Why does this matter?

All banks and credit unions are required by law to maintain a certain amount of capital in proportion to the institution’s assets. Today, the capital structure of a safe institution might be in the range of 7-10% of the total assets.

This means that as assets grow, in order to maintain that ratio, the institution must have a means of putting funds into the capital accounts.

Credit unions have one way to fund the capital account: retain earnings. That is, after covering the cost of operations and dividends on deposits, whatever is left over—the net income—will be placed into capital accounts.

If a credit union is not profitable in a period—perhaps because of extraordinary economic circumstances—and assets increase or stay level, the ratio declines. If it declines too much, regulators must act. The lower the ratio, the more severe the action—up to closing the credit union.

However, lack of profitability is not the only reason that a credit union’s capital ratio may decline. As happened during the pandemic, when the Federal government issued stimulus checks to many consumers, the assets of most credit unions increased at a record pace. While credit unions were generally profitable, and therefore increased their dollars of capital, the ratio of capital decreased. Credit unions simply could not keep up with their growth. They were victims of their own success (and government action).

Banks are subject to the same forces as credit unions, except that they have alternative sources of capital. If they experience very high asset growth, they can issue preferred or traditional stock. The funds raised by this issuance go directly into capital.

Ultimately, this means that credit unions can only grow at the rate they can have a positive net income. Banks, on the other hand, can grow at the rate they have positive net income and issue stock. This gives bank a strong advantage in both good times and bad, as they can overcome net income deficiencies by issuing new stock.

An Example or Three

Federal law requires federally insured credit unions to have at least 7% capital, or equity, to be “well-capitalized.” In fact, to keep the examiners of the insuring agency from getting nervous, credit unions are given the highest rating only when these reserves are in the 9%—10% range.

To maintain this level of safety—safety that is extended to the deposits of the institution—consider the following:

John Q. just retired and decided to take his retirement in a lump sum. Because of the dismal performance of the stock market in recent months, John decided to place the entire $500,000 into his credit union.

If the credit union desires to keep its reserve level at the current 10% level, it will be necessary for the credit union to place an additional $50,000 into its reserve (capital, equity, reserve) account.

Because the credit union does not sell stock, it procures the needed $50,000 by retaining this amount of net income—the money our banking friends want taxed.

If the credit union is large—the process is the same—the requirement is the same. The only difference is that the numbers are larger.

Credit Union ABC increased its deposit base by 15% in the year 2021. This amounted to $260 million dollars of new deposits coming into the institution from its members.

To maintain the required and desired buffer (reserves or level of capital) of 10%, the credit union retained $26 million dollars of its annual earnings.

The retention of this $26 million did not enrich any person, but rather it simply kept the reserve ratio at the same desired level as it was at the first of the year.

All the credit union’s earnings above the $26 million would be available for payment to members on their savings balances, or by offering lower loan rates.

If the credit union is not generating enough new income, could this stifle the growth of the credit union?

Credit union XYZ has a capital ratio of just over 7%. As a result, federal examiners are beginning to pay attention to the credit union on a more frequent basis.

For every $100,000 of new deposits the credit union takes in, it must be able to generate $7,000 of profit (retained earnings).

John Q. decides to make his deposit of $500,000 with this credit union. This means the credit union must immediately place $35,000 (7% of $500,000) into reserves.

The credit union recognizes that it cannot generate enough income during the year to meet the reserve requirement. If it accepts the $500,000 deposit, its equity ratio will fall below the 7% requirement.

While the credit union would like to accept the deposits–that’s what it’s in the business for–to keep peace with the insuring agency, the credit union tells the member it cannot accept the deposit. 

Because a bank can sell stock, it could, finding itself in the same position, simply decide to sell more stock to meet its capital requirements.