Recently I was asked to contribute to a meeting of credit unions
that was reviewing ways to expand capital alternatives. When I sought
some advice from a credit union CEO on the issue, he shot right
back with the question, “Why do we need options? Don’t
we have enough capital right now?”
A number of events have pushed the capital issue to the front of
the stage. Several credit unions that have converted charters to
mutual savings banks have said that one of their reasons for doing
so was to gain more flexibility with future capital choices. Several
of these former credit unions have gone on to issue stock as thrifts.
The dramatic growth of shares in the first six months, over 10%
real growth, was more than twice the rate of capital growth via
net income. If members continue to flee the stock market to gain
the more certain return of the credit union, should they be turned
away because the inflow might reduce capital levels?
Another factor has been the evolving credit union business model.
Many credit unions are selecting more open charters, often serving
communities or other geographic markets. This effort has led to
new opportunities such as indirect lending or small business services
that were not feasible to develop in a more limited market definition.
Some of these efforts require capital for more fixed assets or to
support fast growing lines of business.
The Change in Regulation with PCA
But the most dominate event causing capital discussions has been
the impact of the Prompt Corrective Action (PCA) net worth requirements
mandated for all NCUSIF insured credit unions by HR 1151, the Credit
Union Membership Act.
The law imposed credit unions with the same capital standards as
banks and thrifts, which have multiple means of meeting their legal
“net worth” requirements. Before this change, credit unions,
being cooperatives, grew capital using a “flow” method.
Credit unions were required to set aside either 5% or 10% of total
income into reserves until these accounts equaled 6% of risk assets.
Credit unions have done an exceptional job using this formula, which
is still in effect today. Then PCA mandated a second test. This
new law requires that credit unions maintain at all times a specific
level or “stock” of capital, defined as a percent of all
assets, to be considered safe and sound. Once this stock of capital
(excluding the allowance account) is above 7%, the credit union
is considered well capitalized. Below that level, there is a progressive
set of constraints imposed even if the credit union is meeting the
historical “flow” requirements.
Because credit unions, with minor exceptions, have no other source
of capital except retained earnings, PCA means that a credit union
can only grow as fast as it can generate retained earnings. As shown
in the chart below, growth of capital has been in single digits
in recent years. This new requirement could become a real constraint
in certain environments and thus has fueled the issue of finding
other sources of capital. PCA set new standards but gave no new
options to meet them.
State of Capital Today
Credit unions have never had more capital in dollars or as a ratio
of assets than in the past year. At June 30, 2001, total capital
including allowance accounts was over $56 billion. The capital ratio
has hovered between 11.5% and 12% during the past year of first
slow and then rapid share growth. At June, 1990, or 11 years ago,
the total capital ratio was 7.9% and the total dollars were $16.1
Capital ratios are very much a function of asset size. For credit
unions over $250 million, the ratio is 11% whereas credit unions
under $5 million average over 17%. Most of the dollars of capital
(almost 79%) are in the credit unions over $50 million in assets.
Therefore when the discussion is about options, the credit unions
most likely to need and be able to use alternatives would be the
larger credit unions.
Capital Options are Not New
In two situations NCUA specifically authorizes other capital accounts.
Before PCA, NCUA changed the capital requirements for corporate
credit unions. Both membership shares and member paid-in capital
were authorized to supplement traditional retained earnings or core
capital. At June 30, 2001, the total of all capital accounts in
the 35 corporates, excluding US Central, was $3.8 billion. Of this
total, 11.4% was in earnings and reserves, 47.8% from membership
shares, and 40.8% from paid- in capital.
The second instance of alternative capital is at federal credit
unions with a low-income designation. These credit unions may have
secondary capital accounts that were approved in 1996, before PCA
legislation. The terms of these accounts make clear that this “subordinated
debt” has all of the practical functions of capital covering
Outside of NCUA jurisdiction, state laws in at least 12 states have
recognized other forms of capital accounts for credit unions chartered
under their authority. The latest credit union to use this concept
was the second largest credit union in the nation, State Employees
of North Carolina. This credit union reported a $1 million equity
share investment as of June 30, 2001. Both the North Carolina regulator
and the credit union’s auditing firm agree that the account’s
terms met the tests of equity for a credit union.
Finally, in several situations, privately insured credit unions
have used external capital sources to successfully start their credit
unions. Alec Credit Union was launched in the early 1990’s
with a $6 million subordinated contribution from the sponsor company.
The capital was ultimately paid back to the sponsor and the credit
union today has over $200 million in assets and is a very successful,
growing, single-sponsor credit union.
What is the real issue?
Often when the issue of capital for credit unions is raised, the
first question that comes to mind is, as the CEO above asked, “Do
credit unions need more capital?” I think the more important
question is, “Do credit unions need options for their capital
Regardless of any need that might exist today, I believe the time
to create options is when an organization has plenty of capital
— just ask any dotcom company. Precisely when a firm or industry
needs capital is the least convenient time to create options. So
even though the credit union movement by any standard is well capitalized,
this is exactly the time when alternatives should be developed.
But why is it important to have capital options? I’ll list
- Capital options help to absorb risk and reduce uncertainty.
The more options an organization has, the greater the assurance
of being able to ride out the inevitable cycles of economic and
- Capital underwrites future growth commitments. Whether these
investments are in traditional areas such as fixed assets or in
new businesses via CUSO’s, capital is often critical to successfully
deploying a new service, product or market strategy. Without capital,
a credit union can be locked into traditional ways of doing business.
- Options ultimately reduce the dependence or “in loco parentis”
guidance that regulators inevitably feel duty-bound to provide
cooperatives. At a time of convergence and consolidation in financial
services, credit union regulators are often the last to recognize
the need for significant change.
One need only look at recent topics like member business loans,
changing fields of membership, reactions to mergers and the grasp
of Internet technology to see how difficult it is for regulators
to feel the ebb and flow of the marketplace.
Capital options can only enhance safety and soundness. But the
safety referred to is not the prevention of the insolvency failures
of the past due to asset quality or management problems. The greatest
challenge facing credit unions is remaining relevant in their members’
Capital options will be integral to some of the alternative business
models credit unions will need to develop. Just as credit unions’
intended markets and delivery systems are evolving, so must their
financial thinking. Capital options create the flexibility to serve
members in ways that may not be predictable today. Options are the
essence of deregulation, providing credit unions multiple paths
to the future.