CUSOs Urge Better Model to Rate Risk
More questions than answers continue to shake the industry since the NCUA proposed a rule that would set higher capital requirements for credit unions with more concentrations in member business loans and other assets.
“The message that NCUA is sending, intentionally or not, is that CUSOs are risky and you need to reserve a hefty amount of capital if you dare to invest in them,” said Guy Messick, general counsel for the National Association of Credit Union Service Organizations. “NCUA is even proposing to risk weight the profits of CUSOs. In other words, if your CUSO makes money and the equity value increases, you must reserve for the profits made as well as the original investment.”
In January, the NCUA proposed a risk-based capital rule that says in order for a credit union to be classified as well-capitalized, it must maintain a risk-based capital ratio of 10.5% or above, and pass both net worth ratio and risk-based capital ratio requirements. Adequately capitalized credit unions would have to maintain risk-based capital ratios between 8% and 10.49% and pass ratio requirements. The threshold for undercapitalized credit unions would fall below 8%.
Part of the intent behind the rule is to avoid scenarios such as the failed Telesis Community Credit Union, which succumbed to losses stemming from MBLs.
However, Messick is convinced that CUSOs are being singled because of the sins of others. When risk rating CUSO investments, he wondered why the NCUA was not considering such criteria as the type of services being provided and whether the investment represents necessary operational expenses that would be otherwise incurred.
Other areas that should be taken into consideration are if the CUSO has a history of profitability and whether the investment amount has been fully recovered by the credit union through savings or income, suggested Messick.
The credit union industry needs to generate net income and CUSOs have demonstrated the ability to make millions of dollars per year in net income for credit unions through operational costs savings, additional interest income and additional fee income, said Messick.
“This extraordinarily high one-size-fits-all risk rating for CUSO investments is bad policy and does not account for the actual risk,” he explained. “In fact, the actual risk is not investing in CUSOs and generating net income.”
NACUSO President/CEO Jack Antonini reiterated that concern pointing to a compliance model in existence for 16 years.
“This proposal seems to supplement the current one-size-fits-all net worth system in place since 1998 with what is little more than a revised, and more complicated, one-size-fits-all risk-based capital version,” Antonini wrote in NACUSO's March 5 comment letter.
He added, “The one-size-fits-all nature of the proposed risk ratings is admittedly easier to apply for NCUA than would be a system with credits for historical risk management performance and risk weights that are documented by empirical data on a large-scale basis.”
Read more: Risk weight assigned to CUSOs doesn't measure up ...
Investments in CUSOs are considered by the NCUA to be among the riskiest asset classes for credit unions, according to the proposed rule's risk weighting table.
NACUSO offered examples of how the proposed risk weighting is disproportionate to the risk and reward scenario in CUSO investments. For instance, three large credit unions invested $2 million each in an IT CUSO. As the owners, they estimated that the CUSO provides approximately $4 million in savings each year through a split of a reduction in IT support staff and lower vendor costs.
However, the NCUA risk-based capital proposal suggests that unless the CUSO pays a cash dividend to the credit union owners, there has not been a return on the investment and the investment is at risk, according to NACUSO.
“The credit unions that are receiving annual returns of 100% to 200% on their investments through cost savings, together with markedly higher service levels than they could otherwise achieve on their own, see the CUSO investment risk and return quite differently than NCUA,” said Antonini.
To illustrate further the NCUA proposal's potential impact, NACUSO cited another example of a broker-dealer CUSO owned by more than 50 credit unions. Since its formation in 1997, the CUSO has paid more than $30 million in distributions to the owners and more than $1 billion in networking fees.
The average annual return based on the current offering price has been approximately 12% over the past 10 years with early investors receiving 70% to 80% annual returns based on their original investment. NACUSO said it knows of a credit union that was able to fully offset its losses from a poorly performing lending portfolio through the fee income it received from this CUSO.
“Credit unions are not penalized for making internal investments in costs to launch a new credit union product to generate income and serve their members,” said Antonini. “Credit unions should also not be discouraged from making an investment to launch a financial product within a financial services CUSO.”
It's one thing to issue a proposal that could potentially alter the way credit unions operate. It's quite another to not offer support and context.
“We see many credit unions that are not sufficiently educated or provided the appropriate level of regulatory guidance on how to design an effective risk management program for MBLs,” said William McCluskey, CEO of Willow Capital Group, a Centerbrook, Conn., firm that provides commercial loan origination, underwriting and closing for more than 30 credit unions.
For example, current MBL regulation allows credit unions to lend up to 80% on a loan, said McCluskey. There is no guidance in the development of sub-limits that are based on certain property categories that represent higher inherent risk and may require more conservative leverage constraints, he added.
Sponsor financial strength, management experience and market considerations are just a few other factors that need to be considered when developing the appropriate structure and defining recommendations on the maximum leverage Willow Capital is comfortable with, McCluskey said.
“From our standard starting point, some loans are considered strongly risk mitigated to up to 70%, our maximum comfort, absent SBA or other loss guarantee, while others are risk rated to a maximum, 50% or 55%, leverage point,” he said.
Meanwhile, banks use a variety of risk measurements to ensure that their portfolios produce a more predictable net yield, inclusive of a certain and often predictable level of delinquencies or loss experiences, said McCluskey.
“If regulations continue to be designed to ensure that credit unions have sufficient capital to fund the inevitable disaster without regard to providing credit unions the tools to avoid these events, it will continue to limit the effective and much needed entry of credit union capital into the commercial marketplace,” he warned.