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As we move into 2015, the lingering question of risk-based capital hangs over credit unions. While there is still work to be done to finalize rules, it is inevitable that there will be RBC for credit unions. Directors and managers need to start their analysis of their businesses now rather than wait for the final rules to emerge.
As boards and managers consider the new role of capital in running their credit unions, they will quickly find that the “more is better” era of capital planning is ending. Going forward, credit unions will need to be more sophisticated in their planning, including having a deeper understanding of capital’s relationship with risk appetite and strategic planning.
Historically, discussions about capital within a credit union typically occurred in conjunction with a National Credit Union Administration exam or when a specific business issue arose. Otherwise, capital planning was just a review of the credit union’s capital levels against regulatory minimums. This review was typically divorced from discussions about how a credit union’s business strategy and its inherent risks, such as increased competition and flawed execution, would impact capital levels at the time of the discussion and in the future.
Going forward, RBC will require more attention from management and boards to tighten the link between target capital levels, business strategy and inherent risks, and make sure they are all aligned.
Impact of Risk-Based Capital
The fundamental question boards and management now need to answer is this: What is the right target capital level for our credit union ... and why? Today’s board room capital discussion needs to be about the logic of risk, earnings and growth of the credit union, as opposed to simply planning to stay above well-capitalized regulatory levels.
Cornerstone defines strategic capital as the credit union’s target capital level above the regulatory minimum to cover three areas: strategic growth, enterprise risk management, and balance sheet mix. The proactive management of strategic capital is now a critical conversation for credit union boards and management to have. And the outcome of the discussion will have a significant impact on the organization’s health and success in the future.
The whole idea of RBC is determining the level of capital that is commensurate with the organization’s risks. Credit unions generally do a good job with understanding the impact of credit, asset and liability risks, but these are only three of NCUA’s risk types. Credit unions need to start thinking about how their business strategies and products (and the risks) impact capital, as RBC makes clear: “One size does not fit all.”
For example, NCUA’s current proposal, which is being revisited, views business loans as riskier than consumer loans—thus requiring more capital. Under RBC, how fast a credit union looking at business lending as a growth engine can grow that business will now be more tied to how much capital it has/will need when compared to other growth opportunities. For example, what is the best balance between higher yielding/higher capital business opportunities and lower yielding/lower capital consumer lending opportunities?
Some credit unions that are significantly above net worth and well capitalized may think they have little to manage. However, under RBC, holding too much capital is considered detrimental to the credit union and the membership. The more capital a credit union holds against a business or asset, the greater the risk that growth of that business/asset class will actually dilute the CU’s capital levels. For example, even though a particular lending program might be profitable, growing assets (loans in portfolio) faster than capital will decrease a credit union’s capital ratio—that is, the ratio of capital to risk. (We’ll walk through an example.)
Three Parts to Strategic Capital
To get to the next level in capital planning, boards and management need to manage strategic capital. In the illustration below, determining that 6 percent strategic capital is the “right” number is based on a rigorous understanding and analysis of the capital above regulatory minimums that the particular credit union needs to cover strategic growth, enterprise risk management, and balance sheet mix.
Strategic capital covering strategic growth is how much contingency a credit union needs for investments that don’t come from its current and projected earnings stream. This includes such areas as mergers, channel investment, new business opportunities, and future strategic risks.
If mergers are a component of a credit union’s strategy, how much capital dilution from a merger is the CU willing to accept, and what is the acceptable capital payback period, understanding that capital formation at credit unions can only occur through earnings? The answers to these questions are key factors in defining an appropriate level of strategic capital for the credit union.
Continued electronic, branch and remote channel investments and their impact on capital growth cannot be sustained indefinitely. What investment allocations between channels (physical and virtual) does a credit union need to make to maintain the right level of capital? From a business mix perspective, what is the best balance between growth, value to members, and the need to ensure the long-term viability of the credit union?
Capital planning should also include a contingency for strategic disruptions, such as Apple Pay and Lending Club, which could materially impact future revenue streams, or a new revenue-impacting regulation targeting courtesy pay, interchange or mortgage banking fees.
The risk component of strategic capital planning incorporates such non-balance sheet risks as those associated with reputation, operations and regulations. While this is clearly more art than science, credit unions will need to assess the potential risk and impact of such extraordinary events as a data breach, internal fraud, or even an embarrassing situation regarding executive management.
More importantly, credit union board members need to ensure that their risk appetite is clearly defined and aligned with the CU’s target capital levels. If the risk appetite is moderate and there is too little or too much capital, that misalignment can impact growth and delivery of value to members.
Relatedly, many credit unions have implemented enterprise risk management programs, but these efforts and the related risk assessments have limited linkage to capital, often due to lack of data, analytics and/or maturity. Credit unions have good analytics in credit risk and asset/liability risk to estimate the probability of occurrence and impact of an occurrence (i.e., residual risk analysis). That same level of maturity and attention needs to be applied to other risk types to effectively define and manage capital impact.
Balance sheet mix is the third leg of strategic capital. As stated previously, too much capital can be detrimental. Let’s illustrate this through an example using NCUA’s current proposal. The Dupont model (a widely known cross-industry model that explains the trade-off between growth, profitability and capital) suggests there is a “speed limit” on how much growth a certain business can achieve before it dilutes capital.
The table below shows that if a credit union earns 0.8 percent return on assets and is at 16 percent RBC, the speed limit on home equity growth is 5 percent. If it grows 3 percent, it is adding to capital (+ 27 percent), but if it exceeds its speed limit by growing at 7 percent, it starts diluting capital (-11 percent). This illustrates a scenario where the rate of asset growth is faster than the capital growth rate—resulting in capital dilution as we discussed above.
While this is a simplified example and balance sheets are typically more complex, too much capital can have a negative impact on certain growth areas. If the target capital were lower, the speed limit would be higher. One other point: This assumes that all assets earn the same return. We know that is not true. So, if certain assets have a lower return and the CU has a high target capital, the speed limit is even lower. Conversely, if the CU has higher earning assets, its speed limit will go up.
How to Manage Strategic Capital
Remember how Goldilocks found the bears’ porridge too hot, too cold or just right? Credit unions are entering a “Goldilocks world, in which they will find that too little capital or too much capital can hurt them and their members. While the actual implementation of RBC regulation may not happen until 2016, decisions boards make now will have significant capital implications down the road.
Here are my suggested steps for boards and management that want to put in place good processes and mechanisms now for managing RBC and strategic capital into the future.
Your target capital level is unique to your institution and depends on your risk appetite. So, if you haven’t done so, define your risk appetite and get granular by risk type. Use this as a basis to determine a target capital level and incorporate it into your strategic planning efforts. (A generic capital goal of “greater than x percent” is not going to be good enough in an RBC “Goldilocks” world.)
If you are considering mergers, make sure “level of capital impact” and “payback” are clearly defined evaluation criteria.
Take a hard look at your channel spend and determine its sustainability, especially when taking into account other investment opportunities.
Develop more robust capital planning models to better understand the trade-offs between growth, capital and profitability, and incorporate these models into your planning and forecasting processes. (Using an Excel spreadsheet to do this is more than fine.) Review your profitability metrics (product, channel, member) and make sure they are robust enough to support decision-making.
Adhere to a robust strategic planning process that looks into the industry environment to assess competitive, regulatory and demographic shifts that could impact future revenue streams.
Ask management to ensure your financial systems and core vendors have the capability to develop RBC-related reports.
Enhance the maturity of your risk assessments by incorporating residual risk analysis, and review the data capture and analytics for loss/risk to identify gaps.
Vincent Hui is a senior director with Cornerstone Advisors, a CUES Supplier member and strategic provider based in Scottsdale, Ariz.
*On press day, NCUA published its new RBC proposal. Some of the numbers in the charts in this article would be different if this new proposal became rule. However, NCUA’s overall premise for RBC did not change.
