**SUPERVISORY LETTER**

**NATIONAL CREDIT UNION ADMINISTRATION**

**OFFICE OF EXAMINATION AND INSURANCE**

**1775 DUKE STREET, ALEXANDRIA, VA 22314**

**DATE: August 2006 Supervisory Letter No.: 06-01**

**TO: All Field Staff**

**SUBJECT: Evaluating Earnings**

The determination of an adequate earnings level is a complex facet of
credit union supervision. Lower earnings are being observed nation-wide.
This trend is the result of rising interest rates, a flat yield curve,
and some credit unions incurring costs to position themselves
strategically. There is no simple metric for determining what a credit
union's retained earnings level should be. However, as emphasized in
NCUA Letter to Credit Unions 03-CU-04 (March 2003), *CAMEL Rating
System*, CAMEL ratings are not automatically determined by matrix
ratios. Striving for an arbitrary one percent Return on Average Assets
just to achieve a CAMEL 1 rating based on the CAMEL matrix is not an
acceptable argument, especially in the current economy, for a well
capitalized credit union. Each credit union's earnings level must be
evaluated relative to net worth needs, financial and operational risk
exposures, the current economic climate, and the institution's strategic
plans.

Net worth goals involve both immediate considerations, as well as
strategic ones related to future risks and expansion plans. The
officials have to balance the immediate return of earnings to the
members in various forms (e.g., dividends, lower loan rates, etc.) with
the retention of earnings to fund future member benefits. Thus, NCUA
must take a balanced approach to assessing earnings. We must be careful
not to inadvertently undermine a credit union's ability to achieve
long-term success with an unduly conservative or short-term focused
approach to supervision. An overly simplistic focus on one measure of
earnings performance could drive unsafe and unsound behavior. In fact,
attempting to bolster earnings in the current environment is very likely
to involve strategies that necessitate excessive risk-taking.

If you have any questions on this issue, please direct them to your
immediate supervisor or regional management.

Sincerely,

/s/

David M. Marquis,

Director, Office of Examination and Insurance

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**Evaluating Earnings in Credit Unions**

**Credit Unions are Not-For-Profit**

Credit unions are not-for-profit cooperative financial institutions.
Groups of people sharing a common bond form credit unions to pool their
resources to provide access to affordable financial services designed to
meet their needs. As a cooperative not-for-profit organization, a credit
union's mission is to provide financial services to their members, not
to earn a profit for stockholders. Any economic value generated by the
credit union that is undistributed (i.e., not used to absorb costs or
provide an immediate return to the members) is held on behalf of and
owned by the members.

Though not-for-profit, credit unions must generate revenue for two
primary reasons: (1) to cover the costs of providing members with
financial services, and (2) to maintain a safe and sound level of net
worth. Net worth is necessary to provide protection against unexpected
future costs and a foundation for member service growth and initiatives,
as well as to meet regulatory capital standards. In order to build and
maintain appropriate net worth levels, credit unions must retain
earnings (i.e., have a net income sometimes referred to as a
"profit").[^1]

NCUA's mission statement is "*to foster the safety and soundness of
federally insured credit unions and better enable the credit union
community to extend financial services for provident and productive
purposes to all who seek such service while recognizing and encouraging
credit unions' historical emphasis on extension of financial services to
those of modest means..."* This mission statement highlights a balance
that both NCUA and credit unions must strive to maintain: balancing
safety and soundness with the mission of extending financial services.
Perhaps the most notable way this challenge manifests itself is in
determining the "right" level of net worth.

Net worth is essential to credit unions. Not only does it protect
against uncertainties, but also provides a foundation for the long-term
viability of the credit union, ensuring continued credit union service
for current and subsequent generations of members. When net worth is too
low, an institution is exposed to a high risk of failure. On the other
hand, when net worth is too high members may not be receiving all the
benefits and services that could be safely provided and/or the credit
union may not be taking advantage of opportunities to position itself to
expand member benefits in the future. Despite a natural tendency to err
on the side of conservatism, NCUA's supervisory oversight must support
credit unions' efforts to balance net worth needs with providing value
and achieving longer-term strategic goals.[^2]

**Earnings Assessment Framework**

As the purpose of retaining earnings for credit unions is to build or
maintain net worth, the analysis of earnings is fundamentally linked
with the net worth needs of the credit union. This is reflected in
NCUA's CAMEL rating system (Letter 03-CU-04, CAMEL Rating System) which
lists the net worth level and sufficiency of earnings for necessary
capital formation as key factors to consider when assessing earnings. In
fact, earnings needs in credit unions are a function of the net worth
ratio goal, which in turn is affected by asset growth levels.[^3] Thus,
retained earnings goals set independently, as if net income is an aspect
of a credit union's financial performance that has merit in and of
itself, run the risk of being incompatible with other organizational
goals.

Further, there is distinct time dimension to any analysis of earnings.
This is due to the following:

-   Net worth goals involve both immediate considerations, as well as
    strategic ones related to future risks and growth and member service
    expansion plans. The officials have to balance the immediate return
    of earnings to the members in various forms (e.g., dividends, lower
    loan rates, etc.) with the retention of earnings to fund future
    member benefits.

-   Variations over time in economic conditions affecting a credit
    union's cost structure and rates on loan and share products.

There is no simple metric for determining what an individual credit
union's ROA level should be. A 1-percent ROA level has served as the
"rule-of-thumb" for good performance for financial institutions for some
time. The establishment of the CAMEL matrix in 1987 canonized for credit
unions a 1-percent ROA by tying it to a CAMEL 1 component rating for
Earnings.[^4] However, as emphasized in NCUA Letter to Credit Unions
03-CU-04 (March 2003), CAMEL Rating System, CAMEL ratings are not
automatically determined by matrix ratios. Each credit union's earnings
level must be evaluated based on the credit union's unique needs, as
well as overall economic trends affecting financial institutions.

For example, consider contemporary economic trends. In 2005, aggregate
credit union ROA dropped to 85 basis points, the lowest level in at
least 20 years. Interest rates have been rising steadily since mid-2004,
with the Federal Reserve raising interest rates for the 17^th^
consecutive time. As a result, the net interest margin declined to 3.24
percent, its lowest level in at least 20 years. The low net interest
margin, and thus reduced ROA, is a direct result of both a rising rate
environment and a flat yield curve.[^5] Credit unions partially offset
the pressure on earnings with increased fee and other income, with this
source of income playing an increasingly larger role.

However, credit unions' aggregate net worth ratio is at record levels
and actually increased 30 basis points to 11.24 percent. Despite a
decline in ROA, net worth growth of 7.59 percent outpaced the modest
asset growth of 4.90 percent. Consistent with the purpose of net worth,
credit unions are well positioned with ample net worth levels to accept
lower ROA levels during the current economic climate that has resulted
in reduced net interest margins. Consider that, on average, the modest
asset growth levels credit unions have experienced over the last 10
years require an ROA of only 55 basis points to maintain net worth
levels at their current strong level.[^6]

Thus, credit unions need not engage in reactive or extraordinary
measures simply because earnings levels decline as a result of broader
economic conditions when net worth levels meet or exceed their needs. In
fact, such measures likely involve significant risks, either in terms of
accepting greater risks to generate higher returns, and/or in terms of
short-sighted trade-offs (e.g., increasing fees, selling "less
profitable" business lines, engaging in high risk lending) affecting the
longer-term strategic positioning of the credit union.

**Examiner Assessment of Earnings**

Examiners do not evaluate earnings globally with peer ratios or CAMEL
benchmarks; earnings are evaluated on a case-by-case basis unique to
each credit union's circumstances.[^7] An examiner's review of earnings
is in relation to each credit union's risk profile, operational context,
and strategic plans.

The ROA level is not the primary focus of an examiner's assessment of
earnings. Historical earnings levels are somewhat relevant to assessing
management's record in managing earnings. However, it is quite possible
for a credit union to have impressive profitability ratios by assuming
an unacceptable degree of risk. Thus, examiners assess management's
capability in managing the risk versus reward trade-off, evaluating
earnings by considering the:

-   Quality of the earnings structure.

-   Fit with the overall strategies of the credit union.

-   Future direction of earnings performance.

-   Ability of the credit union to realize an adequate level of earnings
    in a safe and sound manner.

Lower ROA levels will be viewed positively if they are the result of a
sound and well-executed strategy to balance risk exposure or incur costs
to position the credit union to achieve longer-term growth and member
service objectives. In addition, examiners recognize that the purpose
for credit unions retaining earnings is maintaining appropriate, but not
excessive, net worth levels relative to the risk profile of the credit
union. In fact, executing a sound plan to return excess capital to the
membership or utilize capital to achieve longer-term strategic
objectives can contribute greatly to the long-term success of the credit
union. Examiners also positively incorporate such strategies into their
evaluation of earnings and capital.

**Earnings Red Flags**

Examiners need to evaluate the level of earnings in relation to the
credit union's risk profile and the current economic environment. Below
are examples of red flags that trigger a more in-depth review of a
credit union's earnings performance. Note that inordinately high
earnings levels can be just as much a sign of a problem as low earnings
levels.

Inordinately high net income could indicate:

-   Taking on additional risk in the investment or loan portfolio.

-   Not providing competitive dividend or loan rates.

-   Not providing adequate services for the membership.

-   Not planning for new services or infrastructure to support the
    credit union in the future.

-   Undue reliance on fee income to support operations.

-   Management or board goals for high net income levels given ties
    (implicit or explicit) to bonuses, salaries, or performance
    evaluations.

-   Management believes their examiner will not tolerate or accept lower
    earnings and/or net worth, even with a solid plan.

Inordinately low net income could indicate:

-   Inefficient operations resulting in high or out of control expenses
    to the detriment of the membership. Examiners will continue to
    address high operating expenses as a problem area if they do not
    involve an intentional increase in the credit union's investment in
    infrastructure (technology, new services, increased training, etc.)
    as part of a documented, sound strategic plan.

-   Exorbitant compensation systems misaligned with member benefits and
    the mission of the credit union.

-   Inadequate pre-planning for new services.

-   High level of non-earning assets not aligned with the strategic
    needs of the credit union.

-   Economic disruption impacting the field of membership.

-   Unsafe dividend levels attracting volatile share growth.

-   High loan losses due to poor credit quality loans.

The fact that a credit union's net income level is relatively high or
low is not by itself evidence there is a problem. Rather, it is merely a
trigger for examiners to thoroughly review the credit union's earnings
structure to determine the underlying factors that result in the
performance. Examiners assess these factors in relation to the credit
union's overall condition, consistency with the mission of the credit
union, and congruence with the credit union's strategic plans and
budgets.

**Conclusion**

Earnings is one of the five component ratings, contributing to the
overall composite rating, examiners assign under the CAMEL rating
system.[^8] Further, the quality of the credit union's earnings
structure and underlying strategies is one of the key considerations in
assignment of risk ratings in the seven areas of risk under the
risk-focused examination program.[^9] The determination of the CAMEL
composite and component ratings, as well as the risk ratings in the
seven areas of risk, is a judgmental process and necessitates the
examiner take into account all of the subjective and objective variables
that affect a credit union's financial and operational condition, as
well as their interrelationships. The key interrelationship examiners
take into consideration for the Earnings CAMEL component rating is the
net worth needs of the credit union.

It is incumbent on credit unions to proactively develop and document
sound strategic plans. These plans need to articulate the balance the
officials of the credit union are seeking in terms of net worth levels
and the actions affecting earnings to achieve the mission of the credit
union in both the short and long-term. In the absence of documented and
sound plans, attempting to justify poor earnings performance after the
fact is considered not only a weakness in the Earnings component of
CAMEL, but the Management component and relevant risk ratings in the
seven areas of risk as well.

Given their not-for-profit nature, an analysis of Earnings in credit
unions is admittedly challenging. It requires factoring in the role
earnings plays in credit unions fulfilling their mission of providing
*financial services for provident and productive purposes to all who
seek such service.* The elected officials seek to balance the return of
current earnings to the members with retaining earnings to provide an
adequate "safety net" and a base for better, lower-cost, and expanded
services in the future. These, along with a variety of other factors
such as the contemporary decisions affecting the direction of the risk
in a credit union's balance sheet, require examiners to exercise a high
degree of professional judgment when evaluating earnings.

Thus, it is essential credit union management and examiners have an open
and ongoing dialogue on the strategic direction of the credit union in
relation to earnings. Credit union officials and examiners should
welcome any sincere debates that occur on the efficacy of a credit
union's plans. A healthy dialogue will help ensure credit unions are
able to fine-tune and execute their strategies effectively as well as
enable NCUA to balance our mandates of protecting the share insurance
fund with supporting credit unions in fulfilling their mission.

**References**

1\. NCUA Letter to Credit Union 03-CU-04, March 2003, *CAMEL Rating
System*

[www.ncua.gov/letters/2003/03-CU-04.pdf](http://www.ncua.gov/letters/2003/03-CU-04.pdf)

2\. Supervisory Letter 05-01, August 2005, *Evaluating Capital Adequacy*

3\. NCUA *Examiner's Guide*:

-   Chapter 1 -- Risk-Focused Program

-   Chapter 3 -- Total Analysis Process

-   Chapter 15 -- Profitability

-   Chapter 16 -- Net Worth and Other Equity Accounts

[www.ncua.gov/GuidesManuals/examiners_guide/examguide.html](http://www.ncua.gov/GuidesManuals/examiners_guide/examguide.html)

4\. FDIC *Risk Management Manual of Examination Policies*, Chapter 5.1
-- Earnings

[www.fdic.gov/regulations/safety/manual/index.html](http://www.fdic.gov/regulations/safety/manual/index.html)

5\. OCC *Comptroller's Handbook*, Analytical Review of Income and
Expense (Section 401)

[www.occ.treas.gov/handbook/SS.HTM](http://www.occ.treas.gov/handbook/SS.HTM)

[^1]: Other financial institutions have the ability to utilize forms of
    equity other than retained earnings. Except for low-income
    designated credit unions authorized to employ secondary capital
    instruments, credit unions manage net worth levels exclusively via
    retained earnings. The standard measurement for net income for
    credit unions is the Return on Average Assets ratio (ROA).

[^2]: The issue of capital adequacy is explored in more detail in
    Supervisory Letter 05-01, Examiner Guidance -- Evaluating Capital
    Adequacy.

[^3]: The Net Worth Ratio (NWR), the standard measurement for net worth
    levels in credit unions, is calculated by dividing net worth by
    total assets. Mathematically, the NWR is affected by both changes in
    net worth (numerator), which are caused by net income (loss) levels,
    and by asset growth (denominator), which is predominantly driven by
    share growth.

[^4]: The 1% ROA rule-of-thumb has been tenacious, still serving under
    the current CAMEL guidance as the benchmark for a CAMEL 1, despite
    the CAMEL rating system having undergone several revisions since its
    adoption in 1987 for credit unions.

[^5]: Given the maturity and repricing differences between assets and
    liabilities, financial institutions experience reduced earnings when
    short-term rates rise or when the difference between short-term
    rates and long-term rates declines.

[^6]: Over the last 10 years, which includes the extraordinary growth
    levels experienced in 2001 and 2002 due to the weak stock market
    performance and post-9/11 flight to safety, the median and mean
    levels of annual asset growth for credit unions have been 4.53% and
    5.33% respectively. Mathematically, a credit union with an 11% net
    worth ratio and asset growth of 5% only needs an ROA of 55 basis
    points to maintain the net worth ratio.

[^7]: Certainly there is value in NCUA and the credit union community
    reviewing performance ratios on a global basis to understand trends
    in the industry; however, this does not mean all credit unions
    should be operating at the same levels.

[^8]: **[C]{.underline}**apital Adequacy, **[A]{.underline}**sset
    Quality, **[M]{.underline}**anagement, **[E]{.underline}**arnings,
    and **[L]{.underline}**iquidity Management.

[^9]: The seven areas of risk are credit, interest rate, liquidity,
    transaction, compliance, strategic, and reputation.