The document contains few structural mandates. Instead, regulators have introduced stronger capital requirements and risk management measurements that could impact operational strategies.
NCUA Director of Public and Regulatory Affairs John McKechnie agreed that the proposed rule changes were primarily aimed at improving risk management, particularly as it relates to investment products and strategies that have emerged in markets since the last time corporate regulations were updated.
"We wrote the new safeguards and standards to not only address past problems, but hopefully keep corporates ahead of future problems, too."
New capital requirements lead the way for corporate reform. Proposed paragraph 704.3(a) would require a corporate to maintain, at all times, three minimum capital ratios to achieve adequately capitalized status. They include a leverage ratio of 4.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a total risk-based capital ratio of 8.0% or greater. Additionally, retained earnings would have to constitute a portion of capital.
Tier 1 risk-based capital ratio (T1RBCR) would be defined as the ratio of adjusted core capital to the moving daily average net risk-weighted assets. The NCUA said it intends this ratio, along with the total risked-based capital ratio (TRBCR), to "ensure that the corporate has sufficient capital to handle the credit risk associated with its investments and activities."
Basically, the regulations aim to force a corporate to use at least half of its permanent, Tier 1 capital for "purposes of protecting against losses associated with credit risk." Tier 2 capital will be figured into the TRBCR and includes the newly named nonperpetual capital accounts (NCA), which replace member capital accounts (MCA). Tier 1 capital consists of perpetual contributed capital (PPC), formerly called paid-in capital (PIC).
The proposal also increasing their minimum term for NCA account from three to five years.
The leverage ratio is similar to corporates' current core capital ratio, which only includes permanent capital like paid-in accounts. It would measure adjusted core capital divided by moving daily average net assets. The DANA denominator in the equation is very close to what corporates currently use to figure core capital. However, the proposed adjusted core capital numerator requires the corporate to make several modifications to core capital.
The NCUA said the new leverage ratio "ensures that the corporate has adequate capital to provide for losses other than credit losses."
The NCUA said that based on August 2009 5310 data and including U.S. Central's most recent losses, only two of the 28 corporates would meet the proposed adequately capitalized standards, and 16 would be considered critically undercapitalized.
Compliance under the proposed plan would be phased in. Corporates would have to meet the two risk-based capital ratio requirements after one year, in addition to meeting current minimum capital ratios.
"Corporates will have several methods, or combination of methods, to achieve compliance," the NCUA wrote in the proposed rules. The regulator suggested decreasing aggregate assets or portfolio risk, increase retained earnings, or raise new capital.
Beginning with the third year, corporates would have to be in compliance with the new leverage ratio. Corporates have another four years to meet the final requirement that at least 100 basis points of retained earnings contribute toward the institution's leverage ratio.
"Corporates can only achieve this retained earnings requirement by decreasing assets or increasing retained earnings," the NCUA wrote.
Chairman Debbie Matz said in her statements that accompanied the proposal that the NCUA made adjustments to the phase-in schedule according to feedback received at this fall's Town Hall meetings.
"We did this to reflect the economic realities of the rate at which corporates can generate net income based on the proposed limitations on investment authority," she wrote. "The three-year milestone reinforces that corporates must begin working to build retained earnings from the outset."
The NCUA also said although the new regulations would be phased in, it nonetheless expects corporates to begin calculating and reporting the new capital ratios "upon publication of the final rule."
The proposal includes several scenarios under which corporates could increase retained earnings and employ other strategies to meet new capital requirements during the phase in period. Corporates would also be allowed to issue subordinate debt to both members and nonmembers and count it as NCA, provided it meets standards applied to other NCA accounts, like the new five-year minimum term.
Expanded investment authorities would contract under the new rules. The proposal tightens allowed investments for Part I authority and requires corporate to meet new well-capitalized standards to even qualify for Part I. It also eliminates Part II authority completely. Part IV would also be modified to ensure corporates do not use derivatives to take on additional risk but only to mitigate interest rate or credit risk or to create structured products.
Proposed rules also limit investment in single obligors to 25% of capital, which the NCUA said encourages diversification while preventing excessive risk concentration. It also adds a new paragraph, 704.6(d), which establishes 10 distinct asset classes and limits investment in any one sector to either the lower of 500% of capital or 25% of assets. Corporates may invest up to 1,000% of capital or 50% of assets in less riskier sectors, which include corporate debt obligations, municipal securities and FFELP student loan securities.
Further, investment in subordinated securities would be limited to the lower of 400% of capital or 20% of assets. In addition, the investments would be limited to 100% of capital or 5% of assets per asset sector. The regulation intends to limit investment in so-called "mezzanine tranche" securities that have a "junior claim on the underlying collateral or assets to other securities in the same issuance." Such investments have been responsible for the majority of WesCorp's losses.
NCUA Deputy Executive Director Larry Fazio commented on proposed risk management regulation, saying "we need a corporate model that generates income but not one that creates so much risk, losses could quickly blow through capital. Capital is an institution's last line of defense, not its first. The first is risk management."
Another proposal places two new limits on the use of national recognized statistical rating organizations like S&P, Fitch and Moody's. Corporates would be required to report the "lowest available NRSRO rating for compliance purposes." Additionally, a minimum of 90% of a corporate's investment portfolio book value must be rated by at least two NRSROs.
Though higher capital requirements have received the most attention so far, Fazio said regulation addressing average life mismatches between assets and liabilities will "clearly be one of the areas subject to much analysis and debate during the comment period."
At issue is limiting liquidity risk that comes with the revenue-producing opportunities that come with mismatches between investments and borrowings. Fazio said the NCUA attempted to provide a fair and prudent standard for balancing risk and return.
"If assets and liabilities are perfectly matched, it's almost impossible to generate a positive spread," he said.
Net economic value, traditionally used to measure interest rate risk, would also include average life mismatch NEV modeling according to the proposal. Under new paragraph 704.8(e), corporates would have to perform average life NEV stress testing to 300 basis points without dropping its NEV ratio below 2%. Another proposal requires prepayment stress testing.
New paragraph 704.8(h) limits the weighted average life of corporate assets to two years.
"The board believes that an excessive asset average life is inconsistent with a corporate's primary missing and subjects the corporate to unnecessary risks," the NCUA wrote. The two-year limit should give corporates adequate flexibility while "maintaining a risk profile consistent with the corporate mission."
Proposed new prompt corrective action rules for corporates would give the NCUA greater authority. As they do today, corporates who fall below adequately capitalized status would be required to file a detailed capital restoration plan that would be subject to NCUA approval. Under the proposal, they would also be prohibited from allowing daily average net assets to exceed moving DANA unless part of the approved restoration plan and would be prohibited from certain growth strategies.
If a corporate's capital restoration plan is denied or the institution slips into significantly undercapitalized status, the NCUA proposes additional powers, including forced recapitalization, dictated share and deposit rates, prohibition from paying dividends on contributed capital or subordinated debt, restrictions on current business and new growth, the replacement of directors or senior executives with NCUA-approved candidates, limited payments to senior executive officers, salary increase freezes and conservatorship, liquidation or forced mergers.
In the case of a state-chartered corporate credit union, the NCUA would consult with and seek to work cooperatively with appropriate state officials before taking any PCA action. The proposal includes other instances of language that acknowledges the authority of state supervisors.