In the first installment of this three-part series, we observed key trends that dominated the U.S. economy and the credit union system during the past 20 years—many of which have proven to be nonsustainable.
We set forth definitions of “sustainable,” one of which states that “a sustainable system or process must be based on resources that will not be exhausted over a reasonable period.”
Another saying holds that, “If something is unsustainable, it will stop.” This suggests change is inevitable both at the macroeconomic level and in terms of specific business models applied by credit unions.
In the second installment, we explored the Sustainable Growth Model (SGM) developed by the DuPont Corp. in 1919. This model can be applied successfully to individual credit unions today to determine whether or not a credit union has the financial strength to support sustained growth.
In this final segment, we’ll look at how to use the SGM to develop growth strategies. There are many paths to success for credit unions in today’s market, but it’s clear that doing nothing—or continuing along the same path—is not a viable strategy for many credit unions.
Let’s revisit the “CU sustainable growth analysis model” on p. 60. Seven items on the chart are highlighted in gold, beginning at the top right:
These seven factors are the primary “levers” management teams can use to manage their financial strategies. Using these levers is like driving a car with a manual transmission. The car has five primary “levers” you can use: steering wheel, gear shift lever, accelerator, brake pedal, and clutch.
A car also has many secondary levers including turn signal, headlights, and cruise control, but you can drive adequately with only the basic five. More important, you couldn’t drive very well by ignoring any one of the basic five.
We’ll focus on six of the seven credit union levers—again, highlighted in gold boxes—in the “CU sustainable growth analysis” model. We’ll ignore nonoperating income because, in most years, it’s an insignificant factor for credit unions. The year 2009 was an anomaly, however, as many credit unions realized large nonoperating gains resulting from the accounting reversal of the initial NCUA corporate assessment.
Let’s consider each of the primary levers independently.
• Leverage factor: Recall that the leverage factor for a credit union is approximately equal to the inverse of the net worth (also referred to as net capital) ratio. A higher leverage factor will increase a credit union’s return on equity (ROE) and serve to fuel the growth rate, but this requires reducing the net capital level.
NCUA requires a credit union to maintain a minimum 7% net worth ratio to be “well capitalized.” Deciding how much capital to net worth is needed to maintain an adequate capital cushion is one of the most important decisions a credit union board and management team will make. Approximately half of all credit unions currently maintain leverage between 9.5 times and 12.5 times, meaning their capital levels fall between 8% and 10.5%.
• Asset turnover: This is probably the least understood of the six primary levers. Asset turnover equals net revenue divided by average assets. Think of it as the number of times in a year you can generate revenue equal to your asset base.
Asset turnover for the credit union system in general is low relative to many other businesses. Half of all credit unions have asset turnover between 3.75% and 5.10%. This means it would take a typical credit union about 20 years to generate revenue equal to its assets. Other industries have much higher asset turnover rates. Asset turnover can be increased by growing revenue while keeping assets constant, or by maintaining revenue while shrinking assets.
Generally, credit unions with higher levels of noninterest income will have higher asset turnover rates. Note that selling off loans (via securitization or sale to Fannie Mae or Freddie Mac) in and of itself doesn’t increase asset turnover because the loan is replaced by cash on the asset side of the balance sheet. If, however, the sale allows the credit union to originate additional loans and thereby generate new fee income from the same amount of assets, that will cause asset turnover to increase and will cause ROE to rise.
• Net interest income: This is also referred to as “spread” income and is defined as the spread between what is paid for deposits (cost of funds) and what is earned on loans and investments. This is a hugely important lever for all credit unions as net interest income typically is the largest single revenue factor. For three-quarters of all credit unions, net interest income equals more than two-thirds of total revenue.
Although market forces act as a governor, there are many ways to increase net interest income—by raising loan rates, lowering deposit rates, or shifting the product mix to higher-yielding products. Each has to be considered within the context of your credit union’s competitive environment and value proposition to members.
• Fee and other operating income: While net interest income is the largest revenue component, fee and other operating income has also become a critical factor in light of the recent challenges to interchange fees and potential caps to nonsufficient funds (NSF)/courtesy pay fees.
Both credit unions and banks now face the need to re-evaluate fee-income strategies to maintain acceptable revenue levels. This could mean educating members about the value of products and services that carry transparent fees. Fees and other operating income typically account for 5% to 30% of a credit union’s total revenue, although some credit unions generate zero fee income while others generate nearly half of their total revenue from fees.
• Loan loss provision: Loan loss provision accounted for approximately 20% of total expenses in the credit union system in 2010, although this factor varied widely depending on geographic location and lending strategy. In general, larger credit unions had much higher loan loss provision expenses during the financial crisis than did smaller credit unions.
The spike in loan loss provision in 2008 and 2009 was a major factor in driving ROE below its long-term trend line. The question now is how soon loan loss provision will return to its longer-term average.
• Operating expense: This category comprised 80% of total expenses and equaled 73% of net revenue for the system as a whole in 2010. However, this ratio of operating expense to total net revenue (also referred to as the efficiency ratio) varies widely among credit unions and is highly correlated to asset size.
A low efficiency ratio indicates greater efficiency and is better than a high efficiency ratio. Credit unions with less than $100 million in assets have an average efficiency ratio that is more than 30% higher than credit unions with more than $10 billion in assets. Just as in the game of golf, lower scores are preferred.
One observation raises a major concern: More than 25% of all credit unions had operating expenses that exceeded total revenue in 2010, and this was before factoring in loan loss provision. More than half of all credit unions had operating expenses greater than 90% of net revenue. This is the primary reason why almost half of all credit unions had an ROA of zero or less through the first three quarters of 2010.
Our research in applying the SGM to individual credit unions and the system as a whole has led us to the following conclusions:
• Many paths lead to success. When comparing successful credit unions, it’s striking how different the key ratios are that ultimately build up to a strong ROE. Consider the recent financial performance of three successful credit unions: Navy Federal Credit Union, Vienna, Va. ($41.5 billion assets); State Employees’ Credit Union, Raleigh, N.C. ($21 billion); and Star One Credit Union, Sunnyvale, Calif. ($5.2 billion).
While all three credit unions achieved an ROE greater than 10%, each has followed a different financial strategy. Navy Federal emphasized a high net interest margin and high asset turnover, while State Employees’ high ROE is driven by managing leverage. Star One has relatively low asset turnover but maintains one of the lowest operating expense ratios in the credit union system.
• Financial strategy must match your value proposition. Fifteen years ago, the popular business book “The Discipline of Market Leaders” put forth a strategy triangle that showed how successful firms tend to excel at one of three primary strategies or value propositions: product leader, price leader, or customer intimacy leader.
As your board and management team decide which value proposition best suits your credit union and its members, it’s vital to recognize that a credit union’s financial strategy must match and support that value proposition.
If, for example, your credit union wants to be a true price leader in your market, it must have a low operating expense ratio to support that pricing strategy. If, on the other hand, you want to be a product leader, your credit union must be prepared to fund the research and development and staffing necessary to support product innovation.
• Operating efficiency is a major issue for the credit union system. While each of the six primary levers must be managed in a harmonious way, it’s clear that many credit unions must achieve greater operating efficiency to remain viable and grow, especially in an environment of continued corporate assessments.
More than half of all credit unions today have expense ratios exceeding 90% of revenue, which suggests a dramatic change is required to boost ROE and the ability to grow. An individual credit union can improve this ratio by growing revenue without adding cost, or by rationalizing its current cost structure. Other alternatives include collaboration or consolidation.
Each of these options must be considered carefully by boards and management teams. The only other alternative is to burn through existing capital, but this is not a sustainable growth strategy.
Coming full circle
We began this series by warning that it’s dangerous to be complacent and to simply assume that credit unions will continue to thrive. While noting that real threats exist to the credit union business model, we also examined a proven analytic model and specific financial performance tools.
We hope this exploration of the SGM—a financial tool nearly 100 years old—will help you gain useful insights into your credit union’s financial strengths and weaknesses.
We believe the credit union levers derived from the model are vital as your board and management team develop strategies to ensure future growth and viability. We welcome your questions and comments, and we would be happy to assist you in applying the SGM to your credit union.
JOHN LASS is senior vice president of strategy and business development for CUNA Mutual Group, Madison, Wis.
To view a video interview with John Lass, click here.
• CUNA Mutual Group, Madison, Wis.: 800-356-2644