The Need for Capital Options

In mid-August, the comment period for NCUA's proposed rule to apply the Prompt Corrective Action (PCA) section of HR 1151 will close.


In mid-August, the comment period for NCUA's proposed rule to apply the Prompt Corrective Action (PCA) section of HR 1151 will close. How this part of the legislation is implemented could be more critical to credit unions than the rules dealing with field of membership. Those regulations affect only federal charters. The rules on capital impact all federally insured credit unions.

The original threat was that the banker's suit would shut off growth opportunities by preventing credit unions from taking in new members. The PCA legislation could result in the same no growth outcome by preventing credit unions from serving new members in any meaningful way.

Capital Basics in Credit Unions
Until HR 1151, the history of credit unions and capital was that capital was generated as a flow from income. The regulations required that a certain percentage of total income be set aside until certain ratios of capital to risk assets were met. For example, federally insured credit unions were required to "reserve" 10% of gross income until the ratio of capital to risk assets reached 4%. The transfer rate was reduced to 5% at that level.
This regulatory concept was that capital came from revenue over time, not as a set amount required at a point in time. This approach has worked. Credit unions' average equity to asset ratio of approximately 11% at June 1999 is higher than any of their depository institution competitors.

The problem is the new law does not recognize this "flow" over time concept. Rather the theory of Prompt Corrective Action is that depository institutions must maintain a fixed ratio of capital to assets at every point in time or be subject to regulatory oversight and increased supervision. The "floor" on this measure is 7%. Anytime a credit union falls below this, regulatory constraint on its activities are imposed.
The theory of Prompt Corrective Action comes from the banking industry. In that world, banks and thrifts have the ability to raise capital from external sources through sales of stock or subordinated debt which can provide the needed capital when they are presented with a crisis or an opportunity. These options do not exist in the current credit union capital structure. The top of the ratio, capital, comes only from retained earnings.

The Current Conditions
At the present time, credit union capital grows about 9.5 to 10% per year (see graph on page 6). That would be the maximum asset growth that credit unions could support and still retain their capital ratio. At midyear 1999, new member growth in credit unions was running over 5%. The cost of funds is about 4%. So if a credit union just kept up with general market trends, then they would be using up all of their "capital capacity" before they reach out for new opportunities.
These new opportunities are certainly there. The restructuring of the banking and thrift industries where the vast majority of assets are held by a small number of national or super-regional firms, is leaving many communities without locally owned options. San Diego, California; Tampa and Jacksonville, Florida; and San Antonio, Texas are just some of the communities where credit unions are the largest local depository institution.
Moreover, the realignment of the financial services industry driven by the Internet and new competitors is offering growth opportunities of double digits per month. The growth of home banking accounts is estimated to be over 65% per year for the next five years. New products and service options are causing consumers to look for new solutions. Many credit unions are part of this innovative wave.

Leaders Focus on Member Service
Some of the most creative and member service-driven credit unions have single digit capital ratios in the 7 to 9% range (see table on page 6). They have dynamic growth opportunities because of their business leadership and market effectiveness. Their rate of earnings as measured by ROA is in the upper quartile; their delinquency is lower than average and their expense ratios are generally less than their peers. The result of their effectiveness is that their members want to do business with them often resulting in growth of savings and loans in the 15 to 25% range. These credit unions are among the most safe and sound institutions, but their financial dynamics cause them to have lower capital to asset ratios while they still produce above average capital growth from earnings. This flow to retained earnings however, is not as high as the underlying growth rate of savings and loans in times of great opportunity.

Options from the System and Cooperatives
Fortunately options for allowing credit unions to meet the new PCA requirements and fulfill the needs of their members do exist. In the past five years NCUA has supported alternative capital programs for corporate and community development credit unions. These alternatives have included membership shares and term deposits by third parties that are uninsured. These options recognized that parts of the credit union system were "capital rich" and that this surplus could be used to help credit unions that were "capital poor." The actions were a logical extension of the credit union principles where those persons with savings help other members who need to borrow.
But the options are even broader than membership shares and uninsured term deposits. In cooperatives and other member-owned firms, capital has been contributed by members by creating shares or notes that result from the members use (or patronage) of the cooperative. These firms have also accessed the markets by creating new forms of capital that uniquely fit their organization's needs, e.g. trust preferred shares. There have been original solutions to the capital needs of organizations from non-profits to mutual firms that do not issue stock. Credit unions can use these precedents and not compromise any of their democratic, member-owned governance structure.

The Way Forward: Pilots
Market opportunities won't wait because consumers will not continue to use a second class product when a better alternative exists. The world of today is very different from just five years ago because the speed and ubiquity of Internet solutions can cause an enormous shift of loyalties to occur literally overnight. Traditional solutions can be threatened by new upstarts in a matter of months. The founder of Netscape, Jim Clark, describes this New World as similar to riding a motorcycle. "Stability is a function of momentum. In other words, move fast, keep going or end up on your butt. In our business stability and security come from doing things quickly."
Capital is the fuel that enables organizations to act quickly. For credit unions and NCUA, soundness comes not from the level of capital but from capital creation and access. To improve access, credit unions should develop pilot programs that use the best of both credit union and cooperative examples to expand credit union capital options. Pilots encourage innovation, can be accomplished without a lot of administrative bureaucracy and can help identify the best way forward.
Implementing Prompt Corrective Action without capital options will strangle credit unions sitting on opportunity. These organizations will have only two choices: slow death or convert to a more flexible regulatory environment. NCUA has the opportunity to create that environment, provide credit unions greater flexibility and meet the legal mandates of 1151. This could be the most important test of the Agency's responsiveness since deregulation.




Jan. 3, 2000



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