The Federal Deposit Insurance Corporation (FDIC) insures for-profit bank deposits up to $250,000. The National Credit Union Association (NCUA) does the same for credit unions. Many business accounts easily exceed those limits. That is not cause for alarm as insurance – and insurance limits – only come into play if financial institutions fail. Choose a strong institution, and your business may never have to file a claim. Instead of looking to insurance, businesses should return to the foundational issue and assess the strength of financial institutions when choosing who to bank with.
“Increasingly, we hear from the community that businesses are considering credit unions when choosing their primary financial institution,” said Dana Gray, BECU Vice President of Business and Wealth Services. “Many local businesses like to bank with institutions that align with their values.” For some businesses, that might mean keeping their money local by working with a credit union or community bank; or looking for a financial institution that has community outreach programs, supports area non-profits, or has a strong philanthropic record.
According to a recent study by Raddon Financial Group, out of a ten-point scale, “more than one‐half of Community Bank and Credit Union business customers assigned a score of ‘9' or ‘10' in terms of their likelihood to recommend their financial institution to family members or friends.” Businesses that use major and regional banks scored their institutions the lowest in response to this question.
Businesses may have once turned automatically to big banks due to their size, but of course, “too big to fail,” has since been proven otherwise. For those interested in other options, it may help to know that the soundness of all financial institutions is analyzed with the same criteria. Just as insurance limits for the FDIC and NCUA, there is no difference between the way we determine the safety and soundness of national banks, community banks, and not-for-profit credit unions.
Several independent publications provide safety and soundness ratings by doing original research and analysis, including Bankrate and Weiss Research, Inc. In order to understand their ratings, you only need to know that safety and soundness are generally determined by examining four key ratios: capital, asset quality, liquidity and earnings.
The foundation of the four ratios is capital adequacy. This is the only ratio that is influenced by federal regulations, which have set minimums for capital that all financial institutions must meet. The regulators define “well-capitalized” at seven percent asset holdings over current liabilities. Many financial institutions have internal standards that exceed that definition. BECU, for example, the largest credit union in Washington and the fourth largest in the country, reports its capital adequacy on a quarterly basis and is currently evaluated at over 10.5 percent. Bankrate's analysis of capital adequacy takes into account the “quantity, quality, durability, and direction of net worth” of an institution's equity capital over the course of a calendar year.
For most banks and credit unions, the other three ratios – asset quality, liquidity, and earnings – are not mandated by regulations, but are still closely monitored. (Large and high risk institutions may have required standards to meet.) To a varying degree of regularity and sophistication, institutions run stress testing on asset quality, liquidity and earnings. They run simulations of different economic scenarios – severe downturns, various interest rate fluctuations – to ensure that capital, liquidity and asset quality can be maintained within operating norms.
After capital, liquidity is the other key ratio to institutional strength. Capital absorbs financial losses, and liquidity defines an institution's ability to meet financial obligations, such as withdrawals by depositors. Liquidity can be measured by examining the loan-to-deposit ratio, among other things, and should be examined within the context of the size of the institution.
Asset quality is based on a mixture of regional economic conditions, performing to nonperforming asset ratio, reserve coverage for nonperforming loans, and credit card lending activities.
Earnings is the fourth important ratio when evaluating financial institutions. Earnings takes into account return on average assets (ROA), which, according to Bankrate, is “the key measurement of profitability within the credit union industry.” The industry's ROA in 2015 was approximately 0.75 percent. The higher the ROA, the better for a credit union's rating in what is essentially an industry peer-to-peer comparison.
In contrast to ROA for credit unions, the key measurement of profitability within the banking industry is revenue growth for shareholders. While the same ratios are used to measure the strength of all financial institutions, the inherent differences in structure mean that credit unions and banks have different priorities. Credit unions seek to maintain strong capital as a matter of responsibility to their members. Banks are more likely to minimize capital in order to maximize earnings for shareholders.
Priorities will also affect how an institution handles liquidity and asset quality. Extremely conservative institutions, especially smaller ones, may have near perfect liquidity or asset quality ratios, but it's likely at the expense of turning down consumers or businesses who deserve loans.
Your business may not want to seek an institution with a perfect five star rating. Five stars is strong, certainly, and unlikely to fail, but it also indicates conservative lending and lower return-to-member practices that may not be to your benefit. Three stars is generally considered “performing,” to use Bankrate's terminology, but potentially warrants your periodic attention to make sure that institution's ratios have not changed. Institutions with four star ratings exceed the standard definitions of safety and soundness, and are more likely to have policies that will benefit you, such as reasonable underwriting requirements for loans.
Looking for a simple, cheat-sheet way to verify your choice? You likely need look no further than size. That does not mean you need to seek out the biggest institution. If you're truly concerned about the stability of an institution – especially with regard to deposits and insurance limits – just make sure that your deposits will be a small percentage of the overall deposit balance. Diversification in the financial industry, as in all industries, is a sign of strength. This is one case where you don't want to be a big fish in a small pond.