The Goldilocks Concept

Remember how Goldilocks of fairy tale fame had to work at it to find things that were “just right” for her? For example, she tried porridge that was too hot, then too cold, before tasting one that was just right.

In a recent CUES Webinar, enterprise risk management expert Vincent Hui said that getting the right level of strategic capital is similar.

“Having too much or too little strategic capital reduces member value,” said Hui, a senior director with CUES Supplier member Cornerstone Advisors Inc., a CUES strategic provider of strategic planning and enterprise risk management services, based in Scottsdale, Ariz. “It needs to be just right.”

But what exactly is “strategic capital”? Hui defined it as the level of capital a credit union targets having above the required regulatory minimum. This capital can be used to support investments in such things as delivery systems and mergers, and to manage disruptor and non-balance sheet risks.

Hui said he expects risk management to be much more integrated with capital levels going forward, particularly in light of the National Credit Union Administration’s risk-based capital proposal (which defines 10.5 percent capital as being “well capitalized.”)

This is “going to require a shift in thinking for credit unions,” Hui said. It’s “not just about risk but a range of functions that really need to work in an integrated way.” The right level of capital takes into account strategy, risk management and other factors.

Traditionally, all assets were weighted 100 percent in capital calculations. In the new regulatory proposal, however, assets would be weighted differently based on their risk profiles. “This is aligned with what we see in the banking space,” Hui said.

Knowing your risk appetite is key to decision-making in this area, Hui said. If you go through a merger, you might be willing to see your capital level go down, for example. But when would you expect it to go back up? And would you want it to go back up to the same level as it was pre-merger?

Another example he cited is business lending. Many CUs want to grow their portfolios of these loans, “but it has a high capital cost,” Hui noted. “So, what is the right balance of growth and the impact on our future capital levels?”

Key things to think about as you consider your CU’s strategic capital level include:

1. Your business mix will impact how much strategic capital you will need.

According to NCUA’s proposal, if you make an auto loan and want to maintain 10.5 percent risk-based capital, you would need to allocate 7.9 percent capital, as a regulatory minimum. In contrast, maintaining the same risk-based capital level when considering a first mortgage, you’d only need to allocate 5.25 percent.

2. ROE is a growth speed limit indicator.

In a risk-based capital world, if you have a target capital level and a target return on assets level, return on equity is the amount of growth you can achieve before your capital decreases, Hui said.

“Calculation of ROE is important because it allows you to understand your speed limit and allows you to understand the tradeoff” between such elements as profitability and growth.

3. Data and analytics are key enablers.

Effective strategic capital management requires better profitability measures for products, members and channels, as well as such risks as credit, interest rate, liquidity and others.

Traditionally, credit union boards and management teams have held the idea that “more capital is good.” But once a credit union defines a strategic capital target, a sustained “more is better” buffer above that target can slow a CU’s progress—creating complacency related to capital allocation and business strategy decisions, negatively impacting innovation/smart risk-taking, and degrading value added for members through pricing, economies of scale, and field of membership.

“The focus has been on how to continue to build capital versus ‘what is the capital that we need to manage against’” based on a credit union’s strategy, Hui said. But now things are poised to change.

Lisa Hochgraf is a CUES senior editor.