By Tim Harrington, CPA President, T.E.A.M. Resources 7049 E. Tanque Verde Rd. PMB 136 Tucson, Arizona (800) Financial Literacy Requirements for Directors

NCUA Rules and Regulations 701.4(b)(3) (3) At the time of election or appointment, or within a reasonable time thereafter, not to exceed six months, have at least a working familiarity with basic finance and accounting practices, including the ability to read and understand the Federal credit union’s balance sheet and income statement and to ask, as appropriate, substantive questions of management and the internal and external auditors Financially Literacy Regulation

Should identify: Risks within our credit union Level of financial literacy Directors need Individual analysis and plan for each Director in order to achieve financial literacy –Can consider past education or experience CPA, Financial background, etc. –Should include supplemental education where deficiencies are identified Financially Literacy Policy

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5 What You Have What You Owe What Your Members Own What Comes In What Goes Out

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What are the most important items to watch? Depends But there are some Basics –ROA –Capital to Assets Ratio –Loan to Share Ratio –Delinquency and Charge-off Ratios –But if you have Areas of High Risk, you’ll need more Concentration Real estate Indirect lending Commercial (member business) lending

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 can tell you how profitable your credit union is 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 8

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Which CU is Doing Better? Why we use Comparable ratios At a $10,000,000 CU 10 Bil CU 10 Mil CU Interest income $ 496,000, ,000 Cost of funds (175,000,000) (364,000) Net Interest Margin 321,000, ,000 Operating costs (329,000,000) (332,000) Provision for loan losses (111,000,000) (44,000) Net loss before other income (120,000,000) 23,000 NII – Non-interest income (Fee income, Other) 136,000,000 78,000 Net Profit or Loss $ 16,000, ,000 Total Capital $ 50,000,000 $1,000,000 10

As a % of Average Assets 10 Bil CU 10 Mil CU Yield: Interest income Less: Cost of funds (1.75) (3.64) Net Interest Margin (NIM-Spread) Less:Operating costs (3.29) (3.32) Less: Provision for loan losses (1.11) (0.44) Net loss before other income (1.20) 0.23 Plus:NII-Non-interest income (Fee income, Other) Equals: Return on Assets (ROA) Capital to Assets Ratio 5.00% 10.00% Which CU is Doing Better? Why we use Comparable ratios 11

Spread Analysis National Averages 12 As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA)

The ‘Banking’ Business Credit unions make money 2 ways: Interest Income Non-Interest Income 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) 13

Yield on Average Assets Total Interest Income from Loans and Investments / Average Assets National Average = 4.10% Our Example: 763,000/10,000,000 x 100 = 7.63% 14

As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA) Spread Analysis National Averages 15

Cost of Funds Total Dividends and Interest paid / Average Assets Cost of borrowing money from members to loan out at a higher price to other members National Average = 0.94% Our Example: 364,000/10,000,000 X 100 = 3.64% 16

As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA) Spread Analysis National Averages 17

What is Net Interest Margin? Net Interest Margin: NIM Spread You don’t control your Interest Income, the Market does You don’t control you Interest Expense, the Market does You try to control the spread between the two: NIM or Spread 18

Spread or Net Interest Margin Long term decline in Spread The Spread or Net Interest Margin is the difference between Yield on Assets and Cost of Funds. A credit union historically could pay its operating costs from the Spread and still have enough left over for a Profit. What has happened? SpreadYield on Assets Cost of Funds

As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA) Spread Analysis National Averages 20

Net Interest Margin & Operating Expense Ratio Net Interest Margin Operating Expenses You can see in this graph that several years ago, there was enough Spread to more than cover Operating Expenses. Recently, Operating Expenses have exceeded the NIM. This means that a credit union needs to do more than take Deposits and make Loans to earn a profit. If not, credit union profitability can be hard to find. 21

Operating Expenses to Average Assets Total operating expenses / Average Assets National Average = 3.03% Our Example: 332,000/10,000,000 X 100 = 3.32% 22

As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA) Spread Analysis National Averages 23

Provision for Loan Losses to Average Assets National Average = 0.50% Our Example: 44,000/10,000,000 X 100 = 0.44% Total Provision for Loan Losses Expense / Average Assets 24

Not for Profit, Not for Charity, But for Service 25

Is Non-Interest Income (NII) Important? Vital: Where a majority of CU profit is derived Has been growing in importance for decades Is more flexible than other forms of income Causes less financial risk to the credit union when expanded 26

Sources of Non-Interest Income Not 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 27

As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA) Spread Analysis National Averages 28

Credit Union profit in ROA Credit Union profit without Fee Income One more look at it. This graph shows credit union profitability over time. And what that profit would be if all Non-Interest Income were removed. This should give you a very clear picture of the importance of Non-Interest Income. 29

Non-Interest Income (Fee and Service Revenues) to Average Assets National Average = 1.30% Our Example: 78,000/10,000,000 X 100 = 0.78% Measure’s the contribution of non- interest income to profitability 30

As a % of Average Assets 9/30/11 Our CU Yield: Interest income Less: Cost of funds (0.94) (3.64) Net Interest Margin Less: Operating costs (3.03) (3.32) Less: Provision for loan losses (0.50) (0.44) Net loss before other income (0.38) 0.23 Plus: Non-interest income Minus: Corporate Stabilization (0.26) Equals: Net Profit or Loss (ROA) Spread Analysis National Averages 31

Return on Average Assets (ROAA or ROA) Net income / Average assets* *Average assets = Total assets last period + Total assets this period / 2 National Average = 0.66% Our CU: 102,000/10,000,000 X 100 = 1.02% Measures a credit union’s profitability 32

Why is Capital Important?

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 Your ‘rainy day’ fund Your ‘hibernation’ fat

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Capital (Net Worth) To Assets Ratio Total Capital/Total Assets National Average = 10.15% Our CU: 1,000,000/10,000,000 = 10.00% Measures stability of the credit union Total Assets

Capital (Net Worth) To Assets Ratio Total Capital/Total Assets Woops! Now $1,000,000/12,000,000 = 8.33% If Assets grow, and Capital doesn’t grow proportionately, the Ratio will decline Total Assets

How much Capital is enough? No consensus 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

How much Capital is enough? Enough to get you through the 3 Worst Imaginable Years

Arizona Federal CU Capital can disappear fast

Prompt Corrective Action PCA 7% or higherWell capitalized 6%-6.99%Adequately capitalized 4%-5.99%Undercapitalized 2%-3.99%Significantly undercapitalized Less than 2%Critically undercapitalized

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Loan to Share Ratio Total Loans / Total Shares and Deposits National Average = 69.2% Our CU: = 58.2% $5,150,000/8,849,000 % of our Deposits currently loaned out to members? 45

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Delinquency and Charge-offs Delinquency ratio Delinquent loans over 60 days old / Total loans Charge-off ratio Charge-offs (less recoveries) / Average loans Recovery ratio Recoveries / Charge-offs 47

Delinquency and Charge-offs It is important to consider Delinquency and Charge-offs together! Normal9/30/11 Delinquency0.75%1.59% Charge-offs0.40%0.91% Combined1.15%2.60% 48

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Using an Dash Board Event Code: Harp

Goal Safe Range 51

By Tim Harrington, CPA President, T.E.A.M. Resources 7049 E. Tanque Verde Rd. PMB 136 Tucson, Arizona (800) Financial Literacy Requirements for Directors