HARAHAN, La. (12/20/11)--Credit union executives making investments should consider four questions for wise lending and investing:
- What is the potential loss of principal?
- What is the impact on liquidity?
- What is the expected return?
- What is the long-term impact on earnings?
The answers to these four questions are critical for balancing risk and return, said Brian Turner, director of the advisory service for Catalyst Strategic Solutions, the investment arm of Catalyst Corporate FCU in an article in the Louisiana Credit Union League's newsletter, eNews
Dec. 14. Balance is an important financial principle and the impetus for credit union examiners' focus on concentration risk, Turner said.
In a recent letter to credit unions (11-CU-16 State of the Credit Union Industry October 2011), the National Credit Union Administration (NCUA) stressed the need for concentration risk mitigation strategies, said Turner. An elevated percentage of real estate loans to total loans, in combination with declining real estate values nationwide have made these strategies necessary.
Turner said he agreed with the underlying notion that credit unions need to be mindful of concentration risk, but he cautioned against an overly simplistic approach to identifying concentrated risk exposure.
Some credit union managers and examiners identify product concentration risk with basic allocation ratios, Turner said. This approach is reflected in an NCUA supervisory letter that identifies variables with broad labels, such as "real estate loans," "member business loans" and "investments in mortgage-related securities." These labels identify certain asset classes rather than aggregate risk, he said.
"Concentration risk assessment should go beyond simply evaluating whether a credit union has 'all their eggs in one basket," Turner said. "It should encompass all areas of risk--namely credit, liquidity, earnings and capital--to determine the true extent of risk associated with each principle product and how combined product risk affects the overall balance sheet."
Turner offered examples:
- A credit union with a relatively low loan-to-asset ratio might be in a position to absorb a higher level of interest-rate risk because it retains a lower level of credit risk and a stronger liquidity profile.
- In a case where two institutions might have the same percentage allocation of fixed-rate mortgages, one institution's portfolio could have an average loan-to-value (LTV) of 50%, an average Fair Isaac Co. (FICO) score of 760 and a demographic distribution across multiple regions. The other might have an average LTV of 90%, an average FICO of 680 and be demographically isolated within two counties. These two credit unions most likely do not have the same risk profile and should devise different risk strategies, Turner said.
Credit unions should establish a balance-sheet structure that produces a stable earnings stream through a variety of economic and interest rate cycles, Turner said. That stability depends entirely on the relationship between the credit union's earning assets and funding base, he added.