California has 455 CUs with assets of $126.8 billion as of the end of 2009. California is therefore a good microcosm of all CUs. California CUs have total capital at Dec. 31, 2009 of $11.47 billion for an average net worth ratio of 9.04%. California CUs are growing, adding over 500,000 new members in the last three years. The question is whether California CUs, or in fact any CU in the United States, needs alternative capital. The easy answer is yes. Is there a better way to manage the capital that already exists in the CU system?
In the aggregate, analysis shows that there is sufficient capital to fund additional asset and member growth. The NCUA defines a 7% capital ratio as well-capitalized. In aggregate, California CU's current capital would support assets of $163.8 billion at a 7% capital ratio. California CUs could grow another $37 billion, or about 29%, from current assets levels without adding any more capital. That means there is enough surplus capital to support five years of asset growth given the rate of growth over the past five years.
It is fair to say that in aggregate we have enough capital. So where is the problem?
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The problem is the allocation of capital. Capital in the CU system is essentially at zero cost, which increases the chances it is wasted. There is no external pressure to justify the returns that capital is earning. The CU system gives boards and management complete control of capital without any real accountability for how capital is used. This may be why CU capital earns low returns and is not put to its best use. Some believe that CUs have low returns on capital because the CU returns so much to the members. CU members must be ungrateful because many California CUs have low returns on capital and are losing members. In fact returns on capital and member growth appear to be positively correlated. I believe economic returns are the best measure of how well capital is being used. I also believe member growth is a very good measure of member satisfaction.
The 242 California CUs with less than $50 million in assets have the highest capital level, 11.20%, but in aggregate have lost over 20,000 members in the last three years and have a lower return on capital than mid-sized ($50 million to $500 million in assets) or large sized CUs over $500 million in assets. The 146 midsized CUs have the next highest level of capital, 9.36%, but have in aggregate lost over 43,000 members in the last three years and have only a slightly higher return on capital than the smaller asset size CUs.
The large CUs, over $500 million, represent 15% of all California CUs but have 88% of the assets. Their combined capital ratio of 8.87% is the lowest capital ratio of the three tiers of California CUs. The large CUs have the least capital capacity to support future growth. Ironically this group grew by 506,109 members over the last five years. The large size CUs are growing members while the small- and mid-sized CUs are losing members in the aggregate. The large CUs have the lowest operating expense ratio to average assets (2.58%) and they spend on average more per member than the other CUs. The large CUs on average are more efficient and at the same time provide more resources per member than the other CUs. The large CUs also have the highest, although still low, return on equity of 14.16% over the last five years. They also have the highest five year asset growth ratio of 36.22% (asset growth may be inflated by mergers). Assets are growing faster than capital. The large CUs are clearly the group of CUs that needs more capital. They are also the CUs that in aggregate are earning the highest rate on the capital that is employed. A dollar of capital in the large CUs is earning nearly four times more than mid-sized CUs and 14 times more in small CUs.
It is unlikely that there will be alternative capital any time soon. Therefore, it appears that the NCUA should consider changes that will improve the use of capital in the CU system.
The NCUA should consider adopting is prompt and corrective action with regard to underperforming CUs. Prompt corrective action reduces losses and improves the overall performance of CUs. A key lesson from the savings and loan crisis was that lax enforcement allowed bad S&Ls with irrational pricing to force good S&Ls to compete on the same irrational basis. The NCUA does not conserve a CU unless capital to assets reaches 2% or less. The NCUA should conserve CUs when they reach 4% capital to asset ratios. The current policy wastes CU capital and allows bad CUs with irrational pricing to compete with good CUs.
The NCUA should consider member service and member satisfaction a key indicator of future financial health by adding an S to CAMEL. Member service is a leading indicator of future financial viability and therefore of safety and soundness. CUs should be required to measure member satisfaction and NCUA should consider member satisfaction levels in the examination.
Almost all CU mergers are due to the distressed condition of the merging CU. There should be more mergers of healthy CUs to improve the returns on capital and help increase overall capital levels. In most cases, members would support a merger if they realized the benefits. Most CU boards do not make members aware of bona fide merger offers. Members elect the board to represent members. I do not advocate that boards must make members aware of merger offers. However the NCUA should consider whether boards have conducted reasonable due diligence on merger offers as part of the examination. Mergers of two healthy CUs would improve capital ratios.
CUs with declining membership, low returns on capital, under two services per member, low member satisfaction levels and low asset growth should be asked to present a growth restoration plan. It is axiomatic that you either grow or die. The NCUA requires capital restoration plans-they should also require growth restoration plans for shrinking CUs.
Henry Wirz
CEO
SAFE CU
North Highlands, Calif.
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