NCUA, Trades Debate Risk-Based Rule Cost
Few instances of regulatory guidance have created the same stir among credit unions as the NCUA's proposed risk-based capital rule.
But even fewer financial analyses have been as confusing as the one comparing NCUA's explanation of what it considers the true costs of the rule to both CUNA's and NAFCU's accusations of the economic burden credit unions will bear if the proposal passes.
The discussions to date have quite literally been a case of comparing NCUA's relatively small and conservative apples to the trade groups’ really big eggplant, and it's clear that there's little hope of harvesting an equal comparison.
At issue are the additional capital amounts required under the NCUA's new risk-weighting scenarios to protect credit unions from the impact that long-term assets may have on credit unions’ balance sheets, particularly in a rising rate environment.
By the NCUA's estimates, passage of the rule as written would drive only about 10 credit unions from an Adequately Capitalized to Less Than Adequately Capitalized rating, requiring an aggregate $63 million in additional reserves or pursuit of some other risk-reduction measures to bring the 10 or so credit unions back to an Adequately Capitalized level, according to Larry Fazio, the agency's director of the Office of Examinations and Insurance.
“From a Prompt Corrective Action standpoint nothing bad happens to you until you drop below Adequately Capitalized,” Fazio said. “We approached this in the most technically accurate way possible.”
Credit union trade groups have taken a different evaluative approach entirely. Under the proposed rules, minimum credit union capital levels rise from 7% to 10.5% for natural person credit unions, although many well-capitalized credit unions already maintain more than adequate and sometimes substantial capital levels. The additional cushion may have been established for a number of reasons and may add additional security to the institutions.
Acknowledging that many credit unions will need or want to maintain those cushions, CUNA and NAFCU have applied different multipliers to the existing capital numbers across the U.S. credit union movement. As a result, CUNA maintains that credit unions will have to earmark an additional $7.6 billion in reserve funds, while NAFCU has tagged $7.1 billion as the necessary amount.
“Under this scenario, $7.6 billion is the amount required when you take the 7% in current capital required and increase it to the new minimum level,” said Mike Schenk, CUNA's vice president of economics and statistics and interim chief economist. “The NCUA cannot dispute that fact, but the disputable part is whether the $7.6 billion leads to the amount truly required under the proposal.”
CUNA assumes all credit unions would want to hold some kind of buffer, but those with especially large buffers would not need to increase them if the rule passed, Schenk said. Prior to the recent recession, credit unions maintained an average net worth ratio of 11.5%, or 4.5% above the 7% minimum required amount. The margin is again approaching 4%.
Using a scenario in which only reductions of capital buffers to less than 3% of total assets are included, were the rule to take effect as proposed, 1,130 credit unions (45% of potentially affected credit unions) would find it necessary to acquire an additional $4.6 billion in capital to restore desired capital cushions, Schenk said.
Even in a more conservative case of only considering buffer reductions to less than 2% of total assets, 800 credit unions (32%) would likely feel compelled to raise more than $3 billion in capital, or rearrange their balance sheets, the CUNA economist said.
“Regardless of what the final number is, we know it's large and dwarfs the $63 million number the agency has put forth,” Schenk said.
Despite arriving at a slightly lower number, NAFCU agreed with CUNA's assessment, and has challenged the concept of mandating safety levels solely using a percentage figures. Like CUNA and other critics, NAFCU also believes the proposed rule to be unnecessary, according to Carrie Hunt, assistant vice president for governmental affairs and general counsel for the trade group.
“This seems to be a solution in search of a problem,” Hunt said. “Credit unions have fared well during the economic crisis, but the NCUA still seems concerned with levels of risk and hasn't adequately shown why the changes it proposed is necessary.”
In addition, measuring the capital cushion a credit union chooses to maintain solely in percentage points can sometimes paint an inaccurate impression about the institution's safety and soundness, according to Curt Long, NAFCU's senior economist.
“For an apples-to-apples comparison, it's better to measure the cushion in dollar terms,” said Long. “Due to the fact that most credit unions’ risk-weighted assets are much lower than their total assets, their risk-based ratios tend to be more volatile than their leverage ratios. In other words, any change in their capital stock causes their ratio to change by a greater percentage. But at the end of the day, what matters is the dollar value of capital above that arbitrary threshold.”
Fazio at the NCUA disagreed. “I don't accept that premise,” he said. “But even if I did, the buffer is not a function of our rule and not required under our regulatory and supervisory process. It's a choice credit unions are making to feel comfortable, and hopefully the buffer they’ve calculated is necessary for them.”
Despite healthy and sometimes heated levels of debate, the differing analyses do little to resolve the issue's apple-to-eggplant conundrum, according to various experts.
“The trade association numbers are based on the assumption – and I believe a correct one – that credit unions will strategically want to maintain essentially the same amount of cushion above the 10.5% risk-based capital threshold as they have previously maintained above the 7% PCA net worth threshold,” said Dennis Dollar, head of Dollar Associates in Birmingham, Ala., and both a former credit union CEO and NCUA board member.
“History tells us that examiners will continue to encourage credit unions to have a strategic cushion above the new RBC threshold just as they have encouraged a cushion above the PCA net worth of 7%,” Dollar said.
Many credit unions are convinced they will have to maintain that reserves cushion at a considerable cost in additional reserves, he said. Since those reserves come from earnings, they will have a direct economic impact on credit union's ability to invest in new branches, technology, products, services and dividends for members, he said.
Such a requirement would decrease a credit union's competitive capabilities as it attempts to unnecessarily strengthen an already substantial safety net, he added.
“This regulation is by its nature designed to increase reserves at most growing credit unions with more dynamic balance sheets than a plain vanilla model, and that is not a bad public policy,” said Dollar. “However, the devil and the costs – and there will be costs – are in the details. The NCUA needs to get it right, and I believe they recognize from the comment letters that some changes are needed to do so.”
Part of the issue that rankles some critics of the trade association assertions is the assumption that all credit unions will want to increase their equity to maintain the current level of cushion. Like any assumption, there is potential for error and misunderstanding, according to Peter Duffy, managing director of New York-based financial firm Sandler O’Neill + Partners.
“The agency has been clear in saying that these are the dollars required to be raised by the institutions that fall below the Well Capitalized level and have never said that this includes the cushion,” Duffy said. “I understand what the trade associations are trying to do, but the calculation that's been done to maintain cushion has many assumptions that are unknowable in the aggregate because the individual credit union will decide what levers, if any, to pull in order to achieve their idea of adequate capital.
“Credit unions are being very deliberate in what they plan to do if the proposal becomes final, and it's very much a to-be-determined scenario.”
Regardless of which scenario credit unions choose to accept, Duffy urged credit unions to do nothing definitive until the proposed rule becomes final and all requirements are known. Instead, credit unions should use this time to examine their balance sheet for potential tactics, such as selling mortgages and/or long-term investments, or simply keeping them and accepting less cushion.
The situation is fluid and has to be analyzed in the context of risks and other considerations, including the increased cost of compliance, understanding the increasing forms of traditional and non-traditional competition and, especially, the “day of reckoning” when the Fed finally raises rates, Duffy said.
“I believe we’ve already entered a banking era characterized by growing commoditization and increasing challenges from regulatory, technology and cost-of-business issues,” he said. “The difference between being successful today and five years from now is seated at the senior management table.”
The senior management and board teams that embrace this environment as an opportunity can leverage their credit unions’ strengths against weaker competitors and make significant inroads through organic growth and merger opportunities, Duffy said.