2019: A Year for Core Lending Principles



2018 proved to be an eventful, and profitable, year for most credit unions. Amidst heightened volatility from domestic and international  concerns, credit union performance reached post-crisis highs over the year (Figure 1). Now, in early 2019, many institutions are asking  themselves what’s next? Searching for creative ways to maintain and grow profitability in 2019 is a task at the top of many financial  executives’ to-do lists. When faced with uncertainty like this, it’s usually a good idea to go back to tried-and-true core lending principles:  asset pricing discipline, marginal return analysis, and leverage strategies.


For many years now, securities portfolios have dwindled as a percentage of average assets as institutions focus on lending. This allocation  to credit-riskier assets has led to higher profi ts. Figure 2 highlights the change in balance sheet composition starting in 2011. As of Q318,  loans-to-assets sits at over 70%, while securities-toassets was below 15% for the industry.


Despite margin expansion throughout 2018, fears over plateaued earnings remain real. Competition has heightened due to a maturing  credit cycle, a continued rise in short-end rates, and a fl at yield curve putting pressure on low-cost core funding retention. Regardless,  successful lenders abide by a few key tenets independent of the environment.

Tenets of Successful Lenders

Pricing Discipline
While pricing discipline should remain at the forefront of all lending decisions, it becomes particularly important for credit unions given  their cooperative mission and consumer lending focus. ALM First performed an empirical beta analysis for the 2018 calendar year,  highlighted in Figure 3. While residential mortgage products moved in almost lockstep with their respective benchmark, only 50% of rate  change was passed along to auto borrowers.
Particularly for those facing concentration risk concerns, or operating an originate-to-sell model, the harsh realities of poor pricing can  negatively impact earnings should management become complacent. As loan demand has risen over the last decade, and allocation to  credit risk has increased, net interest margins (NIMs) and profi tability have expanded as deposit pricing has lagged signifi cantly relative  to assets. This leaves many institutions susceptible to repricing risk given the relatively low pricing power credit unions have in their primary lending categories: auto loans and residential mortgages. To combat margin compression as funding costs rise, benchmark  pricing can be evaluated through an economic return on equity (ROE) lens and pricing (i.e., yield) can be adjusted as changes in market- based sources arise.


Marginal Return Analysis
Fostering and maintaining relationships is an invaluable trait of most high performing institutions, especially lenders who capitalize on  cross-selling opportunities. However, executive management should be adding profi table assets to the balance sheet, thus increasing the  value of the institution. This means measuring the value of institutional relationships and fi nding a balance between volume and profitability – best accomplished through marginal return analysis.

Efficient allocations of capital should be evaluated on the margin. This involves gauging the perceived risk-adjusted performance of any  two (or more) assets (Figure 4). After adjusting for marginal operating, credit, and funding costs, only those assets that meet the  institution’s hurdle rate (commonly thought to be WACC, or weighted average cost of capital) should be added to the balance sheet.


Deploy Leverage
Funding profi table assets can become burdensome should loan demand remain strong and deposit growth dwindle. Thus, many  institutions have opted to wholesale fund on the margin and leverage. Credit union capitalization remains strong, sitting at 11.22% for the  industry as of 3Q18, a 32-basis point increase year-over-year. Leverage strategies should be evaluated within the broader context of  existing balance sheet risk and capitalization. Figure 5 provides an example wholesale leverage transaction which many institutions have  utilized, supplementing organic loan growth. Wholesale or non-core funding can be a worthwhile avenue to maintain a robust lending  program and mitigate reduced margins if appropriate for the institution’s risk profile.

5In conclusion, depository
financial performance
remained positive in 2018
but maintaining discipline
within lending programs will
help credit unions withstand
headwinds in 2019 and
beyond. Pricing discipline
and marginal return analysis
are a must, and leverage can
be used when appropriate as
part of capital planning and

michael-oravetzMichael Oravetz joined ALM First Financial Advisors in 2016. Michael assists in delivering holistic balance sheet strategies across a  variety of funds management disciplines including loan and deposit pricing, portfolio and liquidity risk management, as well as profitability and funds transfer pricing. Michael participates with implementing firm-wide strategic initiatives and modeling procedures. In addition, Michael conducts research for asset liability management strategies, interest rate hedging strategies, ALM model validations,  loan pool valuation, and credit analyses. Prior to joining ALM First, he worked as an analyst in the Acquisitions and Capital Markets Group for Reef Oil & Gas.
Michael holds a bachelor’s degree in both Finance and Accounting from The University of Texas at Dallas, where he graduated with honors.

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