The Cost to Members of Overcapitalization

The concept of an “overcapitalization bias” in the credit union system was the topic of yesterday’s post.

One comment from financial consultant Mike Higgins showed how to calculate the cost-that is money taken from members’ pockets.  Here is his analysis:

I’d like to bring some specific concerns to the table for discussion on raising credit union capital.
The proposed regulation establishes a phased-in 10% net worth floor.  We all know that credit unions will carry a buffer to avoid going below the floor – most likely in the 1.0% to 2.0% of assets range.  So, the new net worth standard from a practical basis will be 11.0% to 12.0%.
This creates a huge safety reserve, before any consideration for CECL.  Recall that loan loss reserve is effectively net worth too, just specifically earmarked to cover anticipated loan losses.
For perspective, there are 600 credit unions with assets greater than $400 million that have net worth below 11% as of the 3/31/2021 call report.  I specifically included credit unions greater than $400 million because they will have to prepare for the higher capital standards as they approach the $500 million threshold.
The current low interest rate environment is making it difficult to accrete capital via asset growth.  This fact must be considered as part of the discussion.
Any net worth requirement is a tax on asset growth.  Raising the net worth requirement increases the growth tax.  For example, a credit union growing 10% per year with an 8% net worth target must produce a ROA (profit taken from members) of 0.80% to maintain its net worth ratio.  If the net worth requirement increases to 11%, that same credit union must now produce a 1.10% ROA.
Credit unions that cannot produce the higher ROA to support the new net worth target will have their ability to grow and serve new members stifled.  It will also make it more difficult to invest in the cooperative to maintain market relevance.
In a perverse twist, credit unions may have to take more risk because of the proposed regulation to produce the higher ROA necessary to maintain net worth.
Ultimately, a higher net worth requirement harms the people credit unions are designed to serve.
I am genuinely concerned this regulation is a gift to the competition because it erodes the advantages credit unions currently hold in the marketplace.  The concept of evaluating risk to determine necessary reserves, especially in outlier situations, is important, but I agree with Chairman Hood, it should be used as a tool and not a rule.

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