After four years of politicking and revising, NCUA’s risk-based capital (RBC) rule, for all intents and purposes, is now a fact of life. Now, complex credit unions have a four-year window to revamp their balance sheets and renovate internal training procedures for a rule where, as stated on page 1 of the document, “the overarching intent is to reduce the likelihood of a relatively small number of high-risk outliers exhausting their capital and causing systemic losses.”
Last Thursday, NCUA approved its risk-based capital proposal by a vote of 2-1, with board member Mark McWatters the lone dissenter. This final rule, which will take effect on Jan. 1, 2019, incorporated changes to the risk weights from the January 2015 proposal. Still, questions remain.
As board chair Debbie Matz stated during the meeting, “The Federal Credit Union Act (FCUA) requires NCUA to update its risk-based capital standards to be comparable with the federal banking agencies.”
Matz called the current Prompt Corrective Regulations regulations outdated, referencing analyses by both the Government Accountability Office and the NCUA Inspector General that found “the existing [regulation] failed to adequately mitigate credit union losses as a result of the financial crisis.”
Complex credit unions — those defined as having more than $100 million in assets — are bound by this rule. According to NCUA data, 1,489 credit unions meet this definition, representing approximately 24% of industry institutions and 90% of industry assets.
However, according to the NCUA’s calculations (based on Dec. 31, 2014, 5300 data) 1% of these complex credit unions would see their capital ratios downgraded from well-capitalized to adequately capitalized and from well-capitalized to undercapitalized. That’s a total of 16 credit unions, only one of which would be downgraded to undercapitalized (an unnamed institution with more than $1 billion in assets). In total, Matz says, those 16 credit unions have total assets of $10 billion, although nine have between $100-$200 million.
Based on the current risks on their balance sheets, those 16 credit unions would have a combined capital shortfall of $67 million.
Additionally, as the below chart illustrates, nearly 69% of complex credit unions operate with a 500-basis-point margin above the 10% well-capitalized ratio. This is compared to the 26.5% of these same complex credit unions based upon the well-capitalized net worth ratio of 7%.
Capital Buffers For Credit Unions With More Than $100 Million In Assets
Less Than 0 Basis Points Above
0 To 200 Basis Points Above
200 To 300 Basis Points Above
350 To 500 Basis Points Above
More Than 500 Basis Points Above
Final Risk-Based Capital Ratio (10%)
Net Worth Ratio (7%)
Despite only directly affecting, as NCUA estimates, 16 credit unions, both RBC proposals generated 2,000 comments from credit union employees and members (2,056 for the first and 2,169-plus for the second). This fact prompted the agency’s vice chairman Rick Metsger to paraphrase Winston Churchill at the board meeting: “Never have so many commented on a rule that impacts so few.”
Responding to Metsger’s statements in a blog post, State Employees’ Credit Union CEO Jim Blaine referred to it as a “Petty-sburg Address” and wrote, “Had Mr. Churchill had the opportunity to read Mr. Metsger’s harangue, he would have reused another of his famous quotes to note: ‘He is a modest man who has a good deal to be modest about.’”
The Politics Of It All
Matz, Metsger, and McWatters spent two hours “discussing” the final proposal in advance of the vote.
Matz spent her time speaking about the NCUA’s legal obligation to update its risk-based capital standards in accordance with “other banking agencies,” as the rule identifies them, which updated their own capital standards in 2013. She read into the record a letter sent from House Financial Service Committee chair Jeb Hensarling, who opposed the NCUA’s decision to vote on the rule before complying with the request set forth in H.R. 2769, the Risk-Based Capital Study Act. This act, which was approved 50-9 in the committee, would require NCUA to consider the impact of a two-tier, risk-based capital rule on credit unions.
The letter stated, in part:
“It is deeply troubling that you would utterly disregard the express will of this Committee and rush to adopt a misguided rule that risks undermining the safety and soundness of credit unions in contravention of the NCUA’s statutory mandate.”
By reading this letter into the record, she hung a lantern on a point of criticism that McWatters was destined to include in his dissention, effectively beating him to the punch. And in fact, during his time to speak, McWatters discussed H.R. 2769.
Between the two of them, it was less of a discussion on the applications and effects of the rule than an opportunity for each to state tightly crafted statements for the record.
As it has throughout the process, McWatters’ main point of contention lies in an interpretation of Section 216 of the FCUA. Specifically, over whether the NCUA has the legal authority to implement a two-tiered risk-based capital framework.
This section of the FCUA was written into the risk-based capital rule itself as justification. On page 37, it reads: “Section 216(d)(2) of the Federal Credit Union Act requires that the [NCUA] board, in designing a risk-based net worth requirement, ‘take account of any material risks against which the net worth ratio required for [a federally] insured credit union to be adequately capitalized may not provide adequate protection.’”
Last year, NCUA paid the law firm Paul Hastings LLP $150,000 for its interpretation of this particular section. In its review, the firm granted that an interpretation of this language “could” support the legality of a two-tiered framework.
‘"Could’ is the weakest of several gradated legal evaluations in a permissibility review,” says Callahan’s vice president of research, Chris Howard. “That’s why McWatters, an experienced attorney who has personally authored many permissibility reviews, objected to it, particularly to the way Matz originally spun it as an endorsement — which it certainly is not.”
McWatters has also objected to the exclusion of a mechanism for credit unions to raise capital outside of retained earnings from the rule. Although the final rule does not include a mechanism for credit unions to raise supplemental capital, Matz specifically stated the NCUA board plans a separate proposed rule to address comments supporting additional forms of supplemental capital.
Because the RBC rule will not take effect for another four years, however, there’s “no rush to enact supplemental capital into this rule because [credit unions] wouldn’t need it until 2019,” Metsger said.
Yet, despite that good faith promise, the Risk-Based Capital rule, Howard says, still fails the credit union system.
“The rule still treats risk as a one-dimensional issue receptive to a one-size-fits-all policy,” Howard says. “It still only looks at one side of the balance sheet and discounts the value of active risk management by financial professionals – what’s traditionally known as ‘good banking.’ At its core, it strikes as a tone-deaf power play by a cloistered group of regulators who honestly seem to believe that they are the only people who understand and truly care about credit unions — not their staffs, not their member-owners, not the professionals who serve them, and certainly not Congress — just the denizens of Duke Street.”
Next: The Credit Union Effect
The Credit Union Effect
NCUA estimates the final rule will result in estimated incremental non-recurring costs of more than $2 million spread over three years in revising call report, exam, and other data systems, and another $2 million in training costs. The NCUA will put out guidance in 2019 and train examiners during the agency’s 2018 training conference.
The cost to credit unions was framed as such: the average complex credit union has $675 million in assets and the average complex credit union that fails generally incurs total resolution costs of roughly 20% of its assets. Preventing a single average complex credit union’s failure could save the share insurance fund $135 million, a cost all federal insured credit unions would otherwise have to pay through the fund. But that discounts other factors, specifically the opportunity cost of these capital standards.
As page 19 of the rule reads:
“for the most part, the largest cost associated with holding higher levels of capital, in the long term, is foregone opportunities; that is, from the loss of potential earnings from making loans, from the cost to bank customers and credit union members of higher loan rates and lower deposit rates, and the downstream costs from the customers’ and members’ reduced spending. Estimating the size of these effects is difficult. However…the annual costs appear to be significantly smaller than the losses avoiding by reducing the probability of a systemic crisis.”
Howard would disagree.
"None of the estimates takes into account the opportunity cost of reallocated capital, something that will run into the tens of millions of dollars," the Callahan vice president says.
But the costs might run deeper than that, says Callahan chairman and founder Chip Filson, who disagrees with the rule on three grounds.
One, he believes the implementation of this rule is “a caricature of risk management.”
“The idea that you can go down to every item on your balance sheet and make a fixed and one-sized fits all judgment about the relative risk of those assets in relation to one another is foolish,” Filson says. “It doesn’t work. It’s an almost cartoonish governmental response to pass a rule that somehow quantifies every risk in every situation on your balance sheet.”
Statements consistent with those made by FDIC Vice Chairman Thomas Hoenig in a 2014 speech:
"Reliance on risk-based capital measures has coincided with the build up of unacceptible levels of leverage in the largest banks," he says. "It was the reliance on and manipulation of a risk-based capital framework that allowed risk to build up to a point that nearly brought the global financial system to collapse."
Second, for Filson, this adds to the already significant regulatory burden credit unions face.
NCUA Proposed Regulations By Year
Data as of 10.21.15
“It hovers like a shadow over everything you do,” Filson says. “To claim it’s not a burden but will take four years to prepare your balance sheet belies what they’re saying is not a burden.”
Third, it compromises the cooperative model by imposing a bank derived capital model.
"Credit unions were charted to serve their member-owners in unique and focused ways that traditional financial institutions could not or would not," he says. "Requiring one single capital model based on the publically traded banking industry undermines the very rationale and unique democratic governance of a cooperative system. By overlaying a complicated failed capital formula for every asset of a credit union's balance sheet over one that has been successful will only lead to confusion, uncertainty and constantly changing formulas to keep up with market events."