We’ve been told for many years that Credit Unions (CU) need to develop a stronger non-interest income strategy through their associated member services which in turn helps them to create a greater competitive advantage. The case for an increase in non-interest income from fees for services was nicely addressed by Mike Mukian’s 2014 Credit Union Times “5 Ways to Increase Non-Interest Income” and suggests employing the following strategies:
- Promote debit card overdraft protection as a member service
- Promote debit card acquisition and usage
- Maintain member-friendly overdraft policies
- Create instant use debit cards
- Attract more Primary Financial Institution checking accounts
While important for contributing to the overall bottom line, focusing on fee income strategies can nudge CUs away from engaging in taking on deeper lending strategies for C, D and E paper members. Risk based lending is at the core of this strategy. CUs should consider implementing risk based loan pricing as well as credit migration as two primary areas that can help to increase interest income. In addition, these tools will also help in preparing for upcoming CECL and FASB changes. One expert, Bruce Moret from TCT Risk Solutions offers some guidance.
The Current Problem
More than 90% of credit unions in the United States are not generating adequate net interest income to cover operating expenses. This shortfall of interest income makes credit unions increasingly dependent on fee income. A review of recent 5300 reports shows that many credit unions must generate more than 1% of assets in fees just to break even. Is this situation sustainable in the long term?
Imagine if a store developed a business plan that called for it to sell its primary products at a loss and then rely on membership and parking fees to make up the difference. This may sound ridiculous, but it is not far from what is happening in credit unions today.
We all know that loan rates have been irrationally low for years and this has contributed to the problem of low interest income. But, the most irrational rates are at the top of the risk scale.
Managing a credit union is a balancing act between taking risk to increase income and managing risk to control losses. Since the collapse of 2008 many credit unions have been focused primarily on controlling risk. This has resulted in a concentration of loans in the higher credit score ranges.
Because of this strategy the yield on loan portfolios has steadily declined over the past 8 to 10 years. Declining yields have resulted in decreased loan income, which has resulted in inadequate interest income to support ROA.
The typical response to this earnings shortfall has been to supplement interest income with non-interest income. This strategy is problematic for two reasons:
- Lending is the primary business of credit unions. Any business will struggle if its primary business fails to support operations.
- Fee income is susceptible to changes in member behavior and regulation. This means that fee income can be impacted from factors out of the control of the credit union.
Risk Based Lending
It may be time for credit unions to return to their roots. By this I mean, take risk to increase income by using risk based lending to reach out to the underserved members who desperately need our help. NCUA Guidance letter 174, dated August 1995, says that the end result of risk based lending is “… a more diversified loan portfolio mixing lower-yielding, lower risk loans with higher-yielding, but riskier loans.”
The guidance letter continues by stating “Through a carefully planned risk-based lending program, credit unions may be able to make loans to somewhat higher-risk borrowers, as well as better serve their more credit-worthy members.”
So, based on NCUA guidance alone, it would seem timely to focus on expanding risk based lending to a broader cross section of the membership. This can be done with three steps:
- Create distinct underwriting guidelines for non-prime loans (credit scores below 640). Many credit unions have begun this practice and it has helped them lend deeper, more effectively and more profitably.
- Employ credit risk management to detect early warning signs of impairing loans. Our research shows that in most credit unions 60% top 80% of loan losses come from loans with declining credit scores. Early detection and action can significantly reduce losses.
- Implement an active up-migration, or credit migration, program for members with non-prime credit scores and market to them. Many credit unions are seeing 25% -30% of non-prime members achieve an increased credit score within 1 year. These members are ultra-loyal and highly profitable.
By initiating these three steps several credit unions have reversed the fee dependency problem and improved overall financial performance. Is it time for you to do the same?
Contributing Author Bruce Moret was the CFO of UNCLE CU for a number of years.
Bruce is also consultant with TCT Risk Solutions providing ALM, ALCO and CFO support to CUs of all asset sizes. For more information contact email@example.com or call 406-315-2809.