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The overarching goal of planning is to provide long-term direction plus a short-term plan for how get there.
As we head into the new year, credit unions and their boards are typically finalizing their budgets for the upcoming year. This year that means dealing with the operational impacts of the coronavirus pandemic and ongoing implementation or planning for the current expected credit loss accounting standard as well as routine financial matters. Even so, no one wants to spend a lot of time developing the budget.
The good news is a good asset/liability management model has a wealth of information and tools that can be used in the budgeting process. It is just a matter of capitalizing on the model’s abilities and leveraging it in a way to make the process simpler.
A solid understanding of the differences between a budget and the financial forecast are vital to budget preparations. Don’t forget that board members can often benefit from a review of these concepts, given that some are recruited for the position less for their financial expertise (or lack thereof) than for their community involvement. With that insight and an awareness of how the ALM model is used to generate budgets and forecasts in everyone’s mind, your credit union’s planning and execution next year will be on track.
Budgeting, Asset/Liability Management Now Vital
Good budgeting and asset/liability management are especially important now, given how drastically budgets have been upended by the coronavirus pandemic and ensuing financial crisis. Consider how much more quickly a credit union is able to react when it has real-time information to understand where financials are headed. For example, interest rates are evolving in a way that might not be good for a lot of institutions without a solid handle on trends. Many financial institutions have seen a flood of non-maturing deposits increasing their balance sheets. If short-term rates are increasing more than the long-term rates, a credit union can end up with increased cost of funds, which will shrink already-tight margins.
Ultimately, the goal of budgeting and planning is to provide long-term direction for the institution and a short-term plan for how get there. Both the budget and the forecast can help the credit union with this, but they help in different ways.
The Budget
The purpose of a budget is to provide plans for specific growth strategies for the institution for a given time period. This includes creating not only a spending plan that you typically think of when you think of a budget for a business, but for credit unions, it also includes developing a lending plan and a plan for expected deposit growth.
When thinking of a budget, make sure that you focus on the near term–most often, the next calendar year. It is hard enough coming up with that plan for the next year. If you get any longer, there is a greater chance that the plan can get derailed quickly and become outdated. Just look at your plans for last year. The budget is usually created toward the end of the previous year and is generally based on past performance, current economic data that is known at the time and the institution’s specific strategies.
A key component of creating the budget is determining what interest rate forecast will be used, since that forecast drives so many of the estimates on both sides of the balance sheet. Whether you use a flat rate forecast or a best guess rate forecast for the upcoming year, the same rate forecast will be used to generate income and expense budgets based on the budgeted growth on the balance sheet.
What-If Scenarios for Budgeting Using ALM Model
When developing a budget, one of the features of an ALM model that can be helpful for staff and management is the ability to examine what-if scenarios. By inputting different rate scenarios or different management expectations for loan or deposit growth, the ALM model can show the impact across the balance sheet without having to change cell after cell in multiple spreadsheets. This makes it easier to weigh decisions on potential expenditures, new products or other budgetary choices.
The plan for balance sheet growth and the corresponding income and expense along with the plan for non-interest income and operating expenses will become the submitted budget. A good budgeting tool will allow you to run budget variance reports throughout the year that show a comparison of what actually happened in a given month compared to what was budgeted for in that month.
Once the plan is voted on and approved by the board, the budget is then locked down and will not be changed during the year. That is the major difference between a budget and a forecast: The budget is static and will not change based on new factors that develop throughout the upcoming year. The forecast, on the other hand, is all about recognizing changing conditions.
Managing the goals outlined in a credit union’s budget requires the ability to project cash flows and future changes for assets and liabilities, and that’s where the dynamic asset/liability management model becomes even more valuable. Many of the same inputs required for the ALM model are used to develop the forecast and budget at the beginning of the budget year, and to adjust the forecast to better manage throughout the year as conditions change.
The Forecast
A forecast is a rolling estimate of a credit union’s future income statement, balance sheet and cash flow statement that is constantly being updated based on the latest history and current economic expectations. The forecast should be a good representation of expected growth for the next 24 to 36 months.
The forecast generated by the ALM model is used by management to generate quarterly earnings at risk and equity at risk reports, which show how much risk potential changes in interest rates could pose to the credit union’s earnings and equity, or value. Knowing the credit union’s current position helps management and asset/liability committee members understand as rates are changing how those changes will impact their interest rate risk measures.
New information that would cause the credit union to update the forecast could include higher- than-expected deposit growth like what was seen during the last year in many institutions, or much lower loan growth than expected. No one anticipated the impacts a pandemic would have on balance sheet growth, either on the asset side or the liability side. This made many budgets out-of-date very quickly during the past few months, so adjusting the forecast was critical for management and boards to stay on top of the changing conditions.
As forecasts of many of the nuances in the economic environment are rolled forward and adjusted, they can be adjusted for in the forecast to account for changing loan and deposit growth. These adjustments in growth and the much lower interest rate forecast that we are currently dealing with have significantly changed many growth strategies for the remainder of the year. There may also be significant increases in provisions for loan loss as loan defaults are expected to begin increasing.
Overall market rates are much lower than what was anticipated at the beginning of last year. The current rate environment is making things extremely tough to manage an already tight net interest margin. Loan growth may be non-existent and investment options with a decent yield are extremely hard to find. However, by adjusting forecasts based on the latest information, credit unions are able to have a more accurate picture of earnings at risk or equity at risk at any given time. This will help them make the best decisions.
A good ALM model has a lot of valuable information that can be capitalized on when going through the budgeting process. If a forecast is maintained properly throughout the year, you are, in essence, doing a mini-budget every time you update the history and your financial forecast. Scheduled cash flows downloaded from the core system provide the run-off for the balance sheet, and by updating the balance sheet growth you are making sure current and new money cash flows make sense. Add in pricing decisions for your loans, investments, and deposits, and the income statement is on its way to becoming a budget as well. All that is needed then is to pay attention to the non-interest portions of the income statement and you have a completed budget. Utilizing your dynamic forecast to facilitate the completion of your annual budgeting process is a great way to leverage the information found in your ALM model.
Teri Grams, CPA, is advisor with Abrigo, Madison, Wisconsin.
