ELEMENTS OF AN EFFECTIVE MEMBER BUSINESS LENDING PROGRAM (FROM PAGE 8)
financial framework that does not expose the lender to
excessive risk. Breach of a financial covenant provides an early
warning to the lender and the ability to call a loan into default.
As credit unions bring in sophisticated commercial borrowers,
they should look to protect themselves via cash flow, leverage
and liquidity covenants. Bad Sign: A commercial borrower
with marginal capital and cash flow having no requirement to
comply with leverage and cash flow covenants.
Due Diligence on Collateral
Credit unions need to complete adequate due diligence on
collateral securing loans through inspection, commercial
appraisal, environmental assessment, or other method to
confirm valuation and salability of collateral should the need
occur. The extent of due diligence is a function of credit
exposure, collateral type, and likelihood that collateral will
need to be relied upon. The advance rates on collateral should
be a function of the secondary market for securing collateral.
Bad Sign: Collateral is located out of state where a credit
union has not observed the collateral, and has limited
knowledge of market conditions.
Cash Is King
A fundamental difference between a financial institution and
an asset-based lender is the expectation and requirement that
an MBL will be repaid with cash generated from operations,
rather than secondary sources of repayment like collateral
liquidation or a call on guarantors. Credit unions routinely
relying on such secondary sources to make up for the lack of
proven cash flow are likely to have a higher-risk portfolio that
cannot be competitively priced. They are also likely to incur
bad debt and elevated expenses associated with litigation,
monitoring, repossessing, holding, and marketing collateral.
With the possible exception of unencumbered guarantor
liquidity and readily marketable securities serving as
collateral, there are few alternatives to proven cash flow. Cash
flow coverage (also known as debt-service coverage) is
usually calculated as the annualized sum of net income,
interest expense, and non-cash expenses divided by the sum
of existing and proposed principal and interest payments for
the applicable year. Bad Sign: The credit presentations do not
include a cash flow coverage analysis, or contains one based
on cash flow projections that are optimistic relative to actual
historical performance.
Portfolio Controls
Credit unions with new MBL departments are often pressured
to generate sufficient volume to justify the initial investment in
MBL personnel and infrastructure. However, absent
experience in administrating these loans, a rapidly growing
MBL portfolio has the potential to alter the credit risk profile
of a credit union. Management needs to carefully choose the
initial MBLs to build their portfolio while reasonable growth
targets should be set. Bad Sign: A rapidly growing MBL
portfolio concentrated in high-risk industries.
INTEREST RATE RISK POLICY AND PROGRAM: THE NCUA RULE (FROM PAGE 4)
Policies for both loans and investments have long been
requirements of NCUA’s insurance rules. NCUA strongly
believes a written IRR policy and an effective IRR
management program are fundamental to safe and sound
credit union operations.
NCUA has been careful to minimize regulatory burden by
applying the rule only to larger FICUs and those in the
$10–$50 million range with higher risk exposure as indicated
by the SIRRT ratio. Using this approach, the rule would have
covered 95.9 percent of FICU assets but only 45.2 percent of
FICUs as of Sept. 30, 2011. NCUA believes the rule is
warranted by demonstrable increases in IRR exposure at
FICUs. The aggregate SIRRT ratio, for example, rose from
199.1 percent at year-end 2005 to a peak of 271.1 percent in
March 2011—an increase traceable to a steady lengthening of
average asset maturities, most of which are fixed rate.
NCUA is mindful of the need to ensure guidance provided in
the appendix to the IRR rule is not used as a crude checklist.
Credit union examiners will apply the rule in the context of
each FICU’s operations. This means taking into account size,
complexity, and risk exposure in evaluating IRR policies, as
well as assessing the overall effectiveness of IRR management.
Effective IRR programs identify, measure, monitor, and
control IRR at all times. But it is particularly important in
the current environment when low interest rates put
significant pressure on credit union margins.
The supervision guidance issued on various specific IRR risks
over the years is still relevant. The guidance of the new IRR
rule separately addresses the means by which a credit union
can manage these risks through an IRR management
program, and so apply a written IRR policy which the credit
union has adopted. The rule serves to combine the many
elements of asset/liability management guidance into a
comprehensive framework for managing this core risk.
