While an educational institution differs significantly from a financial institution or a corporation in its mission, vision, and operation, there is one area colleges and universities can benefit from the disciplines utilized by the for-profit business organizations: financial management.
Despite their overwhelmingly non-profit status, educational institutions require significant financial resources and prudent financial management to fulfill their mission of excellence. Even though profit maximization is not a goal of colleges and universities in itself, the importance of anticipating, assessing, and taking appropriate steps to avoid significant upheavals in the execution of their core objectives due simply to lack of financial resources cannot be overstated. Financial planning based on rigorous stress testing can help these higher education institutions reduce the inherent risks and increase their viability.
Stress Test Concept
Stress testing is based on the idea of evaluating whether a system can maintain its desired level of effectiveness under unfavorable shocks or stressors. Even though stress testing was initially designed for computer systems, it has become widely used among financial institutions, especially after the financial crisis of 2007 where quantitative models failed to account for or anticipate the magnitude of the damage wrought by the failure of the credit derivatives. The financial regulators have designed and implemented a number of stress tests on various financial markets and institutions to better anticipate how the financial system would fare when faced with unanticipated situations and devise a way to reduce the vulnerability of the worldwide financial mechanisms. A similar exercise can be envisioned for universities.
Identifying the Shocks
In a typical stress test, a matrix of adverse shocks is first identified. Since a number of different factors can affect the system at the same time, it is important to recognize the interactions of these factors. Afterwards, the magnitudes of the shocks are progressively amplified. Similar to scenario and sensitivity analyses in corporate finance literature, the multiple factors could be changed at the same time or one factor could be changed by holding the others constant at a base level. Both of these exercises have their advantages. Changing multiple factors at the same time allows for a deeper understanding of the interactions among various shocks. On the other hand, changing one variable at a time enables stakeholders to identify the specific vulnerability of the system.
One of the requirements of a successful stress test is to identify relevant shocks. There are of course a number of variables that may sound important, but in reality may not have much of an impact. On the other hand, relatively mundane factors could end up being the most important. Therefore, it is the responsibility of the investigators to come up with the groups of variables that are most important and to be imaginative in their assessment of the risks an institution could possibly encounter. Credit risk committees are commonly utilized in banks to perform this task. Larger universities can assemble a threat assessment team that is comprised of stakeholders from faculty, administration, enrollment management, campus safety, student affairs, etc. to provide guidance. Hiring outside experts on university risk management may be a better option for the smaller institutions.
We can provide a simplified example of a stress test by using historical student enrollment data. During the period 2006-2014, the average volatility in the enrollment growth rate of larger (>10,000 students) private institutions was 3.52%, while it was 9.38% for smaller (<5,000 students) private universities. On the other hand, larger public universities had a volatility of 4.83%, while smaller ones had a volatility of 10.54%. Here smaller (or larger) public and private universities have similar volatilities. We can easily illustrate the effects of enrollment growth rate volatility on the revenue growth rate of the universities. The graph below presents the effects of enrollment growth at the mean and one standard deviation above the mean for the top and bottom enrollment growth deciles among both public and private institutions. It is obvious that a change in enrollment growth rate does not affect revenue growth uniformly across different institutions.
To get a better sense of how this volatility affects the revenues of the universities, we can consider the Value at Risk (VaR) metric. VaR is widely used in financial institutions to measure how much of the dollar value of a portfolio can be lost due to an underlying volatility with 95% confidence. Essentially, it can quantify the financial risks of the universities due to the volatility in enrollment growth. We find that large public institutions on average have a VaR of $22 million (6% of annual revenue) and large private universities have a VaR of $43 million (5% of annual revenue) Similarly, the VaR for smaller public institutions is $5 million (11% of annual revenue) while it is $3 million (10% of annual revenue) for smaller private institutions. Therefore, public and private institutions have different dollar values at risk if there is an adverse shock to the enrollment numbers.
Next, we can conduct regression analyses to find what action plan can be devised to reduce the VaR of the institutions. For example, we notice that higher rates of tuition discounting relative to peers, larger student bodies, or better economic growth within the State can reduce the VaR of the institutions. On the other hand, greater dependence on foreign students increases the VaR. The interactions of the variables are informative as well. While higher tuition discounting and larger student bodies can lower VaR, it does not continue forever. In fact, there is a decreasing benefit from tuition discounting. A closer look at tuition discounting shows that it is most effective in reducing VaR only up to a certain level. Afterwards it just makes the financial situation of the institution worse. An analysis of the level of tuition discounting and U.S. News and World Report ranking shows that universities can benefit from tuition discounting in improving their ranking, but only up to certain point. This is especially true for public universities. The relationship totally reverses for private universities. In effect, affordability is of greater concern for constituents of public universities whereas factors other than affordability seem to be of greater import with constituents of private universities.
The simple example involving enrollment growth and the financial management of the universities illustrate the complexity of financial management and the rigor required to properly assess the risks of the educational institutions to arrive at proper responses to their predicaments. In fact, higher educational institutions are experiencing an upheaval in their business models. Colleges and universities – both public and private – increasingly depend on tuitions and fees. Both State and Federal governments have significantly reduced assistance to state colleges and universities. Even private institutions and individuals have lowered their contributions. Moreover, there is immense political pressure to lower tuition and fees, which reduces the pricing power of these institutions. In a recent Kaufman Hall survey, only 15% of university administrators feel confident in their ability to respond to changes in business circumstances. On the other hand, more than 90% of respondents believe that they must do more to leverage financial data and techniques to make strategic decisions vital for their survival. This is exactly where stress testing can assist the higher educational institutions in formulating a plan of response to adverse shocks.
Stress testing can serve a very important purpose for the universities. Like any other sector of the economy, universities are subject to changes in demand and supply. They are also limited by resource constraints, particularly at institutions that rely heavily on brick-and-mortar for delivery of curriculum. Identifying the most appropriate responses to a change in student enrollment or a financial challenge would only serve to make these institutions stronger and better prepared to handle any shock. As researchers and dedicated advocates for higher education, we are continuing to put together models and decision tools for colleges and universities to be able to better assess and manage their risks in a more effective manner that is consistent with their institutional mission and vision.
Tuition Management Systems (TMS) is the sponsor of this post.
The sources who contributed ideas to this post do not endorse or recommend any commercial products or services, including those of TMS. All information and opinions of the contributors are provided for informational purposes only. As with any other service you seek, the recipient of the information is responsible for conducting appropriate research and making relevant decisions. TMS neither endorses, has any responsibility for, nor exercises control over the views of any contributor to this article or the accuracy of the information provided by any of them.