The credit union regulatory structure remains as unique today as it was when it was created. The system was shaped by law and design through continuous and thoughtful evolution from 1970 to 2002. Its three pillars have parallel components in the banking and thrift industries, but the credit union infrastructure is uniquely interwoven compared with those on the banking and thrift side. The pillars are:
- Chartering, supervision, examination, and — critically important — public reporting of call reports
- Liquidity lending
The thrift industry’s consolidation of these three functions within the Federal Home Loan Bank Board was dissolved after the thrift crisis of the 1980s. The Office of Thrift Supervision became an office within Treasury and will soon be merged into a single federal bank charterer. The Federal Home Loan Banks expanded their membership to include banks, credit unions, and others engaged in real estate lending and had an independent regulator, the Federal Housing Finance Board; the banks are now under the Federal Housing Finance Agency. The FSLIC fund was put under FDIC management and eventually merged into a single FDIC fund for banks and thrifts with a common, tiered premium structure.
The banking industry has always had separate pillars in chartering and supervision offices, the FDIC for insurance-liquidation, and the Federal Reserve as the lender of last resort as well as a settlement option.
The Unique Cooperative Model: A Generation’s Design Efforts
The combination of these three functions under a common board at NCUA reflects cooperatives’ collaborative approach, their ability to take the long view, and the unique financial models provided by collective capital, the base for both the CLF and NCUSIF financial structures. The three aspects were not created all at once but evolved from 1970 through the mid-1990s in a constructive, continuing dialogue between credit unions and the regulator, along with periodic rule adjustments.
Credit union regulation is different by design and when used effectively can be a source of enormous advantage and stability. It’s different because the role of credit unions is not the same as banks and thrifts, even if the tools used are similar. Credit unions are a way for members to organize, control, and direct resources and meet the needs for which for-profit firms do not offer solutions or offer solutions on terms not in the consumer’s best interest.
The regulatory design emerged from examples at the state level and in response to external conditions, especially the transition to deregulation and the forces of competition. Moreover, real dual chartering options still exist in credit unions because their insurance, regulation, and liquidity are not solely dependent on a single federal source.
The Uncertainty of Credit Unions’ Liquidity Pillar Today
If any of the three pillars disappears, is uncertain, or just wobbly, the financial stability of the entire system is at risk. If examination and supervision is faulty, everyone pays for mistakes, as were just disclosed by the $170 million loss at St. Paul Croatian FCU. If insurance is not properly funded and used for mutual benefit, it becomes an open-ended expense for liquidation rather than a collaborative resource for renewal and recovery.
However, the most consequential factor in any system is not one of these first two, which are used to some degree or other continuously. In a crisis — when markets become dislocated, credit and traditional lines dry up, and panic ensues — it is the liquidity pillar that matters most. Warren Buffett in Berkshire’s 2009 Annual Report described how he prepared for such a market crisis to illustrate his core business approach of “Invert, Always Invert” traditional concepts of accepted business strategy: “We will never become dependent on the kindness of strangers. . . [W]hen the financial system went into cardiac arrest in September of 2008, Berkshire was a supplier of liquidity and capital to the system.” Berkshire shifted money to no less than Goldman Sachs, Harley Davidson, GE, and Tiffany, and bought its unowned portion of the BNSF transportation firm. These were all blue chip firms, leaders in their market categories but paralyzed by the crisis. In many instances Buffett’s commitment enabled these firms to raise additional funding from other investors.
Only two other sets of institutions can make the same claim as Buffett’s for being suppliers of liquidity in 2008-09: 1) the federal government (the Treasury and the Fed in the form of direct loans and guarantees) and 2) the credit union system, whose total loan originations was a record $258 billion in 2008 and grew by 7.2 % to $272 billion in 2009 — the same year bank lending fell at an “Epic Pace” (as described by a Wall Street Journal headline).
In a crisis, liquidity is the ultimate resource. You can have a perfectly examined system and all the capital in the world, but when a liquidity event erupts, it overrides all else no matter how successful you are. So if Warren Buffet thinks liquidity is critical for a manufacturing firm and other businesses, liquidity is even more critical for a financial intermediary that borrows short and lends long. Only one asset pays par at all times — that’s cash. That outcome assumes the cash is in your control via collateral or other means to force the holder to repay on demand. A liquidity problem trumps capital, trumps regulatory oversight and rules, and makes the strongest, well-run firms weak and vulnerable.
Corporates and Credit Union Liquidity
Corporates are the primary reason credit unions were not reliant on the “kindness of strangers” during the recent Great Recession crisis. As recently as July 31, 2010 (time of the latest available data), the corporate system had more than $62 billion of advised lines of credit to their credit union members. These advised lines are often tied to the settlement account, allowing for convenient overnight advances if a member credit union overdraws its account. They are not contractual obligations and are most often supported by a pledge of assets, so the loan is seamless, convenient, and without worry. If lines are unused, there are usually no fees, and to activate them there are usually no fees, only the interest on the borrowing. These lines are continually monitored by corporates, which developed them as a vital part of their relationship value model.
These lines were a critical factor for why and how credit unions continued to be net providers of loans when the rest of the financial markets was frozen. Corporates had a track record and member confidence built over a 23-year series of events: the October 1987 stock market crash, the 1990-91 recession, the 1997 Russian debt/long-term capital crisis, the Y2K fears of system lockups, the 9/11 market shutdowns, and most recently, keeping liquidity intact in the worst market conditions of modern economic times. The corporate system’s liquidity function worked as it was designed to, even in the most difficult environment since the Great Depression.
The corporates were so dependable that even when a few larger members withdrew their funds early in 2008 at the peak of the crisis, without notice in many cases, the corporates honored billions of dollars of early withdrawals, charging only minimum early withdrawal penalties. And liquidity isn’t just advised lines and formal loans. Corporates had multiple additional programs helping credit unions manage balance sheet related liquidity, such as swaps, participation programs, secondary market aggregation (Charlie Mac), and multiple advisory and business solutions.
These options are at best uncertain today, if not formally eliminated by the conservatorships and the resulting changes in regulation. Some corporates are proactively reducing or canceling lines when credit unions are given specific CAMEL scores or report losses. This uncertainty is compounded in that almost all external sources of liquidity are also facing unknown futures. Thus at the same time the NCUA is removing much of the authority and flexibility to support credit union liquidity, Fannie and Freddie are in conservatorship; the FHLBs have their own investment issues, have much smaller lines, and require full collateralization and a borrower’s CPA opinion audit; and the bankers, if not strangers, are certainly competitors. If that weren’t enough to provide grave concern about system financial soundness, the CLF, the industry-created and -funded lender of unfailing reliability, was missing in action in 2008 despite repeated requests. The CLF was the one cooperative resource that Congress understood and responded to — not TARP allocations or other new programs. Congress raised the appropriated borrowing limit from $1.5 billion to more than $41 billion, the statutory maximum. Unfortunately the funds were not available until NCUA used them as a tool for conservatorships, failing to respond to repeated corporate and industry requests for liquidity and protracted credit assistance in both 2008 and 2009. It’s not even clear the CLF is operational today, let alone will be in the near future, because the source of almost all member capital, the MCS shares, have been extinguished at U.S. Central.
The Liquidity Pillar is Crumbling
With the industry-developed liquidity solutions now being dismantled, the NCUA’s corporate actions raise significant questions:
- How will the advised lines be replaced? If within corporates, what will be their sources now that their internal portfolio of funding is so limited and external borrowing capability unknown at best?
- How will credit unions replace the other liquidity, funding, and balance sheet management tools that are closely integrated with settlement and the continual relationship monitoring these other solutions entail?
- How will credit unions be able to be players in an FHLB system that is under stress and in which they have virtually no governance representation, contribute only about 4% of assets, and provide loans only on an underwriting- and collateral-secured basis for which many credit unions may not be able to easily qualify?
- Where in NCUA’s presentations, plans, and forecasts are these issues discussed and options listed and the consequences of reducing the industry’s internally funded sources analyzed?
Since WWII in only one year did credit unions not expand their balance sheet loan portfolios. That was 1981. The reason was the disintermediation that the deregulated money market mutual funds were having on insured deposits subject to rules on what credit unions could pay consumers, 5 1/4% thrift passbook savings limit and the 7% regular share limit for FCUs. When liquidity falters, the loan window is shut, credit becomes difficult for even the most qualified borrowers, and the ability of credit unions to be a counter-cyclical force for their members and the local economy is compromised.
This “social compact” aspect is one of the most important public policy reasons for credit unions; that is, credit unions are meant to “be there,” and meet member needs when for-profit firms cannot or will not due to market pressures. Cooperatives are different by design so that members can count on their funds being available, come hell (market cardiac arrest) or high water (Katrina).
Because liquidity is so fundamental for system soundness and today completely undefined, the situation raises a much larger topic of what should be the focus now for cooperative efforts. While waiting for more information on actions taken, it is clear the ultimate issue is more than how many corporates might exist and what rules will finally apply. How could the credit union system have been left so vulnerable at this critical moment in both the country’s and the industry’s recovery? This will be the topic of additional analysis in our weekly Industry Insights, plus a special edition of the Callahan Report looking at all aspects of NCUA’s recent actions.