ERM: A Measure of Certainty in Uncertain Times
Assess and improve your CU's readiness while economic aberrations persist.
We are in the midst of an epoch of uncertainty. The global economy is embroiled in rebalance and tumultuous renewal.
Credit unions must gird their balance sheets and capital positions to meet this challenge.
The armor credit unions need now is enterprise risk management (ERM) maturity, including governance independence, analytics, board of directors involvement, and greater reporting frequency.
ERM is integral for credit unions optimizing risk-adjusted returns within constraints imposed by capital, people, technology, internal controls and risk tolerances. ERM maturity takes this to the next level by integrating contingency planning for consequences related to varied stressors.
The rate for the 10-year U.S. Treasury note was 1.89%, as of Feb. 28. Approximately 20% of the time since 1900, this note yielded 8% or more.
The rate of reported inflation, due to governmental definitions unreflective of daily life, is hovering around 2%. Consumers are rightly concerned that both interest rates and inflation will soon regress to their higher historical norms.
In addition to economic aberrations, the industry faces changes in financial institution regulations, loan demand, economic and tax policy, the value of the U.S. dollar, budget deficits, shifting demographics, and post-retirement financial promises.
Economic bubbles have been inflating and bursting since the housing collapse and mortgage crisis. Companies, paralyzed by uncertainty, are holding cash in liquid accounts with poor earnings, preferring safety over return and indecision over action.
In the meantime, the U.S. government persists with quantitative easing.
To cope with this maelstrom, credit unions must don the armor of ERM maturity within the next 18 to 24 months.
The four essential pieces of this armor are governance independence, analytics, board involvement, and reporting frequency.
Credit unions need to diligently compare their current readiness to their optimal state to identify and address gaps. An action plan with clear timeframes and accountabilities must be board approved, funded, and executed.
By following this process, credit unions will be adequately girded. Times are demanding these precautions and regulators are increasingly seeking to enforce new protective measures.
1. Governance independence
Governance independence relates to oversight and segregation of duties between return generation and risk assumption. ERM maturity is often characterized by an independent chief risk officer and board risk subcommittee, complemented by a best practices asset/liability management committee.
Mature governance requires board-approved strategic and capital plans with quantified risk tolerances. The board is responsible for collaborating with executives to establish specific risk tolerances and balanced return expectations.
Plans must be integrated and actionable, and address tactics, product offerings, resource allocations, staffing, compensation, training, and technologies.
Capital decisions, such as appropriate leverage, payment of dividends, earnings retention and risk assumption, as well as mitigation of unacceptable or unprofitable risk exposures, must also be directed by these plans.
Analytics refers to the knowledge, tools, and technologies which complement learned intuition, and are used to measure, analyze, manage, and integrate risk assumption with return generation.
A well-stocked tool box is likely to include dashboard scorecards, forecasting and stress testing software, funds transfer pricing, capital assignment, a centralized database of granular transaction detail, and risk-adjusted profitability measurement at product and member levels.
Entering ERM maturity requires that credit unions stress-test “possible” to “probable” events, as well as those which are likely to render their business model unviable.
The best practice is to anticipate the worst and develop solutions before an occurrence to avoid, delay, mitigate, or endure the consequences.
Credit unions mature in ERM involve the board in all aspects of stress testing in accordance with a specific policy. To identify issues, comprehensive strategic risk/return dashboards are utilized.
These color-coded dashboards, inclusive of historic and peer benchmarks, readily facilitate management by exception, allowing executives and board members to concentrate on metrics outside of guidelines and tolerances.
Risk assessments are integrated across the entire credit union with customized capital assignment (both economic capital and risk-adjusted return on capital) serving as the capstone of the integration and quantification of risk/return analytics.
Capital adequacy is determined by stress-tested capital for all risks across the full probability spectrum, customized to a credit union’s unique risk profile. Capital adequacy is not a one-size fits all determination, since there is not a single regulatory capital ratio that is sensitive to the full risk array.
3. Board involvement
Board members must be active to gain a thorough understanding of the credit union’s risk profile, business model, strategies, performance and operating environment. Board members fulfill their responsibilities based upon clearly delineated duties as well as annual performance evaluations.
Active participation by the board in all phases of stress testing, as well as review of management and independent risk assessments, is a hallmark of ERM maturity.
Boards engage in policy approval as well as capital right-sizing strategies. Time spent in board meetings involves dialogue with executives and includes specific agenda items for risk profile and trends, capital adequacy, strategy updates and ongoing education.
4. Reporting frequency
ERM maturity related to reporting frequency refers to running and reviewing periodic and ad hoc stress testing with semi-annual capital right-sizing. Summary reports reviewed by the board should be graphical and high-level, rather than piles of overwhelming numeric tables and spreadsheets.
The risk subcommittee should meet quarterly for in-depth discussion and analysis, and then an overview of the findings should be presented to the full board.
We are in uncertain times, which require credit unions to safeguard their capital positions. It takes the right pieces of armor to do so.
The good news is that the four essential pieces of armor (governance independence, analytics, board involvement, and reporting frequency) can be addressed over the next 18 to 24 months.
With continuous and focused step-by-step improvement, credit unions will achieve ERM maturity and gird their balance sheets and capital positions to meet future challenges.