Businessman watering growth chart plant Source: Shutterstock

|

Capital is the lifeblood of a credit union, providing a cushionfor anticipated and unidentified losses, a base for future growthand a means to meet competitive pressures as they arise. As ageneral rule, the greater the uncertainty a credit union faces, themore capital it should maintain. A strong capital position providesa credit union additional flexibility to manage risk and respond tofuture uncertainties such as asset losses, sponsor layoffs andadverse economic cycles.

|

The most basic test of a credit union's capitalization is thenet worth ratio, which measures an institution's retained earningsas a percentage of its total assets. As the COVID-19 pandemicarrived, credit unions found themselves very well capitalized. At11.38%, the nation's 5,349 credit unions ended 2019 with one of theindustry's highest average net worth ratios ever recorded, havingadded more than 150 bps to the ratio since the 2009 trough(9.87%).

|

The challenges in response to the coronavirus episode, however,are likely to be as difficult as credit unions have confronted.And, as they navigate unprecedented effects on provisions for loanand lease losses in the short-to-medium term, credit unions wouldbe wise to examine the ongoing pressures that are likely to bebrought on their capital stock. The balance of this articlehighlights three specific headwinds to capital that credit unionsare likely to confront in the months and years ahead.

|

The first headwind on capital stems from the potential forincreased deposit inflows in the shorter term – a typical responseto periods of market volatility. These flows can threaten net worthratios by ballooning the ratio's denominator, total assets, beforethe money can be put to an efficient use. The second challenge –the extension of additional credit and the loan forgivenessencouraged by the regulators in response to the pandemic – islikely to compromise credit union earnings over time. Finally, thethird potential drain on capital can be found in the existingunfunded commitments of credit unions, as struggling members aremore likely to draw on these lines in uncertain times.

|

Together, all three of these possibilities speak to the need toconsider an additional capital cushion.

Deposit Inflows Can Stress Capital Ratios

In recent days, deposits have poured into the largest U.S.banks, as consumers and corporate clients seek shelter from theeconomic toll of the coronavirus pandemic. For example, deposits atdomestically chartered commercial banks rose by a dramatic 42.5% inMarch, according to Federal Reserve data. While the intra-quartercredit union data are more difficult to come by, there is no reasonto believe their experience is dissimilar. Anecdotally, our clientshave certainly reported a pickup in member deposits coming in thedoor and expect more significant inflows as the Economic ImpactPayments are credited.

|

It is not uncommon to see a flight to quality in response to thetype of market upheaval we have witnessed over the past two months.In a whirlwind, the federal insurance on deposits up to $250,000,available at both banks and credit unions, offers a certainstability. Credit unions have witnessed this trend before. Forexample, as the financial crisis took hold a decade ago, theindustry was deluged with share growth at unprecedented levels, asmembers consolidated investments. Industrywide, the fund inflowsresulted in asset growth outpacing the ability to grow net worth,driving the industry's average net worth ratio down 1.49% to 9.87%by in the two years ending in 2009.

|

Share growth chart Source:Callahan & Associates
Net worth/assets chart Source:Callahan & Associates

The Regulatory Response to COVID-19 Can Stress CapitalCushions

Three days after President Trump declared the coronaviruspandemic a national emergency, NCUA Chairman Rodney Hood respondedwith a letter to credit unions observing that "[a] credit union'sefforts to work with members in communities under stress maycontribute to the strength and recovery of these communities." TheNCUA encouraged specific member accommodations, including feewaivers, the easing of credit terms, increased borrowing limits andloan modifications to ease pressure on borrowers.

|

These emergency measures are designed to help people avoidpotential economic catastrophe and make good long-term businesssense, and are in keeping with the credit union spirit of "peoplehelping people."

|

The Federal Reserve echoed these sentiments on April 1, notingthat "financial institutions have more than doubled their capitaland liquidity levels over the past decade and are encouraged to usethat strength to support households and businesses." But, theaccommodations the regulators seek will present significantchallenges to both liquidity and capital.

|

Writing new loans during emergency circumstances – where thenormal operations of the credit union have been interrupted, thetypical borrower is in distress and the regulator is encouragingthe extension of credit – does not suggest the most prudentunderwriting standards. And, maintaining the appropriate level ofliquidity with atypical deposit flows and unnatural loan demandwill challenge even the most well-run credit unions. Regardless,the combination of processing emergency loans and modifyingexisting loans will put pressure on credit union earnings with thepassage of time.

|

Thankfully, credit unions are in a desirable place from which todefend these mounting challenges, with profitability near all-timehighs. Return on Assets, for example, has been creeping up steadilyin the industry since 2009, with the 0.93% at year-end 2019 just atouch lower than the decade's high reached in the quarter earlier.Net interest margin has also been increasing since 2013.

Unfunded Commitments

In this environment, credit unions should also keep an eye onunfunded commitments as a percentage of total assets. The thoughthere is that distressed members might be more likely to pull downon committed lines in these uncertain times. Such actions couldstrain the liquidity (and ultimately the capital) of a creditunion. Looking at all credit unions, in 2019 the average unfundedcommitment to total assets ratio is a modest 17%. There are,however, 24 credit unions with unfunded commitments representingmore than 40% of assets, 57 credit unions with unfunded commitmentsrepresenting more than 33% of assets and 201 credit unions withunfunded commitments representing more than 25% of assets,respectively.

Secondary Capital

If the coronavirus pandemic and the related responses result inthe depletion of capital that historical norms suggest, additionalsources of capital will be in high demand. Such additional capitalaffords credit unions the flexibility to dispense the appropriateaccommodations for members displaced by this event whilemaintaining safety and soundness. The NCUA's recent subordinateddebt proposal, if it comes on board, should help those deemed"complex credit unions." Fortunately, low-income designated creditunions do not have to wait so long, as there is a solution alreadyavailable today.

|

Since 1996, low-income credit unions (LICUs) have been permittedto accept secondary capital. Secondary capital provides a boost tonet worth and opens options to expand loan portfolios, assets andservices, allowing LICUs to stimulate the economies of thelow-income communities in which they operate.

|

As of Dec. 31, 2019, more than 48.9% of all credit unions held alow-income designation. Yet, only 68 LICUs employed secondarycapital. With all the uncertainty and the desire to assist membersreeling from the pandemic and its fallout, we expect this number togrow steadily. In the age of COVID-19, additional capital soundslike an awfully good idea.

|

Mike Macchiarola MikeMacchiarola

|

Michael Macchiarola is CEO of Olden Lane, a financialservices firm based in Chatham, N.J.

Complete your profile to continue reading and get FREE access to CUTimes.com, part of your ALM digital membership.

  • Critical CUTimes.com information including comprehensive product and service provider listings via the Marketplace Directory, CU Careers, resources from industry leaders, webcasts, and breaking news, analysis and more with our informative Newsletters.
  • Exclusive discounts on ALM and CU Times events.
  • Access to other award-winning ALM websites including Law.com and GlobeSt.com.
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.