Optimizing Your Credit Union's Capital
If your credit union is like most, it probably has too much capital. Many credit unions go to exhaustive measures to save every nickel and dime, but then leave earnings on the table when they don't optimize their capital. Those credit unions may want to consider returning the excess capital. Or, they can use some of the strategies below to optimize their capital, and thus drive better returns back to their members. Banks have become more aggressive in attracting new deposits, while many credit unions often struggle to compete. Leveraging capital and using the additional earnings to pay members higher returns can help make your credit union more competitive. I recently attended a conference where an NCUA spokesperson noted the need for credit unions to more effectively balance growth and risk with the appropriate level of capital. To be tilted too much to either side is not effectively managing your balance sheet. He also noted that most credit unions fall into the net worth category of "well capitalized" and have room on their balance sheet for more novel ways of leveraging their capital. While there is no "one size fits all" approach, credit unions have several tools at their disposal to optimize their capital. 1. Borrow short-term and purchase a matched floating-rate investment. For example, borrow funds on a daily basis from a corporate or the FHLB and purchase a floating-rate investment such as an agency-issued CMO or a corporate credit union floater with a coupon that resets or "floats" monthly based on an index such as one-month LIBOR. The positive spread between the cost of funds on the short-term borrowings and the matched investment incrementally increases your income. While the investment in this example will require a maturity that is longer than the short-term borrowings, the effective duration on the investment remains short due to the frequency with which the coupon resets. 2. Borrow longer term and purchase a matched fixed-rate investment. Taking advantage of competitive rates on a term loan and a matched term investment will allow your credit union to lock in a spread for a set amount of time and eliminate the minimal amount of variability in earnings compared to floating-rate products. For example, an FHLB recently offered a 3-month special advance at 5.23% while many corporate credit unions were offering 3-month certificate rates at 5.39%. That's a 9 basis point spread or $2,219 of incremental revenue over 90 days on a $10 million trade for very minimal risk. Be careful to ensure that the funding and the investment have been converted to the same day count. 3. Borrow against your securities portfolio and purchase a short-term investment. Securities, such as agency callable bonds or CMOs, are good sources of collateral for borrowing in the capital markets. For example, credit unions with a portfolio of agency CMOs can lend their securities to a dealer on the "street" and receive cash. The credit union can then reinvest the proceeds in a short-term product with a matching maturity date that offers a positive spread versus the cost of funds. The transaction effectively leverages the balance sheet with minimal risk while increasing net income. Leveraging your capital in this manner will likely lower your credit union's ROA, since the spreads on the trades may not be as high as your current ROA level. However, these types of transactions can help managers strike the delicate balance between short-term and long-term needs of the credit union. The impact of managing your capital by borrowing and investing in matched products will help your credit union generate additional revenue that can be used to stay competitive and re-invest in infrastructure. In fact, a credit union manager with a higher ROA, but lower ROE than a comparable credit union, may actually not be as effective at managing its overall balance sheet as a credit union with a lower ROA but higher ROE. The table below illustrates this point. Assets
Assets after leverage $100,000,000
Earnings on leverage $0
ROA after leverage 1.00%
ROE after leverage 10.00%
Both credit unions have the same assets, capital and ROA before Credit Union B decides to add leverage. Assuming Credit Union B earns 10 basis points on its $10,000,000 of leverage, Credit Union B earns an additional $10,000. While Credit Union A's ROA is 8 basis points higher, Credit Union B's ROE is 10 basis points higher (and Credit Union B has additional earnings of $10,000). Credit Union B now has some great decisions to make for its members that are not available to Credit Union A--pay its members $10,000 more in returns or build $10,000 more in infrastructure. Credit unions should allocate time at each ALCO or finance committee meeting to discuss ways that they can more effectively optimize their capital to drive better returns back to their members. Let's face it--ROA doesn't pay for additional infrastructure or higher returns to members. Net income does.