BY STACEY WILKERSON
What is the most efficient way to utilize your credit union’s capital? CUB’s Currency expert examines the question from a mathematical perspective to get to its root. Read on to uncover the heart of thorough capital management with a breakdown of how to optimize capital in your CU.
Like all financial institutions, credit unions are faced with balancing regulatory dual capital mandates; therefore, allocating capital efficiently is at the heart of thorough capital management. Even though allowance for loan losses and provisions held on a credit union’s balance sheet should adequately cover expected losses caused by normal operating conditions, capital is available to absorb any additional expected or unexpected losses. Capital also promotes member and regulatory confidence that the credit union can survive. In addition, it provides benefits to its members by assuring the strength to engage in new product/service initiatives. Overall, capital is essential to reduce systemic risk and protect members as well as the NCUSIF and Excess Share Insurance Fund (in applicable states).
If capital is so important, why don’t institutions hold large amounts of capital on their balance sheets?
It might be fair to say regulators would like credit unions to hold heavy amounts of capital because doing so moves their put option farther away from impacting the deposit insurance funds. It merely transfers some of the risk from the government to credit union owners. Members, on the other hand, want their credit unions to hold less capital to leverage profitability. In the end, holding excess capital can be expensive if not deployed timely and efficiently. A credit union holding excess capital must take on incremental risk to increase earnings, all else equal, to generate the same return on equity.
Regulatory capital requirements were established to safeguard the stability of the financial system and ensure that institutions don’t engage in excess leverage, which could cause an ultimate insolvency. Currently, all financial institutions, including credit unions, operate under a dual capital mandate: regulatory capital limits and risk-based capital (RBC). The BASEL Committee implemented minimum tier capital and leverage ratio limits. Tier 1 is the core capital, such as retained earnings and shareholder common stock. Tier 2 includes loan loss reserves, subordinated debt and general provisions.