The mission, vision, purpose or (insert your term here) statement at most credit unions includes some verbiage around creating value for members. Read literature about the advantages of credit unions, and you will see the words member-focused or member-owned. Clearly the concepts around value and operating as a cooperative are differentiators. While the spirit of these concepts is well intentioned, the execution and measurement of success is nebulous and difficult.
- How can a management team prove they are operating in a value-based and cooperative manner?
- How can the board of directors ensure the credit union is fulfilling its value-based and cooperative beliefs?
- How do members know if they are getting a “good deal” for what they have invested in the credit union (i.e., member capital and bankrolling the cost of operations)?
Traditional and widely used financial metrics emphasize the wrong things (profit) and objectives such as member satisfaction, customer intimacy, member-based solutions and product innovation are easy to say, but harder to prove that any real differentiation exists.
Member Focused Strategic Priorities
A good place to start in terms of measuring the fulfillment of the credit union ethos is by establishing a series of strategic priorities. The term “priorities” is selected carefully and for reason. There needs to be an order of importance established. Here is an example:
- Sustain the Entity. The credit union must operate in a safe and sound manner. Failing to meet this most basic of priorities means the credit union will cease to exist. Furthermore, if you cannot accomplish this objective, the remaining priorities cannot be fulfilled. This is similar the bottom layer on Maslow’s Hierarchy of Needs. Without food, water, shelter and sleep, it’s hard to move on to the higher order items.
- Create Value for Members. This sounds vague but can actually be measured. How to measure it will be addressed in the next section.
- Recognize Employees. Whether it be monetary, psychological, intrinsic or extrinsic, high-performing employees are what make a high-performing credit union. Regardless of asset size, personnel related expense is about half of all operating cost. The other half is effectively fixed (premise related, operations, regulation and compliance). People are what drive the success of the organization, not the depreciation schedule on a building or piece of equipment.
- Do Good. The mission statement for many credit unions expands well outside of serving only its members. It might include community outreach, the support of a specific charity or philanthropy, service to others—both domestic and abroad. The degree to which you can execute upon “do good” is based upon how well the first three priorities are performed.
Defining, Targeting and Measuring Member Value
From the perspective of creating tangible economic value for members—defining, targeting and measuring performance can be summed up as “Net Worth and the Four P’s.” This set of measures provides focus, fulfills the credit union ethos and supports a hierarchy of member focused strategic priorities.
- Net Worth. Net worth is cumulative profit extracted from members since the inception of the credit union. It should really be referred to as member net worth (always three words instead of two). It’s the cumulative member investment in the credit union necessary to realize the benefits of its products and services, and the manner in which they are delivered. Because it is member net worth, accumulating more than is necessary is not acting in a fiduciary manner. Every credit union should establish a target minimum and maximum net worth ratio. Operating the credit union too far below the minimum may put the priority of “sustain the entity” in jeopardy, while operating too far in excess of the maximum is overcharging members for the products and services provided.
- Product Mix. Because a minimum amount of net worth must be maintained for regulatory purposes, the credit union should be good stewards of the profit extracted from its members. Focus on asset growth is misguided because it carries a hidden tax. Assuming a target 10% net worth ratio, for every $10 million dollars in asset growth, members pay a 10% tax, or $1 million dollars, to maintain the target net worth ratio. The focus should be on leveraging net worth, not growing assets for the sake of growth.
Let’s put this in more personal terms. If you hire an investment advisor, and they take your net worth and invest it and make a below average rate of return, you are not going to be happy. If you have a strategy session with the advisor to discuss ways to increase your return and the advisor says, “If you give me more to invest, I can make you more money” then you should probably fire the advisor. The right discussion to be having is how assets are being deployed into which stocks, bonds and mutual funds—not how to take more money and make the same below-average rate of return.
Unfortunately, that’s what credit unions do when they fixate on asset growth. They are taking more dollars from members (the net worth tax) and not investing it any differently, thereby making the same poor rate of return. The right discussion to be having is how can we take member net worth and deploy it the most effectively and efficiently. There are three measures that can be used to address this:
- Loan to Asset Ratio. How much of the balance sheet is earning the higher loan yield instead of the lower investment (or overnight funds) rate of return? All asset growth starts with liability growth. Growing assets only to place those funds in low yield investments is not a good use of member net worth.
- Relationship Share to Asset Ratio. How much of our funding sources are of the lower cost, longer lived, less interest rate risk sensitive variety? The larger this figure is, the more it helps “sustain the entity.” It is also a widely used indicator of primary financial provider (PFP) status.
- Non-Interest Income to Asset Ratio. How much of our income comes from capital independent sources? Most non-interest income revenue streams have no regulatory net worth requirement. If the credit union can provide a wide array of non-interest income products and services that members want, everyone wins and you avoid the asset growth tax. It’s the most efficient use of member net worth because it does not require net worth.
- Productivity. If you have taken the time to read this far, you are in for a hidden gem. It’s obvious that the more productive the credit union, the more tangible benefit created for members. A credit union with a lower cost of operations, extracts less from its members to cover its expenses, and therefore has more left over to provide better pricing—a tangible economic benefit—and fulfills the member focused strategic priorities of “recognize employees” and “do good.”
Unfortunately, productivity is poorly measured. The two most common productivity metrics, expense as a percentage of assets and efficiency ratio, are horribly flawed because they encourage the most inefficient deployment of member net worth and reward extraction of profit from members.
The expense-to-asset ratio encourages asset growth faster than expense growth. What’s the fastest way to grow assets, outside of merging? It’s by offering the highest rate possible on the least desirable funding source (certificates and IRAs). What are the balance sheet items that take the least amount of activity to support? Certificates, IRAs and investments. So, this is no measure of productivity. In fact, this measure penalizes those credit unions that are thinking “outside the box” and looking at alternative sources of revenue that do not require assets. If you have lines of business such as wealth management, insurance, etc. or add-on products such as identify theft protection or GAP then you have expenses associated with those aspects of operations. The expense-to-asset ratio penalizes the credit union because it recognizes the expense, but ignores the revenue, even when the lines of business or products are highly profitable.
The efficiency ratio (non-interest expense as a percentage of net revenue) while extremely important to banks, it not member friendly. It encourages maximization of profit taking from members due to the net interest income and non-interest income components of net revenue. In addition, it is sensitive to fluctuations in interest rates. A credit union today can truly be more productive today than it was three years ago, but because of changes in interest rates, the efficiency ratio would incorrectly indicate otherwise.
A better measure of productivity is net operating expense as a percentage of activity balance. Net operating expense is total non-interest expense less non-interest income. By netting out the revenue from the expense incurred to generate the revenue, we have a better picture of the “net” cost of operations. That is the top number in the ratio. The bottom number in the ratio is comprised of the balance sheet categories which require the most activity to support, namely loans, drafts and regular shares. It excludes the limited activity categories such as certificates, IRAs, money markets and investments. The ratio produces a dollar-on-dollar measure that cannot be “padded” with low-activity balances and is insensitive to interest rates.
- Provision. Loan loss provision expense is a function of two items. Net charge-offs and the size of the self-insurance fund the credit union must hold against losses in future periods (loan loss reserve on the balance sheet). The more effectively the credit union manages these two areas, the lower the provision for loan loss expense. Risk-based lending may result in higher levels of loan loss provision expense, but it should be offset by higher yield on loans. If that is not the case, then you have members subsidizing losses instead of receiving some form of economic benefit (unless higher levels of credit losses is part of your “do good” strategic priorities).
- Pricing. The ultimate value proposition for any consumer is the economic value proposition. If you don’t believe me, drive by a Walmart at some off hour of the day or night and notice how full the parking lot is. People don’t go to Walmart to window shop. They go there for low prices. The extent to which you succeed at product mix, productivity and provision, determines how much of a value proposition you can deliver in terms of lower loan yields and higher dividend rates on the same products your competitors offer. The other pricing item is surplus funds yield. The rate of return on assets that are not loans and not on a depreciation schedule.
A Self-Governance Scorecard
It is easy to develop a scorecard to monitor performance in these areas as they correlate directly with the member value proposition—maintain the appropriate level of member net worth, effective and efficient use of member net worth via product mix, operating in a productive manner, management of provision for loan loss expense, and the ultimate value proposition, pricing.
Such a scorecard will resonate with the board of directors, executives, staff and credit union members because it includes a balanced and robust set of measures that drive toward member focused priorities—sustain the entity while creating tangible economic value for members, recognize the role employees play in making success happen, and impact the world outside of the credit union.
For each measure, develop a control chart. A control chart is a simple line chart with a minimum and a maximum value. These values can be established using peer percentiles. For example, the minimum level of acceptable productivity may be set at the 50th percentile (perform at average or better) and the maximum at the 85th percentile (to avoid employee burnout). Performance against the standard is plotted on a periodic basis (monthly, bi-monthly or quarterly). If performance falls outside of the minimum or maximum range, the management team should provide a mitigation plan to move the credit union back within the acceptable range, or the minimum and maximum ranges should be reviewed and updated.
The key when developing the ranges is to make sure the sum of the minimum acceptable ranges do not result in the credit union producing an unacceptable rate of return. For example, one might set up the ranges, be within tolerance in each area, and find it is making an unacceptable return on assets. In such an instance, it is where the ranges were set that is the problem, not the measures. Fortunately, it is possible to compute the return on assets assuming each measure is at the lowest point of acceptability to make sure this does not happen. Here is a recap of the measures for the scorecard:
- Net Worth Ratio
- Loan-to-Asset Ratio
- Relationship Share (draft, regular) to Asset Ratio
- Non-Interest Income to Asset Ratio
- Loan Yield (lower is better for member value)
- Surplus Funds Yield
- Cost of Funds (higher dividend rates are better for member value)
- Net Charge-Offs as a Percentage of Loan Balance
- Loan Loss Reserve as a Multiple of Net Charge-Offs
- Net Operating Expense to Activity Balance Ratio
By using a little algebra, combining the minimum acceptable range on each of these measures produces a return on assets figure. That minimum return on assets figure, multiplied by the target net worth ratio, will tell you how much asset growth the credit union can support. If your appetite for asset growth is greater than the minimum return on assets, then you need to go back and revise the targets.
The problem with most “blue sky” strategy sessions is they fail to recognize the fact that you operate in a capital constrained industry. You don’t have unlimited access to capital to grow an infinite amount. Because of that, you don’t have unlimited resources to go and “get what you want” from the marketplace.
The benefit of this set of balanced self-governance measures is that they tell a story. These are not 10 independent measures, they are 10 interconnected measures, which if managed within tolerance, will produce a result that will sustain the entity and create value for members at the same. Start with this set of guidelines, and then devise forward strategies to work within each, and you will literally have a roadmap to success. As one of the board chairpersons that I work with said, “It lets me know that everything is going to be OK.”
Mike Higgins is a performance management consultant to the financial services industry, a Filene Applied Research Advisor, a Pro-Con Board Governance Institute faculty member and founding investor in a top 10% performing community bank. He can be reached at 913.488.4506 or firstname.lastname@example.org.