Do Credit Unions Need Capital Options?

A number of events have pushed the capital issue to the front of the stage, including charter conversions, a dramatic growth in shares in the first six months of the year, and the evolving credit union business model. Find out why Chip thinks that the more important question is not, Do credit unions need more capital? but, Do credit unions need options for their capital strategies?


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.

The 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 billion.

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 risk.
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 strategies?”
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 three.

  1. 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 organizational performance.
  2. 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.
  3. 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’ lives.

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.




Nov. 19, 2001



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