful with rising rates to make sure that we’re effectively pricing.”
Ann Dee Allen is a writer and editor based in the Midwest.