The Critical Difference in Bank Capital Versus Credit Union Net Worth

At September 30, the credit union system’s net worth was  10%, or 300 basis points above the 7% well capitalized level.

Bank’s simple core capital ratio at June 30 is 8.83%.  But comparing these two ratios is extremely misleading.   For $1 of credit union reserves is much more valuable than $1 of bank capital.

Here’s why.

Credit union reserves (equity) is from retained earnings which is free in two senses of the term.  Unlike banks, credit unions pay no taxes on their earnings.  Whereas banks are subject to whatever their marginal tax rate is on each $1 of earnings.

As of June 30 banks pretax ROA was 1.67 for the first six months, but actual ROA was 1.31 after tax.   It takes a $1.27 of net income, on average, for a bank to add $1 to retained earnings.

For credit unions, every $1 of net income adds in full to reserves.  The same $1 in bank net income will, on average, convert to .78 cents of additional equity.

Banks have multiple sources of capital options.  Of the second quarter’s $55.3 billion increase in bank capital, 40% came from additional stock and 60% from retained earnings.

But simple share capital comes with a price and longer term expectation.   The price is whatever the dividend paying practice is for the bank. That is, the bank pays rent to use their owner’s capital.

At June 30, banks paid 51.9% of their earnings in dividends.  Credit unions have no such “dividend” requirement, so it is “free” or no cost, in this second meaning as well.

Moreover, bank owners expect to see the value of their shares appreciate over time, a factor easily monitored by the daily stock price.  Or through comparisons with multiple bank stock indices.

If a bank’s stock price falls below these industry indicators over time, investors can sell, sometimes to owners who will seek better returns or new management.

False Comparisons

So when anyone starts to equate credit union reserve levels with bank capital ratios as an industry standard applicable to all, it is a false comparison.

The purpose of cooperative design is to provide financial services in the member’s best interest.   One of the advantages credit unions have meeting this goal is that there is no conflict between the returns to owners and the benefits offered consumers.  They are one and the same.   In banking this tradeoff occurs continuously.

Credit union’s capital advantages versus banks are real and measurable.  False comparisons not only mislead credit unions and the public; but it has the paradoxical consequence of causing some to lament the absence of capital options used by banks.

What these advocates miss is the costs of these alternatives and the tensions in allocating income between the returns required by capital providers and consumer benefit.

The Ultimate Advantage

Credit union’s simple leverage ratio has worked as an all-sufficient measure of capital adequacy for over 110 years.  But its most conclusive advantage noted by one observer is something more: “It’s the genius of simplicity. Any fool can get complicated.”