CFO Focus: A Timely Reminder About CAMELS

The National Credit Union Administration’s announcement of adding “S” to the CAMEL rating system, separating market sensitivity from liquidity, didn’t cause much fanfare. Ratings for individual credit unions are not expected to change much, but the timing is incredibly relevant.

The “S” is designed to put a spotlight on interest rate risk. An institution’s management of IRR is important for balancing risks and earnings opportunities in any environment, but the importance has increased with the extended low-rate environment, loan demand dominated by mortgages, a surplus of investments that earn little without lengthening the portfolio, squeezed margins and market rates anticipated to rise.

Beyond satisfying examiners, the focus should be on making the best decisions possible to keep your institution competitive, profitable, and safe and sound. The key is to be sure the analysis and quantification of IRR provide actionable decision information that is focused on the right elements—realistic impacts on earnings and net worth in a changing environment.

Four Things to Evaluate

1. Which what-ifs are you doing to proactively manage potential changes in your financial structure and the environment? A way to strengthen your position on the S is not only to do sensitivity testing but also to use your IRR modeling to see any risks of changing the structure ahead of time. Before finalizing the budget, consider what-ifs that jump into the future and assume the budget comes true. What would the IRR of that future structure look like? That kind of analysis and planning can not only strengthen your S but is a good business practice.
2. Look beyond static balance sheet simulations (though balance sheets have been anything but static) and net economic value. Make sure to look at bottom-line profit potential, as the ability to handle operating expenses and potential changes in provision for loan loss and non-interest income is key to earnings. Additionally, after record levels of deposit growth and with consumer spending increasing, address the risk of the deposit mix shifting, as you may not be able to count on the huge growth in non-maturity deposits staying if rates go up. Testing such a shift is beneficial for understanding business exposure.
3. Test a range of other key assumptions in changing rate environments, including changes in the loan mix, provision for loan loss, higher operating expense (especially salaries and benefits), and lower non-interest income. What-ifs on PLL deserve special emphasis because current levels are unsustainably low as pandemic-fueled loss reserves are walked back. According to figures from Callahans, the average credit union with assets between $500 million and $10 billion has PLL of 0.08% for June 2021 but averaged 0.37% for 2017-2019. Test a return to more typical levels as well as other changes in credit risk.
4. Review net interest income or net interest margin volatility risk limits as they sometimes provide a partial view of true risk. With low net interest margins to start with, NII and NIM policy limits could provide a false sense of safety. The average credit union with assets between $500 million and $10 billion had a NIM of 2.50% in June 2021. A policy limit of -30% NIM volatility would result in approving a 75 basis point reduction to the NIM. Managing to this siloed view of IRR could lead to business decisions that are disconnected from sustainable profitability because a 75 basis point reduction in NIM would take the average return on assets for this group down to 0.33%. Additionally, factoring in a return to more typical levels of PLL, as mentioned previously, could drop the approved ROA to 0.04%.

While credit union earnings look pretty good on the surface, more typical levels of PLL will mean that the industry is faced with managing IRR while managing earnings in lean times. Today’s lower net worth ratios with potential for tighter earnings can create pressure to increase IRR to generate more earnings. CAMELS may be viewed as more of an administrative than substantive change until we know more about the implementation, but the emphasis on IRR is particularly timely. Use this shift in focus toward the S as a reminder to be proactive, adopt the mindset of evaluating what can change going forward, and make sure the analysis connects to business decisions.

C. myers helps financial institution decision-makers uncover opportunities and continuously optimize their business models. Their depth and range of experience in linking strategy, talent, desired financial performance and successful execution enables them to work with their clients as strategic collaborators. They have the experience of working with over 600 financial institutions, including 200+ of those over $1 billion in assets. C. myers helps financial institutions think to differentiate and drive better decisions through strategic planning & business model optimization, strategic solutions and implementation, strategic leadership development, real-time ALM and financial forecasting, education, and thought leadership.