Capital Concerns Weigh on RBC2
Credit unions face a new future with capital reform, but experts say another issue – supplemental capital – may have a major influence on whether the industry can compete under new risk-based capital rules.
Most credit unions can only raise capital through retained earnings; banks, on the other hand, aren't subject to that limitation. In turn, banks typically have more venues through which to fund operations or acquisitions. For years, legislators have attempted to even things out by introducing bills that would lift the restriction for credit unions.
At the same time, the NCUA's new risk-based capital rules, or “RBC2,” have been percolating. RBC2 establishes, among other things, new risk-based capital ratios and new risk weights for credit unions. The NCUA board approved the rules on Oct. 15.
The NCUA received more than 2,000 comment letters on RBC2 – proof that that many people are thinking about how the new rules, which take effect in 2019, affect credit unions’ ability to compete. Without access to supplemental capital, some say, the competitive landscape will almost surely be worse.
To see just how RBC2 and supplemental capital intersect, one need look no further than RBC2's exemption for credit unions with fewer than $100 million in assets.
Most credit unions fall into that category, which brings them relief from the regulation. But there's actually little competitive benefit to staying under the cap, according to Peter Duffy, a managing director at investment bank Sandler O’Neill.
Credit unions can't compete on rate unless they’ve got the scale that allows them to do so and still turn a profit, he noted. And scale requires growth.
“What's more, no board should allow a manager to restrict the growth of an institution because of a risk-based capital rule,” Duffy added.
David Giesen, a managing director at Navigant Capital Advisors in Chicago, said many financial intuitions are probably going to have to get larger simply to cover the regulatory and administrative burden.
Some of those burdens are unique, said former NCUA Chairman Dennis Dollar, who is now principal partner at Dollar Associates in Birmingham, Ala.
“Personally, I believe the NCUA should use parity definitions in determining what a smaller institution is and whether those should be exempted from the RBC rule,” he said. “A $300 million bank is a small institution under banking rules, but a $300 million credit union is not, under credit union rules – that doesn't make sense to me, since both face the same marketplace and adhere to virtually the same regulatory requirements.
He continued, “We should not only compare credit union size in relation to other credit unions, because they operate and compete in a much broader market that includes banks, brokerage firms, insurance companies and others. I think, over time, banks and some other competitors will have a significant advantage over credit unions from a regulatory point of view if the definition of a small institution – and the resultant considerations for regulatory exemptions – is not treated similarly and with parity.”
Dollar said that as RBC gets closer to becoming effective, credit union boards and management teams will become increasingly frustrated with compliance.
“This will bring about more, not fewer, mergers as 2020 nears,” he said. “I predict we will have approximately 4,000 credit unions by 2020 when RBC is fully implemented, and examinations are being conducted annually with RBC numbers as driving factors in the exams.”
The search for economies of scale will also drive consolidation, Dollar said.
However, because credit unions can't raise additional capital, acquisition funding has to come from whatever credit unions can muster with retained earnings. That's not much, and it's far below what banks can raise, the experts said.
“Efficiency is going to become even more important,” Giesen explained. “In other words, if all of the capital that's coming into a credit union is coming from retained earnings and income, then you’ve got to begin to manage net income and maximize that income more if you intend to serve your membership base.”
RBC2's new risk weights could have a big effect on how credit unions manage that income.
“Auto loans, which currently are in about 6.5% under the current standard, are moving up to 100% assets at 10%,” Giesen said of risk weights proposed in RBC2, prior to the rule being finalized. “That's a very big difference for credit unions. It may make it more difficult to originate as many auto loans as a credit union may like. From that standpoint, you’re now going to have to reserve 10.5% on an auto loan.”
Risk weights on mortgages are another example, Duffy said. For every dollar of mortgages above 35% of the credit union's assets, the risk weighting goes up by 25 basis points under RBC2 as proposed, he explained.
“At that point, it's 25 basis points more on credit unions than banks. But up to 35%, the banks and the credit union risk weighting for mortgages is identical,” he said.
RBC2's treatment of the allowance for loan and lease losses is a relative advantage, Duffy noted, because it is capped for banks but not for credit unions.
Dollar said that if a credit union needs a balance sheet structure that is not perfectly aligned with the RBC model, it will have to make strategic decisions that are best for it and be prepared to answer examiner questions.
“If the team hopes to score, they cannot allow the referee to call their plays,” he said.
Nonetheless, for some credit unions, RBC2 may present a steep hill to climb without supplemental capital.
“Realistically, it's difficult to imagine, given the underlying trends in consolidating regulation, and shrinking margins, and higher capital requirements and higher liquidity requirements that the institutions that want to grow are going to be able to do it without access to capital,” Duffy said.