Throughout its defense of its risk-based capital rule making, the NCUA has invoked the FDIC’s experience. It has said the NCUA’s rule must be “comparable.” And when explaining why it adopted certain risk weightings, the NCUA's rationale is that this would better “conform” the NCUA’s model with the FDIC’s.
But the NCUA has never addressed the fundamental issue the FDIC board addressed in April 2014 when it unanimously adopted a simple, leverage-based capital model to supersede the requirements of its risk-based capital rule.
Risk-based capital, FDIC vice chairman Thomas Hoenig says, “doesn’t work.” RBC won’t work for credit unions, either.
FDIC Saw Time To Start Over, NCUA Should Too
The FDIC’s vice chairman has twice outlined how and why risk based capital does not work — and the need for a simple leverage ratio instead.
In a Sept. 12, 2012, speech to the American Banker Regulatory Symposium, Hoenig made the following points:
The poor record of Basel I, II, and II.5 is that of a system fundamentally flawed. Basel III is a continuation of these efforts but with more complexity.
It’s no coincidence the financial industry in 2008 could not withstand the pressures of a declining market nor bear anywhere near the losses the taxpayers eventually assumed.
It turns out that the Basel capital rules protected no one: not the banks, not the public, and certainly not the FDIC. The complex Basel rules hurt rather than help the process of measurement and clarity of information.
Given the questionable performance of past Basel capital standards and the complexities introduced in Basel III, supervisory authorities need to rethink how capital standards are set.
Starting over is difficult when so much has been committed to the current proposal. However, starting over offers the best opportunity to produce a better outcome.
“Well-Intended Illusions” Risk Entire Economic System
Speaking this time to the International Association of Deposit Insurers on April 9, 2013, Hoenig argues that real harm can result from good intentions. The FDIC vice chairman cites Aristotle as the first philosopher to systematically study logical fallacies, which the ancient Greek defines as arguments that appear valid but, in fact, are not.
“I call them well-intended illusions,” Hoenig says in that speech. “One such illusion of precision is the Basel capital standards.”
Despite advancements in risk measurement and modeling, it’s impossible to predict how and how much risks will change. Capital standards should serve to cushion against the unexpected, not to divine eventualities.
All of the Basel capital accords — including the proposed Basel III — look backward and then attempt to assign risk weights into the future. That simply doesn’t work, and it won’t with the NCUA’s proposed RBC standards, either.
If the Basel risk-weight schemes are incorrect — as they’ve often been — this could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets.
Basel systematically encourages investments in sectors pre-assigned lower weights — for example, mortgages, sovereign debt, and derivatives — and discourages loans to assets assigned higher weights — commercial and industrial loans.
We might have inadvertently created a system that discourages the very loan growth we seek and turned our financial system into one that rewards itself more than it supports economic activity.
If assigned risk weights could anticipate and calibrate risk with perfect foresight and adjust on a daily basis, then perhaps risk-weighted capital standards would be the preferred method for determining how to deploy capital.
However, they cannot. To believe they can is a fallacy that puts the entire economic system at risk.
Hoenig recommended — and the FDIC board approved — a tangible equity to tangible asset ratio. This easy-to-understand, enforceable leverage ratio is the solution the FDIC adopted in April 2014. The NCUA should do likewise, if it truly wishes to conform to the FDIC’s approach.
Credit Union Voices Needed Now More Than Ever
For more than 100 years, the credit union system has followed the capital adequacy approach that Hoenig urged the international banking community and his fellow FDIC board members to adopt: a simple leverage ratio of net worth to total assets.
This simple, easy to understand and measure practical ratio has worked. Cooperative capital has never been greater; the industry’s collective net worth ratio is more than 50% greater than the 7% well capitalized standard mandated by Congress.
To now overlay a failed, cumbersome, ever-changing rule requiring more than 70 asset risk weights makes no sense.
That is why it’s more important than ever that credit unions comment on NCUA’s second proposal. No matter how much tinkering and adjustments NCUA makes to the rule, the simple fact is it doesn’t work.
Although 98% of credit unions might not have any immediate capital increases under the rule, the second message from the FDIC is that this approach “can put the entire economic system at risk.”
For credit union supporters, that should be reason enough to file comments on whether you believe risk-based capital is a good policy for our cooperative system.
Raise Your Voice for your credit union and the industry. Stop by booth 162 at the GAC to make an RBC comment, grab a button, and take a photo. Bring your colleagues. The first round of risk-based capital comments topped 2,000. Anything less for round two signals approval. Cooperatives have a voice in their regulation; it's time to raise it.
Submit your comment today through the NCUA or through the Raise Your Voices web page.