WEBVTT NOTE This file was generated by Descript 00:00:08.113 --> 00:00:09.873 Hello, this is Samantha Shares. 00:00:10.423 --> 00:00:13.933 This episode covers NCUA's letter to Credit Union's No. 00:00:13.933 --> 00:00:17.453 6 CU4 on the topic of the evaluation of earnings. 00:00:17.923 --> 00:00:22.603 While this letter is many years old, it is still cited in NCUA's examination 00:00:22.653 --> 00:00:24.743 as support for document of resolutions. 00:00:25.278 --> 00:00:29.038 The following is an audio version of that advisory and the press release. 00:00:29.528 --> 00:00:32.768 This podcast is educational and is not legal advice. 00:00:33.078 --> 00:00:37.183 We are sponsored by Credit Union Exam Solutions, Inc., whose team has 00:00:37.183 --> 00:00:42.118 over 240 years of national credit union administration experience. 00:00:42.488 --> 00:00:46.198 We assist our clients with NCUA so they save time and money. 00:00:46.518 --> 00:00:51.378 If you are worried about a recent, upcoming, or in process NCUA examination, 00:00:51.468 --> 00:00:54.788 reach out to learn how they can assist at marktreichel dot com. 00:00:55.233 --> 00:00:59.243 Also check out our other podcast called With Flying Colors, where we provide 00:00:59.263 --> 00:01:02.213 tips on how to achieve success with NCUA. 00:01:02.583 --> 00:01:06.253 And now the letter, Evaluating Earnings in Credit Unions. 00:01:06.673 --> 00:01:10.403 Credit unions are not for profit cooperative financial institutions. 00:01:10.843 --> 00:01:15.203 Groups of people sharing a common bond form credit unions to pool their resources 00:01:15.203 --> 00:01:19.573 to provide access to affordable financial services designed to meet their needs. 00:01:19.983 --> 00:01:23.423 As a cooperative not for profit organization, a credit union's 00:01:23.423 --> 00:01:27.053 mission is to provide financial services to their members, not to 00:01:27.053 --> 00:01:28.843 earn a profit for stockholders. 00:01:29.193 --> 00:01:33.423 Any economic value generated by the credit union that is undistributed i. 00:01:33.423 --> 00:01:33.623 e. 00:01:33.633 --> 00:01:38.123 not used to absorb costs or provide an immediate return to the members is held 00:01:38.123 --> 00:01:40.223 on behalf of and owned by the members. 00:01:40.768 --> 00:01:45.258 Though not for profit, credit unions must generate revenue for two primary reasons. 00:01:45.698 --> 00:01:48.498 One, to cover the costs of providing members with financial 00:01:48.498 --> 00:01:52.488 services, and two, to maintain a safe and sound level of net worth. 00:01:53.088 --> 00:01:56.918 Net worth is necessary to provide protection against unexpected future 00:01:56.918 --> 00:02:01.108 costs and a foundation for member service growth and initiatives, as well as 00:02:01.188 --> 00:02:03.398 to meet regulatory capital standards. 00:02:03.908 --> 00:02:07.498 In order to build and maintain appropriate net worth levels, credit 00:02:07.528 --> 00:02:09.278 unions must retain earnings, i. 00:02:09.318 --> 00:02:12.578 e., have a net income sometimes referred to as a profit. 00:02:13.078 --> 00:02:17.538 NCUA's mission statement is, to foster the safety and soundness of federally 00:02:17.548 --> 00:02:21.718 insured credit unions and better enable the credit union community to extend 00:02:21.718 --> 00:02:25.888 financial services for provident and productive purposes to all who seek such 00:02:25.888 --> 00:02:30.318 service, while recognizing and encouraging credit unions historical emphasis on 00:02:30.318 --> 00:02:35.023 extension of financial To those of modest means, this mission statement 00:02:35.033 --> 00:02:36.793 highlights a balance that both N. 00:02:36.793 --> 00:02:36.963 C. 00:02:36.963 --> 00:02:37.183 U. 00:02:37.183 --> 00:02:37.333 A. 00:02:37.333 --> 00:02:42.213 and Credit Unions must strive to maintain, balancing safety and soundness with the 00:02:42.213 --> 00:02:44.513 mission of extending financial services. 00:02:44.883 --> 00:02:48.563 Perhaps the most notable way this challenge manifests itself is in 00:02:48.563 --> 00:02:50.613 determining the right level of network. 00:02:51.198 --> 00:02:53.458 Net worth is essential to credit unions. 00:02:53.878 --> 00:02:57.278 Not only does it protect against uncertainties, but also provides a 00:02:57.278 --> 00:03:01.878 foundation for the long term viability of the credit union, ensuring continued 00:03:01.878 --> 00:03:05.758 credit union service for current and subsequent generations of members. 00:03:06.288 --> 00:03:10.933 When net worth is too low, An institution is exposed to a high risk of failure. 00:03:11.253 --> 00:03:14.963 On the other hand, when net worth is too high, members may not be receiving 00:03:15.003 --> 00:03:18.933 all the benefits and services that could be safely provided and or the credit 00:03:18.953 --> 00:03:22.733 union may not be taking advantage of opportunities to position itself to 00:03:22.733 --> 00:03:24.733 expand member benefits in the future. 00:03:25.243 --> 00:03:29.663 Despite a natural tendency to err on the side of conservatism, NCUA's 00:03:29.663 --> 00:03:33.773 supervisory oversight must support credit unions efforts to balance net 00:03:33.773 --> 00:03:35.693 worth needs with providing value. 00:03:35.768 --> 00:03:38.218 and achieving longer term strategic goals. 00:03:38.688 --> 00:03:40.208 Earnings Assessment Framework. 00:03:40.748 --> 00:03:44.428 As the purpose of retaining earnings for credit unions is to build or 00:03:44.428 --> 00:03:48.458 maintain net worth, the analysis of earnings is fundamentally linked with 00:03:48.458 --> 00:03:50.498 the net worth needs of the credit union. 00:03:51.048 --> 00:03:56.328 This is reflected in NCUA's CAMEL Rating System, Letters 03 COOS 04 CAMEL Rating 00:03:56.328 --> 00:04:00.678 System, which lists the net worth level and sufficiency of earnings for necessary 00:04:00.688 --> 00:04:04.558 capital formation as key factors to consider when assessing earnings. 00:04:05.188 --> 00:04:08.578 In fact, earnings needs in credit unions are a function of the net 00:04:08.578 --> 00:04:12.698 worth ratio goal, which in turn is affected by asset growth levels. 00:04:13.248 --> 00:04:17.298 Thus retained earnings goals set independently, as if net income is an 00:04:17.308 --> 00:04:21.318 aspect of a credit union's financial performance that has merit in and of 00:04:21.318 --> 00:04:25.818 itself, run the risk of being incompatible with other organizational goals. 00:04:26.328 --> 00:04:30.298 Further, there is distinct time dimension to any analysis of earnings. 00:04:30.768 --> 00:04:32.088 This is due to the following. 00:04:32.098 --> 00:04:32.173 Thank you for listening. 00:04:32.533 --> 00:04:36.803 Net worth goals involve both immediate considerations as well as strategic 00:04:36.813 --> 00:04:41.103 ones related to future risks and growth and member service expansion plans. 00:04:41.623 --> 00:04:44.653 The officials have to balance the immediate return of earnings to 00:04:44.653 --> 00:04:46.353 the members in various forms e. 00:04:46.353 --> 00:04:46.643 g. 00:04:46.673 --> 00:04:49.053 dividends, lower loan rates, etc. 00:04:49.603 --> 00:04:52.643 with the retention of earnings to fund future member benefits. 00:04:53.183 --> 00:04:56.773 Variations over time and economic conditions affecting a credit 00:04:56.783 --> 00:05:00.373 union's cost structure and rates on loan and share products. 00:05:00.733 --> 00:05:04.873 There is no simple metric for determining what an individual credit union's R. 00:05:04.873 --> 00:05:05.063 O. 00:05:05.063 --> 00:05:05.153 A. 00:05:05.153 --> 00:05:06.013 level should be. 00:05:06.533 --> 00:05:07.583 A 1 percent R. 00:05:07.583 --> 00:05:07.763 O. 00:05:07.763 --> 00:05:07.843 A. 00:05:07.843 --> 00:05:11.223 level has served as the rule of thumb for good performance for 00:05:11.223 --> 00:05:13.343 financial institutions for some time. 00:05:13.863 --> 00:05:18.363 The establishment of the Camel Matrix in 1987 canonized for credit unions 00:05:18.423 --> 00:05:22.983 a 1 percent Our OWA by tying it to a CAML one component rating for earnings. 00:05:23.403 --> 00:05:27.973 However, as emphasized in NCU, a letter to credit unions, zero three CUSO 00:05:27.983 --> 00:05:30.593 for March, 2003 CAML rating system. 00:05:30.893 --> 00:05:34.773 CAML ratings are not automatically determined by matrix ratios. 00:05:35.153 --> 00:05:36.313 Editorial comment. 00:05:36.773 --> 00:05:40.293 NCU has eliminated the matrix since this letter was issued. 00:05:40.863 --> 00:05:45.093 Each credit union's earnings level must be evaluated based on the credit union's 00:05:45.093 --> 00:05:49.923 unique needs, as well as overall economic trends affecting financial institutions. 00:05:50.803 --> 00:05:53.773 For example, consider contemporary economic trends. 00:05:54.173 --> 00:05:59.293 In 2005, aggregate credit union, RO, had dropped to 85 basis points, the 00:05:59.293 --> 00:06:01.273 lowest level in at least 20 years. 00:06:01.733 --> 00:06:05.363 Interest rates have been rising steadily since mid 2004, with the 00:06:05.363 --> 00:06:09.213 Federal Reserve raising interest rates for the 17th consecutive time. 00:06:09.763 --> 00:06:13.033 As a result, the net interest margin declined to 3. 00:06:13.033 --> 00:06:16.153 24%, its lowest level in at least 20 years. 00:06:16.763 --> 00:06:20.653 The low net interest margin, and thus reduced ROA, is a direct 00:06:20.653 --> 00:06:24.393 result of both a rising rate environment and a flat yield curve. 00:06:24.773 --> 00:06:27.893 Credit unions partially offset the pressure on earnings with 00:06:27.893 --> 00:06:31.483 increased fee and other income, with this source of income playing 00:06:31.483 --> 00:06:33.043 an increasingly larger role. 00:06:33.458 --> 00:06:37.798 However, credit unions aggregate net worth ratio is at record levels and 00:06:37.808 --> 00:06:40.208 actually increased 30 basis points to 11. 00:06:40.778 --> 00:06:41.558 24%. 00:06:42.088 --> 00:06:45.258 Despite a decline in ROA net worth growth of 7. 00:06:45.638 --> 00:06:48.738 59%, outpaced the modest asset growth of 4. 00:06:48.738 --> 00:06:50.058 9%. 00:06:50.518 --> 00:06:54.258 Consistent with the purpose of net worth, credit unions are well positioned 00:06:54.258 --> 00:06:58.388 with ample net worth levels to accept lower ROA levels during the current 00:06:58.408 --> 00:07:01.978 economic climate that has resulted in reduced net interest margins. 00:07:01.978 --> 00:07:05.938 Transcribed Consider that, on average, the modest asset growth levels credit 00:07:05.948 --> 00:07:11.068 unions have experienced over the last 10 years require an ROA of only 55 00:07:11.088 --> 00:07:15.098 basis points to maintain net worth levels at their current strong level. 00:07:15.538 --> 00:07:19.678 Thus, credit unions need not engage in reactive or extraordinary measures 00:07:19.758 --> 00:07:23.038 simply because earnings levels decline as a result of broader 00:07:23.058 --> 00:07:27.018 economic conditions when net worth levels meet or exceed their needs. 00:07:27.503 --> 00:07:31.363 In fact, such measures likely involve significant risks, either in 00:07:31.363 --> 00:07:35.423 terms of accepting greater risks to generate higher returns, and or in 00:07:35.423 --> 00:07:37.243 terms of short sighted trade offs e. 00:07:37.243 --> 00:07:37.523 g. 00:07:37.533 --> 00:07:42.673 increasing fees, selling less profitable business lines, engaging in high risk 00:07:42.673 --> 00:07:46.573 lending affecting the longer term strategic positioning of the credit union. 00:07:47.023 --> 00:07:48.743 Examiner Assessment of Earnings. 00:07:49.123 --> 00:07:52.163 Examiners do not evaluate earnings globally with peer 00:07:52.163 --> 00:07:53.963 ratios or camel benchmarks. 00:07:54.403 --> 00:07:57.913 Earnings are evaluated on a case by case basis unique to each 00:07:57.913 --> 00:07:59.743 credit union's circumstances. 00:08:00.173 --> 00:08:03.353 An examiner's review of earnings is in relation to each credit 00:08:03.363 --> 00:08:07.583 union's risk profile, operational context, and strategic plans. 00:08:08.013 --> 00:08:12.573 The ROA level is not the primary focus of an examiner's assessment of earnings. 00:08:13.093 --> 00:08:16.783 Historical earnings levels are somewhat relevant to assessing management's 00:08:16.803 --> 00:08:18.383 record in managing earnings. 00:08:18.713 --> 00:08:22.253 However, it is quite possible for a credit union to have impressive 00:08:22.273 --> 00:08:26.213 profitability ratios by assuming an unacceptable degree of risk. 00:08:26.733 --> 00:08:30.953 Thus, examiners assess management's capability in managing the risk versus 00:08:30.953 --> 00:08:36.063 reward trade off, evaluating earnings by considering the quality of the earnings 00:08:36.073 --> 00:08:41.183 structure, fit with the overall strategies of the credit union, future direction 00:08:41.183 --> 00:08:45.988 of earnings performance, Ability of the credit union to realize an adequate level 00:08:45.988 --> 00:08:48.128 of earnings in a safe and sound manner. 00:08:48.528 --> 00:08:53.098 Lower ROA levels will be viewed positively if they are the result of a sound and 00:08:53.098 --> 00:08:57.888 well executed strategy to balance risk exposure or incur costs to position 00:08:57.888 --> 00:09:02.038 the credit union to achieve longer term growth and member service objectives. 00:09:02.353 --> 00:09:06.373 In addition, examiners recognize that the purpose for credit unions retaining 00:09:06.393 --> 00:09:11.163 earnings is maintaining appropriate, but not excessive, net worth levels relative 00:09:11.163 --> 00:09:13.343 to the risk profile of the credit union. 00:09:13.583 --> 00:09:17.883 In fact, executing a sound plan to return excess capital to the membership 00:09:17.943 --> 00:09:21.623 or utilize capital to achieve longer term strategic objectives 00:09:21.643 --> 00:09:25.213 can contribute greatly to the long term success of the credit union. 00:09:25.503 --> 00:09:29.193 Examiners also positively incorporate such strategies into their 00:09:29.193 --> 00:09:31.193 evaluation of earnings and capital. 00:09:31.713 --> 00:09:33.013 Earnings Red Flags. 00:09:33.333 --> 00:09:36.693 Examiners need to evaluate the level of earnings in relation to 00:09:36.693 --> 00:09:40.593 the credit union's risk profile and the current economic environment. 00:09:41.103 --> 00:09:45.123 Below are examples of red flags that trigger a more in depth review of a 00:09:45.123 --> 00:09:47.153 credit union's earnings performance. 00:09:47.653 --> 00:09:51.163 Note that inordinately high earnings levels can be just as much a sign 00:09:51.163 --> 00:09:53.363 of a problem as low earnings levels. 00:09:53.813 --> 00:09:56.053 Inordinately high net income could indicate. 00:09:56.633 --> 00:10:00.043 Taking on additional risk in the investment or loan portfolio. 00:10:00.463 --> 00:10:03.023 Not providing competitive dividend or loan rates. 00:10:03.568 --> 00:10:06.178 Not providing adequate services for the membership. 00:10:06.638 --> 00:10:09.788 Not planning for new services or infrastructure to support 00:10:09.788 --> 00:10:11.368 the credit union in the future. 00:10:11.798 --> 00:10:15.028 Undue reliance on fee income to support operations. 00:10:15.398 --> 00:10:19.168 Management or board goals for high net income levels given ties 00:10:19.168 --> 00:10:23.668 implicit or explicit to bonuses, salaries, or performance evaluations. 00:10:24.108 --> 00:10:28.258 Management believes their examiner will not tolerate or accept lower earnings 00:10:28.278 --> 00:10:30.948 and or net worth, even with a solid plan. 00:10:31.408 --> 00:10:35.938 Inordinately low net income could indicate inefficient operations resulting 00:10:35.938 --> 00:10:39.628 in high or out of control expenses to the detriment of the membership. 00:10:40.078 --> 00:10:44.628 Examiners will continue to address high operating expenses as a problem area 00:10:44.708 --> 00:10:48.618 if they do not involve an intentional increase in the credit union's investment 00:10:48.628 --> 00:10:52.848 in infrastructure technology, new services, increased training, etc., 00:10:53.248 --> 00:10:55.998 as part of a documented, sound strategic plan. 00:10:56.378 --> 00:11:00.158 Exorbitant compensation systems misaligned with member benefits and 00:11:00.158 --> 00:11:01.638 the mission of the credit union. 00:11:02.048 --> 00:11:04.408 Inadequate pre planning for new services. 00:11:04.898 --> 00:11:08.438 High level of non earning assets not aligned with the strategic 00:11:08.438 --> 00:11:09.718 needs of the credit union. 00:11:10.198 --> 00:11:13.188 Economic disruption impacting the field of membership. 00:11:13.688 --> 00:11:16.808 Unsafe dividend levels attracting volatile share growth. 00:11:17.318 --> 00:11:20.408 High loan losses due to poor credit quality loans. 00:11:20.848 --> 00:11:25.398 The fact that a credit union's net income level is relatively high or low is not 00:11:25.398 --> 00:11:27.408 by itself evidence there is a problem. 00:11:27.788 --> 00:11:31.308 Rather, it is merely a trigger for examiners to thoroughly review the 00:11:31.308 --> 00:11:34.968 credit union's earnings structure to determine the underlying factors 00:11:34.968 --> 00:11:36.548 that result in the performance. 00:11:36.878 --> 00:11:37.858 Examiners assess. 00:11:37.948 --> 00:11:42.358 These factors in relation to the credit union's overall condition, consistency 00:11:42.358 --> 00:11:45.538 with the mission of the credit union and congruence with the credit 00:11:45.538 --> 00:11:47.848 union's, strategic plans and budgets. 00:11:48.178 --> 00:11:52.348 Conclusion, earnings is one of the five component ratings contributing to 00:11:52.348 --> 00:11:56.758 the overall composite rating examiners assign under the camel rating system. 00:11:57.358 --> 00:12:00.568 Further, the quality of the credit union's earning structure and 00:12:00.588 --> 00:12:04.598 underlying strategies is one of the key considerations in assignment of risk 00:12:04.598 --> 00:12:09.128 ratings in the seven areas of risk under the Risk Focused Examination Program. 00:12:09.498 --> 00:12:14.248 The determination of the CAMEL composite and component ratings, as well as the 00:12:14.248 --> 00:12:19.128 risk ratings in the seven areas of risk, is a judgmental process and necessitates 00:12:19.128 --> 00:12:22.458 the examiner take into account all All of the subjective and objective 00:12:22.468 --> 00:12:26.478 variables that affect a credit union's financial and operational condition, 00:12:26.718 --> 00:12:28.388 as well as their interrelationships. 00:12:28.888 --> 00:12:32.358 The key interrelationship examiners take into consideration for the 00:12:32.358 --> 00:12:36.528 earnings camel component rating is the net worth needs of the credit union. 00:12:36.918 --> 00:12:40.128 It is incumbent on credit unions to proactively develop and 00:12:40.128 --> 00:12:42.018 document sound strategic plans. 00:12:42.658 --> 00:12:45.948 These plans need to articulate the balance the officials of the credit 00:12:45.958 --> 00:12:50.298 union are seeking in terms of net worth levels and the actions affecting earnings 00:12:50.298 --> 00:12:54.108 to achieve the mission of the credit union in both the short and long term. 00:12:54.798 --> 00:12:59.228 In the absence of documented and sound plans, attempting to justify poor earnings 00:12:59.228 --> 00:13:03.028 performance after the fact is considered not only a weakness in the earnings 00:13:03.028 --> 00:13:07.238 component of CAMEL, but the management component and relevant risk ratings 00:13:07.248 --> 00:13:09.138 in the seven areas of risk as well. 00:13:09.748 --> 00:13:13.378 Given their not for profit nature, an analysis of earnings in credit 00:13:13.388 --> 00:13:15.428 unions is admittedly challenging. 00:13:15.868 --> 00:13:19.948 It requires factoring in the role earnings plays in credit unions fulfilling 00:13:19.948 --> 00:13:23.518 their mission of providing financial services for provident and productive 00:13:23.518 --> 00:13:25.898 purposes to all who seek such service. 00:13:26.438 --> 00:13:29.978 The elected officials seek to balance the return of current earnings to 00:13:29.978 --> 00:13:33.728 the members with retaining earnings to provide an adequate safety net 00:13:34.078 --> 00:13:38.168 and a base for better, lower cost, and expanded services in the future. 00:13:38.448 --> 00:13:42.098 These, along with a variety of other factors, such as the contemporary 00:13:42.098 --> 00:13:45.428 decisions affecting the direction of the risk in a credit union's 00:13:45.438 --> 00:13:49.788 balance sheet, require examiners to exercise a high degree of professional 00:13:49.788 --> 00:13:51.748 judgment when evaluating earnings. 00:13:52.188 --> 00:13:55.688 Thus, it is essential credit union management and examiners have an 00:13:55.698 --> 00:13:59.218 open and ongoing dialogue on the strategic direction of the credit 00:13:59.238 --> 00:14:01.018 union in relation to earnings. 00:14:01.438 --> 00:14:04.318 Credit union officials and examiners should welcome any 00:14:04.318 --> 00:14:08.278 sincere debates that occur on the efficacy of a credit union's plans. 00:14:08.738 --> 00:14:12.668 A healthy dialogue will help ensure credit unions are able to fine tune and 00:14:12.668 --> 00:14:16.898 execute their strategies effectively, as well as enable NCUA to balance 00:14:16.898 --> 00:14:20.618 our mandates of protecting the share insurance fund with supporting credit 00:14:20.618 --> 00:14:22.388 unions and fulfilling their mission. 00:14:22.798 --> 00:14:27.298 This concludes the NCUA letter to credit unions on the evaluation of earnings. 00:14:27.628 --> 00:14:31.648 While it was issued long ago, it is still an important document to understand as 00:14:31.648 --> 00:14:34.588 NCUA still refers to it in examinations. 00:14:35.033 --> 00:14:38.873 If your credit union could use assistance with your exam, reach out to Mark 00:14:38.883 --> 00:14:41.363 Treichel on LinkedIn or at marktreichel. 00:14:41.383 --> 00:14:41.823 com. 00:14:42.303 --> 00:14:44.973 This is Samantha Shares and we thank you for listening.