Asset and Net Worth Growth Loan Allocation Trends 2

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1 Growth, Capital, and Concentration Risk Management Jonathan Jackson, CFA Advisor Catalyst Strategic Solutions Asset and Net Worth Growth 1

2 Asset and Net Worth Growth Loan Allocation Trends 2

3 Loan Allocations to Net Worth Growth Risks Growing too fast New operational needs Staff, Locations, Processes Declining service to members No strategic plan A more complex balance sheet requires additional skill sets 3

4 Capital Supplies the Capacity for Growth Risk Based Capital Risk Based Capital sets the minimum amount of capital based on a credit union s size and risk profile. The RBC rule was set to go into effect January 1, 2019 but the NCUA board has proposed a 1 year delay. The board also proposed increasing the minimum asset threshold from $100 million to $500 million. 4

5 Balance Capital Growth with Asset Growth Retained Earnings Capital Growth Asset Growth Loans Investments Cash Target Asset Growth Levels to Achieve a Desired Capital Profile 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 16.67% 10.00% 10.25% 9.00% 5.00% 5.00% 5.00% 5.00% 2.44% Asset Growth Net Worth Growth Net Worth Ratio Assumptions $500 Million Credit Union with a net worth of 10% 50 bps of ROA equals net worth growth of 5%. This number is held constant. Results Asset growth of $83.3 million or 16.67% results in a net worth ratio of 9%. Asset growth of $25 million or 5% results in a net worth ratio of 10%. Asset growth of $12.2 million or 2.44% results in a net worth ratio of 10.25% 5

6 35.00% 30.00% Leverage Growth 31.25% 25.00% 23.53% 20.00% 15.00% 10.00% 5.00% 16.67% 10.00% 10.53% 9.50% 9.00% 8.50% 8.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 0.00% Asset Growth Net Worth Growth Net Worth Ratio When is The Right Time to Leverage? Do I have sufficient capital? Do I have access to liquidity sources? Are there asset allocation opportunities available at a positive spread? How will adding leverage impact my risk profile? 6

7 Asset vs. Liability Spreads 6.00% 5.00% 4.60% 4.00% 3.00% 2.00% 1.00% 1.87% 0.70% 0.00% Cost of Funds Yield on Average Loans Yield on Average Investments Leverage Scenario A Pre-Leverage Assets $500 Million Net Worth $60 Million Net Worth Ratio 12.0% Asset Yield 3.50% Cost of Funds 0.50% Provision Expense 0.60% Net Operating Expense 1.90% ROA 0.50% NEV +300 bps Post Shock Ratio 14.0% NEV +300 bps Volatility -15.0% Post-Leverage Assets $600 Million Net Worth $60 Million Net Worth Ratio 10% Asset Yield 3.67% Cost of Funds 0.78% Provision Expense 0.60% Net Operating Expense 1.65% ROA 0.64% NEV +300 bps Post Shock Ratio 13.0% NEV +300 bps Volatility -18.0% 7

8 Leverage Scenario B Pre-Leverage Assets $500 Million Net Worth $60 Million Net Worth Ratio 12.0% Asset Yield 3.50% Cost of Funds 0.50% Provision Expense 0.60% Net Operating Expense 1.90% ROA 0.50% NEV +300 bps Post Shock Ratio 14.0% NEV +300 bps Volatility -15.0% Post-Leverage Assets $600 Million Net Worth $60 Million Net Worth Ratio 10% Asset Yield 3.67% Cost of Funds 0.78% Provision Expense 0.60% Net Operating Expense 1.90% ROA 0.39% NEV +300 bps Post Shock Ratio 13.0% NEV +300 bps Volatility -18.0% Leverage Scenario C Pre-Leverage Assets $500 Million Net Worth $60 Million Net Worth Ratio 12.0% Asset Yield 3.50% Cost of Funds 0.50% Provision Expense 0.60% Net Operating Expense 1.90% ROA 0.50% NEV +300 bps Post Shock Ratio 14.0% NEV +300 bps Volatility -15.0% Post-Leverage Assets $600 Million Net Worth $60 Million Net Worth Ratio 10% Asset Yield 3.67% Cost of Funds 0.85% Provision Expense 0.60% Net Operating Expense 1.65% ROA 0.57% NEV +300 bps Post Shock Ratio 11.0% NEV +300 bps Volatility -25.0% 8

9 Non-Term Share Valuations 2.00% 1.50% 1.00% 0.50% 0.00% -0.50% Cost Of Funds 3 Month U.S. Treasury Yield Liquidity Sources 9

10 Things to Consider Prior to Leveraging What is the optimal funding strategy? Will my IRR profile support a mismatch between assets and liabilities? Have I considered all pertinent potential risks? Are there efficiencies that leveraging will allow me to take advantage of? YES NO MAYBE Capital Provides Capacity for Risk Liabilities Equity Assets Liabilities Equity Assets 10

11 Concentration Risk A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution s health or ability to maintain its core operations. -Basel Committee on Banking Supervision Washington Mutual was the 6 th largest U.S. depository institution with $300 billion in assets before it failed in Washington Mutual WaMu had excessive concentrations in option arm loans to high risk borrowers. The bank was unable to withstand the shock of those loans going bad. 11

12 Taxi Medallion Loans Values of taxi medallion loans have declined dramatically as a result of completion from ride sharing services. Three NY Credit Unions lost a combined $423.3 million in 2017 after losing $169.2 million in High concentrations in taxi medallion loans resulted in 2 of those 3 credit unions being conserved this year. Three rules on segmentation: Segmentation Group by similar characteristics. Segments should be divided into loan categories that react to the same kind of economic shocks. Do not over-segment. Could be used to hide concentration risk. Aggregate named borrowers and commercial relationships. 12

13 Set Limits and Create a Policy Determine appropriate limits for the various identified segments. These limits should be viewed in relation to Net Worth. Collateral Type LTV/Lien Geography Individual borrowers Create a Policy Real Estate Loans Residential 1 st Mortgage: 300% Fixed Rate 30-Year Mortgages: 100% Non-Conforming 1 st Mortgages: 50% Excluding loans with LTVs<80% 2 nd Mortgages: 100% Total Mortgage Exposure: 500% Including MBS Investments Auto Loans Total vehicle loans: 400% Indirect vehicle loans: 100% Vehicle loans rated D&E: 50% Share Concentrations Much focus is placed on asset concentrations but liability concentrations can pose risks as well. 1% 1% 6% 18% 22% 15% 37% Term vs. Non-Term Shares Term Maturities Individual Depositors Membership age Regular Shares Share Drafts Money Market Shares Share Certificates IRA/Keogh Accounts All Other Shares Non-Member Deposits 13

14 Non-Term Share Maturities Member Age Concentration 14

15 Investment Concentrations Set appropriate limits on an individual cusip and on an aggregate basis. Aggregate Agency Securities: 250% Single Cusip: 20% Aggregate MBS: 80% FHLB: 20% MBS Concentrations MBS Principal Balances Segmented by Collateral and Coupon Coupon 10 Yr 15 Yr 20 Yr 30 Yr Totals 2.00%-2.49% $ 875 $ - $ - $ 1,050 $ 1, %-2.99% $ 2,278 $ 9,050 $ 982 $ 1,750 $ 14, %-3.49% $ 4,872 $ 17,400 $ 1,250 $ 3,799 $ 27, %-3.99% $ 1,250 $ 2,750 $ - $ 1,025 $ 5,025 >4.00% $ - $ 1,750 $ - $ - $ 1,750 Totals $ 9,275 $ 30,950 $ 2,232 $ 7,624 $ 50,081 15

16 Cash Flow Concentrations Principal Cash Flows Segmented by Type and Maturity < 1 Yr 1-3 Yr 3-5 Yr > 5 Yr Totals CD $ 12,750 $ 27,850 $ 36,202 $ - $ 76,802 Agency Debentures $ 1,000 $ 2,000 $ 6,000 $ - $ 9,000 MBS $ 8,050 $ 12,702 $ 16,555 $ 12,774 $ 50,081 Totals $ 21,800 $ 42,552 $ 58,757 $ 12,774 $ 135,883 Other Concentration Risk Areas Third Party Vendors Perform a higher level of due diligence on providers the credit union is highly dependent on. Indirect Lending Partners What would happen if your lending partner relationship went away? Do a majority of the indirect loans come from one dealership? Earnings Components What percentage of earnings comes from interest income vs. non-interest income. 16

17 Jonathan Jackson, CFA Advisor, Catalyst Strategic Solutions