United States: "National Credit Unions in 2010 (First Quarter)"

We can all acknowledge that 2009 was quite a year, with large provisions for loan losses, premium assessments from the National Credit Union Association, and corporate credit union member capital impairments. We can now put 2009 behind us, but the reality is that many of the same challenges exist for the year ahead—along with new regulatory impositions. Let's take a look at what might lie before us in 2010 and the areas credit unions should be focused on most.

Interest Rate Risk

No one seems to be able to predict interest rates. Today economists are split on when we'll see an increase in inflation and resulting increases in interest rates. The Federal Reserve has kept rates low to provide added margin to struggling financial institutions, stimulate growth in the economy, and encourage home sales. These historically low short-term rates may continue only for the near term. And as we look ahead, there appears to be a consensus—albeit not an absolute one—that inflationary pressure will increase long-term rates as well.

It seems that all regulators of financial institutions are focused on interest rate risk. Credit unions should make sure they have in place the policies, tolerances, assumptions, multiple simulations, and ongoing monitoring they need to manage that risk effectively. With an increased concentration in real-estate loans nationally, managing interest rate risk is of critical importance.

Interest Margin

Who wants to live on interest margin only? Since 2006 the net income for credit unions nationally was not from net interest income. A decade ago, one presenter at a conference declared that interest margin would forever continue to shrink. Why? He indicated it was because of the continual increases in efficiencies in capital markets and efficiencies of national platforms from nationwide financial-services entities.

The exacting science of managing loans and deposit rates will be an increasingly more important part of operations. There's increased competition for loans when at the same time credit unions are finding a strong inflow of deposits—often because they're paying too high a rate. Remember, for every dollar in deposits you bring in, you pay the interest rate plus the share insurance premium assessments. You'll need to increase loans and manage the cost of funds on new deposits in order to increase, let alone maintain, interest margin.

Profitability

Loan-loss provisions, National Credit Union Share Insurance Fund (NCUSIF) assessments, and corporate credit union member capital write-downs significantly hampered net income in 2009. Concerns over a significant reduction of non-sufficient funds (NSF) fee income and a potential decrease in interchange income aren't comforting, to say nothing of remaining asset write-downs and future NCUSIF assessments.

The two largest areas of cost are interest on member deposits and employee compensation. These will continue to require intense management to enhance 2010 income.

Loan Losses

Some are predicting delinquencies and loan losses will decline to some degree in 2010 but not significantly. Economists at the Credit Union National Association estimate the loan charge-off ratio in 2010 will be 1 percent, compared with 1.2 percent for 2009. Credit unions need to continually evaluate collection efforts as well as the adequacy of collection resources.

You'll need to evaluate best-case, moderate, and high scenario losses in 2010 to monitor how loan losses will affect your credit union's capital ratio going forward. Ignoring the brutal reality of loan losses will serve only to preclude management from timely implementation of measures needed to maintain capital.

Allowances and Troubled Debt Restructurings

The allowance for loan and lease losses (ALLL) is a very subjective estimate, and executing it with any precision is difficult given the significant level of delinquencies and declines in real estate values. The use of two-, three-, and five-year historical loss rates is passé. Credit unions must now rely on three-, six-, and 12-month loss rates or other detailed analysis in order to determine a viable ALLL estimate. Additionally there is now the expectation that environmental factors surrounding the loan portfolio and loan loss experience will be considered when determining expected losses. Credit Unions need to document the consideration of and underlying quantitative support for qualitative and environmental adjustments made to expected loss rates as a part of the ALLL determination.

Accounting for Troubled Debt Restructurings (TDRs) continues to be an issue as well. Very few credit unions are accounting for TDRs correctly as Credit Unions are not calculating the impairment of modified loans in accordance with the applicable standards, which generally is the difference in the present value of the estimated future cash flows of the loan, discounted by the loans original effective interest rate, and including the accumulated TDR impairments as a component of the ALLL. . When you modify an impaired loan, you must follow the accounting guidance in order to account for the loss on impairment. Regulators continue to visit this area.

Capital

Projecting future expected capital ratios will be key, considering estimated future loan losses, impairments, NCUSIF assessments, return on assets, and share growth. You'll need to consider best- and worst-case scenarios as part of your planning process. The worst mistake would be to underestimate future loan losses and asset impairments; that would preclude management from making necessary changes in a timely fashion.

Share Draft Accounts

Will there be a dynamic shift in share draft fees? In the past, credit unions have been able to generate a significant amount of income from NSF fees. With the prospect of diminished NSF income, there might be a shift to increase fees to other types of member accounts.

The New Normal

The future will likely be different from the recent past, and as a result credit union management and boards of directors will need to continually reflect on and modify their strategic planning. Clearly, they'll need to take into account increased regulation. That's the challenge. What about the opportunity? Housing provided the engine for the last economic expansion. What sector will propel future economic growth? Each credit union will need to evaluate its local economy and monitor changes in membership dynamics to stay ahead of the curve in 2010.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.