Exam Procedures

An examiner’s review of earnings should consider the credit union’s financial condition, budget, budget variance, risk profile, operational structure, and strategic plans. When a credit union’s earnings are insufficient to maintain an adequate level of capital, examiners should identify the source of weak earnings (low gross income, high expenses, or a combination of both).

When analyzing earnings, examiners should focus on the following:

The relationship between earnings and capital
The credit union's strategic plan
Management's ability to plan for and manage earnings
Trends in earnings
The structure and quality of earnings, as identified through qualitative and quantitative factors
To assess earnings, examiners rely on training, professional judgment, and agency guidance when considering all quantitative and qualitative factors that affect earnings. For additional guidance on assigning the ‘earnings’ component CAMELS rating, refer to NCUA Letter to Credit Unions 22-CU-05, CAMELS Rating System, Appendix A.

Quantitative evaluation—includes a review of various credit union earnings metrics, as well as historical trends and future projections
Qualitative evaluation—focuses on the source of earnings, management's ability to manage earnings by analyzing the credit union's risk profile, operational structure, and strategic plans

Quantitative Evaluation

Examiners should review various ratios and trends during quarterly RATE reviews and when performing examinations. If examiners identify adverse trends, they should consider expanding the review scope to determine the cause and recommend corrective action, if necessary. Examiners have access to a number of ratios and trends that have been calculated using data from the credit union’s Call Report through the FPR, risk reports, and other worksheets in the examination software.

While these ratios and trends provide important information, examiners should not use them to compare a credit union to the ratios and trend of its peers. Instead, they should evaluate earnings on a case-by-case basis, taking into account each credit union's unique circumstances. If examiners identify any unusual ratios or trends during offsite supervision, they should consult with their supervisor and adjust supervision plans to determine the cause.

Examiners use ratios, trends, and a qualitative review to assess and assign the Earnings CAMELS component rating.

Earnings Ratios

Examiners can use the following financial ratios to evaluate earnings:

Return on Average Assets

Net Income (Loss) divided by average assets, annualized as appropriate.

This earnings ratio measures net income in relation to average assets and represents what is commonly referred to as the “bottom line.” A positive ratio reflects income sufficient to cover all the credit union's expenses. A negative ratio, unless planned, could indicate a problem the examiner should address with the officials and senior management. The materiality of a negative return on average assets ratio depends upon the degree of operating losses, factors causing the loss, and the adequacy of capital.

Gross Income/Average Assets

Gross Income (total interest income + fee income + other operating income) divided by average assets, annualized as appropriate.

The gross income to average assets (or yield on assets) ratio reflects the rate at which the credit union’s assets and services produce income. If the credit union has a low gross income to average assets ratio, or declining trend, the examiner should expand the analysis to determine the cause of the low or decreased income. Individually analyzing the yield on loans, yield on investments, and other major income categories can assist the examiner in this determination. If these ratios do not clearly identify the cause of the adverse trend, the examiner may look for other causes like a major fixed asset purchase or some other increase in non-earning assets (for example, the volume of delinquent loans).

Yield on Average Loans

Interest on Loans (gross, before interest refunds) divided by average loans, annualized as appropriate.

The yield on loans is the rate at which loans produce income. This ratio is usually less than the average stated interest rates charged for loans because it does not include non-accrued interest on delinquent loans. Examiners should determine the reasonableness of the yield on loans for the types of loans in the credit union's portfolio. If the yield on loans is lower than expected or reflects a negative trend, the reasons may include an increase in non-performing loans or a reduction in interest rates and may even indicate potential fraud.

Yield on Average Investments

Income from Investments and Trading Profits and Losses divided by average investments, annualized as appropriate.

The yield on average investments ratio measures the income realized from the credit union’s investment portfolio. The ratio will change based on the characteristics of the investments the credit union holds. Examiners should review this ratio in conjunction with the review of investments. The types of investments in the portfolio, including rates and maturities, have a direct impact on this ratio. Higher yields can be associated with increased investment risk.

Fee and Other Operating Income/Average Assets

Fee Income + Other Operating Income (including unconsolidated CUSO income) divided by average assets, annualized as appropriate.

This earnings ratio reflects the amount of non-interest income the credit union generates as a percentage of average assets. Generally, the higher the ratio, the more income the credit union is earning from sources other than loans and investments.

Fee income includes fees charged for services (for example, overdraft fees, ATM fees, credit card fees, etc.). Examples of other operating income include dividends from the Share Insurance Fund, income or loss derived from selling real estate loans, interchange income, and unconsolidated CUSO income.

Generally, a credit union should produce the majority of its gross income from interest income. Examiners should evaluate reliance on fee income or other non-interest income for appropriateness and stability.

Cost of Funds/Average Assets

Cost of Funds (total of dividends on shares, interest on deposits, and interest on borrowed funds) divided by average assets, annualized as appropriate.

The cost of funds to average assets ratio reflects the percentage of average assets used to pay dividends and interest on borrowed money. Examiners should determine the cause of a high ratio or unusual trend. Calculating ratios for the cost of various share types and the cost of borrowed money can help identify the source. The mix of deposits between lower-costing regular shares and higher-costing share products directly affects the cost of shares. Examiners can isolate the reason for a high cost of funds to average assets ratio or unusual trends by reviewing growth trends by share category and comparing rates offered by the credit union to market rates.

Operating Expenses/Average Assets

Operating Expenses (excludes provision for loan and lease losses, and cost of funds) divided by average assets, annualized as appropriate.

The operating expenses to average assets ratio reflects the credit union's operating costs in relation to the credit union's asset size. Examiners should review the ratio trend over time. A decrease in the ratio could indicate increased efficiency, relative reduction in operating expenses compared to assets, or an increase in average assets. An increase in the ratio may mean reduced efficiency or the addition of services that are presently not cost efficient.

Using average assets as a basis for analyzing expense control is useful because assets are a more stable and consistent base for measurement, particularly in a period of rapidly changing rates. Analysis of this ratio is critical when a credit union is experiencing operating losses or declining profitability.

Net Operating Expenses/Average Assets

Total Operating Expenses minus Fee Income divided by average assets, annualized as appropriate.

Net operating expenses to average assets considers net operating cost when evaluating operating expenses because fee income reduces total operating expenses. This ratio tends to put the overall expense picture into focus for those credit unions that offer expensive services but recoup some or all of the costs by assessing fees. Comparison of this ratio with the operating expenses to average assets ratio provides additional information about the degree to which the credit union depends on fee income.

Provision for Loan and Lease Losses to Average Assets

Provision for Loan & Lease Losses divided by average assets, annualized as appropriate.

This earnings ratio reflects the amount of earnings used to fund the ALLL account, as a percentage of average assets. Examiners should review this ratio in conjunction with the review of delinquency, charge-offs, and the adequacy of the ALLL account. Credit unions with high loan losses will experience increased PLLL expenses and reduced earnings. Alternatively, credit unions with low loan losses, or those that have not fully funded the ALLL account, may have lower PLLL expenses.

Net Interest Margin to Average Assets

Total Interest on Loans (gross, before interest refunds), Income from Investments, and Trading Profits and Losses, minus the Cost of Funds divided by average assets, annualized as appropriate.

The net interest margin to average assets ratio measures whether income from loans and investments sufficiently covers the cost of funds.

A fluctuating ratio could indicate a change in loan rates charged, a change in investment practices, or an adjustment of dividend rates paid. The net interest margin also reflects a credit union’s risk management practices and is a factor in assessing interest rate risk management, strategic risk, and planning.

Extraordinary Items

Extraordinary income or expenses (for example, the sale of assets, securities transactions, or Share Insurance Fund distributions) may affect net income for only a specific period. While income from extraordinary items can be beneficial to a credit union, it is typically not a reliable or consistent source of income for most credit unions. Examiners should determine if the credit union's earnings performance is sufficient to maintain or grow capital without extraordinary items.

Two-Minute Profitability Test

The Two-Minute Profitability Test displays the profit necessary to maintain the current net worth ratio under varying growth rate assumptions. Examiners can tailor this worksheet to calculate the additional profit necessary to increase the net worth ratio to a specified level over a selected number of years. Examiners can also use the Two-Minute Profitability Test to review a credit union’s budgeted net income relative to its net worth goals.

Examining Ratios and Trends

Examiners will evaluate a credit union’s level of earnings in relation to its risk profile, current economic environment, and level of capital. A more in-depth review of earnings may be necessary in the case of unusually or inordinately high or low ratios or trends.

Inordinately high or low earnings levels may signal a problem.

Inordinately high net income could indicate a credit union is:

Taking on additional risk in the investment or loan portfolio
Not providing competitive dividend or loan rates (paying low dividend rates or charging high loan rates)
Not providing adequate services for the membership
Not planning for new services or infrastructure to support credit union viability
Tying senior management bonuses, salaries, or performance evaluations to net income levels
Inadequately funding the ALLL account

Low or negative net income could indicate a credit union is:

Operating inefficiently, resulting in high or unnecessary expenses
Paying exorbitant compensation, misaligned with member benefits and the credit union’s mission
Inadequately pre-planning for new services
Maintaining a high level of non-earning assets
Experiencing an economic disruption impacting the field of membership
Paying above market dividend rates
Experiencing high loan losses or weak or declining loan volume

A credit union’s relatively high or low net income level does not necessarily indicate a problem, but examiners should review the credit union’s earnings structure to determine the underlying factors resulting in the performance. Examiners should assess these factors in relation to the credit union’s overall condition and consistency with its mission, capital needs, strategic plan, and budget.

While examiners should evaluate a credit union’s earnings on a case-by-case basis and not compare credit unions to one another, examiners may create custom queries using Call Report data that can be a useful scoping tool to identify whether ratios are extraordinarily high or low. This tool is available on the Financial Performance Report Application on NCUA’s website. The examiner can select a more refined peer group such as geographic state or asset size to identify areas to review.

Qualitative Evaluation

Examiners will also need to look beyond the ratios and review the actual income and expense structure to assess the adequacy of earnings.

When assessing the quality of a credit union’s earnings and management’s ability to manage earnings, examiners should consider the following:

Accounting Treatment

Although all credit unions are not required to comply with GAAP, credit unions generally record accounting transactions in accordance with GAAP. How credit unions record various accounting transactions may affect earnings. Specifically, credit union management could manipulate net income by:

Deferring or not prepaying expenses (operating fees, league dues)
Not properly accruing income on loans or investments
Recording extra accruals on loans or investments
Amortizing prepaid and deferred expenses longer than typically allowed under GAAP
Expensing some acquisitions in full instead of capitalizing them
Capitalizing everything, even very small items and then amortizing the cost
Assigning short depreciation timeframes (useful lives) to capitalized assets
Establishing long depreciation time frames (useful lives)
Not recognizing losses on loans (NCUA regulation § 702.113, Full and fair disclosure of financial condition)
Overfunding or underfunding the ALLL account
Improperly calculating dividend accrual
Not accruing for dividends
Not accruing for payroll expense, unpaid time off, and property taxes

Examiners should confirm earnings trends or fluctuations are not a result of unusual or inaccurate accounting treatment.

Sources of Income

A credit union’s income is sound if it is stable, reliable, and diversified. Examiners should identify the source of a credit union’s income, as it is important that a credit union be able to maintain strong earnings over time. Credit unions can generate strong earnings when they lend to creditworthy borrowers, have several sources of income, and have structured their earnings base for consistent income over the long term. Management should diversify the credit union’s earnings structure to mitigate concentration risk. Concentrating assets in any single product or service increases the potential for adverse consequences. For more information, see NCUA Letter to Credit Unions 10-CU-03, Concentration Risk .

A credit union should maintain capital proportional to its risk exposure. A strong capital position may enable management to take on more risk.

Economy

Examiners should consider current and projected economic conditions because measures such as housing prices, unemployment, and interest rates can affect a credit union’s earnings. Additionally, examiners should consider local or regional factors when assessing whether the credit union’s current and future earnings are sufficient.

Field of Membership

A credit union’s field of membership could have an existing or future effect on earnings. A credit union’s field of membership, and its ability to provide competitive products and services at a sustainable cost, will determine the sources of income and level of expenses. For example, a credit union experiencing a high volume of transactions due to its field of membership may have higher expenses.

Also, the addition of some fields of membership (for example, national associate groups, or groups in geographical areas the credit union is not used to serving) may lead to rapid growth that could result in increased expenses, such as PLLL expense or program administration expenses.

Examiners should focus their review on whether the credit union is appropriately planning and budgeting for such expenses, and its ability to generate adequate net income to support the expense structure. Examiners should also consider any external support the credit union may receive from a sponsor, as well as how the closure of a SEG may impact the credit union.

Additionally, examiners should consider the fields of membership of LICUs and CDCUs when evaluating the income, expenses, and profitability in these institutions. For more information, see NCUA Supervisory Letter10-CU-01, Supervising Low Income Credit Unions and Community Development Credit Unions.

Income Analysis

Credit unions should be able to articulate the strategy behind pricing and product offering, which may include offering certain products at below-market prices to generate demand for more profitable products (also known as a ‘loss leader’). A thorough analysis of gross income is appropriate when:

Net income is inadequate to improve low levels of capital
Gross income is continually well below budget estimates

Interest Income

Interest income is generally the largest source of gross income for a credit union. Low or declining interest income from loans could be an indication of low loan demand, strict loan underwriting standards, declining yields, or a combination of factors. High and increasing income from loans could be the result of liberal lending policies, increased loan demand, or higher loan rates.

Credit unions typically invest using the SLY principle, focusing on the safety and liquidity of an investment before considering the yield.

High and increasing investment income could be a sign of increased risk from chasing yield or maturities. Additionally, the investment type and structure will determine the amount and timing of interest income received from investments. For example, investment products with call features may result in less interest income than budgeted or anticipated if the issuer calls the investment before maturity.

Non-Interest Income

Examiners should identify the extent to which a credit union is relying on non-interest income. Credit unions that are only profitable due to one-time gains may indicate that management is not properly managing the credit union’s assets.

However, some credit unions may rely on non-interest income through grants and sponsor support as a strategic business model. For example, LICUs or those that serve a single employee group may have access to reliable forms of assistance.

Expense Analysis

Examiners should conduct a more thorough analysis of operating expenses when:

Net income is inadequate to improve low levels of capital
Expenses consistently exceed budget estimates
Expenses are high when considering the nature of the services offered and the local economic factors
Net income is less than budgeted

Examiners should exercise care when critiquing operating expenses, particularly when discussing the level of staff compensation and benefits as this can be a sensitive subject. Examiners should review expenses in relation to gross income rather than focusing on specific expense accounts that may be out of line. If concerns are noted, examiners should work cooperatively with management to address operating expense concerns, with credit union management determining how to allocate expenses.

The level of operating expenses should be consistent with the credit union’s size and structure. For example, a small credit union located in a high cost-of-living area with a high percentage of consumer loans and multiple branches may have a higher than average ratio of operating expenses to assets.

Credit union management should have sufficient information to make informed decisions regarding operating expense levels. This information might include:

Direct cost of branch locations
Costs associated with services and delivery channels (such as branches, telephone, internet, mobile, and ATM)
Transaction volume measured at branches and other delivery channels
Variance from budgeted expenses
Salary and benefit information

Examiners should review the information credit union management uses to measure and control operating expenses. How a credit union uses the information should also be evaluated, such as the comparison of expenses against credit union determined benchmarks (for example, regional or asset peers) and against budgeted amounts.

Employee Compensation and Benefits

Employee compensation and benefits are typically one of the largest operating expenses and are driven by the number of people on staff and compensation plans.

The number of staff employed by credit unions varies greatly. Examiners can use the following measures, considered together, to evaluate staffing efficiency:

Average loan balance—a higher average loan balance may allow for a lower level of staff depending on the types of loans granted
Average share balance—a higher average share balance may allow for a lower level of staff
The ratio of loans to members—a higher ratio of loans to members may result in higher levels of staff
Number of loans/full-time equivalents
Number of members/full-time equivalents

Salaries for many credit union staff positions tend to increase as credit union size increases and depend on geographic location and the local labor market. An analysis of compensation expenses should focus on the rigor and quality of a credit union’s own due diligence performed in determining the level of compensation. Along this line of review, examiners should consider:

The timeliness and quality of the most recent salary review for key positions
The appropriateness and controls over any bonus or incentive programs
The documentation produced for the most recent review of employee benefit costs

Management compensation should not be tied to incentives that are contrary to the safe and sound operation of the credit union (such as loan growth), but should focus on the performance of management relative to the standards and objectives established by the board of directors. Additionally, incentive and compensation arrangements must comply with NCUA regulations § 701.19, Benefits for employees of Federal credit unions and part 750, Golden Parachute and Indemnification Payments.

Office Occupancy Expense

Office occupancy expenses depend greatly on the real estate market a credit union operates in, the amount of assets invested in land and buildings, the level of sponsor-provided space, and the extent of a branch network. While physical offices can provide a platform for receiving share deposits, originating loans, and serving the needs of its members, over-investment in facilities may tie up capital and hinder earnings.

Credit unions should routinely analyze occupancy expenses to monitor the performance of facilities, including headquarters and branch offices. Ideally, credit unions with branches should employ effective branch accounting practices and understand how each branch contributes to the overall financial and operational success of the institution.

Travel and Conference Expense

Travel and conference expenses include authorized costs incurred by officers, directors, and employees for travel, attendance at conferences, and other credit union-related meetings.

Credit unions have discretion over the level of travel and conference expenses incurred by staff and officials. Management should assess whether the credit union can afford travel and conference expenses. Management should justify such expenses in the annual budget requests and maintain sufficient documentation for costs incurred.

Loan Servicing Expense

This expense category includes collection expenses, recording fees, credit reports, credit card program expenses, and loan servicing fees. Loan servicing expenses are generally tied to the volume of loan production and collection activity. As with other expense categories, management should periodically evaluate the cost-effectiveness of the chosen operational process against alternative sources.

Professional and Outside Services

Professional and outside services include legal fees, audit fees, accounting services, consulting fees, and outsourced information technology services. Credit unions should conduct a regular review of these major contracts to verify outside vendors are meeting contract terms and pricing remains competitive. Additionally, management should use a competitive bid process to award all major operational contracts.

Provision for Loan and Lease Losses Expense

PLLL is an expense account used to fund the ALLL account. All federally insured credit unions are required to maintain an ALLL account in accordance with the full and fair disclosure requirements outlined in NCUA regulation § 702.113, Full and fair disclosure of financial condition. Credit unions with high loan losses will experience increased PLLL expenses and reduced earnings.

Alternatively, credit unions with low loan losses, or those that have not fully funded the ALLL account, may have a lower PLLL expense. A negative balance in the PLLL expense account may make earnings appear strong, while masking an underlying earnings problem. Management should properly record adjustments to the ALLL account as a PLLL expense.

Interest Expense or Cost of Funds

Interest expense is a non-operating expense shown on the income statement. It is the price a lender charges a borrower for the use of the lender's money. This could include the dividend paid for borrowing funds from members or other financial institutions (such as corporate credit unions). LICUs will also include interest costs associated with secondary capital in this general ledger account. The board of directors is responsible for establishing dividend rates on share accounts. Management should ensure dividend rates and borrowings are consistent with the board of directors’ approved strategic plan.

Last updated on May 01, 2023