3. (a) Review lending and deposit rates and fees. What lending and deposit rates and fees should have been adopted by the Board to boost profitability next year?

(b) Consider, in turn, raising and lowering lending, deposit and commission rates. What were the most likely short and long term effects on volume, composition, credit quality and profitability? Suggestion: Consider any opportunity costs and their effect on quality.

4. Consider the Phenix costing system and the information available to the CEO and board of directors to make pricing and product mix decisions. What additional inside cost information would you like to have? What additional external information (such as competitor data) would you like to have?

5. Credit unions were cooperatives, not public firms. What do you think was Phenix's economic target function? What were the economic restrictions?

6. (a) Compensation contracts have often been seen as an incentive tool used to better align the interests of shareholders and managers. Was the PFCU employee compensation plan an effective incentive to meet the 1999 budget?

(b) Given Phenix's earnings outlook, future bonuses were expected to be modest at best. What alternative incentive systems (other than bonuses) could the board consider for the CEO, employees and members?

7. Phenix's actual loan quality was worse than budgeted and could be worse given the rising bankruptcies across the country. What were the strengths and weaknesses of its loan approval and monitoring systems, such as its credit standards, its multi-stage appeals process, and its collection methods?

Phenix Federal Credit Union: Budgeting and Performance Evaluation I. Introduction In December 1998, the Board of the Atlanta, Georgia-based Phenix Federal Credit Union (Phenix) was conducting its quarterly review of interest rates and finalizing its annual budget for 1999. As in other credit unions, the Board, rather than management, was responsible for setting loan and deposit rates as well as fee policies. Carita Womack, Chair of the Board, reviewed the detailed budget plan prepared by the CEO, Carl Massey. She and the other members of the Board were particularly concerned about a contraction in loans over the last two years and about increases in operating costs. The Board was now meeting to approve the annual budget and was considering changing rates and fees in order to improve the financial performance of this $29 million financial institution. The Board was seeking to balance two constituencies: long-time and new members. Its long-time members were government employees, who were mostly older. These members favored high deposit rates and appreciated the personalized service offered by branch personnel. Newer members were younger. They were more likely to borrow; thus, they favored low loan rates. They also preferred the convenience of ATMs and Web banking to the teller services provided at the branches. Phenix's History Phenix Federal Credit Union was established in 1948 to serve government employees, as well as their immediate families, who worked in regional offices of various federal agencies. In the 1980s, the federal credit union regulator, National Credit Union Administration (NCUA), permitted federally chartered credit unions to expand by accepting additional selected employee groups (SEGs). Each SEG was composed of employees of the same firm. Over time, Phenix came to serve selected groups of federal employees in Atlanta and Birmingham, Alabama, as well as employees of about 100 small businesses in the Atlanta area. In late 1996, Phenix took over a smaller credit union, Employees Savings and Credit Association (ESCA). ESCA was a $4.2 million state-chartered credit union, the company sponsor of which was in the process of being acquired. Phenix benefited from the merger by acquiring a branch office in a growing suburb and by achieving some economies of scale. The neighborhood surrounding the former ESCA branch was thriving, with many new businesses, and both former Phenix and former ESCA members were actively using the branch. The Board viewed the employees working at the new businesses as potentially attractive new SEGs. In addition, the market value of the branch (which was now owned by Phenix) increased markedly over the next several years. Having just celebrated its 50th anniversary, the Phenix staff and Board were optimistic about the institution's future. The Atlanta-based credit union now served over 12,000 members through four branch offices and four ATM cash-dispensing machines. It employed a staff of 23 full-time and 2 part-time employees. In early 1998, it hired a new marketing manager, who developed a business plan to expand the credit union's membership and loan base. Phenix's Philosophy: "Not-for-Profit, Not for Charity, But for Service" Phenix's philosophy was modeled on the credit union industry motto, "not-for-profit, not for charity, but for service." The U.S. credit union movement started in New England in 1909 , based upon a philosophy of self-help and cooperation. The primary goal of the movement was "to make more available to people of small means credit for provident purposes." Prior to the creation of credit unions, it was difficult to obtain consumer credit. Credit unions served members by specializing in short-term personal loans, such as car loans. Over time, credit unions, including Phenix, increasingly offered first and second mortgages. Eventually, commercial banks and thrifts began to offer consumer loans, until commercial banks, thrifts, and credit unions offered similar loan and deposit products. While the products were similar, the pricing and service orientation of Phenix and its fellow credit unions differed from that of commercial banks. Credit unions prided themselves on their reputation for treating their "members" (depositors and borrowers) with respect and providing personal service. Since credit unions were cooperative organizations, the members were actually the owners, Credit unions paid their members a financial return through lower rates on loans and higher "dividends on shares" (comparable to interest on deposits). Most credit unions charged relatively modest service fees in comparison to banks. Finally. credit unions were governed by people elected exclusively from the membership. Their stewardship role was highlighted by the Board's non-delegable tasks, which included approving new members, hiring and compensating the CEO, and determining rates on loans and dividends on shares (deposits). The Credit Union Industry: Field of Membership The ability of a credit union to grow was constrained by its "field of membership." The goal of federally chartered credit unions, like Phenix, was to serve individuals with a "common bond," such as occupation, association, or residential affiliation. The predominant premise of credit unions was occupational, with members working for a common employer, such as a company or government agency. For example, to have had a deposit or borrowing relationship with Phenix, a person must have been employed by a federal government agency or a firm that was one of Phenix's SEGs. The Phenix core members consisted of government employees working in Atlanta-based regional offices of several federal agencies. One benefit for Phenix of the SEGs admitted in the 1980s and the ESCA merger was an influx of younger members with borrowing needs. Although credit unions were prohibited from adding new SEGs in the 1995-6 period pending the outcome of a Supreme Court case, Congress soon after enacted legislation permitting federal credit unions to add SEGs comprised of 3,000 or fewer members. Accordingly, in the late 1990's Phenix was again preparing to market its services to prospective SEGs in the Atlanta vicinity. II. Phenix's Financial Situation In the early 1990s, Phenix suffered some financial difficulties arising from poor bookkeeping practices, slow loan processing, and substantial loan defaults. In order to restore profitability and rebuild the capital base, the Board canceled dividends on shares (equivalent to not paying interest on checking and savings accounts) for several months in late 1991. The dividend cut resulted in a number of long-time members closing their accounts. Total assets declined almost 5%, from $22.9 million at year-end 1991 to $21.8 million as of June 30,1992 . A new President/CEO, Carl Massey, recruited during 1992, turned around the operations with the active involvement of the Board. The ratio of delinquent loans to total loans fell from over 3% at year-end 1991 to 1.20% by mid-year 1992. Loan applications, which once took two weeks to process, were given same-day review. In the mid-1990s, Phenix operated profitably and grew substantially. However, in 1996. the credit union began exhibiting new problems. Phenix discovered that its 1996 merger partner. ESCA, had understated its problem loans. As a result, the number of delinquent loans climbed in late 1996, and substantial charge-offs were incurred in 1996, 1997, and 1998. Table 1 depicts the health of Phenix's loan portfolio. In addition to the loan quality concerns, Phenix was forced to relocate unexpectedly. The project entailed moving the main branch from the lobby of one government building into a central corridor of the new "Federal Center," a major United States government office complex in Atlanta. The administrative offices were also relocated to another nearby location in late 1997. Moving had not been anticipated, and it substantially increased 1997 and 1998 operating expenses. As was the case with the old main branch, the new location was provided rent-free by the U.S. government: however, Phenix now paid market rent on its administrative offices. The new main branch location put Phenix in more direct competition with the $221 million state-chartered Associated \& Federal Employees Credit Union, which operated a branch on the same corridor. Traditionally, credit unions have avoided competition among themselves by having non-overlapping fields of memberships. The State of Georgia, however, had granted a license to Associated and Federal Employees with a field of membership that overlapped with 25% of Phenix's membership. Phenix's Budgeting Process Phenix engaged in an extensive and formal budgeting process. This commenced each September with a Board planning session. During this session, the Board and CEO discussed trends in the credit union industry, reviewed financial projections for the current year, and set corporate goals for the coming year. The CEO then took the financial targets and developed a conservative budget with monthly income statements and balance sheets. In December, the budget was presented to the Board for discussion and approval. At the September 1998 meeting, the Board and CEO set financial targets for the next five years. The planning process also produced the following non-financial goals: to complete Y2K compliance, to evaluate the feasibility of a new branch office in downtown Atlanta, to install two new ATMs, to provide more home banking services via the Internet, to consider offering shared branching services at one branch, to expand the membership base, to provide members with more marketing and educational services, and to develop a technology plan. Setting Target Financial Ratios Table 2 compares the financial targets set for the current budget to those of the previous year and actual performance, if available. "Annualiece "Capital is defined as the loan loss allowance, regular reserves, and undivided earnings \# a key ratio used to determine a credit union's CAMEL rating Several financial ratios in Table 2 were selected to coincide with regulatory requirements. Credit unions were rated according to Capitalization, Asset quality, Management, Earnings, and Liquidity (CAMEL) ratings developed by the federal credit union regulator. Four of the target financial ratios (capital/assets, delinquent loans/total loans, charge-offs/total loans, and return on average assets) were relied upon to determine the C,A, and E components of the CAMEL rating. Table 3 provides the cut-off points of key ratios for credit unions with $10 million to $50 million, as announced by the NCUA in 1994. While the single overall CAMEL ratings were not publicly disclosed, NCUA examiners were known for setting these as a conservative function of component ratings. Table 3. CAMEL. Ratings for Credit Unions with $1050 million in assets CCa One key CAMEL ratio, return on average assets (ROAA), was not used as a target goal by Phenix in its 1998 budget. Unlike publicly traded firms, credit unions did not focus on profitability, but rather sought to deliver member benefits, such as low loan rates, high dividend rates, low fees, and high quality service. ROAA for credit unions was computed after dividends on shares were calculated. These dividends could be considered partially deposit interest and partially a return on members' investment. As credit unions could build their equity only through retained earnings, ROAA could be viewed as a capital rather than an earnings measure; i.e, at what pace the credit union was building its equity. By building equity and distributing fewer benefits, a credit union could invest more in providing customer service and offer greater benefits to members in the future. Since Phenix's equity base was strong, the importance of ROAA was being downplayed. At Phenix, supplemental target ratios were added based on CEO Massey's experience in managing credit unions. Massey found that the net operating expense ratio was closely related to whether a credit union operated profitably. Specifically, a credit union with a 6% operating ratio or lower generally operated profitably. He also observed the importance of maintaining a high loan/share ratio, as it indicated whether the credit union was serving its borrowers and showed that shares were invested in loans, rather than lower-yield investments. The asset growth ratio helped focus management's attention on the need to market services to existing members as well as expand the membership base. Developing the Projected Income Statement and Balance Sheet The CEO created the projected monthly balance sheet by relying on the financial targets to determine total assets, total loans, delinquent loans, and shares. He first computed total assets. Shares were computed based on the share/asset ratio, while loans were determined by applying the projected loan/share ratio. Investments were viewed as a liquidity buffer, dropping if loans expand relative to total assets and expanding if loan growth is slower. The loan loss allowance was generally held as a constant fraction of total loans. Depreciation was set at historical amounts. A number of other factors, such as cash, were determined by common-sizing the balance sheet; i.e., taking the ratio of the account to total assets and applying that ratio to the projected year-end total assets. Dividends were declared quarterly and payable in the following quarter. Accounts payable was set based on the need to keep the accounting equation in balance. Net income for the year was reflected by an increase in undivided earnings on the balance sheet. Once the balance sheet was prepared, then the CEO developed the projected income statement. The interest and investment income were computed using the lower of a five-month average yield or the current month's yield multiplied by month-end loan and investment balances, respectively. Dividends on shares (comparable to interest on deposits) were computed by taking the higher of current month's yield or the five-month average multiplied by the month-end total shares. The compensation numbers were developed based on a detailed schedule that included all job positions (including vacancies) and current salaries. The forecasted numbers were based upon a cost of living increase for all employees and additional raises based on performance. In addition, employee benefits were 18% of total compensation. Finally, a performance bonus of about 3% of net income was budgeted. Many operating expense items were computed by determining the ratio of the actual current year operating expense/total assets and then applying that ratio to projected total assets (after correcting for any unusual expenses). The loan loss provision was determined by the increase in the loan loss allowance over the year plus the targeted amount of charge-offs. The 1999 Budget Situation To prepare the 1999 budget, the CEO collected recent actual financial performance data as well as the 1998 budget information in Appendix A. He stated assumptions for use in the proposed 1999 budget in Appendix B. An analysis of the Phenix revenue and cost structure revealed that most of its operating costs were relatively fixed. From an activity-based costing perspective, the supply exceeded the usage of resources. The office move created unexpected one-time office operating and occupancy expenses in 1997. Massey expected 1999 occupancy expenses to remain unchanged from 1998, since the new administrative offices increased the ongoing office operating and occupancy expenses. He expected compensation to increase by a cost-of-living increase of 1.3% plus $26,000 for the hiring of one new full-time and one new part-time employee. To cut costs, he considered cutting travel and conference expenses substantially. In addition to operating expenses, a key budget area was the pricing of deposits, loans, and fees. The current yields were as follows: Massey then submitted a proposed 1999 annual budget (Appendix C) to the Board for approval. III. Products and Services Deposit Services: As with all credit unions, dividends on shares (i.e., deposit interest) at Phenix were subject to available earnings. Deposits were federally insured up to $100,000 by the National Credit Union Share Insurance Fund operated by the NCUA. In order to join the credit union, Phenix required that members open a regular share account for at least five dollars. The minimum initial deposit for a money market account was $1,000. Recent share balances and dividend rates are listed in Table 5, with comparable data for a larger local credit union. Associated and Federal Employees, presented in Table 6. " on average monthly balance of \$5uw and over *o on average monthly balance of $100 and over Table 6. Associated and Federal Emolovees Share Balances and Dividend Rates Dividends on regular shares, share drafts, and IRAs were set quarterly by the board. Phenix maintained dividends on share draft and regular shares at 0% and 3%, respectively, for many years. The money market and CD rates were adjusted more frequently to respond to changing market conditions. The Board generally sought to keep these rates at 25 basis points above the rates offered by banks in the Atlanta area. In late 1997 and 1998 , members shifted their deposits away from the interest-free share draft accounts and low-paying regular shares into money market and CDs with maturities over three years. The rates for other banking institutions are shown in Table 7. Loan Services While shares were relatively stable, Phenix had greater difficulty maintaining and expanding its loan portfolio. As a result, Phenix concentrated its new marketing efforts on loan, rather than deposit, growth. The Board's loan policy was to have rates at or just below the market. Phenix members actively shopped for good rates when making a car purchase and in selecting credit cards. Phenix established a call center at its administrative offices to streamline loan approval procedures so that members could get approvals in about an hour. The current loan mix is displayed in Table 8 , with Associated and Federal Employees' loan information presented in Table 9. A comparison to loan rates offered by five local commercial banks is given in Table 10. Table 10. Comparative Loan Rates at 6/30/98 Unsecured loans and auto loans were generally fixed-term at either a fixed or variable rate. The Phenix Board set a variable-rate consumer loan (VRCL) index, which was used to change the rate on outstanding variable-rate loans. The loan rate schedule indicated the initial three-month interest rate offered on variable-rate loans. Approximately 25% of the home equity loans were "open-ended"; i.e., repayable at any time with variable interest rates; and the remainder were close-ended and fixed-rate. Historically, Phenix offered one fixed and one variable loan rate per product, rather than applying risk-based pricing. The one-rate policy was common in the credit union industry. Some credit unions were reluctant to shift to risk-based lending. believing that it infringed on the egalitarian and cooperative credit union principles by which the borrowers were treated equally. More recently, some marginal borrowers were offered credit, but at a higher rate, in order to compensate Phenix for the additional risk. For most long-term loans, Phenix charged an additional 0.5% if the loan was not repaid using payroll deductions. At Phenix, a potential borrower filed a loan application with one of three loan officers. The loan officer collected a credit bureau report and additional data and made a loan decision. Applications that were rejected or marginal were then reviewed by the staff loan review committee (composed of all three loan officers). Rejected applicants could appeal the loan decision to a volunteer loan review committee composed of credit union members and then appeal further to the CEO and eventually to the Board of Directors, which was composed of volunteer credit union members. Complaints by existing borrowers were filed with the member loan review committee and were investigated. In making their lending decisions, credit unions had to comply with several banking and consumer protection laws, such as the Home Mortgage Act and the Truth in Lending Act. As credit unions were required to serve their members, they were exempt from the Community Reinvestment Act. The consumer lending laws explicitly prohibited lending institutions from using age, race, gender, religion, national origin, marital status, and receipt of public assistance as factors in granting loans or credit. In most cases, individuals who were denied credit had to be provided with an explanation for the credit denial. Phenix used an informal set of credit standards rather than a formal. computer-based scoring system. The CEO had previous experience in an institution that relied on credit scores generated from data in credit bureau reports. As credit bureau reports often included incorrect data, the credit scores could be unreliable. Since the scoring criteria were not explicit, the lending officers often had no way to determine why a seemingly good risk received an unfavorable score or a poor risk was associated with a favorable score. The CEO believed that such a "black box" scoring system did not serve members well and left Phenix vulnerable to lawsuits for violating consumer lending laws. The Phenix credit standards were designed to examine a wider range of factors than were included in many credit scoring systems, including a member's personal history. reasons behind previous borrowing problems, etc. In contrast, advocates of credit scoring systems suggested that their credit standards were more objective and facilitated a faster turnaround time for credit applicants. The largest source of consumer loan losses at Phenix arose from borrowers filing for personal bankruptcy. A major concern among consumer lenders nationwide was the increased frequency of personal bankruptcy in the current period of low unemployment. Traditionally. individuals declared bankruptcy only if no other options appeared available. As a result, the frequency varied with unemployment and inversely with economic growth. The other major factors contributing to bankruptcy were divorce and family medical problems. In the 1990 's, excessive credit card debts and gambling were becoming more common reasons for bankruptcy. In addition, the stigma of bankruptcy had been reduced, and many people filed for bankruptcy sooner than in the past. Phenix experienced an increase in bankruptcies during 1997 and 1998, with an associated negative impact on delinquent loans and charge-offs, as seen in Table 1. Despite making many secured loans, Phenix was affected by Georgia's bankruptcy laws, which generally permitted borrowers to keep their homes and automobiles. Phenix, like many credit unions, had traditionally been willing to work with borrowers who declared bankruptcy but reaffirmed their debt to Phenix. Although legally discharged from the debt, these borrowers could become eligible for new loans from Phenix if the old debt was fully repaid. This self-help philosophy was credited with helping to reduce loan losses. First, Phenix, like many credit unions, offered education on budgeting and financial planning to its members. Phenix monitored loan repayments, contacting borrowers if they fell behind in their payments and often charging penalty interest on late payments. Once a loan became one or two months delinquent, Phenix worked more actively with the borrower, often using an employee or an outside agent to collect payments. Credit union members were encouraged to discuss any loan repayment problems with loan officers early on and to negotiate workable payment terms. Weekly payments or per paycheck terms were frequently possible. Phenix, like other credit unions, offered credit counseling services to its borrowers. Eventually. Phenix might have repossessed any collateral or foreclosed on a house. When loans became delinquent or charged off, the CEO and Board reviewed the loans to identify factors contributing to these problems. Fees for Services The non-profit philosophy led most credit unions to offer virtually fee-free banking services, Generally credit unions did not require minimum balances or charge check-processing fees. They also did not charge for most teller services. They did, however, charge penalty fees for bounced checks and late loan payments in order to discourage members from abusing their banking privileges. Many credit unions, including Phenix, billed their members a fee for using ATMs operated by other financial institutions. The 1998 fee schedule at Phenix was: Compensation and Incentive Systems Phenix had 24 full-time positions, of which 6 were vacant in 1998. Employee turnover averaged about 3-4 employees a year, with most employees leaving to assume more prestigious positions at other credit unions or for personal reasons. Many of the job openings were filled internally through promotions. PFCU had a reputation for re-hiring former employees who left in good standing. The PFCU compensation plan was similar to that of many credit unions. The Board of Directors set the compensation of the CEO, and the CEO set the compensation of the remaining employees in accordance with Board policy. Traditionally, the employees were paid a salary and are eligible for a bonus. Salaries were generally increased based on a cost-of-living index as well as merit raises. The salary scale was relatively flat, with the CEO making no more that 5 times the newest teller. Bonuses were paid based on the financial performance of the entire credit union in the prior year. The most recent bonus pool was set at about 3% of net income before bonuses, with each employee receiving an identical dollar amount in bonus. The employees also benefited from being members of the credit union. New Marketing Initiatives The Phenix Board and management recognized that the long-term health of the credit union relied upon increasing the membership base and developing a higher quality, yet expanding loan portfolio. Membership and new loan performance data from 1996-1998 are provided in Table 12. Phenix recruited a new marketing manager in early 1998; this individual developed a marketing and promotional plan to be implemented in 1999. Phenix also invested in new banking technologies. In 1997, Phenix opened a call center staffed by three member service representatives and an automated response center. Most members commented that the call center was an improvement over the existing telephone system, although some older members were disappointed that they couldn't call their longtime bank contact directly for information. The younger members quickly moved to using the automated response center for many transactions. Phenix also offered a Website (www.phenixfederalcu.org), which members could access to examine rates or apply for loans. The response was less than expected. In addition, numerous credit unions offered services jointly with other credit unions to achieve economies of scale and reduce pressure to merge. Phenix offered its members use of other firms' ATM machines for cash withdrawals for a fee as well as access to a network of "shared branches" across the country. Phenix was at this point considering additional technological investments that could improve its service delivery. As a midsize credit union, Phenix wanted to be on the leading edge with service delivery but could not afford to invest in risky or untested technology. Phenix was considering investing in one or two automated kiosks, which would be located in the Atlanta area. Unlike ATMs, which could only dispense cash in the state of Georgia, kiosks could accept deposits, take transfers between accounts, and could be designed to accept loan application information. Secondly, Phenix investigated creating a shared branch office that would provide service to members of several credit unions. The proposed office would have been located in a building close to its administrative office/call center and two blocks away from its main branch. Finally, Phenix was exploring the possibility of expanding its Internet services to allow members to do their banking from their home or office