Record-setting test pilot Chuck Yeager said: “You don’t concentrate on risks. You concentrate on results. No risk is too great to prevent the necessary job from getting done.”
The credit union’s necessary job is providing financial services to its members. However, another necessary job is to produce a good return on your members’ capital, which not only supports a healthy institution, it ensures you can meet the first objective, which is to provide the best financial services possible.
Although credit unions are not-for-profit, in order to provide the high-quality services and products that members expect, you must produce beneficial returns and concentrate on profits. Since the crisis, we often see a division within the credit union community between profitable credit unions and those that have drifted along with negative, minimum, or no returns. The rationalization for the lack of earnings is, more often than not, the commonplace assertion of being “conservative”, thinking that by maintaining a capital ratio in the high teens, keeping a tight rein on loan underwriting or refusing to leverage capital to produce net interest income is the safe and riskless course of action.
Choosing the status-quo over well-managed risk isn’t safe or conservative, it’s risky. After all, credit unions are in the risk-leverage business. It has been shown that credit unions with flat or negative ROE lack the ability or are unwilling to effectively manage their capital base to produce profit. The lack of profit increases risk. Without profit, the ability to offer competitive rates is extinguished, magnifying a competitive disadvantage, which is also risky. Without profit, investment in the services that all members need today, such as technology, is impossible. This further increases the risk of membership loss to the competitors who can provide these essential financial tools. If you aren’t retaining or attracting new members – especially young ones – your future is bleak. And if you’re not producing and re-investing profits in these services, you’re not likely to attract and retain members.
It’s been more than 30 years since credit unions began moving away from double digit net worth ratios and leveraging their capital and assets, accessing non-member funding sources and borrowing from the FHLB to purchase revenue-generating loans and investments. This strategy isn’t rocket science or even a new concept, yet some react to this basic, essential financial strategy as if it’s radioactive, from another planet, while desperately clinging to elevated capital ratios like its safe, solid ground.
NCUA has a clear definition of “well-capitalized”. Maintaining a capital ratio significantly above this threshold does not make a credit union “super well-capitalized”, it simply means that the capital is not managed effectively for the benefit of the members. Prudent stewardship of assets doesn’t mean tucking member funds away into a capital account or cash and saving it only for a rainy day. That’s the equivalent of mattress stuffing and can only result in a slow and painful death for any financial institution.
It is easy to point out the small credit unions that lack critical asset size . Yes, small credit unions produce far less revenue than their larger, more complex peers. However, there are billion-dollar credit unions with cash and investment accounts that are larger than their loans outstanding. What good does that do members?
Attention to return on equity should be as equally scrutinized as the return on average assets. While a healthy ROAA can indicate that a credit union is creating a positive spread on assets, it does not indicate if the credit union is creating a reasonable return on their equity. ROAA doesn’t report if a credit union has too much capital and if the capital is managed effectively.
So why is it that many credit unions are unwilling to leverage their capital base? Is it low rates? While it’s true the low rate environment hasn’t produced high yields for the last decade, it has also meant that cost of funds has been next to nothing. The Federal Reserve raised rates twice last year and raised them again already this year. That makes the current cost of funds slightly higher than next to nothing. Credit unions tell their members that a low rate environment is the right time to borrow, but many of them don’t follow their own advice.
And then there is the myth that yields are so low, it’s not worth the effort to pursue additional net interest income. Absolutely not true. There are many asset choices available that can yield 100 basis points of net interest income or more without creating undue interest rate risk– and anytime you can clear 1%, its well above average. Compare that to the industry average return on average assets of 0.66%.
Additionally, low-income credit unions currently have authority to raise secondary capital, which can be used to thrive and grow. Now, the NCUA is now considering expanding that authority to include all healthy credit unions. This opportunity could provide a much-needed income boost to the entire credit union community, which could spur innovation and help credit unions not only compete with other financial services providers, it could transform financial services in a way that benefits consumers, not Wall Street.
However, in order to obtain this ability and make the most of it, credit union leaders must rise to the occasion. Bankers are already flooding the NCUA with comment letters that argue against secondary capital, because they know that restricting credit unions to capital management practices that have been outdated for decades will inhibit credit union growth and deprive credit union members of high quality financial products and services. Not only have the needs of members changed over the last 30 years, the financial markets have as well. Failure to seize this opportunity, embrace new strategies and concepts, will force credit unions to join encyclopedias, 5.25″ floppy discs and buggy whips in the annals of history.
Credit unions deserve the chance to utilize the tools and the financial practices that have benefited other depository and financial institutions. Credit unions have the right to serve members without the impedance of those within and outside the movement who endeavor to stifle their growth. Each credit union field of membership is unique and each credit union has unique needs. However, the mission to provide the best financial products and services to members is a mission inherent among all credit unions. Embracing this opportunity to enhance financial performance, access secondary capital and other regulatory relief actions that improve credit unions’ ability to generate profits and retained earnings is key to this noble endeavor. And this chance may not come around again.