Evolution: Glatt Consulting Updates HealthScore Model

HealthScore Background

Glatt Consulting’s HealthScore was an outcome of a Glatt Consulting client merger project. In 2007 we were asked by a client greatly impacted by the recession to help them quickly identify and rank the overall “health” of potential merger candidates. Their desire was to find a partner healthy enough to take on the challenges of the credit union’s increasingly risky balance sheet, and that could continue to provide good service to the credit union’s members. We created a rudimentary scoring system that allowed us to determine the relative health of potential partners, and to rank their “fit” given the credit union’s objectives.

Following the completion of that project we began to experiment with the scoring model for the purpose of settling on a final version to aid in assessing general industry health as well as the health of individual credit unions. We eventually established the following scoring methods and score process workflow:

  1. Call report data for every US-based credit union imported into a custom database following the conclusion of each calendar quarter.
  2. Industry-standard ratios calculated for every credit union for the quarter. Eleven of those ratios scored/graded against a scale of 0 to 5, with 0 indicating poor health and 5 indicating exemplary health. Ratios include:
    • Asset Growth
    • Average Loans per Member
    • Average shares (deposits) per Member
    • Delinquent Loans
    • Efficiency
    • Membership Growth
    • Charge Off
    • Net Worth
    • Operating Expense
    • Return on Average Assets
    • Loan to Share
  3. For every credit union the eleven scores averaged to determine a “HealthScore” for the credit union. An industry score calculated by averaging all of the individual credit union scores.

Other than minor adjustments to the score threshold for efficiency in 2013, the model and process above has remained unchanged. And since approximately 2009/2010 we have used it to report on individual credit union scores for client credit unions, and on industry scores for those interested in tracking general industry trends.

A Time for Adjustment

In the years since the public launch of our score model we have encountered certain issues that prompted discussion regarding the need for model updates. For example, the 5-point grading scale poses certain challenges. First, the scale segments the wide range of credit union ratios and general performance too narrowly. This leads to the second challenge, which is that the differentiation between exceptionally healthy credit unions and those of lesser health is more difficult to determine and/or present.

In addition to the scale challenges, the eleven components making up the score may not adequately/equally consider other aspects of financial performance that contribute to health. For example, when assessing health, regulators consider a number of ratios. Those ratios are classified into one of the following categories:

  • Capital Adequacy
  • Asset Quality
  • Earnings
  • Asset/Liability Management
  • Productivity
  • Growth

The current score model components fall into the categories noted above as follows:

Capital Adequacy Asset Quality Earnings Asset/Liability Management Productivity Growth
Net Worth Delinquent Loans Efficiency Loan to share Loans per member Asset growth
Charge Offs Operating expenses Shares (deposits) per member Membership growth
Return on average assets

While the components of the score system are equally weighted, clearly earnings-related performance has a greater impact on the score than other categories – and Asset/Liability Management and Capital Adequacy-related scores have less impact. This has led to perhaps an overly-punitive scoring of small credit unions positioned with high capital relative to earnings, and of credit unions that closely align with the not-for-profit credit union philosophy (i.e., credit unions that “give back” a higher proportion of income).

If such an earnings situation directly relates to a greater likelihood of failure, then the punitive impact of the scoring model may be necessary – but we have nonetheless determined that the components included in the HealthScore may need to be amended to more properly balance the consideration of other health factors.

HealthScore 2.0

As a result of the challenges above, the noted determination regarding the need to balance score components, and also due to the fact that the score methodology and assumptions were created in the midst of the recession using depressed performance data, we have concluded that it is time to update the score scale and segments, and amend the underlying ratio components.

With regard to scale, we decided to expand the scale from 0-5 to 0-10, and to further subdivide the 10-point scale in half-point increments (e.g. 1, 1.5, 2, 2.5, etc.), to allow for more nuanced scoring.

With regard to components, we are now utilizing the following:

Capital Adequacy Asset Quality Earnings Asset/Liability Management Productivity Growth
Net worth Delinquent Loans Efficiency Regular shares to total shares and borrowings Loans per member Asset growth
Solvency Charge Offs Operating expenses Cash and short-term investments Shares (deposits) per member Membership growth
Texas Ratio Return on average assets Loans to assets Borrowers per members Loan growth

Our decision regarding which components to include drew on our industry experience, and also on the results of a ratio correlation assessment which we used to determine the ratios possessing the highest connection to sound financial performance. While we may continue to adjust the model somewhat as we settle in to using score results in support of client projects, what we have to-date is a solid step up over our already effective HealthScore system.

Using the HealthScore

To-date our HealthScore has been used to support the development of credit union merger strategy, as a reference tool for client strategy planning and assessment, for CEO performance evaluation criteria, as a means for credit unions to track and evaluate competitors, and for general market assessment. The updated score will provide even more granular support for these types of projects – and more.

One of the “and more” HealthScore uses is as a tool for credit union leaders to use to spark dialogue focused on understanding and/or validating the reasons for their credit union’s scores. Strategies often require tradeoffs; the HealthScore can be used to challenge the tradeoffs a credit union is making in some areas for the benefit of others.

Here is an example of what we mean. The chart below tracks the health of a credit union that ended up in conservatorship.

HealthScore Proof of Concept
HealthScore Proof of Concept

This particular credit union suffered a serious decline in health starting in 2006 (though with a warning bell rung in early 2005). Even as the credit union’s overall health was declining, the credit union doubled down on its strategy. Though the regulator eventually stepped in and conserved the credit union, it was not until many successive quarters of poorer and poorer health – and seven years after the first signs of trouble.

During this seven-year period the HealthScore could have been a catalyst to drive serious board/management discussion regarding the state of the institution’s health and the soundness of its strategic plan. While such discussions may not have saved this particular credit union in the end, they certainly could have led to the development of a credit union-defined exit strategy – one that might have perhaps preserved a higher value for the credit union’s member owners.

In any case, it is this kind of discussion we hope to inspire through sharing our HealthScore results – though based on our most recent score report, such discussions are more likely to be focused on strategies to sustain positive health rather than on defining a response to declining health. We think that is a welcome change in perspective!

If you have questions pertaining to the HealthScore, please feel free to contact our office at (888) 217-5988, or send us an email to healthscore@glattconsulting.com. We look forward to hearing from you.

Photo Credit: “Evolution-The Ride” by Kevin Dooley is licensed under CC BY 2.0

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