Proposed Capital Rule Counterproductive
The proposed changes to credit union capital requirements illustrate the difficulty the NCUA faces in writing regulation and administering the prudential supervision of approximately 6,700 vastly different financial institutions.
The proposal seeks to address credit risk, interest rate risk, and concentration risk. Its focus is very different from the Basel III capital requirements, which concentrate on increasing the quantity and quality of capital for banking organizations with $500 million or more in assets. The differences likely produce the unintended consequence of making credit unions less competitive and less able to accumulate capital.
In short, the proposal as written works against its own purpose.
All credit unions are not alike; recent new rules prove this.
The proposal seeks to cover credit unions with assets greater than $50 million, but we would argue that, as with banks, credit unions greater than $500 million in assets are very different than small credit unions. These groups vary greatly in sophistication, product offerings, scale, market presence, and therefore should receive substantially different types of supervision and authority.
We have pointed out the top heavy distribution of assets among credit unions before. Approximately 410 credit unions have $500 million or more in assets. This means that 7% of credit unions account for 71% of industry assets.
The size difference alone makes these institutions very different. For comparison, the recent final derivative rule excludes over 6,000 credit unions, as does the new liquidity rule, because the asset threshold used to determine compliance is $250 million.
Our research indicates that credit union (and banks) with $1 billion in assets begin to achieve economies of scale. The aggregate group of credit unions with assets less than $1 billion does not produce net income without including fee income; or, put another way, net interest margin does not cover the cost of operations. This research is based on call report data and while there are individual exceptions, both above and below $1 billion, the trends clearly point toward $1 billion not being enough going forward.
Size and its related impact on the ability to produce income generate profound differences between large and small credit unions while new and contemplated legislative changes to reduce fee income will broaden the cleavage.
Without earnings, an institution cannot afford to invest in the people, systems, marketing and branching required to win business and secure technology. There were 9,555 credit unions with assets less than $100 million in 2000, but most were not nearly as profitable as larger credit unions or banks. At the end of 2012, 93% still have assets less than $100 million or have been merged into other entities.
Proposal puts credit unions at a competitive disadvantage.
Including interest rate risk and concentration risk limitations in a proposed capital rule becomes punitive for the larger credit unions, as they compete with banks that do not have the restrictions and yet maintain access to equity capital. For example, the rule proposes that a Fannie Mae bond with a five-year average life be risk weighted at 150%, which is more than seven times the risk weight for banks (20%). In contrast, the proposed risk weight for a credit union auto loan is 25% less than for banks. These disparities will dampen credit unions’ ability to make money because short duration bonds and auto loans are less profitable than longer duration bonds, small business loans and mortgage loans.
Mortgage loans are also treated differently for credit unions, which likely puts them at a competitive disadvantage because the risk weight increases at higher concentration levels as a percentage of assets. At the top end, the risk weight for credit unions is double that of banks. This could force some credit unions to turn away business to competitors.
Sandler O’Neill research to determine the impact of the proposed rule on credit unions with assets greater than $500 million indicates that 182 of the approximately 410 credit unions will be materially impacted by the rule. On the proposed risk weight basis, many lose enough cushion above adequately capitalized that a change of strategic direction in overall growth, or growth in certain assets seems inevitable.
The individual minimum capital requirement articulated in the proposed rule makes the interest rate risk and concentration risk elements of the proposal unnecessary.
The IMCR describes the agency’s authority to require a higher risk based capital level for credit unions whose balance sheets “are not contemplated by the rule.” Examples include, but are not limited to, high degree of exposure to interest rate risk, high degree of concentration risk, or poor liquidity or cash flow. Clearly, this provision allows for interest rate risk and concentration risk to be dealt with through supervision. If a credit union cannot demonstrate rigorous analysis and reasonable strategies for these risks, the IMCR provides a process for dealing with it. Blanket supervision of risk management through a capital rule would unnecessarily restrict earnings and capital accumulation in many credit unions that already demonstrate the expertise.
The most important tool for capital management is not contemplated by the rule or by Congress. Large credit unions increasingly tell us that receiving legislative authority to access equity capital has become vital to their strategic plans. Yet there is no relief in sight. These management teams are frustrated by the contradictory reality that, direct access to equity capital is unlikely; while the more difficult path to equity capital through charter change has become even harder, longer and more expensive. Note we are emphasizing equity capital which, along with retained earnings is the only capital that qualifies for Tier 1 under BASEL III.
Without access to equity capital, most of these credit unions would not be interested in acquiring average and lower-performing credit unions or banks. Credit unions are limited to cash as tender in acquisitions. This means that merger of sizeable competitors will not occur for larger credit unions because the combination will be dilutive to capital ratios. Our clients find this chilling as they witness their bank competitors add scale and efficiency through mergers and acquisitions.
Differences in capital treatment and supervision are no longer justified and are risky.
Large credit unions should have the same capital rules as banks. Large credit unions look and operate more like community banks and have little in common with small credit unions. To continue to regulate large credit unions differently than banks (and as if they are small institutions) implies operational distinctions that have all but vanished and ignores the fact that large credit unions and banks are offering the same financial products to the same households at generally the same rates and through the same distribution channels. To treat them differently on capital requirements and prudential supervision could prove harmful and fails to support the objective of Financial Stability Oversight Council for coordinated supervision of regulated financials.
Peter Duffy is managing director with Sandler O’Neill & Partners LP in New York City. He can be reached at email@example.com.