The proposed changes to creditunion capital requirements illustrate the difficulty the NCUA facesin writing regulation and administering the prudential supervisionof 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 BaselIII capital requirements, which concentrate on increasing thequantity and quality of capital for banking organizations with $500million or more in assets. The differences likely produce theunintended consequence of making credit unions less competitive andless able to accumulate capital.

In short, the proposal as written works against its ownpurpose.

All credit unions are not alike; recent new rules provethis.

The proposal seeks to cover credit unions with assets greaterthan $50 million, but we would argue that, as with banks, creditunions greater than $500 million in assets are very different thansmall credit unions. These groups vary greatly insophistication, product offerings, scale, market presence, andtherefore should receive substantially different types ofsupervision and authority.

We have pointed out the top heavy distribution of assets amongcredit unions before. Approximately 410 credit unions have $500million or more in assets. This means that 7% of credit unionsaccount for 71% of industry assets.

The size difference alone makes these institutions verydifferent. For comparison, the recent final derivative ruleexcludes over 6,000 credit unions, as does the new liquidity rule,because the asset threshold used to determine compliance is $250million.

Our research indicates that credit union (and banks) with $1billion in assets begin to achieve economies of scale. Theaggregate group of credit unions with assets less than $1 billiondoes not produce net income without including fee income; or, putanother way, net interest margin does not cover the cost ofoperations. This research is based on call report data andwhile there are individual exceptions, both above and below $1billion, the trends clearly point toward $1 billion not beingenough going forward.

Size and its related impact on the ability to produce incomegenerate profound differences between large and small credit unionswhile new and contemplated legislative changes to reduce fee incomewill broaden the cleavage.

Without earnings, an institution cannot afford to invest in thepeople, systems, marketing and branching required to win businessand secure technology. There were 9,555 credit unions withassets less than $100 million in 2000, but most were not nearly asprofitable as larger credit unions or banks. At the end of2012, 93% still have assets less than $100 million or have beenmerged into other entities.

Proposal puts credit unions at a competitivedisadvantage.

Including interest rate risk and concentration risk limitationsin a proposed capital rule becomes punitive for the larger creditunions, as they compete with banks that do not have therestrictions and yet maintain access to equity capital. Forexample, the rule proposes that a Fannie Mae bond with a five-yearaverage life be risk weighted at 150%, which is more than seventimes the risk weight for banks (20%). In contrast, the proposedrisk weight for a credit union auto loan is 25% less than forbanks. These disparities will dampen credit unions' ability to makemoney because short duration bonds and auto loans are lessprofitable than longer duration bonds, small business loans andmortgage loans.

Mortgage loans are also treated differently for credit unions,which likely puts them at a competitive disadvantage because therisk weight increases at higher concentration levels as apercentage of assets. At the top end, the risk weight for creditunions is double that of banks. This could force some creditunions to turn away business to competitors.

Sandler O'Neill research to determine the impact of the proposedrule on credit unions with assets greater than $500 millionindicates that 182 of the approximately 410 credit unions will bematerially impacted by the rule. On the proposed risk weight basis,many lose enough cushion above adequately capitalized that a changeof strategic direction in overall growth, or growth in certainassets seems inevitable.

The individual minimum capital requirement articulatedin the proposed rule makes the interest rate risk and concentrationrisk elements of the proposal unnecessary.

The IMCR describes the agency's authority to require a higherrisk based capital level for credit unions whose balance sheets“are not contemplated by the rule.” Examples include, but arenot limited to, high degree of exposure to interest rate risk, highdegree of concentration risk, or poor liquidity or cash flow.Clearly, this provision allows for interest rate risk andconcentration risk to be dealt with through supervision. If acredit union cannot demonstrate rigorous analysis and reasonablestrategies for these risks, the IMCR provides a process for dealingwith it. Blanket supervision of risk management through a capitalrule would unnecessarily restrict earnings and capital accumulationin many credit unions that already demonstrate the expertise.

The most important tool for capital management is notcontemplated by the rule or by Congress. Large creditunions increasingly tell us that receiving legislative authority toaccess equity capital has become vital to their strategic plans.Yet there is no relief in sight. These management teams arefrustrated by the contradictory reality that, direct access toequity capital is unlikely; while the more difficult path to equitycapital through charter change has become even harder, longer andmore expensive. Note we are emphasizing equity capital which, alongwith retained earnings is the only capital that qualifies for Tier1 under BASEL III.

Without access to equity capital, most of these credit unionswould not be interested in acquiring average and lower-performingcredit unions or banks. Credit unions are limited to cash as tenderin acquisitions. This means that merger of sizeable competitorswill not occur for larger credit unions because the combinationwill be dilutive to capital ratios. Our clients find this chillingas they witness their bank competitors add scale and efficiencythrough mergers and acquisitions.

Differences in capital treatment and supervision are nolonger 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 andhave little in common with small credit unions. To continue toregulate large credit unions differently than banks (and as if theyare small institutions) implies operational distinctions that haveall but vanished and ignores the fact that large credit unions andbanks are offering the same financial products to the samehouseholds at generally the same rates and through the samedistribution channels. To treat them differently on capitalrequirements and prudential supervision could prove harmful andfails to support the objective of Financial Stability OversightCouncil for coordinated supervision of regulated financials.

Peter Duffy is managing director with SandlerO'Neill & Partners LP in New York City. He can be reached [email protected].