The Bermuda Triangle of misguided credit union metrics
Credit unions have a virtuous desire to create value for their members. So why do their management teams and member elected directors, fixate upon and reward for measures based upon profit extraction from members, instead of value created for members?
For the past twenty years, I have worked with credit union executive teams and board members. When asked how they measure and compensate for success, the top three measures mentioned are return on assets, net worth and asset growth. Let’s break down these measures for what they really are.
- Return on assets is the rate of profit extraction from members in the current year.
- Net worth is cumulative profit extracted from members since the inception of the credit union.
- Asset growth carries a hidden member tax. At a target 10% net worth ratio, for every $10 million dollars in asset growth, members pay a $1 million dollar “tax” to maintain net worth at the target ratio.
For each of the measures, more is not necessarily better. To be sure, a minimum level of performance in each area is required to keep the “financial house” in order, but celebrating and rewarding for higher levels of each violates the credit union ethos of creating value for members. Stated simply, your goal should not be to extract profit from members and hoard it away as capital. Your goal should be to create value for members and be good stewards of the profit you have taken for regulatory compliance.
There is a better way, and I am going to share it with you.
Instead of focusing upon asset growth, focus on balance sheet mix. As noted earlier, asset growth carries a hidden member tax. The best way to be a good steward of member capital is to deploy it in the most efficient manner possible. Be smart about what you measure. Focus on the following:
- Loan to asset ratio. This tells us how much of the balance sheet is deployed in higher yielding loans as opposed to lower yielding investments, or worse yet, non-earning assets. Higher is better up to the point of minimum liquidity you want to maintain. Higher ratios also demonstrate institutional capability to extend credit; a strategic characteristic of a successful organization. The better you are at lending, the less reliance upon the “investment yield curve” for your survival.
- Relationship share to asset ratio. Relationship shares are draft and regular shares. They are the longest lived, lowest cost, least interest rate risk sensitive funding source available to credit unions. Higher is better, period. Money markets, CDs and IRAs are rate sensitive funding sources; consumers will move their money where they can get the best rate, with very little loyalty to the current holder of their funds.
Instead of focusing upon net worth in terms of maximization, establish a range – a minimum and maximum net worth the credit union can comfortably operation within. Performance below the minimum is not desirable for obvious reasons. Performance above the maximum means the credit unions is hoarding away capital – profit taken from members.
Instead of focusing upon return on assets in terms of maximization, focus on the optimal return on assets and set a minimum and maximum range. This is very simple to do. The minimum optimal return on assets is rate of asset growth multiplied by target net worth. For example, if the credit union is growing assets by 5% per year and has a target net worth of 10% then 0.50% return on assets is the optimal figure to maintain 10% net worth. Add a safety margin, of 0.20%, for example, and the optimal return on assets range is 0.50% to 0.70%.
There are a handful of other measures that can be used to quantify, with a high degree of precision, tangible economic value created for members, but that is another article for another day. In the near term, think about establishing target ranges around loan to assets, relationship to assets, net worth and optimal return on assets and you will be focused upon the most efficient use of member capital.