3 minutes
Retaining earnings that could be returned to members has long been a controversial subject for credit unions. I remember calls in the 1980s for 3 percent capital evoking moans of “It can’t be done” and “All this capital is unnecessary!” Decades later, new National Credit Union Administration capital standards of 7 percent drew similar responses. Now, risk-based rules that tie capital to a CU’s asset allocation are final. These make crystal clear that more capital is desired by regulators and provides more flexibility for CUs.
The Value of Capital
Capital resides on the “liabilities/equity” side of the balance sheet along with member shares and borrowings. To attract and retain savings (such as regular shares, certificates and money market accounts), the CU must pay dividends. It must also pay interest on borrowed funds. This “cost of funds” is one of a CU’s largest expenses.
Fortunately, residing on this side of the balance sheet is an account that costs the CU absolutely nothing: “equity,” aka capital.
The building of equity should be thought of as a strategy to partially offset funding expenses of the CU. The more equity/capital you have, the more expense is offset. The chart at right describes two $800 million CUs that are identical but for their equity levels:
Note that Credit Union B has achieved the same asset size as A, but with a higher level of zero-cost capital. Credit Union A must pay an average of 3.2 percent on an additional $32 million in shares ($712 vs $680) to achieve the same asset level. These savings flow directly to the bottom line, increasing Credit Union B’s ROA by nearly 13 basis points. With assets of $800 million, this amounts to a $1.04 million advantage in net income due solely to higher levels of equity/capital.
Capital When Rates Rise
Moreover, the value of equity increases as interest rates climb. An increase in the cost of funds by 50 percent results in the chart on the next page.
Now Credit Union B has an advantage of 19 basis points. This translates into a 50 percent difference in net income. Similarly, the value of having higher equity has grown 50 percent to $1.52 million per year.
Capital Accumulation
Some CUs have had success with interest rate rebates and/or bonus dividends. These programs have philosophical feel, but no financial benefit for the CU. Building and retaining higher levels of equity/capital benefits all members, in perpetuity, by reducing a major cost. That savings may be used to benefit members and the CU.
During my career as a CU CEO, we built equity to over 14 percent (from 7 percent), while growing assets from $120 million to $1.2 billion. Higher capital levels lowered our costs and helped our CU return more value to members year after year. We did this through higher rates on savings, lower rates on loans, and lower fees while, at the same time, consistently achieving one of the nation’s top ROA ratios.
Given the new RBC rule, higher capital levels will allow flexibility in asset allocations and, perhaps, make exams a little less painful.
Exercise 1: Discuss your CU’s capital accumulation trends. What is the value of its capital? Exercise 2: Assess your current/projected RBC position. What actions should your CU take now—well ahead of the new rule’s implementation date of Jan. 1, 2019?
William J. (Bill) Rissel is retired from 23 years as CEO of $1.2 billion Fort Knox Federal Credit Union. He served two years with distinction on the Federal Reserve Bank’s Community Depository Institution Advisory Council. He occasionally assists CUs in financial management and governance issues. Reach him at 941.626.0330 or wjrissel@gmail.com.
