Before we dive into the detail let’s examine some home truths or some facts of credit union life.
Operating costs and expenses tend to only go up and credit losses always occur. Both cause a pull or drag against your net revenue return on assets and so consequently if left unchecked they will cause a subsequent drag on your net worth or capital ratio. Being adequately capitalised via a credit unions net worth is of course one of the main regulatory controls that provide strength to the credit union industry and protection to the members but also at the same time provides a capital constraint on a credit unions ability to grow. It is however one of the credit union facts of life that says the return on equity (i.e. your growth of your net worth) must be at least the same or greater than your asset growth for your net worth ratio to be maintained or to increase.
Is Your Net Worth Higher than your Asset Growth?
Your Net Worth is an interesting topic as it reflects the prior profits that your credit union has retained after paying interest, dividends, expenses and making loan loss provisions. Credit unions as cooperatives have a double bottom line mandate, something we have written about before in the context of the microfinance industry and their social performance mandate. For credit unions the double bottom line is the balance that you need to strike between financial sustainability and ‘making a difference’. I used the term ‘making a difference’ because for a credit union it can be as simple doing good in the community or it could be endeavouring to reach the financially unserved in your community. Along the way of course ‘making a difference’ also means giving value back to members and ensuring staff are suitable paid, trained incentivised and motivated. So the bottom line actually becomes two bottom lines: firstly how much revenue do we need to make to sustain and outgrow expenses and loan losses and so maintain or grow our capital ratio, secondly how much additional revenue do we need to ‘make a difference’ for members, staff and the community. Of course, delivering member value can also imply giving back or conceding revenue to members via higher deposit rates or lower loan rates.
Is your Return on Equity (RoE) higher than your asset growth? It would also be nice to know also if it is higher or lower than your peers. This would of course tell us whether the net worth ratio is being maintained, decreasing or increasing. There are of course rare times when maybe a reduction in the net worth ratio is a deliberate strategy and so what I am saying needs to be read in conjunction with your own plan or strategy.
The Power of Non-Interest Income in your Financial Factory
We have already stated that expenses or costs tend to always rise, and loan losses always typically occur and so both metrics require further examination. In addition, we have established that as we need to grow revenue to outweigh the drag on RoE that expenses and loan losses exert then our balance sheet composition and the strength of the net interest margin (NIM) needs also to be measured and analyzed. But hang on a second there is an elephant sitting in the room, and we need to establish if he’s a baby elephant or a big friendly elephant. That elephant is of course our Non-Interest Income (NII). Why do I refer to NII as the elephant in the room? Well because credit unions tend to focus on cost control and on setting interest rates and not on the power of their financial factory they are running. One of the most powerful things you can increase is your non-interest income as it improves your financial factory power with little or no drag on your net worth ratio. Granted some NII is associated with lending products and therefore the assets and so it maybe be useful to break out the NII into assets related and non-asset related products.
You may have noticed that I introduced the term ‘financial factory’, I am not sure many credit unions employees think about their workplace as a financial factory but run with me a little on this to see if I can convince you. In the financial factory members join, pay a subscription and start saving money. These member shares and deposits are the raw ingredients into the financial factory process. These raw ingredients get re-packaged into banking services, checking accounts, cards and of course personal, vehicle and mortgage loans. Along the way the factory has other inputs in the form of non-interest income that is generated from the manufacturing process. To run the financial factory you need staff, premises and equipment and you consume utilities and you need to provide against those customers that fail to pay for the goods and services they received. Now the financial factory runs 24 hours a day with a minimal night shift but it both services banking transactions as well as continuously accrues interest revenue income and expense. At the heart of the financial factory is your financial engine which represents the balance between high interest-bearing loans versus low interest or dividend paying relationship shares. The balance you have between the non-interest income the high paying loan and the amount of deposits you derive from lower paying relationship shares determines how powerful the financial engine is at the heart of your financial factory.
Why the Frequency and Timing of Financial Performance Reporting is Crucial
It has always struck me as odd that given a credit union operates 24 hours a day and accrues interest daily, historically performance has tended to be measured on a monthly basis several days after the month end. It’s hard to imagine any other factory where you only measured how much you made on a monthly basis! At the heart of this is a key point and that is there is a big difference between financial reporting for the board or the regulator and measuring credit union performance. You may only need to pull financial statements together on a periodic basis, but sales are occurring daily in your financial factory. If stuff happens daily then stuff needs to be measured daily otherwise you have no chance to gain insight, make decisions and take actions. Why wait until the financial balance sheet or income statement is produced to realise you missed the target or plan? Now I know a daily balance sheet and income statement seems to make little sense. However, when you think about it, it does especially as you head into the month end and the last few days when most costs and expenses are in, depreciation and payroll have been run. Ok let’s put aside the question of daily balance sheets and instead think about measuring the most valuable activity a credit union undertakes, providing loans. Performance for a credit union really involves initially tracking new production of loans and taking deposits. In fact, the net interest margin is the key input to the financial statement and so daily monitoring and analysis of new loan production month to date by channel, branch, product, loan officer seems like a must have kind of performance measure. If you agree, do you have it? Is it automated? Can you get it on any device, anywhere and anytime of the day? If your answer is No, No and No then you may have found a good place to start your strategic investment in BI and analytics. Start with a top down solution that tells you every day how well your credit union is performing, how strong the financial factory is and whether month to date sales are keeping you on plan.