Capital is the last line of defense against insolvency. More importantly, adequate capital protects members' deposits. As such, regulatory capital requirements are one of the fundamental elements of financial supervision.

Failure to maintain adequate capital can lead to intervention by regulatory agencies or loss over control of the credit union by the board.

The Regulation of Capital

While the Basel Committee on Banking Supervision of the Bank for International Settlements develops capital requirements for banks, in the U.S. it is the NCUA that has responsibility for setting credit union capital requirements.

It's important to know that the NCUA has made recent changes to its capital rules. This latest set of rules is known as risk-based capital 2 or RBC2.

RBC sets forth how the NCUA, through its supervisory authority, can address a credit union that does not hold capital that is commensurate with its risk and importantly establishes a risk-based capital ratio of 10% to be considered well-capitalized and 8% to be considered adequately-capitalized.

RBC2 also revised the existing asset risk weights to mirror recent changes made by other banking regulators under the Basel system, including those for member business loans, CUSOs, corporate credit unions, real estate loans and long- term investments.

It raised the threshold of what's considered a "complex credit union," and thus covered under RBC2, from $50 million to those with greater than $100 million in assets.

In an important point related to credit union mergers, it clarifies that "excluded goodwill" and "excluded other intangible assets" applies to mergers completed on or before 60 days after publication of the final rule in the Federal Register. It also extended the expiration of this definition to Jan. 1, 2029.

Finally, the changes provide an extended implementation period until Jan. 1, 2019.

What RBC2 Means for Your Credit Union

In short, before 2019, many credit unions will need to significantly increase their capital to adequate levels.

Most of these credit unions will likely face the choice of raising capital via retained earnings and/or reducing their asset base (i.e. loans). Additionally, some will raise capital by increasing membership share investments, restricting the redemption of existing shares or issuing non-membership share capital.

Of these choices, most will likely choose to build their retained earnings.

Retained earnings represent income earned that has not been paid out to members in the form of dividends. It is an inexpensive form of capital, as it does not require the payment of dividends or carry the contingency of having to redeem membership shares on demand.

Retained earnings can be grown in two ways: Improving profitability or reducing cash dividends to members. While reducing cash dividends may not be popular with members, if a credit union's profitability can't be improved, reducing dividends may be necessary to prevent capital reserves from dropping below regulatory or policy minimums.

Lawrence Pruss is senior vice president of Strategic Resource Management, Inc. in Memphis. He can be reached at 800-748-2577 or [email protected].