Navigating Red Tape

With new regulations and rule changes issued at a dizzying pace, year-end offers an opportunity to take stock: Are credit unions better or worse off operationally and financially given the current state of compliance requirements?

In March, National Credit Union Administration Chair Debbie Matz promised a “year of regulatory relief,” touting initiatives to eliminate the fixed-assets cap, ease restrictions on member business lending, expand fields of membership by adding new categories of associational groups that federal credit unions can add automatically, and permit certain forms of debt to be classified as supplemental capital for the risk-based capital ratio.

Yet in the balance, 2015 marked the sixth year of “regulatory activism,” with fallout from the financial crisis of 2008-09 still in the air, contends Dennis Dollar, principal partner of Dollar Associates, Birmingham, Ala. “In an effort to prove that they are tough regulators in tough times, NCUA and the states have increased exam team sizes, begun staying longer at exams, and are focusing on smaller items for exam findings.”

In terms of rule changes, federal regulators have imposed new risk-based capital, credit union service organization, interest-rate risk, and loan participation rules over the past two years, “each of which would have to be classified as more restrictive than previous regulations in those areas,” Dollar says.

The most significant regulation, based on its potential to have a long-term impact on credit union finances, is the risk-based capital rule, he suggests.

“The RBC rule will impact how credit unions structure their balance sheets going forward and will require them to hold additional reserves in accordance with that balance sheet risk,” Dollar explains. These requirements pose a strategic challenge for credit unions planning to invest more in technology channels and/or expansion of their branch networks.

“Can RBC be accommodated within a credit union’s strategic goals? Certainly. Will it be an additional challenge to manage? Yes,” he adds.

The Consumer Financial Protection Bureau may have replaced NCUA as the regulator to be watched most closely, Dollar continues. In addition to the new mortgage disclosures this fall, the newest federal regulator has also issued new wire transfer, credit card and ability-to-pay rules. In addition, “pending actions on key credit union sources of income, such as indirect lending and overdraft fees, lurk as very significant and would, if enacted in an unreasonable manner, impact income statements considerably,” he cautions.

“The vastness of the Dodd-Frank rules has affected credit unions of all sizes and most, if not all, departments within each,” says Leah Hamilton, chief compliance officer for Temenos USA, a financial services software provider. “The compliance requirements bear a heavy burden, too much for the typical one-compliance-officer-shop. Credit unions have had to add more staff, resources and budget dollars to compliance to address all of the rules, regulations and guidance issued.”

On the other hand, Hamilton adds, “compliance has historically been under-valued in the grand scheme of a credit union’s business strategy. Now, the value of engaging compliance upfront and throughout the enterprise is ultimately a cost-saving measure when you consider the billions of dollars in fines and restitution for noncompliance violations.”

No Rest for the Weary: New Mortgage Disclosures

The most significant regulatory change of 2015 is the implementation of new integrated disclosure forms required by the Truth in Lending Act and Real Estate Settlement Procedures Act, suggests E. Andrew Keeney of the Norfolk, Va., law firm of Kaufman & Canoles, P.C.

The disclosures, which must be provided to borrowers after they submit a mortgage application and before closing, have expanded from three pages to seven; the regulations guiding the content and distribution of the new forms exceed 3,000 pages; and the penalty for noncompliance is steep, Keeney says. “If there’s a defect in the disclosures, the lender could face a minimum penalty of $5,000 per day until the defect is corrected.”

Mortgage lenders, including all credit unions, were required to begin using the new disclosures on Oct. 2. Fortunately, NCUA has said it would exercise discretion on enforcement in the early months of transition, and CFPB has pledged that financial institutions working hard to be in good-faith compliance wouldn’t face disciplinary action for early missteps.

Implementing the new TILA-RESPA forms has required credit unions to revise software processing, implement new policies and procedures, and offer staff training. According to some estimates, completing and issuing the new forms could add as much as $35 to operational costs for every mortgage application, even those that aren’t approved and/or closed, Keeney notes.

The rationale for the new disclosures is to allow borrowers to “shop and compare line by line, dollar for dollar, and make a more effective decision. But when you’ve got that much paperwork, I think many consumers are just going to say, ‘Where do I sign?’” he adds.

The new TILA-RESPA disclosures follow on the heels of revised mortgage servicing rules implementing Dodd-Frank that took effect in 2014, Hamilton notes. The revisions apply to Regulation X rules on responding to borrowers who allege loan servicing errors, providing information about mortgage loss mitigation options to delinquent borrowers, and evaluating borrowers’ applications for available loss mitigation options. In addition, Regulation Z revisions address rate adjustment notices on adjustable-rate mortgages, prompt crediting of mortgage payments, and responses to requests for payoff amounts.

On the positive side, implementing these mortgage rule changes has resulted in credit unions studying their lending practices closely and, in some cases, changing their business model by centralizing home loans or outsourcing mortgage lending, notes Larry Edgar-Smith, SVP/product evangelism at Akcelerant. “Focus is never a bad thing—even if sometimes forced upon us.”

More Upside Than Down: Eliminating the Fixed Asset Ceiling

Also in October, NCUA removed the 5 percent aggregate limit on federal credit unions’ investments in fixed assets, or property and equipment that cannot easily be converted to cash. Examiners will now use the supervisory process to monitor whether credit unions are judiciously managing their investment in branches and technology.

Removing the fixed asset limit gives credit unions more flexibility to grow their branch infrastructure and fully develop prime locations, suggests Paul Seibert, CMC, principal/financial and retail design with EHS Design, a NELSON Company, Seattle.

The downside of the ruling concerns the need for smaller credit unions to carefully manage their investments in property and equipment, which will make up a significantly higher percentage of assets for them than for larger organizations, Seibert says. “This ruling may lead to the demise of more small credit unions if they are not diligent about their fixed assets today and ROI projections in the future.

“We must be careful about what we wish for,” he adds. “More latitude comes with more risk and responsibility. It is exciting to develop new branch concepts, open new branches and get ‘wows’ from members and staff, but will all this investment truly generate better service to members, deeper relationships, more productivity and more income driven to the bottom line?”

Potential Good News: Relaxing MBL Restrictions

NCUA’s proposed changes to Rule 723 on member business lending could be among the biggest positive regulatory changes for credit unions, says Ryal Tayloe, VP/credit unions with nCino, Wilmington, N.C. The proposal would give credit unions more flexibility in making commercial loans by removing personal guarantee requirements for borrowers, prescriptive loan-to-value and collateral requirements, and unsecured loan limits; increasing concentration limits of construction and development loans from 15 to 25 percent of the net worth of the commercial portfolio; eliminating requirements that business lending staff have at least two years of experience; and excluding nonmember loan participations from the MBL cap.

“These are huge changes to the previous approach by the NCUA, all geared toward loosening regulatory requirements to further promote business lending in the credit union industry,” Tayloe says. “What’s scary to credit unions is that compliance [would now be more] ambiguous, and more of the onus of ensuring safety and soundness [would be] on them. They need solid processes and systems in place and a firm handle on the decisions they’re making.”

In Congress, Senators Rand Paul and Sheldon Whitehouse proposed in September the Small Business Lending Enhancement Act, which would raise the business lending cap from 12.25 to 27.5 percent for well-capitalized credit unions. In sum, these proposals could make credit unions “more relevant” in commercial lending, Tayloe suggests.

“There seems to be a dramatic shift toward credit unions to fill the need for small business lending in America,” he adds. “If these changes go through, it will change the way credit unions need to manage their business loan portfolio. It may no longer be the smallest portion of their overall loan portfolios.”

It’s important to consider the interconnected impact of proposed regulatory changes, Tayloe adds. For example, the new RBC rule could have the effect of increasing the business lending limit for well-capitalized credit unions.

Under current business lending rules, a CU is limited to an aggregate MBL cap of the lesser of 1.75 times its net worth or 12.25 percent of total assets. The NCUA proposes removing the 12.25 percentage stipulation and changing the language of the cap limit to “1.75 times the applicable net worth requirement for a CU to be categorized as well-capitalized.” Previously, these two figures were identical because capital regulations classified a well-capitalized credit union as holding 7 percent net worth (7% x 1.75 = 12.25%), Tayloe explains. However, under the new RBC rule, the definition of a well-capitalized credit union increases to 10 percent, which in turn would raise the MBL cap of an individual credit union to as high as 17.5 percent.

Stepped-up Scrutiny: Fair Lending Laws

In 2015, credit unions also had to contend with the potential for stepped-up enforcement of long-standing regulations, including fair lending laws. In conjunction with the U.S. Department of Justice, CFPB has started to investigate banks for compliance with Regulation B, which implements the Equal Credit Opportunity Act. NCUA has also increased scrutiny of credit unions in this area, conducting 500 to 750 fair lending examinations annually, Keeney says.

Penalties for violating fair lending laws can be steep. Ally Financial agreed to pay $98 million in 2013 over a U.S. Department of Justice investigation that found patterns of racial discrimination in auto loan rate setting.

Even if your credit union hasn’t done anything wrong, there’s still an extensive amount of staff time required to prepare, so the examinations are timely and complete and there aren’t any adverse findings,” says Keeney.

Up Next: New Cyber-Security Rules?

Looking ahead to 2016, Keeney suggests that cyber-security regulations will garner the most attention. Regulators are working hard to stay in front of hackers: The Federal Financial Institutions Examination Council is generating checklists and guidelines to help credit unions and banks hold off the threats, and NCUA is accelerating examiner training on cyber-security. “With almost daily reports of hacking and identity theft, staff training, system preparation, and fraud management are major expenses, but credit unions can’t prevent everything that comes their way,” he notes.

He cites the widely reported example of a 2014 data breach at Palm Springs Federal Credit Union, which resulted from an NCUA examiner losing a thumb drive containing the personal data of 1,600 members. NCUA Chair, Debbie Matz, put the cost of that breach at $15,000 to $20,000 to send letters to affected members and offer them identity theft protection (to date, no losses to members have been reported). NCUA covered those costs and has also been studying whether to require credit unions to implement new encryption protections as a result of that breach.

Unending Cycle: Costs of Compliance

“Compliance costs are growing and have become a major merger driver for smaller and mid-sized credit unions,” Dollar says. “Additional compliance staffing is required in many circumstances, and significant third-party costs for CPAs, attorneys, and consultants are being added to budgets throughout credit union land. It is part of the cost of doing business. All credit unions recognize it, and few expect it to get much better in the next few years.”

Even as NCUA promised regulatory relief, CFPB seems to be building rule-making momentum. By Dollar’s count, the bureau approved 47 final regulations in 2014, following on 42 in 2013 and 21 in 2012. This year, it proposed 106 areas of focus for public comment. “The CFPB seems to just be getting warmed up, and with each new rule comes a cost to credit unions,” he says.

Keeney concurs. “Compliance costs are mounting against small margins. These are costs that really impact a credit union’s bottom line, and how do you budget for them? If you budget on an extraordinary basis, the credit union may not be in the black at the end of the year.” His advice is that credit unions “double the line item for compliance as they work on their 2016 budgets.”

The cumulative impact of recent compliance challenges has been to shift staff effort away from member service, lending, and collections, Edgar-Smith contends. “At the same time, on the whole, credit unions are better positioned for the future. As a direct result of the regulatory changes, they are more automated to ensure they are meeting compliance, and they are more aware of their members’ communication preference.”

As an indirect result, the regulatory shifts over the last two years could benefit forward-thinking credit unions that evaluated key strategies and fine-tuned operations, he says.

Credit unions have an advantage over big banks in building trust with members who are “more willing to give their credit unions the benefit of the doubt and less demanding in threatening legal action” when compliance lapses occur, Keeney suggests. Still, “if a credit union finds an instance of human error by its staff, the quicker it responds and discloses it, the less liability it will face—and the less it’s going to cost.

“If you find you made a mistake, respond proactively and take care of it as soon as possible,” he adds. “There’ll be less cost and less liability, and you’ll remove yourself the likelihood of a major Excedrin headache.”

Karen Bankston is a long-time contributor to Credit Union Management and writes about credit unions, membership growth, marketing, operations and technology. She is the proprietor of Precision Prose, Stoughton, Wis.