Effective Oversight of the Accounting System W E L O O K A T T H I N G S D I F F E R E N T L Y Effective Oversight of the Accounting System David Matthews, ILCU National Supervisors’ Forum November 2014, Derry

W E L O O K A T T H I N G S D I F F E R E N T L Y What we will cover Overview of credit union finance What’s important and what’s not Assessing Performance – Supervisors’ Perspective Ratio Analysis Other Key Performance Indicators The importance of trends Plans, Forecasts & Budgets Non-financial factors

W E L O O K A T T H I N G S D I F F E R E N T L Y Context Difficult economic climate (ongoing) Increasing Regulatory demands (North & South) Loans, investments, premises, interest rates, expenditure Cost of regulation affects business decisions Role of Supervisors in the finance function Part of your Board Performance Review Is the Board as a whole capable of making important decisions with a financial impact? Is the Board focused on what is important? Is the Board focused on the future? Boards are expected to be able to explain their decisions – pros and cons, risks and rewards.

Overview of credit union finance W E L O O K A T T H I N G S D I F F E R E N T L Y Overview of credit union finance The credit union business model Accept savings from members Lend funds to members Invest what we cannot lend Provide additional services Use income to pay operating expenses Use some surplus to fund reserves Use some surplus to reward savers (dividend) Credit unions have a relatively simple business model, so why would our financial systems be complicated? They’re not! Don’t have complicated products like derivatives, swaps, securitisation.

W E L O O K A T T H I N G S D I F F E R E N T L Y What’s important? Income & Expenditure Account Loans generate around 75% of income Investments generate around 25% of income Salaries / Wages will absorb 20% of income Management expenses will absorb 30% of income Costs of regulation & compliance – an increasing % Depreciation – depends on Fixed Assets Bad Debt costs – the great unknown! In the medium to long term, surplus must be sufficient to fund reserves & pay a dividend

W E L O O K A T T H I N G S D I F F E R E N T L Y What’s important? Balance Sheet Loans (30% of Total Assets and falling) Investments (65% of Total Assets and rising) Fixed Assets (ideally should represent less than 5% of Total Assets) Savings (generally static) Capital / Reserves (key indicator of success and solvency for Regulators)

W E L O O K A T T H I N G S D I F F E R E N T L Y Where is the risk? Loans to Members Key driver but biggest risk Policy, procedures, assessment Deposits & Investments Small in number, large in size, diminishing return Policy, compliance, spread Fixed Assets High value, security is key Other Assets Cash, savings stamps, stationery, etc. Where is the risk? If you look at a credit union Balance Sheet you will see that on the asset side there are three big figures. This is where the most serious risk is located. This is where the most damage can be done to the credit union. As a result, I would suggest that this is where most of a Supervisory Committee’s work should be focused. The biggest risk lies in our loans. In the current climate, loans that were perfectly good when they were granted are now in serious difficulties. In addition, most credit unions have a percentage of loans that should never have been given and these are also in difficulties. Supervisors’ primary duty is to ensure that policies and procedures are followed. However, I would argue that as part of their Board performance review they should be looking at the adequacy and efficacy of the policy selected by the Board. Is it resulting in a proper assessment of loan applications? Are loans being managed properly? Is the credit control process operating in line with best practice? The key test here is the level of bad and doubtful debts. Is it higher than it should be? If so, something must be wrong. The second largest area of risk is our investments. There will be relatively few of these but they will have a large monetary value. Again, Supervisors’ primary duty is to assess whether policy and procedure have been adhered to. However, they should also satisfy themselves that the policy complies with the law and with the Regulator’s guideline in the South. Fixed assets also carry some risk. This can be mitigated by insurance, health & safety procedures and of course by security. The Supervisors’ role is to assess whether these factors are adequate. Finally, there are smaller risks associated with items like cash and stationery. In the past, most supervisory activity was in these areas, but the focus now must be more on the big ticket items.

Typical Credit Union Balance Sheet W E L O O K A T T H I N G S D I F F E R E N T L Y Typical Credit Union Balance Sheet Income Investments 6,300 (126) Loans 3,000 (300) Fixed Assets 500 0 Other Assets _ 200 0 Total Assets 10,000 426 Savings 9,000 Reserves 1,000 Total Liabilities 10,000 Typical CU Balance Sheet – 4 or 5 big figures.

Ideal Credit Union Balance Sheet W E L O O K A T T H I N G S D I F F E R E N T L Y Ideal Credit Union Balance Sheet Income Investments 3,000 (50) Loans 6,300 (680) Fixed Assets 500 0 Other Assets _ 200 0 Total Assets 10,000 730 Savings 9,000 Reserves 1,000 Total Liabilities 10,000 But how do we get there? The big question!

The importance of Capital W E L O O K A T T H I N G S D I F F E R E N T L Y The importance of Capital Investments 6,300 Loans 3,000 Fixed Assets 500 Other Assets 200 Total Assets 10,000 Savings ## 9,000 Reserves 1,000 Total Liabilities 10,000 ## includes dividend of 500 from recent years I would now like to talk about the importance of Reserves to a credit union. You will be aware that the Regulator is always concerned that credit unions have adequate reserves. Sometimes we think that he goes too far. But what are reserves and how do they operate? This slide shows a simple credit union Balance Sheet, with investments of 5k, loans of 6k and savings of 10.5k, a fairly typical credit union asset business breakdown. Let’s assume that this credit union has been paying a high dividend and that around 1k of members savings are made up of dividends paid in recent years. The credit union has reserves of 1.kk, which represents 12% of total assets.

Revaluation of Premises down to £/€200k W E L O O K A T T H I N G S D I F F E R E N T L Y Revaluation of Premises down to £/€200k Investments 6,300 Loans 3,000 Fixed Assets 500 Other Assets 200 Total 10,000 Savings 9,000 Reserves 1,000 Total 10,000 Investments 6,300 Loans 3,000 Fixed Assets ** 200 Other Assets 200 Total 9,700 Savings 9,000 Reserves ** 700 Total 9,700 Now let’s assume that the credit union’s premises is valued by a local auctioneer at 200 (instead of the book value of 700). This represents a loss of 500 in the I&E. This has the effect of reducing the reserves by 500 to 900. Lucky we had these reserves!

Write-Off of Loans £/€500k W E L O O K A T T H I N G S D I F F E R E N T L Y Write-Off of Loans £/€500k Investments 6,300 Loans 3,000 Fixed Assets 200 Other Assets 200 Total 9,700 Savings 9,000 Reserves 700 Total 9,700 Investments 6,300 Loans ** 2,500 Fixed Assets 200 Other Assets 200 Total 9,200 Savings 9,000 Reserves ** 200 Total 9,200 Now let’s assume that the Regulator tells us to get a Loan Book review done and this results in a write-off of 1,200, or 20% of our loans, not too far-fetched in the current climate. Now we have a loss of 1,200 but our reserves are only 900. Where does the difference go?

Revaluation of Investments £/€500k W E L O O K A T T H I N G S D I F F E R E N T L Y Revaluation of Investments £/€500k Investments 6,300 Loans 2,500 Fixed Assets 200 Other Assets 200 Total 9,200 Savings 9,000 Reserves 200 Total 9,700 Investments ** 5,800 Loans 2,500 Fixed Assets 200 Other Assets 200 Total 8,700 Savings 9,000 Reserves ** ??? Total 8,700

Potential Effect on Members’ Savings W E L O O K A T T H I N G S D I F F E R E N T L Y Potential Effect on Members’ Savings Investments 5,800 Loans 2,500 Fixed Assets 200 Other Assets 200 Total 8,700 Savings 9,000 Reserves (300) Total 8,700 Investments 5,800 Loans 2,500 Fixed Assets 200 Other Assets 200 Total 8,700 Savings ** 8,700 Reserves 0 Total 8,700 In theory, it goes against the members’ savings. We now have savings of 10.5k but our assets are only 10.2k. That might get some reaction from our savers! In practice, the SPS would have intervened before we reached this stage. Worst case scenario, we would have to call on the Government Deposit Guarantee.

Reserves are a buffer against risk W E L O O K A T T H I N G S D I F F E R E N T L Y Reserves are a buffer against risk Investments 6,300 Loans 3,000 Fixed Assets 500 Other Assets 200 Total 10,000 Savings ** 8,500 Reserves ** 1,500 Total 10,000 £/€500k extra to Reserves Investments ** 5,800 Loans ** 2,500 Fixed Assets ** 200 Other Assets 200 Total 8,700 Savings 8,500 Reserves ** 200 Total 8,700 Savings unaffected Finally, let’s assume that the credit union had been more prudent in earlier years and had paid a lower dividend, thereby leaving more in its reserves, around 16% of Total Assets. In this case, we still have a loss of 1.7k, but we have sufficient reserves to absorb it.

Non financial Factors Not everything can be measured in £ / € W E L O O K A T T H I N G S D I F F E R E N T L Y Non financial Factors Not everything can be measured in £ / € But every decision will have an impact Member services Member satisfaction Opening Hours Service Quality Credit union reputation Social role of credit unions Effectiveness of marketing activity Credit unions should monitor & measure performance in these areas too! A credit union’s strategy should consider these issues. So, people are responsible for decisions that they agreed to but don’t understand the implications of. Regulators North & South are concerned about this, hence the discussions on Fitness & Probity, etc. They are increasingly asking questions about Board decisions and have begun to ask for financial plans and forecasts to see where the Board think the credit union is heading. So how does this impact you as Supervisors? In my view, part of your Board performance reviews should be an assessment of the ability of the Board as a whole to make important financial decisions. Is the Board overly reliant on one or two individuals or on the credit union’s Auditor? To do this, I would suggest that the Supervisory Committee itself should have a reasonable understanding of the finance function.

W E L O O K A T T H I N G S D I F F E R E N T L Y Tools for assessing financial performance Ratio Analysis PEARLS / CAMELS Other Key Performance Indicators The importance of trends Plans, Forecasts & Budgets Supervisors’ perspective Is the Board using these tools? Is it correctly interpreting the results? Are its decisions focused on improvement?

W E L O O K A T T H I N G S D I F F E R E N T L Y Ratio Analysis Converting financial data into simple mathematical ratios for ease of use and comparison PEARLS & CAMELS – standardised ratio calculations Objective, therefore comparable But can be distorted by differing accounting policies E.g. bad debt write-off policy, outsourcing policy Interpretation and use in decision-making are key factors Why did it happen, did we expect it to happen, etc.? Loans Total Assets Loans / Assets % Credit Union A 5,750,275 12,674,128 45% Credit Union B 43,711,053 115,029,103 38%

Total Loans after write-off W E L O O K A T T H I N G S D I F F E R E N T L Y Impact of differing write-off policies Credit Union A – aggressive write-off policy Credit Union B – moderate write-off policy Credit Union C – zero write-off policy Total Loans after write-off Arrears > 9 Weeks Arrears > 52 Weeks Written-Off A1 Ratio Credit Union A 10,000,000 1,500,000 1,000,000 5% Credit Union B 10,500,000 500,000 9.5% Credit Union C 11,000,000 13.6%

W E L O O K A T T H I N G S D I F F E R E N T L Y Key PEARLS Ratios P1 Bad Debt Provision Requirements Should be at least equal to Resolution 49 requirement P3 Solvency *** E6c Capital as a % of Total Assets Must be at least 10% A1 Gross Loans > 9 Weeks in arrears *** R3 Total Income / Average Total Assets *** L1 Liquid Investments / Uncommitted Savings Minimum 20%

W E L O O K A T T H I N G S D I F F E R E N T L Y Ratios that the Board can strategically influence in the medium to long term P3 Solvency Influenced by operational efficiency, credit control performance, dividend policy, etc. A1 Gross Loans > 9 Weeks in arrears Influenced by lending policy, quality of assessment, credit control performance, etc. R3 Total Income / Average Total Assets Influenced by pricing decisions, investment quality, operational efficiency, cost management, etc. Part of your review of Board performance

W E L O O K A T T H I N G S D I F F E R E N T L Y Other Key Performance Indicators (KPIs) Should reflect the strategy of the credit union For example: Loan growth by loan type or class Key expenditure items compared to income, total expenses, assets Growth in number of members By age band By location in the Common Bond Member usage of the credit union Member Satisfaction survey results Social performance & social auditing

W E L O O K A T T H I N G S D I F F E R E N T L Y The importance of trends Historic performance can’t be changed! But - where are we heading? Are things improving or deteriorating? Trend should be a key determinant in board’s decision-making process Negative or harmful trends must be addressed Credit unions should try to capitalise on positive trends Boards must evaluate why trends have occurred Supervisors should ensure that Board is focused on trends (i.e. not just on historic performance)

W E L O O K A T T H I N G S D I F F E R E N T L Y Planning, Forecasting & Benchmarking “Direction” is about the future The past and present are indicators of what will happen if we continue to do the same thing Role of directors is to steer the credit union in the right direction Must know where they are trying to get to! Will involve change! Change must be managed and planned Supervisors should review Board’s planning and review processes

W E L O O K A T T H I N G S D I F F E R E N T L Y Planning, Forecasting & Benchmarking Plan should be specific, measurable, achievable, realistic & time-bound (SMART) Measure by comparing to forecasts – financial & non-financial Forecast should be combined with benchmarks and targets Performance should be critically reviewed against plan at least annually Plan can be amended if required Supervisors should ensure that this is done

W E L O O K A T T H I N G S D I F F E R E N T L Y Conclusion & Key points Supervisors should have a working knowledge of finance Credit union business model Ensure that Board is focused on key areas and risks Don’t ignore non-financial factors The credit union difference! Supervisors should be familiar with the tools that Boards should be using to measure performance Ensure that your Board understands and is using these tools Ensure that your Board is focused on the future Ensure your Board has a SMART plan

W E L O O K A T T H I N G S D I F F E R E N T L Y Thank you for your attention Any Questions?