By Dr. Harold M. Sollenberger
Recently, the National Credit Union Administration sent proposed legislation to Congress to “reform” the Prompt Corrective Action measures now used to determine capital adequacy within all federally insured credit unions. As a strong advocate of having each credit union make an all-risks assessment of its capital needs to arrive at its “ideal” capital position, I view the proposed changes with some apprehension and some enthusiasm. There appears to be some good news and some reason for continued concern about the regulatory view of what is “enough” capital.
The document is called Prompt Corrective Action Proposal for Reform and it is worthy of a quick perusal to get a feel for the intent and the recommended process and capital standards. The proposal depends heavily on the Basel II agreement, tying the credit union industry closer to the banking and thrift capital adequacy measures and processes. (Basel II is the International Convergence of Capital Measurement and Capital Standards, A Revised Framework, June 2004, Basel Committee on Bank Supervision, Bank for International Settlements.)
I would also encourage a flash-back to a Filene Research Institute study that Kurt Schneckenburger and I wrote in 1994, called Applying Risk-Based Capital Ratios to Credit Unions. In this study, we looked at the then-relatively-new risk-based capital definitions being applied to banks and thrifts. We used those definitions and credit union 5300 call report data and compared banks to credit unions.
Assumptions had to be made, but the results suggested that banks operated well above the well-capitalized level–implying there were other risks not captured in the risk-based formulas. Credit unions were well capitalized at rates similar to banks and somewhat below current well-capitalized percentages (but equity ratios were a lot lower in the mid-‘90s also). This report is for late night reading.
Below are a few very quick thoughts about the proposal as written, plus the implied approach to implementation by the NCUA.
Observations
1. In the Executive Summary, the NCUA still says that the first and foremost “purpose of prompt corrective action for credit unions is to protect the share insurance fund.” This is certainly important. But shouldn’t the industry regulatory agency worry more about the safety and competitiveness of the entire industry and the organizations it serves? The NCUA’s focus instead is on a narrow last recourse for the members of a few failed credit unions–the insurance fund!
2. Fortunately, we do get around to what should be the more important concerns when the NCUA recognizes in the Preface that the agency needs:
a. “to ensure the efficient use of capital in the economy,” (Great, since the return on equity for credit unions has been well below an acceptable level for corporate America for the past many years.)
b. “to optimize the performance of an institution with appropriate leveraging” (Great, since NCUA pressures to increase capital through examination and other processes have allowed equity-to-total assets to move to nearly 11 percent. This means that probably two-thirds or more of all credit unions are overcapitalized now.), and
c. “to achieve strategic objectives in providing low-cost services and meeting the service needs of members.” (Great, since this implies that the NCUA is encouraging strategic thinking and building competitive advantage at the credit union level.)
This may be a first for the NCUA–recognizing that credit unions need to be competitive and to operate efficiently, not just be safe and sound.
3. Also, a positive, the NCUA recognizes that capital standards are minimum levels (not the “ideal” or complete risk assessment) of capital that work in tandem with a supervisory review process, coming out of the Basel II report. This is a mixed statement. Unless the NCUA examination process is truly reformed, the new capital standards will be a basis for examiners and other regulations to add, formally and informally, to that minimum level–continuing to encourage overcapitalization.
4. No one should assume these new capitalization levels are adequate. The Executive Summary again draws from the Basel II statements that financial institutions will be expected to operate above the minimum regulatory capital levels based on their “specific business needs and holistic assessment of all relevant risks.” (Great, we see a clear difference between minimum and “ideal.” Both are needed.)
5. The “reform” adds and takes away–we win some and lose some. While it is not clear, capital levels are generally lowered. The denominator and the ratios (percentages) are changed, so a direct comparison is hard at this point. Fewer risks are measured. The current risk-based system for “complex” credit unions measures some credit risk, a fair amount of interest-rate risk, and a little liquidity risk. The new system focuses on measuring credit risk better, does not measure any interest-rate risk directly, and does not address any liquidity risk.
6. In the calculation of the new Risk-Based Net Worth Ratio and the Net Worth Ratio, the NCUSIF deposit is deducted from the numerator and the denominator. My opinion is to write it off; you will never see the money! But, that flies in the face of decades of NCUA dogma. It is a joke that the current system says it is risk free! The suggested process eliminates it from both sides and effectively reduces the amount of equity available for protection. The NCUA estimates the impact to be about a 70 basis point reduction in the Net Worth Ratio—partial justification for reducing the overall capital hurdles.
7. The new ratios get new hurdles for well, adequately, under, significantly under, and critically undercapitalized. Remember that the denominator for the Risk-Based Net Worth Ratio is not total assets; rather it is the sum of the risk-weighed assets and off-balance risks. In the original bank version, this generated a risk-asset number that was anywhere from 50% to 70% of total assets, depending on the relative riskiness of the balance sheet assets. So, the Risk-Based Net Worth Ratio is higher (8%) to be adequately or well capitalized than under the old system.
It is strange that they use the same hurdle for both levels—I say change that! The old Net Worth Ratio levels are lowered, partly for the NCUSIF deduction, partly to respond to credit unions’ requests for lower hurdles (claiming this will help economic growth), and partly to make credit unions levels to be equal to bank levels. We just won the trifecta!
8. The really good news is that the risk-based system will apply to all credit unions. Now, officially, only “complex” credit unions are evaluated using the risk-based net worth ratio. Technically, all other credit unions currently need only worry about net worth-to-total assets meeting predetermined percentages to be adequately or well capitalized. We need all credit unions to be assessed using risk-based assessments.
9. This proposed legislation moves credit unions into a parallel capital adequacy assessment framework with banks and thrifts. The NCUA should have participated in the FDICIA legislation in 1991 that introduced risk-based capital to financial institutions. It opted out but was forced into a risk-based system by the CUMAA legislation in 1998. The NCUA version of risk-based capital was innovative and purposeful, given the limited data available from the 5300 call reports and the banking industry’s past failed efforts to quantify interest-rate risk in its risk-based system. Having a risk-based system similar to other financial institutions is good, but we lose something in the process—objective measures of interest-rate risk, however crude today’s approach is.
10. Questions arise as to how the examination process will assess interest-rate risk and maybe other risks. Credit union managers are mixed in their trust and hope that the NCUA examiners will be able to make these interest-rate risk assessments within a broader risk arena, be able to evaluate “risk protection” tools that more-capable credit union managers will use to cover their interest-rate risk, and to put this risk into a framework for determining well, adequately, or undercapitalized status. There is a lot of work to do here.
11. In a footnote later in the report, the NCUA suggests that they will still use different capital measurements for different purposes. The impact of current capital actions that use higher capital standards as a basis for evaluation or for permission to do something is an indirect way of imposing higher capital levels on credit unions arbitrarily. CAMEL, RegFlex determinations, and financial analysis are three items mentioned that would not use the Net Worth Ratio. So, we still will have a multitude of other (probably higher) capital hurdles applied to us.
12. A “good news” item is the better credit risk data that will be generated. The current system of dumping all assets not in another portfolio into an “average risk” portfolio puts unsecured loans into the same category as vehicle and guaranteed student loans. Investments will be weighted using credit risk, not interest-rate risk based on maturities.
13. Quibbles over the weights of various assets are premature now and probably immaterial in the long run. Arbitrary decisions will need to be made, but most will be linked to the Basel II and banking percentages where relevant. In any case, for our political protection, the percentages should look as “tough” as the bankers’ version. I get very tired of the “we’re tougher, stronger, better … than you” arguments!
14. Overall, the new proposals are less objective for interest-rate risk and more objective and detailed for credit risk. All other risks are largely ignored.
15. The NCUA claims that a few more credit unions will be in the undercapitalized levels under the new system. Without testing their claims, I’d guess that the majority of new violators come from the really small credit unions—under $1 million in assets. There are some really strange looking credit unions in these small categories. I would guess that no large credit union will suddenly be labeled undercapitalized that had been well capitalized. In fact, the one large credit union that finances church buildings as member business loans and that has been technically undercapitalized for years gets a special provision in the new law to exempt it from these ratio hurdles!
16. Again, few credit unions have anything to worry about!
Conclusion
Well, I’m back to square one. The new system has some good things and some not so good things about it. I welcome it as a way to sort of “standardize” the capital adequacy measures across most of our financial institutions. The thrust should still be to help credit unions be safe and competitive.
And, the basic need for a comprehensive risk assessment to determine an “ideal” capital level still exists. The new proposal doesn’t do the job that is incumbent on managements and boards of directors—to find and work toward a capital level that covers all risks facing a credit union yet allows it to function as an aggressive competitor in its marketplaces.
That methodology is available, workable, and proven.
Harold M. Sollenberger, DBA, is professor of accounting and information systems at Michigan State University, 517.432.2914.
Read Sollenberger's three-part series on capital in Credit Union Management:
//www.cues.org/repository/comingandgoing-part1.pdf
//www.cues.org/repository/capitalscrutiny-part2.pdf
//www.cues.org/repository/capitalpart3.pdf
Read more thoughts on capital reform from Credit Union Management online columnist Pete Duffy of Sandler O'Neill & Partners L.P.
