Hello, this is Samantha Shares.
This episode covers NCUA's letter to Credit Union's No.
6 CU4 on the topic of the evaluation of earnings.
While this letter is many years old, it is still cited in NCUA's examination
as support for document of resolutions.
The following is an audio version of that advisory and the press release.
This podcast is educational and is not legal advice.
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And now the letter, Evaluating Earnings in Credit Unions.
Credit unions are not for profit cooperative financial institutions.
Groups of people sharing a common bond form credit unions to pool their resources
to provide access to affordable financial services designed to meet their needs.
As a cooperative not for profit organization, a credit union's
mission is to provide financial services to their members, not to
earn a profit for stockholders.
Any economic value generated by the credit union that is undistributed i.
e.
not used to absorb costs or provide an immediate return to the members is held
on behalf of and owned by the members.
Though not for profit, credit unions must generate revenue for two primary reasons.
One, to cover the costs of providing members with financial
services, and two, to maintain a safe and sound level of net worth.
Net worth is necessary to provide protection against unexpected future
costs and a foundation for member service growth and initiatives, as well as
to meet regulatory capital standards.
In order to build and maintain appropriate net worth levels, credit
unions must retain earnings, i.
e., have a net income sometimes referred to as a profit.
NCUA's mission statement is, to foster the safety and soundness of federally
insured credit unions and better enable the credit union community to extend
financial services for provident and productive purposes to all who seek such
service, while recognizing and encouraging credit unions historical emphasis on
extension of financial To those of modest means, this mission statement
highlights a balance that both N.
C.
U.
A.
and Credit Unions must strive to maintain, balancing safety and soundness with the
mission of extending financial services.
Perhaps the most notable way this challenge manifests itself is in
determining the right level of network.
Net worth is essential to credit unions.
Not only does it protect against uncertainties, but also provides a
foundation for the long term viability of the credit union, ensuring continued
credit union service for current and subsequent generations of members.
When net worth is too low, An institution is exposed to a high risk of failure.
On the other hand, when net worth is too high, members may not be receiving
all the benefits and services that could be safely provided and or the credit
union may not be taking advantage of opportunities to position itself to
expand member benefits in the future.
Despite a natural tendency to err on the side of conservatism, NCUA's
supervisory oversight must support credit unions efforts to balance net
worth needs with providing value.
and achieving longer term strategic goals.
Earnings Assessment Framework.
As the purpose of retaining earnings for credit unions is to build or
maintain net worth, the analysis of earnings is fundamentally linked with
the net worth needs of the credit union.
This is reflected in NCUA's CAMEL Rating System, Letters 03 COOS 04 CAMEL Rating
System, which lists the net worth level and sufficiency of earnings for necessary
capital formation as key factors to consider when assessing earnings.
In fact, earnings needs in credit unions are a function of the net
worth ratio goal, which in turn is affected by asset growth levels.
Thus retained earnings goals set independently, as if net income is an
aspect of a credit union's financial performance that has merit in and of
itself, run the risk of being incompatible with other organizational goals.
Further, there is distinct time dimension to any analysis of earnings.
This is due to the following.
Thank you for listening.
Net worth goals involve both immediate considerations as well as strategic
ones related to future risks and growth and member service expansion plans.
The officials have to balance the immediate return of earnings to
the members in various forms e.
g.
dividends, lower loan rates, etc.
with the retention of earnings to fund future member benefits.
Variations over time and economic conditions affecting a credit
union's cost structure and rates on loan and share products.
There is no simple metric for determining what an individual credit union's R.
O.
A.
level should be.
A 1 percent R.
O.
A.
level has served as the rule of thumb for good performance for
financial institutions for some time.
The establishment of the Camel Matrix in 1987 canonized for credit unions
a 1 percent Our OWA by tying it to a CAML one component rating for earnings.
However, as emphasized in NCU, a letter to credit unions, zero three CUSO
for March, 2003 CAML rating system.
CAML ratings are not automatically determined by matrix ratios.
Editorial comment.
NCU has eliminated the matrix since this letter was issued.
Each credit union's earnings level must be evaluated based on the credit union's
unique needs, as well as overall economic trends affecting financial institutions.
For example, consider contemporary economic trends.
In 2005, aggregate credit union, RO, had dropped to 85 basis points, the
lowest level in at least 20 years.
Interest rates have been rising steadily since mid 2004, with the
Federal Reserve raising interest rates for the 17th consecutive time.
As a result, the net interest margin declined to 3.
24%, its lowest level in at least 20 years.
The low net interest margin, and thus reduced ROA, is a direct
result of both a rising rate environment and a flat yield curve.
Credit unions partially offset the pressure on earnings with
increased fee and other income, with this source of income playing
an increasingly larger role.
However, credit unions aggregate net worth ratio is at record levels and
actually increased 30 basis points to 11.
24%.
Despite a decline in ROA net worth growth of 7.
59%, outpaced the modest asset growth of 4.
9%.
Consistent with the purpose of net worth, credit unions are well positioned
with ample net worth levels to accept lower ROA levels during the current
economic climate that has resulted in reduced net interest margins.
Transcribed Consider that, on average, the modest asset growth levels credit
unions have experienced over the last 10 years require an ROA of only 55
basis points to maintain net worth levels at their current strong level.
Thus, credit unions need not engage in reactive or extraordinary measures
simply because earnings levels decline as a result of broader
economic conditions when net worth levels meet or exceed their needs.
In fact, such measures likely involve significant risks, either in
terms of accepting greater risks to generate higher returns, and or in
terms of short sighted trade offs e.
g.
increasing fees, selling less profitable business lines, engaging in high risk
lending affecting the longer term strategic positioning of the credit union.
Examiner Assessment of Earnings.
Examiners do not evaluate earnings globally with peer
ratios or camel benchmarks.
Earnings are evaluated on a case by case basis unique to each
credit union's circumstances.
An examiner's review of earnings is in relation to each credit
union's risk profile, operational context, and strategic plans.
The ROA level is not the primary focus of an examiner's assessment of earnings.
Historical earnings levels are somewhat relevant to assessing management's
record in managing earnings.
However, it is quite possible for a credit union to have impressive
profitability ratios by assuming an unacceptable degree of risk.
Thus, examiners assess management's capability in managing the risk versus
reward trade off, evaluating earnings by considering the quality of the earnings
structure, fit with the overall strategies of the credit union, future direction
of earnings performance, Ability of the credit union to realize an adequate level
of earnings in a safe and sound manner.
Lower ROA levels will be viewed positively if they are the result of a sound and
well executed strategy to balance risk exposure or incur costs to position
the credit union to achieve longer term growth and member service objectives.
In addition, examiners recognize that the purpose for credit unions retaining
earnings is maintaining appropriate, but not excessive, net worth levels relative
to the risk profile of the credit union.
In fact, executing a sound plan to return excess capital to the membership
or utilize capital to achieve longer term strategic objectives
can contribute greatly to the long term success of the credit union.
Examiners also positively incorporate such strategies into their
evaluation of earnings and capital.
Earnings Red Flags.
Examiners need to evaluate the level of earnings in relation to
the credit union's risk profile and the current economic environment.
Below are examples of red flags that trigger a more in depth review of a
credit union's earnings performance.
Note that inordinately high earnings levels can be just as much a sign
of a problem as low earnings levels.
Inordinately high net income could indicate.
Taking on additional risk in the investment or loan portfolio.
Not providing competitive dividend or loan rates.
Not providing adequate services for the membership.
Not planning for new services or infrastructure to support
the credit union in the future.
Undue reliance on fee income to support operations.
Management or board goals for high net income levels given ties
implicit or explicit to bonuses, salaries, or performance evaluations.
Management believes their examiner will not tolerate or accept lower earnings
and or net worth, even with a solid plan.
Inordinately low net income could indicate inefficient operations resulting
in high or out of control expenses to the detriment of the membership.
Examiners will continue to address high operating expenses as a problem area
if they do not involve an intentional increase in the credit union's investment
in infrastructure technology, new services, increased training, etc.,
as part of a documented, sound strategic plan.
Exorbitant compensation systems misaligned with member benefits and
the mission of the credit union.
Inadequate pre planning for new services.
High level of non earning assets not aligned with the strategic
needs of the credit union.
Economic disruption impacting the field of membership.
Unsafe dividend levels attracting volatile share growth.
High loan losses due to poor credit quality loans.
The fact that a credit union's net income level is relatively high or low is not
by itself evidence there is a problem.
Rather, it is merely a trigger for examiners to thoroughly review the
credit union's earnings structure to determine the underlying factors
that result in the performance.
Examiners assess.
These factors in relation to the credit union's overall condition, consistency
with the mission of the credit union and congruence with the credit
union's, strategic plans and budgets.
Conclusion, earnings is one of the five component ratings contributing to
the overall composite rating examiners assign under the camel rating system.
Further, the quality of the credit union's earning structure and
underlying strategies is one of the key considerations in assignment of risk
ratings in the seven areas of risk under the Risk Focused Examination Program.
The determination of the CAMEL composite and component ratings, as well as the
risk ratings in the seven areas of risk, is a judgmental process and necessitates
the examiner take into account all All of the subjective and objective
variables that affect a credit union's financial and operational condition,
as well as their interrelationships.
The key interrelationship examiners take into consideration for the
earnings camel component rating is the net worth needs of the credit union.
It is incumbent on credit unions to proactively develop and
document sound strategic plans.
These plans need to articulate the balance the officials of the credit
union are seeking in terms of net worth levels and the actions affecting earnings
to achieve the mission of the credit union in both the short and long term.
In the absence of documented and sound plans, attempting to justify poor earnings
performance after the fact is considered not only a weakness in the earnings
component of CAMEL, but the management component and relevant risk ratings
in the seven areas of risk as well.
Given their not for profit nature, an analysis of earnings in credit
unions is admittedly challenging.
It requires factoring in the role earnings plays in credit unions fulfilling
their mission of providing financial services for provident and productive
purposes to all who seek such service.
The elected officials seek to balance the return of current earnings to
the members with retaining earnings to provide an adequate safety net
and a base for better, lower cost, and expanded services in the future.
These, along with a variety of other factors, such as the contemporary
decisions affecting the direction of the risk in a credit union's
balance sheet, require examiners to exercise a high degree of professional
judgment when evaluating earnings.
Thus, it is essential credit union management and examiners have an
open and ongoing dialogue on the strategic direction of the credit
union in relation to earnings.
Credit union officials and examiners should welcome any
sincere debates that occur on the efficacy of a credit union's plans.
A healthy dialogue will help ensure credit unions are able to fine tune and
execute their strategies effectively, as well as enable NCUA to balance
our mandates of protecting the share insurance fund with supporting credit
unions and fulfilling their mission.
This concludes the NCUA letter to credit unions on the evaluation of earnings.
While it was issued long ago, it is still an important document to understand as
NCUA still refers to it in examinations.
If your credit union could use assistance with your exam, reach out to Mark
Treichel on LinkedIn or at marktreichel.
com.
This is Samantha Shares and we thank you for listening.