Relationship Between Capital and Earnings

Capital is essential to credit unions to protect against uncertainties and provide a foundation for the long-term viability of the credit union. Generally, to build and maintain an appropriate level of capital, credit unions generate net income, which increases capital. A credit union with a weak capital level requires more net income to increase its capital position, while a credit union with a high level of capital may only need modest earnings sufficient to maintain its current capital position. Some credit unions, such as those that are low-income designated, may have access to other forms of capital (for example, subordinated debt) to build capital even if net income is weak. Refer to the Capital chapter of the Examiner’s Guide for more details.

Future earnings potential is a key element in assessing both earnings and capital adequacy. Examiners assess earnings and capital by gaining a thorough understanding of the strategies management employs to achieve the desired level of net income. For example, it is possible for a credit union to record strong net income levels in the short term by assuming an unacceptable level of credit or IRR. Asset quality and ALM should also be considered in the analysis of earnings and capital.

An inordinately high return on assets can indicate a risky business strategy. Fixation on a net income target established in a vacuum (such as striving for an industry average ROA) often leads to poor decision-making with negative long-term consequences for a credit union.

Taking planned and controlled actions to reduce risk exposures may lead to periods of low or negative net income. Planned actions that reduce income may include:

• Selling fixed-rate real estate loans
• Returning excess capital to the membership
• Incurring costs in service of long-term strategic objectives (such as improved member services)

Even though these actions may result in lower net income, they may be advantageous to a credit union’s long-term strategy. Examiners should comprehensively evaluate such strategies when assessing the adequacy of earnings and capital.

Last updated on October 1, 2020