Credit union board members and employees are likely to measure their credit union using two metrics: asset size and capital ratio. For the former, bigger is always better; for the latter, there is a range of thought on what constitutes a reasonable capital level. Most credit unions have a general preference for more capital in the service of safety and soundness.
We wanted to know whether the “more capital is better”preference has led to U.S. credit unions holding too much capital. The result is a newly released study by William E. Jackson III, Professor of Finance at the University of Alabama, and a Filene Research Fellow. In Is the U.S. Credit Union Industry Overcapitalized? An Empirical Examination, Jackson addresses two fundamental questions: Was the capitalization rate in 1990 reasonable given the risk profile of the credit union industry? And has the risk profile of the credit union industry increased to such an extent as to warrant an increase in capitalization to current levels?
Jackson reports that the capital level of the U.S. credit union industry stood at 11.6% at the end of 2006, more than four percentage points higher than the legislatively mandated level of Well Capitalized and exactly four percentage points higher than U.S. credit union capital in 1990. Before making his conclusions, Jackson studied and analyzed the data. He concluded that the industry capitalization rate in 1990 was reasonable and perhaps a bit too high; and that the credit union industry in 2006 was less risky than it was in 1990.
These answers, coupled with an analysis of credit union regulatory capital regime and a comparison of credit union and bank capital requirements, lead Jackson to state that U.S. credit unions are “overcapitalized by an amount in the 30% – 40% range.” Translated into dollars, U.S. credit unions are overcapitalized between $8.8 billion and $11.7 billion.
Listen to an exclusive interivew with Professor Jackson below:
Comments
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I have just read the hard copy version of this report and it is outstanding! However, there seems to be a material inconsistency between a statement in the Executive Summary and Commentary and the details of the report. At the top of page x (roman numeral) of the Executive Summary, the conclusion is that US credit unions are overcapitalized between $8.8 and $11.7 billion. However, page 2 of the report, near the bottom of the page, indicates that the overcapitalization dollar amount is $29.3 billion. Based on the evidence in the full report, it looks like the figure on page 2 is correct. In doing some quick calculations, I’m guessing that while preparing the Executive Summary, somebody took $29.3 billion and then multiplied it by the lower and upper end of the overcapitalization rate range, 30% and 40%, to come up with $8.8 and $11.7 billion, respectively. However that rangea was already considered in deriving the $29.3 billion figure, as it resulted from the conclusion that at least 4.0% of the 11.6% in CU capitalization is excess and 4.0/11.6 = 34.5%. Therefore, the $8.8-$11.7 figures seems to represent an erroneous duplication of the application of those rates.
The reason I’ve gone into such detail on this matter is not to be critical, but rather because this truly is an otherwise exceptional report that I would love to share with my Board of Directors and management group. Therefore, if my analysis is incorrect, I would like to be set straight before going forward.
However, in either case, the gerenal conclusion that credit unions are tremendously overcapitalized seems indisputable.
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Thanks for your comments Wally. We asked our author, Will Jackson, to respond to your comments.
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Mr. Murray is absolutely correct. $29 billion is the correct overcapitalization number. For a 30% to 40% range the numbers would be about $25 billion to $33 billion.
Thank you again for your important comments.
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As I read Professor Jackson’s recent Filene research paper on credit union capital I couldn’t help but wonder what conclusions might be different if the selected base line of 1990 had been, say 1980 when the Carter year’s inflation peaked.
I all too well remember the effects of the 1969-82 inflation (and misery index) rates had on individuals, credit unions, the Savings & Loan mess and so forth. At one point I was paying 21% interest on a mortgage and watching all sorts of defaults happening all around, including very large credit union and bank bad debt write-off’s. The cu was paying greater interest rates while losing large sums on the fixed return investment portfolio, a most unpleasant situation indeed.
If today’s GAAP mark-to-market portfolio requirements were in effect during that same period many, many more credit unions and banks would have been showing deficit capital and would have been placed in the hands of the receivers. It was not a fun time for volunteers or management alike in cu’s or other financial institutions as huge losses were apparent in the fixed retrurn investments, be it mortgages or governments, if liquidated.
Can’t happen again? I don’t believe that for a milli-second. At the worst of the Carter inflation years we experienced a 13 percentage point rise in 13 months! That was a lot for the US, but something that other countries have experienced sufficiently often that we should study what happens to them. At our cu we test what would happen to our member’s capital if we were to again experience a 13/13 event, rather than rely on lesser stress testing. Stewardship occasionally requires some seemingly out-of-the-mainstream decisions and maintaing a sound capital base that can withstand a reoccurrance of a 13/13 event is one. That capital base we hope will enable us to scramble to cope with the unexpected and unplanned-for events, all the while ensuring that we will be able to maintain sufficient sound capital that our cu will continue to exist and thrive, as is our responsibility to our member/owners.
Does the capital ‘belong’the current member/owners? Not unless one believes that the capital of a for-profit corporation ‘belongs’ to the stockholders. In the cu the accumulation of the capital reaches back to the earliest beginnings when those long dead members made their initial deposits. It has changed over time as the net result of the interactions of a mini-slice of each and every transaction ever entered into, deposits, loans, charge-offs, bricks and mortor additions, etc. Is it all cash? No, but some portion of the capital account is earning returns for the benefit of the member/owners.
What’s the role of our capital? In my view our capital is the first-line insurance defense that will enable the cu to survive as an entity, not being taken over by the regulators. The NCUIF insurance is the second-line defense as it protects the member/owners accounts, but not the entity of the credit union, it’s employees and volunteers, nor members accounts in excess of the NCUIF limits. It will be interesting to observe the effect of the sub-prime mortgage mess on cu capital accounts and attitudes about capital levels, as it plays out over the next few years. Let’s hope the cu industry doesn’t need the infusions of cash some other financial institutions have recently needed!
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If today’s GAAP mark-to-market portfolio requirements were in effect during that same period many, many more credit unions and banks would have been showing deficit capital and would have been placed in the hands of the receivers. It was not a fun time for volunteers or management alike in cu’s or other financial institutions as huge losses were apparent in the fixed retrurn investments, be it mortgages or governments, if liquidated.
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within the netherlands we were afraid of the negative side effects of this overcapitalization. Till now the bigggest problem is the low dollar. Real issues we did not have yet fortunately. But the problem isnt gone yet!
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Indeed fellow Americans please do something about the low dollar.
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At the moment they need the low dolar to support there credit situation. It is there policy at the moment. They will see the problem with there policy at the fuel pump.
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I think we have to be patient. The US is going to be allright!
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I’m scared about the concequences, what do we do if this continues?
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Really nice written
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Just hang in there guys. Everything will turn out just fine.
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Mr. Murray, I’m curious to see what you think about over capitalization now that you are faced with a reduction in capital and ROA. Over capitalized not-for-profit credit unions don’t chase after taxpayer-paid based TARP funds.
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I n the early eighties, Credit Union National Association formed a committee to study capitalization. The Committee’s report cited that CUs 30+-years ago maintained higher capital ratios than other institutions on average. The Committee’s conclusion was for CUs to maintain a capital (net worth ratio) of 8 – 12%. In the years since, as a, director, CEO and consultant, I believe that range holds up. The recent Filene study says much to support that range. Regulators will continue to want more, and that’s a big reason why CUs maintain above 10%. In my experience, the typical CU balance sheet requires a range of 7 – 8%. When adopting a strategy that increases risk (e.g. indirect lending, risk-rated lending, payday loans, exotic investments), the target needs to be higher for that CU. The reasons for CUs in general to hold more are the external events, the unknowns that can drain almost any amount of net worth. CUs do their members a disservice by just setting a target based on the industry averages and not taking their own unique risks into account. Better is to combine internal and external risks to set a thoughtful individual target.
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Yes i think the US Credit Union Industry is Overcapitalized
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Enough capital? There’s never enough.
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