Credit unions are constantly grappling with how much capital they should keep
on their books to mitigate unforeseen circumstances. According to the NCUA,
a seven percent net worth to asset ratio is considered "well capitalized"
and six percent is considered "adequately capitalized."(1) A closer
look, however, reveals that almost 96% of credit unions are in excess of the
seven percent threshold and two-thirds are above ten percent. Such high levels
of net worth beg the question, does a high capital balance benefit credit union
members and the institutions themselves?
Argument For a High Net Worth Ratio
The primary rationale for a high net worth ratio is to protect the credit union
against financial losses caused by unforeseen risks. These can include event
risks (e.g. natural disasters), operating risks (e.g. fraud), market risks (e.g.
unexpected interest rate changes), and credit risks. Hurricane Katrina is an
extreme example of event risk, but it illustrates the point that an adequate
amount of net worth should be retained to protect against unexpected occurrences.
There are other reasons to justify a high net worth ratio. Certain credit unions
that engage in specific "risky" lending practices may want to maintain
a higher net worth ratio. For example, business loans are considered more risky
than much of the loan portfolio. The average business loan has grown to almost
$146,000 and has higher loan loss rates than other consumer loans, which credit
unions must closely monitor.
Argument Against a High Net Worth Ratio
Many executives advocate that credit unions should maintain a lower net worth
Examples of how credit unions could use the excess capital include:
- Offering better loan rates to their members.
- Providing higher dividend rates on members' share accounts.
- Investing in technology that enhances the member experience.
- Issuing a one-time bonus dividend before a merger.
Credit unions that have a high net worth ratio also report a lower return on
equity (ROE) ratio. As of June 2005, credit unions with a net worth ratio above
10 percent had a ROE of 7.85 percent versus a ROE of 8.83 percent for credit
unions with a net worth ratio below 10 percent. According to John Dolan-Heitlinger,
CEO of Keys Federal Credit Union ($170 million in assets, Key West, Florida)
in an article he wrote in February on CreditUnions.com (view
this article), "in a competitive economy, capital flows to businesses
that can earn satisfactory returns on equity and away from businesses that cannot
maintain an adequate return." Credit unions could be setting themselves
up for slower growth rates as they become less competitive in relation to other
Regardless of asset size, credit unions are maintaining net worth ratios well
in excess of the NCUA's regulation. (see chart above). Assuming the definition
of "well capitalized" is sufficient, the argument against a high net
worth ratio holds that the credit union should find a more productive use of
the funds or give it back to the members.
(1) NCUA Rules & Regulations §702.106.