Coastal Supervisory Committee & internal auditor conference Carolinas Credit Union League...

transcript

Coastal Supervisory Committee & internal auditor conference

Carolinas Credit Union League

Accelerating the Performance of Your

Supervisory CommitteeJuly 24, 2015

Ron Parker, CPA

Parkerconsult@cox.net

520-275-5043

Questions--Background

• Supervisory Committee

• Board of Directors• Both• Management/Staff

How many have been in your current position for:

–20 years or more–10-20 years–5-10 years–1-5 years–Less than 1 year

Asset size of your Credit Union:

–Over $1B–$500M to $1B–$250M to $500M– $100M to $250M–$50M to $100M–$Under $50M

How many CPA’s?

If a CPA’s wife can’t sleep, what does she say?

Honey, tell me about your work!

When does a person decide to become a CPA?

When he realizes he doesn’t have enough personality to be an actuary or an undertaker!

HOW MANY OF YOUR ARE UNDER 35 YEARS

OF AGE?

Cowboy Wisdom

No one is listening until you Make a mistake

There’s two theories about arguin’ with your spouse or a regulator Neither works

Good judgment comes from experience, and a lotta that comes from Bad judgment

When your leadin’ the herd, its a good idea to look back once in a while To see if anyone’s followin’

A bumble bee is considerably faster than a John Deere tractor

Don’t judge folks by their relatives

Timing has a lot to do with the outcome of a rain dance

• Don’t corner something that you know is meaner than you

• Always drink upstream from the herd

• Letting the cat outta the bag is a whole lot easier than puttin’ it back in

• A good horse don’t come in no bad color

• The average person thinks he isn’t.

• The only way to get rid of a temptation is to yield to it.

• The fellow that agrees with everything you say is either a fool or he is getting ready to skin you.

• I don't know the key to success but I know the key to failure is trying to please everybody.

• 99 percent of lawyers give the rest a bad name.

If a matter is mentionable it is

generally manageable

Topics• Your Credit Union and Your

Supervisory Committee

• Credit Union Fundamentals

• Brief History of the Credit Union Movement

• Brief Credit Union Philosophy

• Duties, Responsibilities and Regulatory Requirements—including regulatory audit requirements

Topics• What Does the Committee Do

• Credit Union Financial Statement Literacy

• Credit Union Fundamentals

• Credit Union Financial Statements

Topics• Fundamental Accounting Concepts

• RISK

• Compliance …. BSA et. Al

• 25 Suggestions to Improve your Committee’s Effectiveness

• Questions You should Consider Asking

PLEASE ASK QUESTIONS AND

SHARE YOUR PERSONAL

EXPERIENCES WITH THE GROUP!

WHAT ARE YOUR CREDIT UNION’S

OR YOUR COMMITTEES

CHALLENGE(S) FOR 2015-2016?

The Credit Union System and How it

Functions

Why is a Credit Union Different

than other Financial Service

Providers?

What Is a Credit Union?Credit unions are financial institutions formed by an organized group of people with a common bond.

Members of credit unions pool their assets to provide

loans and other financial services to each other.

Is this definition accurate today!

Credit Union s Other Financial

Not-for-profit For profit

Cooperatives Owned by outside stockholders

Owned by members Owned by outside stockholders

Credit Unions Other Financials

Operated by mostly Controlled by paid boardsvolunteer boards and committeesand committees

IT’S NOT WHAT WE DO…IT’S HOW WE DO

STATE VS. FEDERAL CHARTERS/REGULATOR/INSURER

The National Credit Union Administration (NCUA) is the federal agency that charters and supervises federal credit unions.

They also insure savings in federal and most (95%) of state-chartered credit unions through the National Credit Union Share Insurance Fund (NCUSIF), a federal fund backed by the full faith and credit of the United States government.

History of the Credit Union Movement

Credit Union HistoryThe history of credit unions began in 1844, with a group of weavers in England, who sold shares to members to raise the capital necessary to buy goods at lower than retail prices, and then sold the goods at a savings to members. In doing so, they became the first credit union.

The movement then spread to Germany in 1850, Canada in 1901 and the United States in 1908

Cooperative Activity in America

The success of the cooperative movement in Canada influenced many Americans, including Pierre Jay, the Massachusetts banking commissioner, and

Edward Filene, a Boston merchant.

Cooperative Activity in America

In 1921, Filene created the Credit Union National Extension Bureau, and invested over $1 million of his own money to work towards establishing effective credit union laws in all states and at the federal level.

(FILENE INSTITUTE)

Credit unions banded together into

leagues on a state-wide basis.

Leagues provided financial and legal

advice, organizing know-how, and an instrument for credit unions to seek

favorable state legislation.

Post WWII EraIn 1945 there were 8,683 credit unions in the country;

by 1955 there were 16,201, and by

1969 the U.S. movement reached its peak of 23,876 credit unions.

About 6,000 today!

Post WWII Era

Since the 1970s, many smaller credit unions have merged into larger ones that offer a wider range of services.

Although this has caused the number of credit unions to decline, membership continues to climb.

Mergers Will Continue to Cull the CU Herd

Credit Union Philosophy

Credit Union PhilosophyIn 1935, when credit unions were helping Americans through the Great Depression, the treasurer of a Midwestern credit union said that credit unions were "not for profit, not for charity, but for service,“ What does this philosophy mean to you and does this philosophy

still holds true today?

Seven Cooperative Principles for Credit Unions

Voluntary Membership

Many cooperatives, such as credit unions, operate as not-for-profit institutions with volunteer board of directors. In the caseof credit unions, members are drawn from defined fields of membership.

3. Members’ Economic ParticipationMembers are the owners. As such they contribute to, and democratically control, the

capital of the cooperative.

This benefits members in proportion to the transactions with the cooperative rather than on the capital invested.

(HOW MUCH CAPITAL HAVE MEMBERS INVESTED?)

Duties, Responsibilities and

Regulatory Requirements of the

Questions• Who establishes the regulatory

requirements for your Committee?• Where are those requirements

found?• What are the key regulatory

requirements?

Questions• What are the common

requirements of all Committees?• What powers does the Committee

have?• What qualifications are required by

Committee members?

Regulatory Requirements

• May differ depending on whether you are a Federally or State Chartered Credit Union and/or

• You are insured by NCUSIF vs. a Private insurer

• Federally Chartered• State Chartered—Federally Insured• State Chartered—Privately Insured

§ 715.3 General responsibilities ofthe Supervisory Committee.

(a) Basic. The supervisory committee is responsible for ensuring that the board of directors and management of the credit union—

(1) Meet required financial reporting objectives and

§ 715.3 General responsibilities of

the Supervisory Committee.

(2) Establish practices and procedures

sufficient to safeguard members’ assets.

(b) Specific. To carry out the responsibilities set forth in paragraph (a) of this section, the supervisory committee must determine whether:

(1) Internal controls are established and effectively maintained to achieve the credit union’s financial reporting objectives which must be sufficient to satisfy the requirements of the supervisory committee audit, verification of members’ accounts and its additional responsibilities;

(2) The credit union’s accounting records and financial reports are

promptly prepared and accurately

reflect operations and results;

(3) The relevant plans, policies, and control procedures established by the board of directors are properly administered; and

(4) Policies and control procedures are sufficient to safeguard against error, conflict of interest, self-dealing and fraud.

(c) Mandates. In carrying out the responsibilities set forth in paragraphs (a) and (b) of this section, the Supervisory Committee must:

(1)Ensure that the credit union adheres to the measurement and filing requirements for reports filed with the NCUA Board under

§ 741.6 of this chapter;

(2) Perform or obtain a supervisory committee audit, as prescribed in § 715.4 of this part;

REPORTS FILED WITH THE NCUA BOARD—CALL REPORTS/5500 REPORTS

SUGGESTION

READ, DISCUSS AND DOCUMENT YOUR REGULATORY

REQUIRMENTS.

PREPARE AN ANNUAL REPORT DETAILING HOW YOUR

COMMITTEE HAS COMPLIED WITH THE REGULATORY

REQUIREMENTS AND SUBMIT TO THE BOARD OF DIRECTORS.

• Is generally appointed by the _________ and consists of _3-5___ members, one of whom may be a director other than a compensated officer of the board.

• The term “audit committee” designated by state statute or regulation is the equivalent of a Supervisory Committee.

Supervisory Committee Term

• The _BOARD_____________ determines the term

1, 2, or 3 years Staggered, with one position up for appointment

each year Regular terms expire after the first regular board

meeting One member of the Supervisory Committee

may be a Director

Supervisory Committee Leadership

• Committee Members select a

chairperson and a secretary.

• The offices of Chairperson and Secretary may be held by the same person.

Qualifications of a Supervisory Committee Member

• Must be a member of the Credit Union

• Must be bondable by the Credit Union’s surety bond company

Qualifications of a Supervisory Committee Member

• Employees and Credit Committee members are not eligible for membership on the Committee.

• Experience in bookkeeping, accounting or auditing helpful but not necessary!

Suspension Authority

• The Supervisory Committee may suspend, by unanimous vote, any ____________, _______________, or ________________ member.Board Member Executive OfficerCredit Committee

Suspension Authority• If you suspend someone, you must call a

special meeting of the _________ to act on the suspension

members

7-14 days The special meeting must be held within

_________ after the suspension

The person being suspended must be given an opportunity to present a defense and be given due process

Cowboy wisdom…

If you believe that you’re a person of some influence, try ordering

someone else’s dog around.

Attendance at Board Meetings

• The Supervisory Committee MAY attend Board Meetings, the Supervisory Committee Guides encourages at least one Supervisory Committee representative to attend each Board Meeting

Attendance at Board Meetings

• Attendance is permitted only with permission of the Board

• Committee members do not have an unqualified right to be present

Minutes of Meetings

• The SC secretary must maintain records of all actions taken–Monthly or quarterly meetings minutes–The minutes should document

significant discussions and summarize procedures performed

–Minutes should be approved by the Committee at the next scheduled meeting

Confidentiality

• Supervisory Committee members must keep any information obtained about the Credit Union and member account

records confidential.

SC Regulatory Requirements

• Regulation _715 of the NCUA Rules and Regulations sets forth Supervisory Committee audit requirements in standards consistent with the Credit Union Membership Access Act (CUMAA)

Regulatory Audit Requirements

Requirements and standards are linked to asset size and type of audit

Any federal credit union can fulfill its SC audit responsibility by obtaining a _FINANCIAL STATEMENT OPINION audit

• Federally insured Credit Unions with assets of 500 MILLION OR OVER must obtain a financial statement audit consistent with generally accepted auditing standards (GAAS) by an independent Certified Public Accountant licensed by the appropriate state authority to perform those services.

Regulatory Audit Requirements• Federal Credit Unions with assets <$500 million but

>$10 million may obtain a financial statement audit or

• A balance sheet audit or

• Report on the examination of internal control over call reporting under attestation standards or

• Supervisory Committee Guide audit procedures

• Federally insured Credit Unions with <$10 million in assets may obtain any of the optional audits to satisfy their requirement.

Availability of Work Papers

• The Committee must maintain or make available to NCUA a complete set of the _________ audit working papers

• NCUA staff must have unconditional access to the working papers upon request

original

This requirement should be stipulated in the

auditor’s ENGAGEMENT

LETTER

Availability of Work Papers

Independence of Compensated Auditors and Supervisory

Committee Members• Exercise impartiality necessary for the

reliability of the compensated auditor’s findings

• Exercise of fairness

• Objective and free from influences that may impair your objectivity

Independence of Compensated Auditors and Supervisory

Committee MembersIf a Committee member is or is perceived

to be unable to objectively perform a specific duty, it is the Supervisory

Committee member’s responsibility and the responsibility of the committee as a

whole to determine that the task is performed by a member who can act

independently.

What Does the Supervisory Committee Do?

• You must ensure that the Board of Directors is safeguarding assets, and that management complies with their policies and plans.

You must report to members at the annual meeting as stipulated in Article V of the standard by-laws.

What Do We Do?

• Depends on asset size, complexity, and Supervisory Committee work plan

• Hire and work with the internal auditor

• Hire and work with the external auditor or

• Perform the Supervisory Committee audit

What Do We Do?

• Review examination and audit findings

• Meet with Examiner as you or the Examiner may request

• Research member complaints

• Complete other recommended procedures

When? At least _ONCE A year, you

must complete the Supervisory Committee audit and provide a report on the audit to the BOARD.

The audit must cover the period lapsed since the last audit.

• At least once every 2 years you must conduct a verification of members’ accounts—DONE ANNUALLY WITH OPINION AUDIT

Board Plans and Policies

• To determine what the Board’s plans are you should:– Attend monthly Board

meetings or review Board minutes

– Review the business plan of the Credit Union for reasonableness and implementation

Audits Vs. Examinations

• Primarily focus on the accuracy of accounting records, and the effectiveness of internal controls related to the accounting records

• Performed by CPA’s or other independent auditors

• Focus on safety and soundness concerns, as well as overall controls, regulation compliance and record keeping

• Performed by applicable federal and/or state regulatory personnel

_____________Audits Examinations

Management’s Responses to Audit and Examination Findings

• Request a report from management that outlines actions taken to correct the problems identified

• Review management’s response to ensure that corrective actions appear reasonable and adequate

Management’s Responses to Audit and Examination Findings

• If management did not adopt the corrective actions suggested in the auditor examination report, they should have

developed an adequate alternative plan.

• If the SC believes that management may not have addressed the problems cited in audit and examination reports, the committee should further review and discuss concerns with management.

Meetings with Examiners

• Discuss the examination process

• Areas of focus

• Findings and reporting process

• Let the committee know of any SIGNIFICANT findings noted during the examination

Complaints about policy or procedure corrections must be followed through to ensure that THE BOARD AND MANAGEMENT implement corrective action

Member Complaints• Handling member complaints is

an essential role for the SC• Complaints must be handled in

an PROFESSIONAL AND CONFIDENTIAL manner

Types of Member Complaints• Lending policies and

procedures• Loan rejection• Annual meetings• Share withdrawals• Dividend rates and terms• Credit Union services• Other

Hiring an Outside Auditor

THE SUPERVISORY COMMITTEE must hire the auditor

The BOARD must authorize the budget and approve the expense

Hiring an Outside Auditor

• Experience level of the individuals who will complete the audit and the firm’s knowledge of Credit Union operations

• Professional certification of the individuals who will complete or supervise the audit

• Time period for scheduling the audit

• Individual or firm’s audit program and approach

• Time frame for receiving the final audit report

• Exit meetings with in-charge auditors at the end of the engagement

Regulatory personnel will be provided UNCONDITIONAL access to the complete set of working papers

Engagement Letter

Notice in writing of any internal control reportable conditions

Specific target DATE of the written report

Working papers retained for AT LEAST THREE years from date of report

• Regulatory personnel will be provided UNLIMITED access to the complete set of working papers

Engagement Letter• Notice in writing of any

internal control reportable conditions

• Specific target DATE of the written report

• Working papers retained for AT LEAST 3 years from date of report

SUGGESTION

READ AND DISCUSS THE ENGAGEMENT LETTER

(ENTIRE COMMITTEE) AS WELL AS OTHER CONTRACTUAL

ARRANGEMENTS

Internal Audit Function

• When should your Credit Union have an Internal Audit Function?

– All large Credit Unions with complex operations should give serious consideration to having an internal audit department

– Other Credit Unions are urged in the Supervisory Committee Guide to have internal audit functions

Internal Audit Function• Employment of an internal auditor does

not replace the SUPERVISORY COMMITTEE

• It does not change the function of the SUPERVISORYCOMMITTEE__________

• Responsibility for the SC audit and the SC functions still resides with the SC

Duties of the SC may be performed in part by others BUT

Internal Audit Function• Regulators suggest that the internal audit

function is most effective when the internal auditor reports directly to the Supervisory Committee. Other reporting alternative may work within

your Credit Union

If Your Committee does Your Audit

1. Obtain a copy of the NCUA Supervisory Committee Guide/Manual and complete:

• The minimum procedures outlined in Appendix A (or similar procedures) and

• The final audit checklist outlined in Chapter 25

2. Focus on key risk areas---risk of significant loss to the credit union.

3. Remember, in very small credit unions you may be the primary control and oversight function!

Credit Union Financial

Statement Literacy

You Might be From the Dakota’s If:

You got stopped by a state trooper.

He asked you if you have an I.D.

And you said, 'Bout What?'

2011 Letters to Federal Credit Unions

11-FCU-02 Duties of Federal Credit Union Boards of Directors

Key Provisions--BOD

1.Responsible for the credit union’s general direction and control

2. Carry out duties in good faith, in the best interests of the membership

3. Administer affairs fairly, impartially, and without discrimination

4.Maintain a working familiarity with basic finance and accounting practices

5.Direct operations in conformity with Federal Credit Union Act, NCUA Rules and Regs, other laws, and sound business practices

6.Rely on information prepared or presented by employees or consultants to be reliable and competent

Credit Union Financial Fundamentals

Basic Credit Union Operations

--Members--Directors--Savers--Borrowers--Owners--Users of Services

Members

Savers

Borrowers

Users of other financial services

Profitable and Unprofitable

Is it important to know the

profitability of your credit union’s

products, services, members and

delivery systems?

Basic Credit Union Operation/Transaction FlowsWe have Savers/Depositors

Why Save with Us?

Basic Credit Union Operation/Transaction Flows

Savers/Depositors

How are Deposit Rates

Determined?

Under what circumstances might it be appropriate to pay above market rates?

Member Deposits are Funds Borrowed from our Members

and others!

Our members and others expect a

return on their borrowed funds—

dividends!

Member Deposits/Dividends

Cost of funds = Dividend rates x Mix of deposits

Basic Credit Union Operation/Transaction

What are your most and least costly savings

products?

Economic forecast and CU outlook

Source: CUNA’s economics and statistics department

For updates, visit cuna.org and select “research & strategy,” then “national economic data,” then “data.”

Economic forecast Five-year average 2013 2014 2015

Economic growth (% change in GDP) 1.24% 1.90% 3.01% 3.75%

Inflation (% change in CPI) 1.60 1.46 1.50 1.75

Core inflation 1.64 1.76 1.50 1.75

Unemployment rate 8.70 7.40 6.40 5.90

Federal-funds rate average 0.14 0.11 0.10 0.75

10-year Treasury rate average 2.68% 2.35% 2.98% 3.40%

CU outlook Five-year average 2013 2014 2015

Savings growth 6.00% 3.60% 3.50% 3.00%

Loan growth 2.70 7.30 7.50 8.00

Asset growth 5.40 3.90 3.60 3.50

Loan-to-share ratio 73.90 68.60 71.40 74.80

Delinquency rate 1.46 1.02 0.90 0.80

Net charge-off rate 0.91 0.57 0.55 0.50

Return on average assets 0.59 0.77 0.80 0.85

Net worth ratio 10.30% 10.80% 11.00% 11.50%

6.0 6.0

4.14.8

4.45.2

3.6 3.53.0

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Credit union savings growth

Source: CUNA’ s economics and statistics department

Repricing of Member DepositsDuring what length of time would

the following generally reprice?

(Repricing is the time period (duration) where

we can expect a member deposit amount to

change its rate)Term Certificates

Money markets Shares

Share draftsOther share accounts

Basic Credit Union Operation/Transaction Flows

Borrowers/Lending/Loans

Why do members borrow from us?

Borrowers/Lending/Loans

Rates?

Should be commensurate

Credit union loan growth

10.610.9

7.07.5

10.8 11.0

7.8 7.6

1.2 1.2

7.3 7.58.0

'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 11 '12 '13 '14 '15

CU loan growth Recession

Forecast

Source: CUNA’ s economics and statistics department

Loan Income

Loan Income =

Loan rates x Mix of loans outstanding

Loan Income

Two Credit Unions have equal total loans:(A) has a majority of loans in real

estate (B) has a majority of loans in

automobiles.

Which will have a higher loan income?

Higher loan income does not necessarily mean higher NET

INCOME!!

CU net loan yield

'94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13

Loan Risks

Which loan products have the highest

and lowest credit risk (risk of loss)?

Is there a relationship between the risk of loss and

the profitability of the various loan types?

Repricing of LoansDuring what period of time would the

following generally reprice?

(Repricing is the time period (duration) where we can expect a loan

to change its rate)

• Real Estate

• Auto • Unsecured• Credit Card

CU loan-to-share ratio

'94 '96 '98 '00 '02 '04 '06 '08 '10 '12 March '14

Which is better, low Loan to Share or high Loan to Share ratio?

Low Loan to Share ratio often results in lower

income

Asset Liability Management (ALM)• ALM Reports are often divided into two primary

and two secondary interest rate risk measurements.

• The primary tools that the NCUA uses for measuring interest rate risk are Net Economic Value (NEV) and Net Interest Income (NII).

• Both tools measure interest rate risk under seven interest rate shock scenarios: basecase (no change – flat), up 100, 200, and 300 basis points (bps) and down 100, 200, and 300 basis points (bps).

Asset Liability Management (ALM)• The secondary or supporting interest rate risk

measures are duration and repricing gap.

• Duration primarily supports the NEV analysis for interest rate risk sensitivity

• Repricing gap lays out the cash flows and interest rates over different maturity buckets.

• The report should also provides key assumptions used by the credit union in their analysis.

CREDIT UNION FINANCIAL

STATEMENTS

Financial Reports

• Statement of Financial Condition (BALANCE SHEET)–This statement shows the financial

condition of the Credit Union.•Assets—What we own•Liabilities—What we owe•Member’s Equity—What we have

Statement of Income (PROFIT AND LOSS)

• Reflects all income, expenses, gains and losses of the Credit Union.

Statement of Reserves and Undivided Earnings

•Shows changes in members equity during the period for which it is prepared.–It will show the total increases and the total decreases in each account representing the equity (ownership—RIGHT TO ASSETS) of the Credit Union.

Assets - What we OwnEarning

Cash and equivalentsLoans

InvestmentsNCUSIFOther

Non-EarningCash

NCUSIFProperty and equipment

HOW DO YOU INCREASE OR DECREASE ASSETS??

WHAT IS THE RELATIONSHIP BETWEEN DEPOSIT

GROWTH AND ASSET GROWTH?

Liabilities - What we Owe

To Members

SHARES

To Others

Liabilities - What we Owe

What portion of our Assets are funded by

borrowed funds?

All but Member’s Equity (Capital)

Member’s Equity aka Members Capital

Assets minus Liabilities

Regulatory Capital + OCCI (Other comprehensive income)

(Commonly referred as Capital or Net Worth)

Member’s Equity (Capital) –

What we HaveHow can you increase

Member’s Equity (Capital) on

your Financial Statements?

NET INCOME

What is Capital?Capital is not cash

• It is the accumulated earnings and losses since you started the credit union.

• Tells you what portion of your assets belong to your members (collectively) and what part is dedicated to your depositors and other creditors

Member Deposits vs. CapitalAll of our Funds areBorrowed....except

Capital!!

We have to pay for borrowed funds…we don’t have to pay for Capital!

Liabilities/CapitalHow much is a typical credit union leveraged? (about 10

to 1)Total Assets = 100%Total Liabilities = 90%Total Capital = 10%

Net Worth and Earnings

A Credit Union’s ONLY source of Capital

is____________?

SUPPLEMENTAL/ALTERNATIVE SOURCES??

NET INCOME

Net Worth and Earnings

The primary Capital ratio is the ratio of capital (member’s equity) to assets.

What are the two ways to increase your Capital ratio?

INCREASE CAPITAL==HOW??DECREASE ASSETS==HOW??

How much Capital is enough?

• Prompt Corrective Action Rules• National or Peer Averages• Depends on how much risk your

assets and liabilities represent

• Depends on level of growth• Depends on profitability of CU• Depends on future plans

PCAWhat is it?

Prompt Corrective ActionWhat are the key provisions?

Required and defined actions to be taken when undercapitalized

What is 7% or more capital termed?Well capitalized

What is 6 to 7% capital termed?Adequately capitalized

What is 4 to 6% capital termed?Undercapitalized

4 to 5 % capital—no capital restoration plan or not implemented timely

Significantly undercapitalized

2 to 4 % capital

Significantly undercapitalized

Less then 2% capital

Critically undercapitalized

Prompt Corrective Action (PCA)

Mandatory Supervisory Actions– Below 7% - transfer 0.1% of Total Assets

to Regular Reserve each month (get back to 7% ASAP!)

– Below 6% • Develop a Net Worth Restoration plan• Limit asset growth• No new member business loans

Discretionary Supervisory ActionsThe lower you go, the more authority the Regulators take away from management

and the Board

INCOME, EXPENSES AND NET INCOME (LOSS)

HOW OUR BUSINESS WORKS

Credit unions make money 3 ways:

• Interest Income—LOANS AND INVESTMENTS

• Non-Interest Income—FEES AND CHARGES

Credit unions spend money 3 ways:

• Cost of Deposits-- (Cost of Funds)• Operating Expenses-- (cost of people,

buildings, etc)• Provision for Loan Losses-- (cost of bad

loans)

Revenue/Income - What we Earned

Sources of Revenue/IncomeLoans---Loan Income

Investments –-- Investment IncomeFees, Charges and Other Income

Costs/Expenses

Cost of funds--DividendsProvision for loan losses

Operating expenses--overhead

Net Income (Loss)Total Income

Total Expenses =

Net Income or Loss!

Income StatementLoan and Investment

Income

(less):Dividends =

Margin/Spread

+ Fees and Other Income

Provision for Loan Losses

- Operating Expenses

=NET INCOME

Earnings/Net IncomeWhat are the 6 ways

to increase net income?

INCREASE LOAN INCOME

INCREASE INVESTMENT INCOME

INCREASE FEE OR OTHER INCOME

Earnings/Net IncomeWhat are the 6 ways

to increase net income?

•DECREASE PROVISION FOR LOAN LOSSES

•DECREASE DIVIDENDS

•DECREASE OPERATING EXPE NSES

What is ROA?ROA stands for Return on Assets (or Return

on Average Assets)• It is a standard measure of profitability in

financial institutions• It allows you to compare your profitability

to other credit unions of any size (as it is based on Asset size)

• It tells you how effectively the credit union is using its Assets and Liabilities

Credit Union ROA and Capital Ratio

ROA necessary to maintain a given capital ratio under a given asset growth rate:

Capital Ratio (Percent)6 8 9 10 11 12

Asset 5 0.29 0.39 0.44 0.49 0.54 0.59Growth 7.5 0.43 0.58 0.65 0.72 0.80 0.87

Rate 10 0.57 0.76 0.86 0.95 1.05 1.14(percent) 12.5 0.71 0.94 1.06 1.18 1.29 1.41

15 0.84 1.12 1.26 1.40 1.53 1.6717.5 0.97 1.29 1.45 1.61 1.77 1.93

20 1.09 1.45 1.64 1.82 2.00 2.18

Sources of Non-Interest IncomeNot Just Fees!!!

•Fee Income – NSF and late loan fee•Service Revenues –Overdraft Protection•Commission Income –sales of something•Interchange Income – Debit and Credit cards•Other Non-Interest Sources – CUSO selling some product or service

Some Fundamental Accounting Concepts

Fundamental Accounting Concepts

Most assets and liabilities are recorded at cost.

Some assets are marked to market i.e. generally valued

at the lower of cost or market.Some investments and

assets held for sale (loans) for example

Most of the numbers on a Credit Unions

financial statements are fairly well defined

(not many judgments or estimates)

Cost or cost less depreciation oramortization

Lower of cost or market—where market is determined in a formal and orderly market place

Some assets require a valuationAccount!

Loans: Not all are collectible so a valuation account is

established for probable losses in the loan portfolio

Fundamental Accounting ConceptsInvestment Accounting: Debt

Securities

Management intention and ability at acquisition date determines

classification as:

Available for sale—marked to market through member’s equity (capital)

Held to maturity—market values disclosed...no impact on net income

or capital.

Fundamental Accounting ConceptsIf an investment or other asset

(such as your investment in the share insurance fund) is deemed to be permanently impaired (OTHER THAN TEMPORARY IMPAIRED--

OTTI) then it is

marked to market with the results

going through the income statement.

NCUSIFFunding, premiums and dividends

In 1970 Congress approved and creating the National Credit Union

Administration as an independent agency.

Soon after, Congress established the National Credit Union Share Insurance Fund and made the NCUA responsible

for its administration.

NCUSIF

Funding, premiums and dividends

The NCUSIF is funded by deposits from insured credit unions.

All Federal credit unions, as well as any state chartered credit union

insured by the fund, are required to maintain a balance equaling 1% of all covered deposits in the fund.

The NCUA is required to set a target equity balance of at least 1.2% and no more than 1.5% of the total of

insured deposits.

NCUSIFFunding, premiums and dividends

In the event that the equity ratio of the fund falls below 1.2%, the NCUA will charge a premium to insured credit

unions to maintain the required minimum. In years when the fund achieves a ratio above 1.3%, it will pay out excess funds to insured credit unions in the form of a dividend.

Since the fund was recapitalized by credit unions in 1985, the fund has charged one premium in 1992. The fund has

issued several dividends to member credit unions, the most recent in 2007.

AFTER 2007—A DIFFERENT STORY!!

Assets---LoansThe loan account is stated at the

amount of loans outstanding less:

The allowance for loan losses which is a deduction from

the loan account and represents management’s estimate of

losses in the loan portfolio as of the date of the financial

statementsNEW PROPOSED METHOD—

FORWARD LOOKING PROCESS!!

Allowance for Loan Losses and Provision for Loan Losses

How many of our numbers require significant

estimates by management?

Not very many i.e. Most numbers are recorded at

cost or fair value (market) or lower of cost or market!

Allowance for Loan and Lease Losses (ALL) and Provision for Loan Losses (PLL)

Why all the interest in these two accounts??

ALL—An estimate of losses in the loan portfolio.

An increase in the ALL will result in a increase in expenses through the

provision for loan losses (PLL).

ALL and PLLThe ALL is increased by:

Charges to the income statement through the

Provision for Loan Losses (PLL) account and

Recoveries of loan amounts previously charged

The ALL is decreased by:

Charged off loans

04:1 05:1 06:1 07:1 08:1 09:1 10:1 11:1 12:1 13:1 14:10.0%

2.0%Loan Loss Provisions Allowance for Loan Losses Net Charge-offs

Credit union credit quality(as a % of loans)

Source: NCUA

Types of Risk1. Credit Risk2. Interest Rate Risk3. Liquidity Risk4. Transaction Risk5. Compliance Risk6. Strategic Risk7. Reputation Risk8. Concentration Risk9. Growth Risk

Credit Risk

The Risk that we won’t get our

money back from a loan, investment or

other asset!

Measuring Credit Risk

•Delinquency Ratio•Net Charge-off Ratio•Earning assets to non-earning assets ratio

•Trend in credit score or grade mix of your loan portfolio•Product mix of your loan portfolio•Mix of your investment portfolio

Interest Rate Risk

The risk of loss due to rising or falling interest rates.

Arises when a credit union’s assets do not mature or re-price at the same interval as its liabilities

If interest rates change, what will happen to: – Net Interest Margin?– Net Income?– Capital?

Interest Rate Risk

1.If interest rates change, what will happen to our earnings?

2.How much capital is at risk?

Measuring Interest Rate RiskCompare rate sensitivity of the credit union’s earning assets to that of its interest-bearing liabilities

–Gap Analysis - Income Simulations–Net Economic Value (NEV) Calculations

Computer simulations Shock tests

–Measuring effect on asset values if interest rates rise or fall 300 basis points

Liquidity Risk

Risk that adequate cash will not be available to fund loans, meet withdrawal demands, or pay bills.

Transaction Risk

Risk of fraud or operation problems in transaction processing

that results in an inability to deliver products, remain competitive, and

manage information

Controls

Pay attention to:•Audit comments on Internal Controls•Regulator comments on Internal

Controls•Internal feedback on Internal Controls•Consider Fraud Hotline

Bank Secrecy, Anti-Money

Laundering & OFAC

• Designed to aid federal government in detecting illegal activity through tracking certain cash-based transactions.

• Requires credit unions to file reports of daily transactions conducted in currency in amounts over $10,000.

• Requires recordkeeping on beneficiaries and originators of funds transfers in amounts over $3,000.

• Requires information gathering and recordkeeping on sales of money orders, cashier’s checks, and traveler’s checks in amounts between $3,000 and $10,000.

• Establishes certain exemptions to the currency transaction reporting requirements.

Bank Secrecy Act (BSA)

Bank Secrecy Act (BSA)Identifying Reportable Transactions

• The Credit Union is required to fill out a Currency Transaction Report (CTR) for ANY cash transaction that totals over $10,000.

• A cash transaction is one that involves the physical transfer of actual cash between Credit Union personnel and any customer.

Bank Secrecy Act (BSA)

The Credit Union must: Complete a CTR immediately for any transaction over

$10,000.

Make sure there is proper ID (driver’s license, passport, armed forces card, government ID or alien registration card).

Be as exact as possible.

Complete a Log-Entry for purchase of negotiable items for currency of $3,000 or greater.

Strategic Risk

Risk of adverse business decisions through management’s or board’s actions or inactions

Reputation Risk

Risk of negative public opinion or perception leading to a loss of confidence and/or severance of relationships

Concentration Risk

Risk that you have “too many eggs in one basket”

•Mostly concerned about–Mortgage loans–Member business loans–Loan participations–Loans to single borrower or group–Sub-prime loans–Indirect loans from single or few auto dealers

Growth Rate Risk

Risk that rate of change in balances of loans and deposits will be different than you had planned OR Growth of both Assets and Liabilities will out pace Capital growth

What would the following say about a glass half full of water?

• PessimistHalf Empty

• Optimist

Half Full• Regulator

Looks like you’ve got twice as much glass as you need there!

Suggestions

1.Gain a clear understanding of management’s risk tolerance.

2.Understand the level of each risk in your Credit Union and assess and discuss changes in these risk areas.

SuggestionsGain an understanding of

how Management Monitors the levels of Risk in these seven areas!

Particularly Credit and Concentration Risk!

25 SUGGESTIONS ON HOW TO

IMPROVE YOUR COMMITTEE

Many of us have some unique problems…

1. Gain an Understanding of the

Duties, Responsibilities and

Regulatory Requirements of the

SupervisoryCommittee

2. Gain an Understanding of the Fundamental

Requirements of the Committee

3. If Possible, Recruit a Board Member to Your Committee as a Liaison to the

4. Maintain Accurate and Comprehensive

Minutes of Your Meetings and

Committee Activities

5. Develop a Code of Ethical Conduct for

Your Committee

6. Gain an Understanding of

the Audit and Examination

Requirements for your Credit Union

7. After Reviewing the Regulatory Requirements

Determine What, When and Who will be Performing the

Requirements

8. Develop Procedures for the Hiring of an

External Auditor

9. Assess Needs then Recruit, attract, and retain qualified members.

10. Formulate a Supervisory Committee Charter and Obtain

Approval by the Board of Directors

Your Charter should define how the committee intends to carry out their

responsibilities.

Should confirm and define committee duties and responsibilities.

• Will allow the committee to compare actual performance with duties and responsibilities

• Understand the difference between oversight and decision-making functions.

• Inform the BOD as to their intentions

11. Review all Minutes of Board of Directors

and Committees– To stay informed– To determine policy changes and

direction– To determine if actions may be increase

risk of loss to member assets

12. Review entire Board Packet including

Financial Reports, Ratio’s and Risk Analysis:

–Develop a checklist of key data

–Allocate responsibilities

–Develop questions to be asked

–Review annually for value and relevance of information

13. Obtain necessary resources for training and education

–Subscribe to credit union periodicals and other financial publications

–Develop a reference library–Develop applicable reference web sites—

NCUA, CUAM, CUNA, NAFCU, Leagues–Provide for attendance at conferences and

seminars –Require a report to committee and board

of all educational training

14. Develop a written plan for working with your External Auditor

Working with the Outside Auditor

Meet with outside auditors before and after the audit field work and discuss:

– Audit program and risk assessment processes

– Evaluation of internal controls methodology

– Type and nature of audit test work performed

– Audit report and management letter

Working with the Outside Auditor

Inquire of outside auditors as to:

–Material weakness or significant deficiencies in internal controls

–Errors or irregularities noted during audit

– Illegal acts noted during audit

–Significant accounting policies

15. Develop a written plan for working with your Internal Audit function

16. Develop a written plan for working with your Regulators

17. Develop and utilize an Annual Work Plan

Your plan should contain a monthly

outline of what the Committee will be

doing throughout the year.

DIVIDE UP RESPONSIBILITIES FOR ALL CRITICAL AREAS---PRIMARY AND SECONDARY RESPONSIBILITIES

18. Understand Credit Union Risks and how they are Measured, Monitored and Managed by Management.

RISK ASSESSMENT, MEASURING AND

MONITORING

WHAT CAN CAUSE OUR CREDIT UNION

SIGNIFICANT LOSSES AND/OR THREATEN

OUR FUTURE EXISTENCE!

19. Develop a Risk Assessment Plan that will focus on the areas of greatest risk to the credit union and make certain that audit and oversight processes are focused accordingly.

RISK MANAGEMENT

IN WHICH RISK AREAS DO YOUR RISK

MANAGEMENT PERSONNEL SPEND

THEIR TIME?

ARE WE SPENDING THE PROPER

AMOUNT OF RESOURCES

MONITORING THE KEY RISK AREAS?

RISK MANAGEMENTTHE FOLLOWING RISKS ARE

GENERALLY MEASURED AND

MONITORED BY A SPECIFIC

INDIVIDUAL:

• COMPLIANCE• TRANSACTION• INTEREST RATE• LIQUIDITY

RISK MANAGEMENTTHE FOLLOWING RISKS ARE

GENERALLY MEASURED AND

MONITORED BY VARIOUS GROUPS:

• CREDIT RISK• STRATEGIC RISK• REPUTATION RISK

20. Gain an Understanding of credit union financial

statement fundamentals

C re d it U n io n F in a n c ia l S ta te me n t A n a ly s is

Ratio Analysis: The Ratio Analysis are financial ratios that are grouped into six categories. The first four categories are derived from the four financial areas of the CAMEL Rating System (Capital adequacy, Asset quality, Earnings, asset/Liability management). The remaining two ratio categories are productivity and other ratios.

The Ratio Analysis page allows in-depth analysis of fundamental financial ratios and trends. [It is important to remember that peer ratios are simply for comparative analysis and a credit union’s ratios must be evaluated in relation to other available data, including any factors unique to the credit union, prior to drawing any conclusions.

22. Gain an Understanding

of Fundamental Accounting Concepts

23.Prepare an Annual Report of Committee Activities throughout the year and Submit to the Board of Directors

24. Prepare an Annual Evaluation of the Supervisory Committee.

• Internal evaluation of the Committee

• Board and management evaluation of Committee

25. Develop a Watch List of Key

Areas of Focus

Develop a list of Questions Your

Committee Should be Asking

General Questions Is there a need to:

– Improve Business Processes– Reduce or control Operating Expenses– Review our Fee structure

• If so, what are the steps and time frames.• When can we expect to see changes in

efficiency and expenses?

Succession Planning• How often is a projection/assessment of

future management needs made?

• How is the assessment made?

• The assessment should be an appraisal of the quality and quantity of senior and middle management and should be relative to the size and complexity of the Credit Union.

Succession Planning• Has the Credit Union developed a formal

written succession plan?

• When was it last updated and approved by the board of directors?

• Does the succession plan address the steps to be followed in finding new management personnel in the event of termination, retirement or resignation?

Succession Planning

• Does the plan address both retirement and extended absences of key Credit Union personnel?

• Is there a Board of Directors and SC succession plan?

Strategic Planning

• Does the Credit Union have a written plan and how was the plan developed?

• What time period does the plan address?

• How is the strategic plan utilized by management?

Strategic Planning • Does it identify Credit Union strengths and

weaknesses? • Does it outline and define the Credit Union

objectives, action plans, goals, etc.?

• The plan should contain a long-range plan of what we hope to achieve “down the road” and an operational plan that has goals for business units or departments to focus on and action steps needed for the achievement of those goals.

Budgeting• Does Credit Union management prepare an

annual operating budget? Does the board of directors provide input and

final approval of all budgets? Are changes and revisions to the budget

approved by the board? Has the Credit Union developed a formal

written Technology Plan and related budget?

What time frame does it cover? ZERO BASED??

Budgeting • Are explanations of monthly variances

and their cause presented in writing to the board of directors by management?

The final and most important steps are measuring results against the budget, seeking explanations for variances, and evaluating the performance of the persons responsible for carrying out delegated duties and responsibilities.

Pricing of Loans, Dividends and Fees for Member Services

• Does the Credit Union have a well-defined ALM system that consistently assesses interest rate, credit and liquidity risks? What software or outsourced vendors are used?

• Who are the members of the ALCO committee?

• What reports are issued by the ALCO committee and who reviews them?

Field of Membership• What is our relationship/dependency with

our primary corporate sponsor?

• How dependent are we on our sponsor group?

• What are our limitations regarding field of membership expansion?

Questions regarding Profitability and Capital

• What are our profitability trends (ROA) for the past 5 years? What is our expected profitability (ROA) for the coming year(s)?

• What is our capital ratio trends for the past 5 years?

Questions regarding Profitability and Capital

• NCUA web site (ncua.gov)—Financial Performance Reports:– Financial Summary —quarterly financial

information for the past 12 months.– Ratio Analysis—Capital adequacy; Assets

quality; Earnings; ALM; Productivity; Other Ratios by quarter for past 12 months.

LENDING AND COLLECTIONS QUESTIONS

Lending

• Who is responsible for assessing the adequacy of loan policies, practices, procedures and internal controls?

• When were loan policies last reviewed and approved by the board of directors?

Lending• What procedures are in

place to prevent unauthorized, fraudulent loans being set up by Credit Union employees?

• If a fraudulent loan were set up by an employee, how and when would the fraud be determined?

Collections

• How are the number and nature of loan extensions and collection work out loans monitored?

Collections• When were collection policies last reviewed and

approved by the board of directors?

• Do collection personnel have the ability to file maintain member loans i.e., advance due dates, waiver of interest/late charges/fees, change addresses or loan codes and other data changes? If so, who and how are file maintenance changes reviewed and monitored?

Recoveries• What percentage of charged-off loans do

we subsequently recover? (10 to 15% normal)

Are all charged-off loans turned over to a collection agency or attorney?

Are all charged off loans reported to a credit bureau?

Lending

• Delinquency, Charge offs and Recoveries must be monitored by appropriate credit risk components—for example by loan types, credit scores and grades, fields of membership and geographical areas, loan to value at loan date and at present etc.

• Loan portfolio trends must be divided

and monitored by risk areas.

Lending

• Review the monthly charge offs by loan type for the past two years for consistency and trends.

• Compare the Allowance for Loan Losses to Outstanding Loans by loan type by month for the past two years.

Lending

• What are examiners and auditors saying about our Charge Off and Allowance for Loan Loss policies and procedures?

• What are our available lines of credit trends? Trends of available vs. used amounts.

• What loans types and areas are of greater concern to management?

Lending• How is possible impairment/losses in Member

Business Loans, Loan Participations, and Real Estate Loans being monitored (who).

• Which employees can originate, process and fund a loan? If so, what controls prevent the origination of fictitious loans?

• Who has the ability to advance due dates on loans? What controls prevent the advancing of due dates on delinquent or other loans?

Allowance for Loan Losses Questions

ALL and PLL

THE ALL IS GENERALLY THE LARGEST ESTIMATED NUMBER ON THE FINANCIAL STATEMENTS AND IS AN ESTIMATE OF PROBABLE LOSSES IN THE LOAN PORTFOLIO AS OF A DATE IN TIME.

The ALL is increased by:– Charges to the income statement through the Provision

for Loan Losses (PLL) account– Recoveries of loan amounts previously charged off

The ALL is decreased by:– Charged off loans

Allowance for Loan Losses

• Who determines the adequacy of the allowance for loan losses?

• How is the adequacy of the allowance determined?

Allowance for Loan Loss Questions

• Determine the loss period being used by management in their assessment of the adequacy of the Allowance for Loan Losses (ALL).

• Why does management that this loss period is the most reflective of current probable losses?

• Determine how troubled debt restructuring, watch list loans and other troubled loans are tracked, monitored and included in the assessment of the ALL.

ALL and PLLWhat factors would you typically consider when assessing probable losses for the ALL computation?• Charge off history and trends by loan credit risk

area: You need to divide the loan portfolio into credit risk groups—for example:–Automobile loans

• New vs. used• Direct vs. indirect origination• Credit score• Loan to value• Other

ALL and PLLOther factors you would typically consider

when assessing probable losses for the ALL

computation?• Delinquency history and trends by loan credit risk

area.• Underlying collateral by loan credit risk area• Other internal factors—quality of underwriting,

collection, recoveries etc.• Other external factors—economic factors,

unemployment etc.

Allowance for Loan Losses Problems• Results bear no relationship to probable losses

in portfolio based on credit risk assessment and industry knowledge.

• Bottom line pressure and related incentives make this account subject to possible manipulation.

• Increased delinquency and related reluctance to charge off timely.

• Should be Directionally Consistent! If all indications are that credit risk is increasing—the ALL should be increasing accordingly!

Investments• Monitor the changes in Unrealized Losses

and Gains in Investment Securities in both the available for sale and held to maturity categories.

• Ask about investment classifications i.e. Available for Sale vs. Held to Maturity for ability and intent.

Investments

• Determine how investments are monitored for impairment. Do we have any permanently impaired investments?

• Determine how many investments do not have a market price and/or are not readily marketable.

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