An important part of the risk-based capital discussion is missing: human capital. As presented, the debate revolves around a ratio calculated by using adjusted accounting entries for net worth divided by assets with weightings based on relative riskiness. This complex calculation creates a single number that suggests a cooperative’s position is acceptable only if the result exceeds 10.50%.
But is capital management, or even the concept of capital calculated in this manner, meaningful? Or as an assessment of risk, is the ratio merely a license to continue operating the credit union with minimal regulatory bother?
Founded With No Capital
When credit unions are founded, they have no financial capital, thus their risk-based net worth is at or near zero. They only have the drive and desire of people who want to work together in the spirit of mutual self-help. Is capital that critical to success? If so, why is it not required at the opening of every credit union operating today?
At the other extreme, many credit unions have a risk-based capital ratio that exceeds even what NCUA’s unmodified rule would require. And more than 1,669 credit unions report a simple leverage ratio in excess of 15% at year-end; that's double the 7% well-capitalized level.
Financial capital, as measured by ratios, is desirable and useful, but not necessarily sufficient or even necessary. Capital includes more than money or excess reserves. In fact, the most critical component of capital for a cooperative is human capital.
Human Capital: The Dominant Economic Input
Along with physical and financial resources, every economic model includes human capital, or labor, as one of the inputs when creating a firm or economy. Almost 70% of the total capital of the U.S. economy is accounted for by the skills and knowledge embodied in the workforce. This number closely relates to the credit union’s actual expenses where, on average, 50% of operating expenses goes toward salaries and benefits. Another 10% goes toward office operations necessary for member interactions.
It isn’t the amount of reserves that make a credit union successful; it's how the credit union aggregates then redeploys its resources in the form of loans, investments, fixed assets, and services. This human oversight of a business strategy is what creates the value that retains members and differentiates a credit union from other financial institutions. The contribution, or labor input, by the credit union’s leadership and staff converts the inert potential of financial capital into services member-owners will support via ongoing relationships.
Credit unions can accomplish this transformation by labor without an advantage in capital resources. In fact, an excess of financial capital as shown by a high capital asset ratio might indicate a business model that is ineffective at using member resources. That’s because, in such a situation, excess financial capital is not compensation for relative risk; instead, it is serving as a substitute for uninspired leadership.
The Critical Advantage: Cooperatives Investing In Human Capital
The cooperative focus on human capital management has two components. First, there is member empowerment. A credit union’s primary purpose is to invest in members’ success primarily through loans that enable them to achieve personal goals such as education, housing, transportation, or leisure. The credit union’s goal is to be the member-owners’ financial partner in lifelong relationships, able to meet needs at every stage of a person’s life.
The second aspect of human capital management is continuous reinvestment into system talent and network solutions. This model not only pays forward all of the institutional wealth such as reserves and physical resources to benefit future generations of members but also encourages systemwide collaborative investments to augment each credit union’s individual capabilities. These system resources leverage each employee’s capabilities and expand options for member benefit beyond any individual firm’s reach.
A Narrow Focus: Risk-Based Capital Undermines Cooperative Competencies
By focusing solely on a balance sheet financial ratio as an indicator of viability, the risk-based capital approach skews thinking by not taking into account the critical factors of human capital in cooperative success. Such a regulatory focus can also distort analysis when a credit union’s ratios don’t meet certain thresholds. Regulators prioritize short-term financial outcomes versus sustaining viable member-owner relationships, which are the foundation of every credit union’s soundness.
Cooperatives are different by design. They prioritize human capital, member-ownership, as their sole reason for existence. Banks start with financial capital and then focus on earning an above-average return on that capital. The cooperative model has succeeded throughout every phase of the national economic cycle and in circumstances where other models fail. Risk-based capital should be a tool, not a rule. The tool should help inform a credit union’s decision-making, not be the primary yardstick of successful performance.