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The effect of risk-based capital

By: Tammy Cantrell, Executive Vice President, Asset/Liability Management

Tammy CantrellMay 26, 2015 -- The creation of a more risk-sensitive framework for capital regulation is at the heart of the changes in the recent NCUA–revised, risk-based capital proposal.

One of the key objectives of a risk-sensitive approach is to provide financial regulators with a measure of capital adequacy that better reflects the true financial condition of a large credit union. Should this proposal pass, the goal is to put all financial institutions on a level playing field by providing all constituents the ability to compare their financials to other financial institutions on a risk-adjusted basis.

In a risk-sensitive capital structure, there is a stronger incentive to manage and measure your credit risk as opposed to the environment wherein all assets are risk-weighted the same. Further, risk-based capital charges are intended to encourage credit unions to make lending and investment decisions based on the underlying economics of the transactions, which may not necessarily mean the highest yielding option.

To illustrate this point, I’ve taken two investment options with different yields and risk-weightings to demonstrate that you have to assess the overall capital charge in order to accurately determine the relative value between the two alternatives.

Investment Option Par Amount Yield Risk Based % Risk Weighted Asset Earnings over 3 Years
Agency bond $10,000,000 1.55% 20% $2,000,000 $465,000
Federally insured CD $10,000,000 1.00% 0% $0 $300,000

In this example, the agency security yields 55 more basis points than the insured certificate of deposit, resulting in additional interest income of $165,000 over a three-year period. However, the agency security is also risk-weighted at 20% compared to the 0% risk-weighting of the insured certificate of deposit. Your capital charge for the agency investment is calculated as follows:

Risk-based capital charge = Desired capital ratio x Risk-Weighted Asset

Using the example above, the capital charge for a credit union that desires to operate at a 10% risk-based capital level would be $200,000 for the agency investment compared to a federally insured certificate of deposit capital charge of $0.

Desired capital ratio 8% 10% 12%
Capital charge - Agency bond $160,000 $200,000 $240,000
Capital charge - Federally insured CD $0 $0 $0

Looking at the pros and cons
As credit unions are in the business of making member loans and not investments, the opportunity cost of choosing an investment with a capital charge could mean fewer opportunities to extend credit to your members. Conversely, an investment with a 0% risk-weighting frees up current capital that can be deployed in making higher yielding loans, as demonstrated in the table below.

Desired capital ratio 8% 10% 12%
Capital re-allocated to lending with 0% risk-weighted insured CD $160,000 $200,000 $240,000
Incremental lending capacity created due to investment in insured CD $2,000,000 $2,000,000 $2,000,000

Estimated yield on loan

5% 5% 5%
Interest income on loan over 3 years $300,000 $300,000 $300,000

With a 0% investment risk-weighting, such as a federally-insured certificate of deposit, a credit union now has the capital flexibility to invest in its members by extending credit. 

Examining economic impact
Let’s examine the overall economic impact and the capital charge of the two investment options above in the following table:

Investment Option Par Amount Yield Risk Based % Risk Weighted Asset Earnings over 3 Years
Agency Bond $10,000,000 1.55% 20% $2,000,000 $465,000
vs.
Federally insured CD $10,000,000 1.00% 0% $0 $300,000
Unsecured loan $2,000,000 5.00% 100% $2,000,000 $300,000
Total $12,000,000     $2,000,000 $600,000

As you can see from this example, the economic decisions made under a risk-based capital environment can be costly if you do not consider the overall impact your decision has on your capital ratio and earnings. A simple 20% risk-weighting on a $10 million investment compared to a 0% risk weighting has an opportunity cost of making a $2 million loan to your member, as the risk-weighted asset in both of these scenarios is the same.  

Further, the combined earnings on the insured certificate of deposit and the unsecured loan is $135,000 more over the three-year period than the agency bond.

It is important to properly assess the chance you take in a risk-based capital environment and the capital charge associated with that risk to truly compare different investment options and the impact those options have on your ability to make other investments or loans.

Conclusion
Take your capital charge with your members, not with your investment portfolio.

For further assistance or if we can help you answer any questions, please contact your personal investment representative at 800/366-2677.