BY ALEC HOLLIS
Your credit union shouldn’t believe everything it hears when it comes to blanket statements about the entire CU industry. Keep reading to experience the most common of these myths being debunked. The truth may just set your credit union free of misunderstandings and false beliefs.
Occasionally, conversations with credit union executives reveal either a misunderstanding or a misapplication of certain topics. To address this issue, ALM First Financial Advisors has compiled a list of three of the most common of these statements, along with responses we believe might be helpful when addressing them.
“Return on equity is for banks and return on assets is more appropriate.”
When compared with return on assets (ROA), return on equity (ROE) is one of the most underutilized and misunderstood profitability metrics. Managers often perceive ROE as a banker’s measure of value provided to shareholders that isn’t relevant to credit unions. However, it is critical to understand the limitations of ROA, which shows the effectiveness of total balance sheet utilization but doesn’t adjust for balance sheet leverage. In certain cases, this oversight may lead credit unions to hold excessive amounts of capital, which improves ROA through less allocation to interest-bearing liabilities but is a drag to ROE. So if a credit union isn’t effectively deploying its capital base, that fact would not be reflected in the ROA.
Over the long run, an institution can maintain business viability only by generating comparable value for stakeholders relative to their alternatives. Managers should regard profitability and member value as synonymous concepts because members can benefit from the enhanced capabilities as a credit union becomes more profitable.
ALM First recommends adding ROE to the management toolbox. Another important point regarding ROE/ROA analysis of a credit union is that profitability may be understated due to distribution of retained earnings to members (inclusive of above/below market deposit/loan rates). Adjusting for this understatement will make the analysis more meaningful. ROE/ROA analysis should regard risk as well to arrive at a comprehensive assessment of financial performance. Such ideas relate to assessing capital adequacy and allocating risk-based capital, known as risk budgeting.
