Look What's Coming: Risk-Based Capital and Basel II
On April 4, 2005, the NCUA announced that they had delivered to Congress a report titled "Prompt Corrective Action Proposal for Reform" (available at www.ncua.gov/ReportsAndPlans/special/special.html). The report describes the recommended statutory changes from the NCUA to meet Basel II (the latest international agreement on standardized capital ratios for financial institutions), and put credit unions' capital requirements on par with FDIC insured institutions. Furthermore, it discusses how these changes affect credit unions and provides a proposed method for the NCUA to design and implement a new risk-based system for federally insured credit unions. The reform proposal was published initially in draft form in February 2005, following over a year of work to analyze alternatives to the current Prompt Corrective Action structure. The proposed changes, according to NCUA's press release, "will result in net worth requirements which more precisely reflect the credit union risk, while providing an appropriate safeguard for the NCUSIF." The significance of these changes, if approved, to credit unions insured by the NCUSIF will be felt in required capital levels. Currently, a credit union calculates their net worth ratio by dividing net worth by total assets. Under the existing Prompt Corrective Action (PCA) standards, this net worth ratio must meet a minimum standard 6% for the credit union to be considered well capitalized. The NCUA is requesting that the minimum capital level ratio be dropped to 5%, and that an additional net worth ratio based on risk-weighted assets be added. The proposal's recommendation is a dual capital measurement; one using the traditional calculation method, and the second using risk-weighted assets in the numerator. The NCUA is making sure that credit unions do not grow their assets at a pace that their retained earnings will not support, and that capital ratios reflect the underlying credit risk of the assets a credit union has on its balance sheet. During a period of rapid growth, a credit union could fall below the minimum capital standards because its retained earnings (its main source of capital) would not grow in proportion to their new assets. In many instances, a credit union may have to turn away new business in order to stay in accordance with regulations. A criticism of the existing PCA standards is that it does not differentiate credit unions based on their risk profile. A credit union that takes on higher credit risk activity, such as a high level of business loans, is treated the same way as a credit union that is more conservative in its structure with a high level of cash and investments in Treasuries or Agencies. Since many credit unions seek to maintain a cushion of capital above the minimum standard, many financially sound credit unions are tying up reserves that could otherwise be used to provide services to their members. his is because the net worth ratio currently tracked by the NCUA is not based on the level of credit risk embedded in the assets owned by credit unions. This proposal from the NCUA is intended to alleviate the capitalization problem and treat credit unions based on their risk profile by using a Risk-Based Capital (RBC) approach to calculate a credit union's net worth. The concept behind RBC is to apply different weights to the different asset classes held by a credit union. Those assets considered to be riskier would carry higher risk weights than those less risky assets, such as cash. A credit union with a lower risk profile would have to maintain less capital to be in accordance with PCA standards. In many cases a credit union would find that it is more than sufficiently capitalized. A credit union operating at the proposed minimum 5% Net Worth Ratio would need to have assets with an average risk weight greater than 62.5% before they would not meet the proposed 8% Risk-Based Net Worth Ratio for the well capitalized classification. Given the proposed asset risk weightings, this should not be a challenge for most credit unions. With a higher capitalization ratio, a credit union could focus on growing their business and not worry about triggering PCA thresholds. "The Prompt Corrective Action Proposal for Reform" is indeed a positive step for credit unions. It strengthens the standards for managing credit unions, but also creates a standard by which credit unions can compare amongst themselves. This also increases competition in a very healthy manner. The quantification of asset-risk weighting categories will also help some credit unions gain comfort in investing in safe, but previously unconsidered asset categories, to increase performance measurements. While this is a change of thinking for credit unions, the proposal will only strengthen the Credit Union Movement.