By way of explanation, two key statutory requirements guided the proposal:
First, section 1790d(b)(1)(a) of the Act requires the NCUA's prompt corrective action requirements to be comparable with those of the other federal banking agencies. The NCUA used the FDIC's capital rule, which is based on Basel III and was finalized in July 2013, as a baseline. However, the NCUA is proposing to adapt capital standards that account for credit unions’ assets and risk profiles.
Second, section §1790d(d)(2) of the Act requires the NCUA's risk-based requirement to account for all material risks. Thus, while Basel and the FDIC's rule focus primarily on credit risk, the NCUA's proposed rule factors in interest rate and concentration risk.
It would be informative, in evaluating the proposal, to be aware of the above guiding requirements, FDIC's capital rule, international capital standards (Basel), and accounting rules.
Following are several issues that provide additional perspective on the genesis and intent of the rule:
Since the NCUA first put the risk-based capital requirement in place over a decade ago, it has not been updated. In fact, two updates to Basel (II and III) were published during this period. In addition, the Government Accountability Office in a 2012 report to Congress recommended the NCUA update and improve credit union capital requirements. Further, the FDIC issued a final rule in 2013 updating capital standards for banks. To maintain comparability with the other federal banking agencies, the NCUA needed to act to modernize the capital standards for credit unions.
While the credit union system as a whole weathered the financial crisis relatively well, many individual credit unions did not. The lessons of the financial crisis confirm capital standards need to be well correlated to risk.
Only two credit unions are required to hold more capital under the current risk-based capital requirement – as opposed to 199 credit unions that would be required to hold more capital under the proposed rule. This is compelling evidence the current risk-based capital requirement is not sufficiently recognizing risk.
How would the proposal affect credit union capital levels?
The proposal is intended to improve the correlation between minimum required capital and risk. Collectively, the 199 credit unions that would decline in their PCA category have over $80 billion in assets and would need to add a total of about $700 million in additional capital (less than 1% of their assets on average), or reduce some of their risk, to be considered well capitalized under the proposal.
When credit unions fail by taking excessive risk without sufficient capital to back it up, the remaining credit unions are required by law to pay for their losses through the National Credit Union Share Insurance Fund. So if the riskiest credit unions were required to hold more capital, all other credit unions would face less of a threat to their own capital.
Over 94% of credit unions would remain well-capitalized under the proposed rule.
Reflecting the strength of the system, most credit unions maintain capital levels well above the regulatory minimum.
Some credit unions set their capital level based on their strategic plans and an in-depth analysis of their risks. Others, perhaps, maintain a large “buffer” to avoid falling into a PCA category that is less than well capitalized. Because of this, some analysts have suggested the proposal will require credit unions to hold billions of dollars more in capital. However, that is not necessary.
The proposed risk-based capital requirements would give credit unions more options.
Unlike the leverage ratio, where the only remedies are increasing capital or shrinking assets, credit unions can also manage their balance sheet mix (risk) to remain well capitalized under the risk-based requirement. Also, the more calibrated the proposal is to risk, the less there is a perceived or real need for capital levels above the minimum regulatory requirement.
In either case, capital levels above those required by regulation are a strategic risk management choice made by credit unions, not an obligation created by the proposal.
How would the proposal affect credit unions’ ability to grow?
All financial institutions need to make sure their capital keeps pace with growth. However, capital needs have always been, and always will be, a necessary constraint on growth. This means both growth and capital must be managed. Uncontrolled growth has led to the demise of many institutions.
The NCUA's proposal provides growing credit unions with flexibility in managing compliance with the risk-based capital requirement. If an influx of member deposits occurs, a credit union can invest these funds in lower risk-weighted assets, like Treasuries, and therefore not dilute its risk-based capital ratio.
How were risk-weights determined?
The NCUA carefully evaluated each rationale behind the different risk-weights in the proposal. We made significant efforts to calibrate the risk weights within the context of available data for credit unions, comparability to the risk-based system for banks, and recognizing several cost-benefit trade-offs.
For example, we were mindful of the trade-offs between precision and additional complexity, and between automated calculations and burdensome information reporting. If the rule is finalized, we intend to amend the NCUA's Call Report program so that a new risk-based capital ratio will be calculated automatically for each credit union.
While striving for overall comparability with the FDIC's rules, we did make adjustments such as weighting consumer loans at 75% in comparison to the banking system's risk weight of 100%. We retained the tiered risk-weight approach from the current rule to account for higher concentrations in member business loans and mortgage loans. The 2012 GAO report specifically recommended concentration risk be addressed.
How can we improve the proposal?
While the proposal is more calibrated to risk than the current system, it is nevertheless a high-level approach intended for broad applicability. To determine its optimum level of capital, each credit union will be encouraged to perform more precise capital modeling and planning relative to their unique market, risk profile, and strategic plans.
In the meantime, the NCUA will continue to explore ways to improve the rule. The comment process is very helpful in this regard. The NCUA Board provided a 90-day comment period given the importance of this proposal. Your input on how to improve the proposal is welcomed and encouraged.
Larry Fazio is Director of Examination and Insurance at the NCUA. He can be reached by contacting Public Affairs Specialist John Fairbanks at email@example.com or (703) 518-6336.