Net Worth Ratio May Not Identify Capital Deficiencies

The net worth ratio may mask capital deficiencies at credit unions, delaying mandatory corrective actions under the prompt corrective action (PCA) framework.

Credit unions hold both capital (net worth) and loan loss reserves for the purpose to absorb losses.

However, looking strictly at the net worth ratio as an indicator for triggering corrective action without examining the adequacy of loan loss reserves may not accurately measure the financial resiliency of credit unions.

In other words, capital deficiencies may be hidden by inadequately funding loan loss allowance accounts relative to the level of nonperforming assets.

The loan loss allowance account is funded by provisions for loan losses. Reducing provisions for loan losses will cause net income to increase, which will increase the amount of net worth for a credit union.

The following example examines the impact on credit unions that are currently well-capitalized, if the loan loss reserves was funded at 100 percent, 75 percent and 50 percent of nonperforming assets plus other real estate owned (OREO).

If loan loss reserves were funded to equal 100 percent of nonperforming assets plus OREO, 96 credit unions that are currently well-capitalized would slip to undercapitalized and another 152 credit unions would go from well-capitalized to adequately-capitalized. (All information is pulled from the September 30, 2013 call report).

If loan loss reserves were funded at 75 percent of nonperforming assets and OREO, 48 well-capitalized credit unions would become undercapitalized and 103 well-capitalized credit unions would become adequately-capitalized.

If loan loss reserves were funded at 50 percent of nonperforming assets plus OREO, we would see 13 credit unions transition from being well-capitalized to undercapitalized and 51 credit unions would switch from being well-capitalized to adequately-capitalized.