Feb 13 2014

Credit Union Capital Adequacy: What's New and What's Next?

Report  
Number  
324

The global financial crisis has put reserve capital in the spotlight. North American credit unions weathered the crisis well, so now is an excellent time to standardize and streamline their net worth rules. Policymakers should respond accordingly.

A. Michael Andrews
Principal
A. Michael Andrews and Associates Limited
Report Number 324

Executive Summary

More capital in banks and credit unions might not have staved off the economic meltdown that began in 2007, but regulators around the world want to put more cushion between private balance sheets and public coffers. In the wake of the global financial crisis, policymakers in North America and Europe have focused intently on capital adequacy as a defense against future financial stress. 

The crisis itself has ramifications for the long-standing discussion over the appropriate capital treatment for credit unions, which have, by regulation and habit, usually relied only on retained earnings for regulatory capital. Credit unions in Canada and the United States need to track the changes, effective and proposed, and understand their implications.

What is the research about?

The timing is good for an update on alternative capital. The global recession proved that, by and large, the existing capital structure and risk-aware operations of credit unions were enough to weather the storm. It also showed that, unlike commercial banks, credit unions that were stressed by the downturn often had no choice but to shrink their balance sheets.

Credit unions’ long-standing inability to access alternative capital impairs their stability during times of stress and their ability to grow in both good and bad times. Michael Andrews outlines the mismatch between credit unions and investor-owned banks, with special attention to the implications of Basel III capital guidelines, prompt corrective action (PCA), and the challenges of maintaining member ownership in the face of outside capital.

What are the credit union implications?

The adoption of risk-weighted capital adequacy standards would put banks and credit unions on the same safety and soundness footing. Simple credit unions could stick with a leverage-only requirement, while those with more complicated balance sheets could opt for risk-weighted reporting.

For US lawmakers, the case to revise the current regime is compelling. Alternative capital would moderate draconian PCA requirements by providing an alternative to jacking up income or shrinking assets. The GAO concluded in 2004 that it was too early to recommend changes to credit union PCA, but the financial crisis showed that the risks posed by credit unions do not warrant more stringent PCA triggers.

The newly released US Final Capital Rule for banks should be a catalyst for capital reforms. An approach for credit unions that mirrors the Rule, and related Basel III requirements, would support a safer, more resilient credit union system. It is possible to balance member ownership with outside stakeholders. Credit unions would be safer and more flexible with additional access to capital. Policymakers need to respond accordingly.

This report is sponsored by Credit Union Central of Canada.