Is the U.S. Credit Union Industry Overcapitalized? An Empirical Examination
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978-1-932795-25-7
An Empirical Examination
Is the U.S. Credit Union Industry Overcapitalized?
Is the U.S. Credit Union
Industry Overcapitalized?
An Empirical Examination
William E. Jackson III, PhD
ideas grow here
Professor of Finance, Professor of Management, and the
Smith Foundation Chair of Business Integrity
PO Box 2998
Madison, WI 53701-2998 Culverhouse College of Commerce
Phone (608) 231-8550 University of Alabama
PUBLICATION #144 (11/07)
www.filene.org ISBN 978-1-932795-25-7Is the U.S. Credit Union Industry Overcapitalized? An Empirical Examination William E. Jackson III, PhD Professor of Finance, Professor of Management, and the Smith Foundation Chair of Business Integrity Culverhouse College of Commerce University of Alabama
Copyright © 2007 by Filene Research Institute. All rights reserved.
ISBN 978-1-932795-25-7
Printed in U.S.A.
iiFilene Research Institute
Deeply embedded in the credit union tradition is an ongoing
search for better ways to understand and serve credit union
members. Open inquiry, the free flow of ideas, and debate are
essential parts of the true democratic process.
The Filene Research Institute is a 501(c)(3) not-for-profit
research organization dedicated to scientific and thoughtful
analysis about issues affecting the future of consumer finance.
Through independent research and innovation programs the
Institute examines issues vital to the future of credit unions.
Ideas grow through thoughtful and scientific analysis of top-
priority consumer, public policy, and credit union competitive
issues. Researchers are given considerable latitude in their
exploration and studies of these high-priority issues.
The Institute is governed by an Administrative Board made up
of the credit union industry’s top leaders. Research topics and
priorities are set by the Research Council, a select group of
credit union CEOs, and the Filene Research Fellows, a blue
ribbon panel of academic experts. Innovation programs are
Progress is the constant developed in part by Filene i3, an assembly of credit union
replacing of the best there is
executives screened for entrepreneurial competencies.
with something still better!
— Edward A. Filene The name of the Institute honors Edward A. Filene, the “father
of the U.S. credit union movement.” Filene was an innovative
leader who relied on insightful research and analysis when
encouraging credit union development.
Since its founding in 1989, the Institute has worked with over
one hundred academic institutions and published hundreds of
research studies. The entire research library is available online at
www.filene.org.
iiiAcknowledgments
I offer my deepest appreciation to George Hofheimer of the Filene
Research Institute and Michael Schenk of CUNA for providing very
valuable comments and suggestions. Their input greatly improved the
overall quality of this report. Any errors or omissions are my own.
vTable of Contents
Executive Summary and Commentary ix
About the Author xi
Chapter 1 Introduction 1
Chapter 2 Was the Credit Union Industry Adequately
Capitalized in 1990? 5
Chapter 3 Did the Risk Profile of the Credit Union
Industry Increase Significantly from 1990
to 2006? 9
Chapter 4 Review of Legislated Capital Requirements
and Prompt Corrective Action for Credit
Unions 21
Chapter 5 A Comparison of Credit Union and
Commercial Bank Capital Requirements 25
Chapter 6 Review of the NCUA’s PCA Proposal for
Reform of March 2005 31
Chapter 7 Conclusion 35
References 39
viiExecutive Summary and Commentary
By George A. Hofheimer, In the movie Caddyshack, Chevy Chase and Ted Knight engage in
Chief Research Officer one of the wittiest dialogues I can recall in the world of cinema. It
goes something like this:
Judge Smails (played by Ted Knight): Ty, what did you shoot today?
Ty Webb (played by Chevy Chase): Oh, Judge, I don’t keep score.
Judge Smails: Then how do you measure yourself with other golfers?
Ty Webb: By height.
Credit unions gauge themselves in a similarly peculiar manner. At
your next credit union conference you may notice board members
and employees alike sizing up their credit union using two measure-
ments: asset size and capital ratio. For the former, bigger is always
better; for the latter, there is a range of thought on what constitutes
a good capital level. Most credit unions tend to believe their capital
level is appropriate, with a general preference for more capital in case
of the proverbial rainy day. The Filene Research Institute was curi-
ous to know whether the “more capital is better” preference has led
to U.S. credit unions holding too much capital. William Jackson,
professor of finance, management, and ethics at the University of
Alabama, meticulously answers the question, Are U.S. credit unions
overcapitalized?
What Did the Researcher Discover?
Jackson reports that the capital level of the U.S. credit union indus-
try stood at 11.6% at the end of 2006, more than four percentage
points higher than the legislatively mandated level of Well Capi-
talized and exactly four percentage points higher than U.S. credit
unions’ capital ratio in 1990. Looking at these figures, most analysts
would conclude that credit unions are overcapitalized today. But
before any concrete conclusions can be made, this nuanced subject
must be studied and analyzed. Jackson’s research approach, therefore,
asks two critical questions:
• Was the capitalization rate in 1990 reasonable given the risk
profile of the credit union industry? Jackson concludes the rate was
reasonable and perhaps a bit too high.
• Has the risk profile of the credit union industry increased to such
an extent to warrant an increase in capitalization from 7.6% to
11.6%? Jackson concludes the credit union industry in 2006 was less
risky than it was in 1990.
The answers to these questions, coupled with a thorough analysis of
credit unions’ regulatory capital regime and a comparison of credit
ixunion and bank capital requirements, lead Jackson to conclude that
U.S. credit unions are “overcapitalized by an amount in the 30%–
40% range.” If you translate this assertion into real dollars, Jackson
contends that U.S. credit unions are overcapitalized between $8.8
billion (B) and $11.7B.
Practical Implications
The dramatic conclusions from this research on overcapitalization
may cause a great deal of debate across the credit union industry.
This report calls attention to important issues. Credit unions are in
the business of helping people. What benefit accrues to members
when their credit union holds on to excessive levels of capital? Credit
unions need to balance their efforts to achieve safety and soundness
with efforts to put their capital to its best use. While credit unions
have done a superb job in the distant and recent past serving the
financial needs of consumers, the future success of the industry holds
a host of challenges. To meet these challenges, credit unions need
capital to invest in new delivery channels, technology, innovative
products, talent development, collaborative strategies, marketing,
and many other capital-intensive activities. According to Jackson’s
assessment, almost all credit unions are overcapitalized to some
degree. Therefore, the most practical thing you can do after read-
ing this report and sharing it with your management/board team is
to have an honest discussion about the most appropriate balance of
safety and soundness vs. reinvestment in the credit union vis-à-vis
your institution’s capital.
Credit union capital is emblematic of the historical legacy of member
involvement and usage. The accrual of such a storehouse of capital
over the years represents a raging economic success story; however, as
credit unions move forward, an honest debate must ensue about the
most appropriate use of this accumulated goodwill.
xAbout the Author
William E. Jackson III, PhD
William E. Jackson III holds the appointments of professor of finance,
professor of management, and the Smith Foundation Endowed Chair
of Business Integrity in the Culverhouse College of Commerce at the
University of Alabama. Before joining the faculty at the University of
Alabama, Dr. Jackson was a financial economist and associate policy
advisor in the research department at the Federal Reserve Bank of
Atlanta. At the Atlanta Fed, Dr. Jackson conducted original research
on financial markets and financial institutions. He was also an advisor
to the bank on the making of monetary policy in the United States.
Previous to his position at the Atlanta Fed, Dr. Jackson was an associate
professor of finance at the Kenan-Flagler Business School of the Univer-
sity of North Carolina at Chapel Hill. His academic areas of expertise
are financial intermediation and industrial economics. Dr. Jackson’s
research focuses on the role financial markets and financial institutions
play in making the modern economy more efficient and productive.
Specific areas of research include corporate governance, business ethics,
entrepreneurial finance, monetary policy and macroeconomics, indus-
trial economics, financial markets and institutions, corporate finance,
financial literacy, and public policy.
Dr. Jackson earned his BA in economics and applied mathematics at
Centre College, his MBA in finance at Stanford University, and his
PhD in economics at the University of Chicago.
Dr. Jackson’s research has been published in some of the leading
academic journals in the areas of empirical economics, management,
and financial institutions and markets. His articles have appeared in
the Review of Economics and Statistics, the Journal of Money, Credit
and Banking, the Review of Industrial Organization, the Journal of
Banking and Finance, Management Science, the Journal of Small Busi-
ness Management, and Small Business Economics Journal.
Dr. Jackson is currently an associate editor of one of the premier
small-firm research journals, the Journal of Small Business Manage-
ment. His monograph The Future of Credit Unions: Public Policy Issues
was published by the Filene Research Institute in 2004.
In July 2004, Dr. Jackson provided expert testimony before the U.S.
House of Representatives on the deregulation of credit unions. In
2005 and 2006 he served as founding special issue editor for the
Journal of Small Business Management. The special issue was entitled
“Small Firm Finance, Governance, and Imperfect Capital Markets.”
Dr. Jackson is also an inaugural member of the prestigious Filene
Fellows Program.
xiCHAPTER 1
Introduction
This study seeks to answer the important
question of whether the credit union industry is
overcapitalized by addressing two fundamental
questions: Was the capitalization rate in 1990
reasonable given the risk profile of the credit
union industry? Assuming that the answer to
this question is yes, has the risk profile of the
credit union industry increased to such an
extent to warrant an increase in capitalization
from 7.6% to 11.6%?At the end of 1990 the percentage of net capital to assets for the credit
union industry stood at 7.6%. By the end of 2000 this percentage had
risen to 11.1%. It remained around this relatively high level, and at the
end of 2006 it was 11.6% (see Figure 1). So why did the credit union
industry need an 11.6% net capital percentage in 2006 if it had needed
only a 7.6% net capital percentage in 1990? Or, stated differently,
was the credit union industry severely undercapitalized in 1990, or is
it severely overcapitalized today? Of course, there is at least one other
possibility. Perhaps 7.6% was the correct capitalization rate in 1990
given the risk profile of the industry, and perhaps the risk profile of the
industry has shifted (or increased) to the degree that 11.6% is the cor-
rect capitalization percentage today—perhaps, but not very likely.
This study seeks to answer the important question of whether the
credit union industry is overcapitalized by addressing two fundamen-
tal questions: Was the capitalization rate in 1990 reasonable given the
risk profile of the credit union industry? Assuming that the answer to
this question is yes, has the risk of the credit union industry increased
to such an extent to warrant an increase in capitalization from 7.6%
to 11.6%? If the risk profile has not increased, then the 7.6% capi-
talization rate may still be appropriate (or it may be too high). This
would suggest that the credit union industry is at least four percentage
points (11.6 – 7.6 = 4.0) above the appropriate capitalization rate.
The total assets of the credit union industry were $732.5B at the end
of 2006. A four percentage point overcapitalization rate translates to
an overcapitalization dollar amount of $29.3B ($732.5B × 4%) for
the credit union industry. This suggests that the industry was holding
$29.3B in capital that could have been used for other purposes by
and for credit union members. This also means that the typical credit
union held $34 of unnecessary capital for every $1001 of capital on its
1 4.0/11.6 equals 34%, or 34/100ths.
2Figure 1: Credit Union Industry Net Worth Ratios, 1990–2006
12.0
11.0
10.0
Percent
9.0
8.0
7.0
6.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
Source: CUNA (2007).
books! However, before this conclusion can be reached, we must first
answer the two questions asked at the beginning of this chapter.
The remainder of this report is organized as follows:
• Question number one, Was the capitalization rate in 1990 reason-
able given the risk profile of the credit union industry? is addressed
in Chapter 2.
• Question number two, Has the risk profile of the credit union
industry significantly increased? is addressed in Chapter 3.
• A brief review of the legislatively mandated capital requirements
and prompt corrective action procedures for credit unions is
offered in Chapter 4.
• A discussion comparing credit union and commercial bank
capital requirements is presented in Chapter 5. This chapter
also includes a summary of a recent study investigating whether
the capital needs of credit unions and commercial banks in the
United States are identical.
Chapter 1 3• An overview of the National Credit Union Administration
(NCUA) proposal on reform of prompt corrective action and
capital requirements for credit unions is presented in Chapter 6.
The NCUA proposal presents a system of requirements that is
very closely aligned with BASEL II. It also suggests that the credit
union industry is currently overcapitalized. This may be the first
time in U.S. history that a regulator of federally insured deposi-
tory institutions has recognized a need to lower mandated capital
requirements in an effort to balance safety and soundness objec-
tives with an efficient use of capital in the economy.
• I present my conclusions in Chapter 7. This chapter summarizes
the evidence and provides a direct answer to the question of
whether the credit union industry is currently overcapitalized.
The answer is yes.
4CHAPTER 2 Was the Credit Union Industry Adequately Capitalized in 1990? Unlike the commercial bank and savings and loan insurance funds, the credit union insurance fund was able to withstand the most turbulent and stressful financial institution crisis in U.S. history since the Great Depression.
Adequate capital levels allow individual financial institutions to
absorb losses, often caused by unforeseen events (or bad luck), and
survive. Capital is often considered the capstone on which a deposi-
tory institution builds its operations. It is not unusual for capital
to be called the lifeblood of commercial banks, thrifts, and credit
unions.
Capital serves many roles. At federally insured depository institu-
tions, capital ensures the safety and soundness of the industry. From
a public policy perspective, capital also acts to protect the appropri-
ate deposit insurance agency (or fund) from bankruptcy and the
necessity of taxpayer bailouts.
The years 1980–1993 were very turbulent and volatile for financial
institutions. During this period, U.S. depository institutions experi-
enced failure rates not seen since the Great Depression. The period
was often categorized as a
banking crisis. It was also called
The years 1980–1993 were very turbulent and volatile for
the “S&L debacle” by several
financial institutions. During this period, U.S. depository
influential finance scholars.
institutions experienced failure rates not seen since the Great
At the end of the 1980s, the
Depression.
deposit insurance funds for
commercial banks (the Federal
Deposit Insurance Corporation [FDIC]) and the insurance funds
for the S&Ls (the Federal Savings and Loan Insurance Corporation
[FSLIC]) needed taxpayer bailouts to credibly support the continua-
tion of these deposit insurance programs.
However, the credit union industry insurance fund, the National
Credit Union Share Insurance Fund (NCUSIF), did not experience
a similar fate. The NCUSIF was recapitalized by the credit union
industry without any assistance from taxpayers. Thus, unlike the
commercial bank and S&L insurance funds, the credit union insur-
ance fund was able to withstand the most turbulent and stressful
6financial institution crisis in U.S. history since the Great Depres-
sion. Many financial researchers consider the banking crisis of this
time period to be analogous to a hundred-year flood. As such, it
served as a natural experiment that tested the financial integrity of
U.S. depository institutions. In particular, the question of whether
the commercial banking industry, the S&L industry, and the credit
union industry were adequately capitalized during the 1980s may be
evaluated by considering the ability of their deposit insurance funds
to survive this high-risk period.
During the 1980s there was not enough capital held by S&Ls or
commercial banks to prevent large numbers of these institutions
from failing. About one-third of S&Ls and almost 1 out of 11 banks
failed during this period. This
was also a difficult time for
During the 1980s there was not enough capital held by
credit unions, as the industry
S&Ls or commercial banks to prevent large numbers of
experienced average failure
these institutions from failing. About one-third of S&Ls and
rates similar to those of com-
almost 1 out of 11 banks failed during this period.
mercial banks. However, larger
credit unions fared much better
than larger banks over this period. The result was that on an asset-
weighted basis, the credit union industry experienced a much lower
failure rate compared to commercial banks over this time period (see
Wilcox 2007, 10, Figure 1).
It is apparent that credit unions entered the 1980s with a stronger
capital position and a lower risk profile than commercial banks. This
allowed the credit union industry to survive one of the most failure-
prone periods of modern U.S. financial institution history without
bankrupting its deposit insurer and seeking a taxpayer bailout.
This suggests that the capital levels of the 1980s were adequate for
the credit union industry’s risk profile. Net capital averaged 6.6% for
credit unions over the 1980–1989 period. If this 6.6% was adequate
during the 1980s, it is reasonable to assume that a capitalization rate
of 7.6% in 1990 was adequate for the risk profile of the credit union
industry at that time. (Note: It is just as reasonable to argue that a
capitalization rate of 6.6% would be adequate for the credit union
industry in 2006, because that was the average rate over the period
1980–1989.)
Chapter 2 7CHAPTER 3
Did the Risk Profile of the Credit Union Industry
Increase Significantly from 1990 to 2006?
Different types of risks are used to develop the
overall risk profile for the credit union industry.
Credit risk, interest-rate risk, liquidity risk,
operational risk, and industry composition are
considered when calculating the overall risk
profile.In this chapter I evaluate the risk profiles of the credit union industry
in 1990 and 2006 using the two prescribed risk metrics from BASEL
II, plus two additional universally accepted risk factors associated
with depository institutions. From BASEL II, I use credit risk and
operational risk. The two additional risk factors are interest-rate risk
and liquidity risk. I also consider changes in aggregate risk for the
credit union industry that may be related to the changing composi-
tion of the industry itself—for example, the asset size distribution of
the industry, since relatively large credit unions are likely to be more
efficient and less risky than smaller credit unions.
Overall, my analysis in this chapter leads me to the same conclusion
reached by Sollenberger (2005): The credit union industry not only had
much more capital in 2006 than it did in 1990, but it also had a lower
risk profile. In the next five sections I discuss measures for the different
types of risks used to develop the overall risk profile for the credit union
industry in 1990 and 2006. These risks are credit risk, interest-rate risk,
liquidity risk, operational risk, and industry composition.
Credit Risk
Credit risk is typically given a place of prominence when evaluating
the overall riskiness of depository institutions. Following the logic
of BASEL II, I evaluate credit risk by reviewing the composition of
credit union industry assets in 1990 relative to 2006. I start with a
simple ratio of loans to total assets, as loans are typically more risky
than the other assets held by depository institutions. As shown in
Figure 2, two trends stand out concerning the loans-to-total-assets
ratios. First, the ratios are volatile over time. They fluctuate from a
low of about 55% in 1993 to a high of almost 70% in 2006. Second,
the ratio in 1990 of about 64% is not significantly different from
the ratio in 2006 of about 70%. However, this is just the first step in
evaluating credit risk. A much more telling piece of evidence is the
composition of loans, which is examined next.
10Figure 2: Credit Union Industry Loans-to-Total-Assets Ratios, 1990–2006
75.0
70.0
65.0
60.0
Percent
55.0
50.0
45.0
40.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
Source: CUNA (2007).
Figure 3 presents evidence of a significant change in the composition of
credit union industry loans. The major change is associated with a shift
from unsecured and other loans toward real estate loans. For example,
total real estate loans represent about 34% of total credit union indus-
try loans in 1990. However, by the end of 2006 this percentage has
increased to almost 50%. Over the same time frame, unsecured and
other loans drop from about 32% to about 15% of total credit union
industry loans. From a BASEL II perspective, this trend suggests that
the overall credit risk of the loan portfolio held by the credit union
industry decreased from 1990 to 2006. I explain why below.
BASEL II applies different risk weights to different categories of loans.
Those loans secured by residential property are assigned a risk weight
of 35%. This is the risk weight that applies to the “total real estate”
category in Figure 3. BASEL II would apply a risk weight of 100% to
the unsecured and other loan categories in Figure 3. Given that the
percentage of loans with the much lower risk weight (total real estate)
increases significantly, from a BASEL II risk measurement calculation,
the overall risk of the credit union loan portfolio decreases significantly.
Chapter 3 11Figure 3: Composition of Loans at Credit Unions (Percentage of Total Loans)
Automobile First mortgage First mortgage Other real Total real
Year (new and used) (fixed-rate) (variable-rate) estate* estate Unsecured Other
1990 33.2 11.1 8.2 14.9 34.2 20.4 12.0
1995 40.0 12.7 7.8 11.7 32.2 20.0 7.8
2000 40.0 18.1 7.3 13.4 38.8 14.6 6.6
2006 35.4 21.0 11.4 17.0 49.4 9.9 5.2
60.0
50.0
Automobile
(new and used)
First mortgage
(fixed-rate)
40.0
First mortgage
(variable-rate)
Other
real estate*
Percent
30.0 Total
real estate
Unsecured
20.0 Other
10.0
0.0
1990 1995 2000 2006
Year
Source: CUNA (2007).
* Home equity plus second mortgages.
To further investigate the changing credit risk profile of credit
union industry loans, I also examine trends in loan delinquency
ratios over the 1990–2006 time period. Figure 4 presents these
ratios in bar chart form. At the end of 1990, the credit union
industry loan delinquency ratio (loans 60 days past due) stands at
about 1.7%. By 2006 the delinquency ratio has dropped by more
than half, to just 0.7%. This strongly suggests that the quality of
the credit union industry loan portfolio in 2006 was significantly
higher, and credit risk significantly lower, than it was in 1990.
And, as the BASEL II risk-based capital requirements system
makes explicit, if credit risk is reduced, the amount of capital nec-
essary to maintain a well-capitalized position is also reduced.
12Figure 4: Credit Union Industry Loan Delinquency Ratios, 1990–2006
2.0
1.9
1.8
1.7
1.6
1.5
1.4
1.3
1.2
1.1
Percent
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
Source: CUNA (2007).
Interest-Rate Risk
If unexpected changes in market interest rates have a material effect on
the net interest income or market value of a depository institution, then
that depository institution is exposed to interest-rate risk. The funda-
mental cause of interest-rate risk is an imbalance in the cash flow matu-
rity structure of interest-bearing
assets and liabilities. It is com-
Credit unions tend to be subject to less interest-rate risk mon for most financial institu-
than depositories such as thrifts because credit unions carry tions (especially depositories) to
a much more diversified portfolio of loans. assume some amount of interest-
rate risk. In the normal course of
business, depository institutions often borrow short term (deposits) and
lend longer term (loans). However, the institution must be diligent in
monitoring and managing the amount of interest-rate risk undertaken
through proscribed asset-liability management processes.
Credit unions tend to be subject to less interest-rate risk than depositories
such as thrifts because credit unions carry a much more diversified port-
folio of loans. Nonetheless, Figure 3 provides evidence that suggests credit
unions were exposed to more interest-rate risk in 2006 than in 1990.
Chapter 3 13This evidence is provided in the column “First mortgage (fixed-rate).”
From this column we observe that the percentage of total credit union
industry loans in fixed-rate mortgages increases from 11.1% in 1990 to
21.0% in 2006. Fixed-rate mortgages tend to carry a substantial amount
of potential interest-rate risk. However, it is unlikely that an industry
portfolio composed of 21.0% fixed-rate mortgages is a significant risk
to the overall health of the credit union industry. To some extent, the
increase in interest-rate risk associated with adding relatively more long-
term assets (fixed-rate mortgages) to the current credit union loan portfo-
lio has likely been offset by changes in the industry deposit portfolio.
For example, in Figure 5 we observe that the percentage of credit union
deposits in CDs increases from 21.7% in 1990 to 31.5% in 2006. This
very likely resulted in an increase in the cash flow maturity of liabilities
(deposits) to help offset the increase in the cash flow maturity of assets
Figure 5: Composition of Shares/Deposits at Credit Unions (Percentage of Total Deposits/Shares)
Money market Regular shares
Year Share drafts accounts CDs IRAs and other
1990 9.4 8.5 21.7 14.5 45.8
1995 11.2 9.2 21.3 12.0 46.3
2000 13.3 13.3 27.7 9.5 36.2
2006 11.7 16.7 31.5 8.6 31.5
50.0
40.0
Share drafts
30.0
Money market
Percent
accounts
CDs
20.0 IRAs
Regular shares
and other
10.0
0.0
1990 1995 2000 2006
Year
Source: CUNA (2007).
14(fixed-rate mortgages). However, also notice in Figure 5 that IRAs
decrease from 14.5% in 1990 to 8.6% in 2006, while money market
accounts increase from 8.5% to 16.7% of total deposits. Both of these
trends may have resulted in decreasing the cash flow maturity of liabili-
ties. Interest-rate risk, especially at the industry level, is imprecise and
costly to calculate based on a balance sheet assessment. This is why both
the BASEL II and the current FDIC system deal with interest-rate risk
under the second pillar of their capital requirements system—that is, a
detailed and robust supervisory review process.
Overall, I would evaluate the changes in observed cash flow maturity
of assets and liabilities to suggest a very moderate increase in interest-
rate risk in the credit union industry from 1990 to 2006.
Liquidity Risk
Credit unions have a reputation for using conservative management
practices. In the case of liquidity risk, this reputation is well deserved. In
1990 the credit union industry kept about 33.6% of its assets in surplus
funds. These surplus funds are essentially investments. Credit union
investments tend to be very high quality and very liquid. By the end of
2006, the credit union industry had reduced the ratio of surplus funds to
about 26.3% of total assets. This is more than a seven percentage point
decrease in the ratio of surplus funds to total assets. For other deposi-
tory institutions, this large of a decrease in surplus funds relative to total
assets would be a concern, but for the credit union industry it’s a sign of
management moving in the right direction.2
Overall, the reduction in the surplus funds percentage from 33.6 to
26.3 for the credit union industry over the 1990–2006 time period
does not result in a significant increase in liquidity risk. If anything,
this reduction moves the credit union industry toward a more effi-
cient use of members’ funds.
Operational Risk
Under BASEL II, operational risk is quantified using a basic indica-
tor approach based on 15% of average gross income of the individual
financial institution over the previous three-year period. This variable is
then converted to a risk asset by multiplying by the inverse of 8% (or
12.5). This approach would be very difficult to rationalize as providing
an adequate proxy for aggregate credit union industry operational risk.
Operational risk is often considered to be very broad and complex.
It usually encompasses important factors such as managerial qual-
2 Actually, it may simply be the result of the changing composition of the credit union industry. The size of the average credit union increased by over
400% from 1990 to 2006 (not adjusted for inflation). As large, well-diversified credit unions hold relatively lower proportions of surplus funds, this
trend of credit unions getting much larger on average may explain this phenomenon.
Chapter 3 15ity, governance integrity, technological capabilities, and competitive
strategies. Because it is so broad, I chose to examine three very broad
and general trends in assessing whether there is a significant change
in operational risk for the credit union industry from 1990 to 2006.
The three trends are profitability (return on assets), overall annual
growth in assets, and average asset size of credit unions.
The first two of these three trends are presented in Figures 6 and 7,
respectively. The ratios of credit union industry annual net income
to total assets (ROA) from 1990 to 2006 are presented in Figure 6.
In 6 of these 17 years, ROA is 0.9% or less—but never below 0.8%.
In 1990 and 1991, and again in 2004 and 2005, ROA is about
0.9%. In 2006, ROA for the credit union industry is a little above
0.8%. Overall, the profitability of the credit union industry does not
change significantly between 1990 and 2006.
A similar picture can be drawn from Figure 7 for credit union industry
annual asset growth rates. Annual asset growth rates are at or above
10% for 5 of the 17 years shown in Figure 7. From 1990 to 2006,
annual asset growth rates are never below 4%, and they are below 6%
Figure 6: Credit Union Industry ROAs, 1990–2006
1.5
1.4
1.3
1.2
1.1
1.0
0.9
Percent
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
Source: CUNA (2007).
16Figure 7: Credit Union Industry Annual Asset Growth Rates, 1990–2006
16.0
14.0
12.0
10.0
Percent
8.0
6.0
4.0
2.0
0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
Source: CUNA (2007).
in only 5 of the 17 years. The annual growth rate in 1990 is over 7%,
while the annual growth rate in 2006 is not quite 5%. Overall, asset
growth seems to moderate somewhat by 2005 and into 2006.
Moderating asset growth, coupled with continued strong profitability and increases in size-
related efficiencies, suggests that operational risk for the credit union industry very likely
remains relatively stable, or decreases, over the 1990–2006 time period.
Credit unions tend to be relatively small financial institutions. For
example, in 1990 the average size in assets for U.S. credit unions
was only $15.2 million (M). Small asset size may limit a financial
institution’s ability to exploit economies of scale and scope, especially
with regard to advances in technology. However, by the end of 2006,
the average asset size of credit unions in the United States had risen
to $84.6M. This represents more than a fivefold increase in average
asset size. Even after adjusting for inflation, this represents more than
a 3.6 times increase in average asset size. This large increase in aver-
age asset size suggests an increase in the ability of the average credit
Chapter 3 17union to take advantage of economies of scale and other size-related
efficiencies. This increase in efficiency potential is likely correlated
with a decrease in aggregate operational risk in the industry.
Moderating asset growth, coupled with continued strong profitability
and increases in size-related efficiencies, suggests that operational risk
for the credit union industry very likely remains relatively stable, or
decreases, over the 1990–2006 time period.
Industry Composition
Data from Wilcox (2007), which are reproduced in Figure 8 below,
demonstrate that about 0.56% of small credit unions failed each year
during the period 1981–2005. Wilcox defines small credit unions
as those with less than $25M in assets. Wilcox (2007) also reports
that over the same time frame not a single large credit union failed.
Wilcox defines a large credit union as one with more than $250M
in assets. Given that expected failure rates for large credit unions
are much smaller than those for small credit unions, changes in the
relative proportions of large and small credit unions will change the
overall aggregate risk profile of the industry.
Figure 8: Failures of Federally Insured Credit Unions
Time period All Small Medium Large
Panel A. Failure rates (%)
1981–1993 0.77 0.85 0.20 0.0
1994–2005 0.18 0.23 0.04 0.0
1981–2005 0.49 0.56 0.12 0.0
Panel B. Number of failures
1981–1993 1,478 1,430 48 0
1994–2005 231 220 11 0
1981–2005 1,709 1,650 59 0
Panel C. Number of institutions (year-end)
1980 17,324 16,274 1,010 40
1993 12,317 9,709 2,356 252
2004 9,014 5,915 2,576 523
Source: Wilcox (2007, 10, Figure 1). Small is less than $25M in total assets, medium is $25M to $250M in total assets, and large is
more than $250M in total assets.
18Using Figure 8, I calculated that in 1993 small credit unions repre-
sented 78.8% of the number of federally insured credit unions in
the United States. In that same year, large credit unions represented
only about 2.1% of the number of federally insured credit unions in
the United States. However, by the end of 2004, large credit union
representation had increased to 5.8%, and small credit union rep-
resentation had fallen to 65.6% of the number of federally insured
credit unions in the United States. This change in industry composi-
tion toward relatively more large credit unions in 2004 compared to
1993 suggests that, over the 1990–2006 time frame, average credit
union failure risk decreases. Of course, the benefits of this decrease in
average credit union failure risk may have been mitigated somewhat
by an increase in the average expected cost of each individual credit
union failure. Nonetheless, the overall result from this change in
industry composition is likely a decrease in credit union industry risk
borne by the deposit insurer.
Overall Industry Risk
After examining credit risk, interest-rate risk, liquidity risk, opera-
tional risk, and industry composition for the credit union industry
in 1990 and 2006, I arrived at the same conclusion as Sollenberger
(2005). That is, the credit union industry in 2006 was less risky
than it was in 1990. Figure 9 summarizes my conclusions about the
changes from 1990 to 2006 for each component of the risk profile of
credit unions examined in this study.
Figure 9: Summary of Changes in the Components of Credit
Union Industry Risk Profile from 1990 to 2006
2006 risk level compared to
Risk category 1990 risk level
Credit Much lower
Interest rate Moderately higher
Liquidity Similar
Operational Lower
Industry composition Lower
Overall Lower
Chapter 3 19CHAPTER 4
Review of Legislated Capital Requirements and
Prompt Corrective Action for Credit Unions
Capital adequacy requirements use a five-tier
system based on a ratio of net worth to total assets.
For most credit unions, this ratio is about the
same as the traditional total-equity-to-total-assets
ratio. More than 99% of U.S. credit unions are in
the Well Capitalized or Adequately Capitalized
categories.The Credit Union Membership Act of 1998 (CUMAA) required
the NCUA to establish and implement a net worth classification
system that paralleled the current system used by banking regulators.
The specific regulations implementing the legislation were defined
at year-end 1999 and became effective in early 2001. The regula-
tions were derived almost directly from the legislation because the
legislation contained unusually specific directions for defining capital
adequacy within a prompt corrective action (PCA) framework.
The PCA rules created a new system for evaluating capital adequacy
(Sollenberger and Taggart 2006). The new system applies a single
scale to all credit unions regardless of size and (except for complex
credit unions) asset composition. The new system uses a five-tiered
classification scheme based on a net-worth-to-total-assets ratio.
Net worth is basically a measure of equity that includes all equity
accounts reported on credit union call reports. For most credit
unions, this ratio is about the same as the traditional total-equity-to-
total-assets ratio.
The five-tiered classification scheme is based on the following catego-
ries and ratios:
• 7% and above = Well Capitalized.
• 6% to 6.99% = Adequately Capitalized.
• 4% to 5.99% = Undercapitalized.
• 2% to 3.99% = Significantly Undercapitalized.
• Under 2% = Critically Undercapitalized.
By the time these regulations became effective in 2001, more than 99%
of U.S. credit unions were in the Well Capitalized or Adequately Capi-
talized categories. This continues to be the case today.
It is interesting that net worth requirements and PCA were not the
original purpose of CUMAA. The stimulus for the 1998 CUMAA
22was a decision by the Supreme Court that prohibited the NCUA
from approving credit union “fields of membership” comprising
more than one group. It has been suggested that the PCA require-
ments of CUMAA were introduced into the act more for political
reasons than for sound economics. There may be some support for
this view when a comparison of PCA for banks and credit unions is
examined.
For example, CUMAA directed the NCUA to implement regula-
tions that established a system of PCA for credit unions that was
consistent with the PCA regime for banks and thrifts under the
Federal Deposit Insurance Corporation Improvement Act (FDICIA)
of 1991. However, there are several differences between the PCA
for credit unions that Congress
codified into CUMAA and
By the time these regulations became effective in 2001, more the PCA that covers banks and
than 99% of U.S. credit unions were in the Well Capitalized thrifts through the FDICIA. I
or Adequately Capitalized categories. This continues to be believe there are two key dif-
the case today. ferences. First, the net worth
levels for determining a credit
union’s net worth classifica-
tion are not allowed to be fine-tuned by the regulator (the NCUA),
because they are specified in CUMAA. This is not true for the
bank and thrift regulators. Second, the net worth ratios required in
order for a credit union to be classified in the Well Capitalized or
Adequately Capitalized categories are much higher—two percentage
points—than those in place for banks and thrifts. This is especially
egregious given that the overall risk of failure imposed on the credit
union deposit insurance fund by credit unions is very likely to be
lower than the respective failure risk imposed on the bank deposit
insurance fund by banks.
Because of the relatively high PCA capital requirements imposed
on credit unions by CUMAA, many credit unions today hold more
capital than they need to in order to operate in a safe and sound
manner (Sollenberger 2005).
As a result of the effect of potential asset growth on a credit union’s
net worth ratio, a very efficiently run credit union is essentially safe
and sound from a regulatory perspective, yet it would be significantly
constrained by operating with a net worth ratio of 6% or 7% given
the current PCA system. This is because credit unions do not have
access to external capital markets in order to build net worth on a
timely basis. Instead, credit unions must build net worth using only
retained earnings (a few specialized exceptions apply). Given this
situation, any significant unexpected growth—perhaps as the result
of members increasing their life cycle savings patterns—may quickly
Chapter 4 23lower a credit union’s net worth ratio below the planned 6% or 7%.
This could occur even in the face of healthy additions to capital
funded by generous ROAs.
The concern on the part of credit union management and boards
goes far beyond those credit unions that are close to the 6% or 7%
line of demarcation for being considered Adequately Capitalized
or Well Capitalized. Overall, credit unions have very conserva-
tive management that appears to be part of their cooperative and
volunteer-run culture. As a result, most credit unions seek to be
Well Capitalized as opposed to Adequately Capitalized. This means
that if they do not want to fall below a 7% net worth ratio and they
are uncertain about future growth prospects, they must maintain
a cushion above 7% to effectively manage their capital ratio. Some
suggest that a typical target (or cushion) is to hold enough capital
to stay about 200 basis points above the 7% standard (Sollenberger
2005). This suggests that the current PCA regulations for credit
unions provide powerful incentives that have induced credit unions,
on average, to hold more than 50% more capital than is necessary for
safety and soundness purposes. Indeed, the regulation states that a
6% net worth ratio is Adequate. Unfortunately, the PCA regulation
in its current form induces most credit unions to operate at highly
overcapitalized levels, which results in an inefficient use of members’
resources. On the positive side, the NCUA, the credit union regula-
tor, recognizes that the current system must be amended to correct
this problem. I discuss the NCUA proposal to remedy this situa-
tion in Chapter 6. In the next chapter, I discuss differences in the
necessary capital requirements for credit unions and banks based on
respective risk profiles and organizational structures.
24CHAPTER 5
A Comparison of Credit Union and
Commercial Bank Capital Requirements
Theoretical and empirical evidence support the
notion that the credit union industry needs less
capital, or a lower capital requirement, than the
banking industry.One of the most interesting aspects of CUMAA is that Congress
included a preamble that describes the major differences between
credit unions and other depository institutions. The preamble states
that “Credit Unions, unlike other participants in the financial services
market, are exempt from Federal and most State taxes because they
are: (1) member-owned, (2) democratically operated, (3) not-for-profit
organizations, (4) generally managed by volunteer boards of directors,
and (5) have the specific mission of meeting the credit and savings
needs of consumers, especially persons of modest means.”
Of interest is that CUMAA then goes on to establish PCA capital
requirements for credit unions that are higher than those for banks
or thrifts. However, the characteristics of credit unions described in
the preamble suggest that the capital requirements for credit unions
should be lower—not higher—than those for banks or thrifts. In this
chapter, I discuss the theoretical and empirical evidence that supports
this proposition.
Theory
The idea that not-for-profit credit unions are likely to be less risky
than for-profit commercial banks is not new. For example, Smith
(1984) provides the seminal report on the theory of credit union
decision making. His report explains why the cooperative organi-
zation of credit unions provides their management with less of an
incentive to hold a portfolio of risky assets, relative to for-profit com-
mercial banks.
A more recent article by Kane and Hendershott (1996) adds to this
literature by providing a comprehensive analysis of how differences
in incentive structure serve to mitigate the desirability of risk-taking
activities by credit union managers and regulators.
Kane and Hendershott (1996, 1309) state that the differences
between credit unions and commercial banks “make it less feasible
26for managers [of credit unions] to pursue and to benefit from either
corrupt lending or go-for-broke strategies of risk-taking. Manage-
rial willingness to bet a credit union’s future viability on large risky
projects is curbed by three constraints: its field-of-membership
limitations; its cooperative form; and private and federal monitor-
ing.” For example, the authors state that the cooperative form of
credit unions lessens any personal gains that can be captured by
managers who successfully shift risk to the credit union deposit
insurer, the NCUSIF. Specifically, incentives to shift the downside
of a high-risk project to the NCUSIF is mitigated by the difficulties
that credit union managers would face in attempting to divert to
themselves a relatively large proportion of the gains if this high-risk
project was successful.
Of course, if credit union managers know that conversion to a stock-
holder organization is easily available, then these effects are limited.
This suggests that obstacles to credit union conversions established
by the NCUA may help to make the industry less risky. This is
because these obstacles—by reducing the attractiveness of conver-
sion—help align the interests of credit union managers (in avoiding
high-risk projects) with those of the NCUSIF.
Kane and Hendershott state that the differences between credit unions and commercial banks
“make it less feasible for managers [of credit unions] to pursue and to benefit from either cor-
rupt lending or go-for-broke strategies of risk-taking.”
Another factor that serves to mitigate risk taking by credit union
managers is the extent and quality of private monitoring to which
they are subjected (Kane and Hendershott 1996). For example,
according to Kane and Hendershott (1996, 1311), the activities of
credit union managers and boards of directors are typically bonded
more extensively by outside private insurers than the activities of
managers or boards of commercial banks. This more intense bond-
ing coverage at credit unions transforms the private bonding agencies
into coinsurers with the NCUSIF that have a much stronger financial
incentive to monitor internal controls and managerial policies to
restrict behavior that threatens credit union failure and the NCUSIF.
Agency theory dictates that the quality of monitoring done by a
private insurer, whose managers recognize that the profitability and
survival of their company depend on their activities, can be expected
to be superior to that done by insulated federal employees. But even
if private monitoring were only of equal quality, the very existence
of the independent private bonding agencies that cover some of the
loss in failure-type events reduces the federal insurer’s (the NCUSIF)
expected loss exposure (Kane and Hendershott 1996).
Chapter 5 27Another factor that serves to restrain credit union risk taking is the
structure of the industry’s deposit insurance fund, the NCUSIF.
Credit unions insured by the NCUSIF actually insure one another.
That is, all institutions insured by the NCUSIF are “jointly and
severally” responsible without limit for covering any shortage that the
fund experiences. As Kane and Hendershott (1996) recognize, this
responsibility effectively transforms total industry net worth into a
supplementary off–balance sheet fund of insurance reserves avail-
able to the NCUSIF to use as needed. Not only does this expand the
effective size of the NCUSIF fund by several orders of magnitude,
but it also enhances incentives for credit unions to cross-monitor one
another.
The NCUSIF since 1985 has been organized as what Kane and
Hendershott (1996) call a deposit insurance premium “prepayment”
system. This idea refers to the fact that insured credit unions are
required to hold 1% of their shares on deposit with the NCUSIF,
which is called the “capitalization deposit.” Income on interest
received by the NCUSIF on this deposit is used to close insol-
vent credit unions and cover operating expenses. Establishing the
NCUSIF as a fund based on prepaid premiums aligns the incentives
of all major stakeholders (e.g., the NCUA, politicians, credit union
management, other credit union members, and taxpayers) better
than the pay-as-you-go system of commercial banks (Kane and
Hendershott 1996).
Thus, the theoretical evidence suggests that the credit union indus-
try is less likely to engage in levels of risk taking as high as those in
the banking industry. This leads to the conclusion that the theory
supports the notion that the credit union industry needs less capital,
or a lower capital requirement, than the banking industry. There is
empirical evidence that supports this, and I present a summary of
that evidence in the next section.
Empirical Evidence
In a report by Smith and Woodbury (2001), the authors investigate
whether the capital needs of U.S. credit unions and commercial
banks are the same, given their respective aggregate risk profiles. To
operationalize their investigation, the authors use a simple regression
model that estimates the effects of macroeconomic shocks on credit
union and commercial bank risk measures over the business cycle.
State-level unemployment rates are used as the measure of macro-
economic shock. The dependent variables are aggregate loan delin-
quencies and charge-offs for credit unions and commercial banks at
the state level. The authors use panel data covering all 50 states and
the District of Columbia (51 panels) over 29 semiannual periods
28from 1986 to 2000. The authors estimate models that include both
contemporaneous and lagged independent variables as well as just
contemporaneous variables.
Using the coefficients on the independent variable unemployment
as the measure of sensitivity, the authors report the following find-
ings. First, commercial bank loan delinquencies are more than twice
as sensitive to the business cycle as credit union loan delinquencies.
They estimate that an increase of one percentage point in the unem-
ployment rate is associated with a 23.7% increase in bank delinquen-
cies but only a 10.0% increase in credit union delinquencies.
Second, they report that credit union loan losses are less than two-
thirds as sensitive to the business cycle as commercial bank loan
losses. Their regression estimates suggest that a one-percentage-
point increase in the unemployment rate is associated with a 30.8%
increase in commercial bank charge-offs over a one-year period.
However, the corresponding increase in credit union charge-offs is
only 19.0%.
The authors suggest that their findings have important implications
for capital requirement regulations for credit unions and commercial
banks. As their analysis indicates, credit unions are only about two-
thirds as sensitive as commer-
cial banks to macroeconomic
As their analysis indicates, credit unions are only about two- shocks, and they suggest that
thirds as sensitive as commercial banks to macroeconomic this difference be reflected in
shocks, and they suggest that this difference be reflected in credit union capital require-
credit union capital requirements. ments. Stated differently, any
capital requirements designed
to cover macroeconomic
shocks for credit unions should be approximately three-quarters of
the requirement for commercial banks. Given credit unions’ lower
sensitivity to macroeconomic shocks, this level would produce a rea-
sonably equivalent coverage for commercial banks and credit unions
from the risks of loan losses.
These findings by Smith and Woodbury (2001) are important
because macroeconomic risks are extremely relevant in evaluating the
overall financial health of the credit union industry.
Chapter 5 29CHAPTER 6
Review of the NCUA’s PCA
Proposal for Reform of March 2005
The NCUA proposal recognizes that there are
inherent limitations in any given risk-based
capital system, that the changes are designed to
be comparable to the capital standards for the
FDIC, that achieving comparability for the
leverage standard requires the consideration of the
NCUSIF, and that the risk-based requirement
addresses only credit risk and operational risk.In the preface to the NCUA’s Prompt Corrective Action Proposal for
Reform, Chairman JoAnn M. Johnson highlights several key elements
of the recommended statutory changes to the current PCA system
for credit unions. These four key elements are as follows.
First, the proposal recognizes that there are inherent limitations in
any given risk-based capital system. Therefore, the NCUA advo-
cates a system that includes both leverage and risk-based standards
working in a complementary fashion. Second, the changes recom-
mended in the proposal are designed to be comparable to the capi-
tal standards for FDIC-insured financial institutions because there
should not be unwarranted differences in the capital standards for
different types of depository institutions. Third, achieving compa-
rability for the leverage standard requires the consideration of the
NCUSIF deposit-based funding mechanism. And fourth, consis-
tent with BASEL II and the FDIC’s PCA system, the risk-based
requirement addresses only credit risk and operational risk. Given
that there are other forms of risk, for example, interest-rate risk,
this proposal includes recommendations to address these other
risks through a robust supervisory review process.
On page 4 of the proposal, the current PCA system for credit
unions is discussed. It is interesting to note the NCUA’s assess-
ment of the current capital requirement regulations. For instance,
the NCUA states that
PCA for credit unions does not adequately distinguish between
low-risk and higher risk activities. The current PCA system’s high
leverage requirement (ratio of net worth to total assets) coupled
with the natural tendency for credit unions to manage to capital
levels well above the PCA requirements essentially creates a “one-
size fits all” system. This penalizes institutions with conservative
risk profiles. While providing adequate protection for the insur-
ance fund, a well designed risk-based system with a lower leverage
32requirement would more closely relate required capital levels with
the risk profile of the institution and allow for better utilization
of capital.
The current high leverage ratio imposes an excessive capital
requirement on low-risk credit unions. With a lower leverage require-
ment working in tandem with a well-designed risk-based requirement,
credit unions would have greater ability to serve members and
manage their compliance with PCA. By managing the composi-
tion of the balance sheet, credit unions would shift as needed to
lower risk assets resulting in the need to hold less capital.
Recognizing that the current PCA system for credit unions
imposes an unreasonably high leverage requirement, the NCUA
proposes changes to the current system that include lowering the
leverage requirements for the Well Capitalized category from a
7% net worth ratio to a 5% ratio. The Adequately Capitalized
category would likewise be reduced from 6% to 4%. These net
worth ratios would be comparable to those used by the FDIC for
thrifts and commercial banks.
Additionally, the risk-based net worth ratios would also be set at
levels comparable to the FDIC’s total risk-based capital require-
ments and BASEL II. That requirement would be an 8% risk-
based net worth ratio to be considered a Well Capitalized credit
union.
The NCUA’s proposal incorporates the risk weights for specific port-
folio items based on BASEL II. Without any substantial or notewor-
thy differences, the NCUA proposal applies the BASEL II risk-based
system to credit unions.
I believe the NCUA proposal to be a very good alternative to the
current PCA system for credit unions. The NCUA may reconsider
its proposed leverage ratio schedule, however. The NCUA states
that its objective is to create a PCA system for credit unions that is
comparable to the existing PCA system for FDIC-insured deposi-
tories. To do so, the NCUA
proposes the same net worth
The NCUA should consider that equal leverage ratios in its
ratios (leverages) for credit
PCA systems is not the same as comparable capital require-
unions as for FDIC-insured
ments to risk levels for credit unions and other depositories.
banks and thrifts. This has the
effect of lowering the leverage
ratio of credit unions by 200 basis points for the Well Capitalized
and Adequately Capitalized categories. This is a good start, but it
may not achieve true comparability. The NCUA should consider
that equal leverage ratios in its PCA systems is not the same as
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