What’s Your Credit Union’s Liquidity Strategy

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Compliance preparations for the National Credit Union Administration’s new emergency liquidity rule must have been completed by March 31 2014.

The liquidity rule sets up three-tiered emergency liquidity requirements for credit unions with less than $50 million in assets, between $50 million and $250 million in assets, and more than $250 million in assets.

Federally insured credit unions (FICUs) with less than $50 million in assets must maintain a basic written emergency liquidity policy but will not be required to take further action. All FICUs with assets of $50 million or more are required to develop contingency funding plans describing how their credit union will address liquidity shortfalls in emergency situations. FICUs with assets of $250 million or more would be required to have access to a backup federal liquidity source for emergency situations.

Why wouldn’t credit union’s with less than $250 million in assets not want to have access to a backup federal liquidity source such as the discount window or CLF for emergency situations?

The final rule does not include the Federal Home Loan Banks (FHLB) as an acceptable source of emergency liquidity, although eligible credit unions required to meet the federal source provisions would be free to borrow from a FHLB for nonemergency purposes. Without the FHLB, credit unions have two options to ensure a federal liquidity source for emergency situations: Becoming a member of the NCUA’s Central Liquidity Facility (CLF) by subscribing to CLF stock or access to the Federal Reserve’s discount window.

I strongly supports the use of the home loan banks for liquidity.

Why be concerned now about liquidity when most credit unions are still awash with funds resulting from a flight-to-safety fund inflows and loan portfolio outflows due to lack of loan demand?

• Rising rates typically are used to manage economic recoveries. so it is likely rising rates will be accompanied by a return of flight-to-safety funds to the market and a spike in loan demand, putting many credit unions back in the tight liquidity environment of a few years back.

• Many credit unions have rate floors under their variable rate loans.  As rates move up, rates on these loans won’t move for a while. But your cost of funds will.  The result is a compressed net interest margins or NIM

The objective of a viable liquidity policy and strategy is to provide a framework to minimize the adverse effects of a significant and sustained liquidity crisis.  This can result from changing economic or interest rate conditions, deposit outflows, unusually strong loan demand, intense competition, an international crisis, or any other factors that can deplete the liquidity of the credit union.

In the event of a serious and sustained liquidity crisis, various strategies, of which some would be considered preventative and must be implemented prior to the onset of a crisis.  Other strategies are reactive and may be implemented immediately.   The strategies will differ in terms of the implementation time, costs, risks, financial implications and regulatory consequences.

The first place to look for sources of liquidity is within your own balance sheet. More

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Concentration Risk

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CU officials and management have a fiduciary responsibility to identify, measure, monitor, and control concentration risk.  Concentration risk must be managed in conjunction with credit, interest rate and liquidity risks; as a negative event in any category may have significant consequences on the other areas, as well as strategic and reputation risks.

Concentration risk has increased in importance during the recent economic recession.  Poor risk management of residential and commercial mortgage loan concentrations, in particular, is having an adverse effect on credit unions nationwide; resulting in significant loan losses, earnings deterioration, capital depletion, and increased credit union failures.

The board of directors should establish a policy addressing its philosophy on concentration risk, limits commensurate with net worth levels, and the rationale as to how the limits fit into the credit union’s overall strategic plan.  Take a global perspective when developing the policy, including identifying outside forces (such as economic or housing price uncertainty) which will affect the ability to manage concentration risk.

The parameters set by the board should be specific to each portfolio and should include limits on loan types, share types, third party relationship exposure, etc.  The risk limits should correlate to the overall growth objectives, financial targets, and net worth plan.  The risk limits set forth in the concentration risk policy should be closely linked to those codified in related policies, including, but not limited to, real estate loan, member business loan, loan participation, asset/liability management (ALM), investment and liquidity policies.  Any Concentration exceeding 100 percent of net worth must be monitored carefully, and the board of directors should document an adequate rationale for undertaking that level of risk. More

An Understanding of a Credit Union Net Worth Restoration Plan

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Due to recent declines in the equity markets, some credit unions may experience an increased flow of funds coming into their organization at a time of weak loan demand and low investment returns. This “flight-to-safety” for some credit unions could result in the need to submit a “Net Worth Restoration Plan”.

The Net Worth Restoration Plan commonly referred to as NWRP serves as a blueprint for the board and management to restore and maintain for four consecutive quarters the credit union’s net worth ratio to 6% or greater and to establish a financial framework for the 1/10th percent (0.1%) quarterly earnings waivers transfers.

Understanding the implications of the credit union having an inadequate level of net worth is important.  Your primary goal should be safeguarding the member’s deposits through sound policies and practices, and by creating and sustaining a sufficient amount of net worth and reserves to absorb possible losses without endangering the stability of the credit union.

Your plan needs to meet the criteria set forth in NCUA Rules and Regulations 702.206-NWRP including: More

Allowance for Loan Loss

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The ALL estimate is guided by NCUA Rules and Regulations and Generally Accepted Accounting Principles (GAAP). The following resources were considered in the creation of this article:

  1. FASB ASC Topic 450: Accounting for Contingencies [formerly FAS 5];
  2. FASB ASC Topic 310: Accounting for Receivables [formerly FAS 114];
  3. NCUA Interpretive Ruling and Policy Statement 02-3: ALLL Methodologies and Documentation for Federally Insured Credit Unions;
  4. NCUA Letter to Credit Unions 03-CU-01: Loan Charge-off Guidance; and
  5. NCUA Accounting Bulletin No. 06-01

Because of the newly implemented ASC, it maybe difficult, especially for those, like myself, who are familiar with the original FASB standards, to identify the most current accounting reference materials.

There are two primary topics under the ASC that address the ALL. Key concepts extracted from Topics 450 and 310 of the ASC are summarized below.

  1. Topic 450, Subtopic 20, “Loss Contingencies,” addresses accounting for loss contingencies. Much of this topic is derived from Statement of Financial Accounting Standards (SFAS) Statement 5, “Accounting for Contingencies.  Topic 450 specifically references Topic 310, noting that the ALL is a subset of loss contingencies.
  2. Topic 310, “Receivables,” addresses various issues related to accounting issues subsequent to the origination or acquisition of receivables, such as impairment. Former accounting standards SFAS 5, SFAS 15, and SFAS 114 provide much of the content for this section.

Subjective and Imprecise

The appropriate degree of allowance involves a high degree of “management judgment” within a “range of estimated losses.”  Moreover, determining the allowance for loan and lease loss, hereafter referred to ALL is “subjective and imprecise.”  ALL estimates are based on a comprehensive, well documented and consistently applied analysis of the credit union’s loan portfolio.

ALL takes into consideration available information as of the financial statement date including environmental factors. The ALL provides an estimate of probable but unconfirmed losses in the loan portfolio as of the financial statement date; it is not a reserve for future anticipated losses.    The use of environmental factors may likely cause estimated credit losses associated with the credit union’s existing loan portfolio to differ from the historical loss experience.  Your analysis should consider significant factors affecting the collectibility of the portfolio and attempts to support the credit losses estimated by the ALL process. A credit union should adopt methodologies and documentation practices that are appropriate for their size and complexity.  Credit unions with fewer and less complex loan products, the amount of supporting documentation for the ALL may be less exhaustive than for credit unions with more complex loan products or portfolios. Your methodology and documentation needed to support the ALL estimates should be prepared in accordance with generally accepted accounting principles (GAAP).  The Statement of Financial Accounting Standard (FAS) 5 will be most relevant to the majority of credit unions. Finally, understanding the theory, building strong policies and analytics, and increasing director governance are key to a successful ALL outcomes. More

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