By Vincent Hui
The National Credit Union Administration just released its proposed new risk-based capital rules. While the new rules were somewhat expected (as they aligned credit union capital requirements closer to Basel III), they will cause significant changes in how credit unions need to manage their businesses, capital and balance sheet.
NCUA kept the net worth ratio minimum the same and adopted higher levels for its new risk-based capital requirements--especially the 2.5 percent buffer that bank regulators are implementing. The calculation methods are also different and in alignment with the broader financial services industry. (Whether CUs should have the same capital approach as banks is a separate discussion for another time.)
Assuming that the proposed rules stay the same, here’s our initial thoughts on CU business impact:
- These new rules will mean a smaller capital buffer for some CUs, which may impact the level and pace of investments in such areas as remote channels and branches, as well as growth in certain asset classes. Capital allocation and planning will take on more prominence during strategic planning.
- On the flip side, some CUs may actually have higher buffers, e.g., the amount that exceeds the risk capital minimum is more than the amount that exceeds the net worth minimum. In this case, the CU actually has an opportunity to take on a little more risk and still have a strong capital position. This is especially important as CUs seek yield/net interest margin growth.
- The proposed rules also give NCUA more leeway to impose a higher minimum risk capital requirement as an output of its exams, e.g., assessment against NCUA's seven risk types. This makes the definition and regularly reporting of risk appetite and risk profile critical to demonstrate that the institution has a handle on all risk types and has the governance to proactively address them.
- Small CUs of $50 million to $250 million in assets will be the most squeezed. This likely further restricts the pace of capital investment at these institutions, which are already struggling to invest in new channels and products that their members are seeking. This will increase the pressure to merge with a larger CU to make investments competitive.
- Member business loans will require more capital--potentially putting a damper on growth strategies that rely on business lending. It is already a tough market in terms of getting strong business lenders and loans. This will reduce the impact business loans will have on earnings and capital creation, especially for smaller CUs or only adequately capitalized CUs. Many CUs are in investment mode in this area, which means it is likely generating earnings that are not building risk-based capital--if they are generating any earnings at all.
- Branch building in its traditional form will take a further hit. These are large investments, costs and assets. When and how will new branches generate the returns to build risk capital?
- A silver lining is that this provides a clearer opportunity to define the required returns on investments, both overall and by product type. If a CU wants to maintain its current risk capital levels, there is a better line of sight on what returns are required. We expect more rigorous standards will be put on product and customer profitability, as well as the returns on investments in such assets as branches and technology.
- CUs that may have been thinking about new capital-based profitability measures like risk-adjusted return on capital will likely accelerate their efforts. Even traditional return on equity takes on a new context. An ROE above the traditional net worth ratio may actually reduce your risk-based capital based on the level and nature of the earnings/asset growth.
- The reporting requirements will increase resource requirements, but the bigger resource need is the modelling of capital so management and boards can make better decisions. Since this is a new approach to calculating risk-based capital, CUs will need to see how quickly they can adapt the existing reporting and financial systems to develop actionable reports. The good news is that banks have some of these capabilities already, and hopefully vendors can port over solutions quickly and effectively.
- Non-interest income takes on even more importance in capital building since it is less asset-dependent (e.g., payments). For the non-interest income that is asset-dependent, fees may be the difference between a return on a loan or relationship that adds to risk capital or reduces it.
These new risk-based capital rules go beyond supervisory exams and will impact CU strategies and business performance. We’re still in the early stage of the analysis, so expect more discussion!
Vincent Hui is senior director with CUES Supplier member and strategic provider Cornerstone Advisors, Inc., Scottsdale, Ariz.
Check out Cornerstone's enterprise risk management services.
Learn more about this September's CUES School of Risk Management and CUES Advanced School of Risk Management, to be held in Denver.
