CCULR/RBC Unconstrained by Statute: An Arbitrary Regulatory Act

The new RBC/CCULR rule must meet two administrative procedural tests, as any other rule, when NCUA claims to be implementing a law.  The first was outlined yesterday:  Was there substantial objective evidence presented to justify the rule?

As I described, NCUA presented no systemic data or individual case analysis whatsoever. In fact, the credit union performance record  shows an industry well capitalized and demonstrating prudent capital management over decades.

In the December board meeting Q&A , staff confirmed that in the last ten years, only one failed credit union would have been subject to RBC.  But today 83% of the industry’s assets and 705 credit unions are now subject to its microscopic financial requirements.

The second test is whether the rule conforms to Congress’s legislative constraints when giving this rule making “legislative” authority to an agency.  The PCA law was very specific in this regard when extended to the credit union system.

NCUA’s PCA implementation must meet three tests: that it apply only to “complex” credit unions, “consider the cooperative character of credit unions,” and be comparable to banking requirements.

NCUA had already passed these PCA implementation tests before. In 2004 GAO reviewed NCUA’s risk based net worth (RBNW) implementation of the 1998 PCA requirement and concluded:

The system of PCA implemented for credit unions is comparable with the PCA system that bank and thrift regulators have used for over a decade. and,

. . . available information indicates no compelling need. . . to make other significant changes to PCA as it has been implemented for credit unions.

At that time the risk based capital (RBC)  requirements had been in place for banks since 1991.

Today  NCUA’s new RBC/CCULR rules clearly fail all three of these constraining criteria.

A “Simple” Interpretation of “Complex”

NCUA 2015 RBC rule declared that the complex test include all credit unions over $100 million.  After the full burden of the rule was apparent, in 2018 the board changed complex to mean only credit unions over $500 million in assets.

Some credit unions clearly undertake operational activities or business models that are more involved than what the majority of their peers might do.

Examples could include: widespread multi-state operations, conversion to an online only delivery model,  lending focused on wholesale and indirect originations, high dependence on servicing revenue, using derivatives to manage balance sheet risk, funding reliant on borrowed funds versus consumer deposits, innovative fintech investments, or even the recent examples of credit unions’ wholesale purchases of banks.

The agency did not define “complex” using its industry expertise and examination experience to identify activities that entail greater risk.

Instead, it made the arbitrary decisions that size and risk are the same. In fact, most data suggests larger credit unions report more consistent and resilient operating performance than smaller ones.

In changing its initial ”complex” definition by 500%, it demonstrated Orwellian logic at its most absurd.  Complex turns out to be whatever NCUA wants it to mean, as long as the definition is “simple” to implement.

Universal for Banks; Targeted for Credit Unions

For banking PCA compliance, RBC was universally applied.  Every bank must follow, no complex application was intended.

By making size the sole criterion for “complex” the board reversed the statute’s clear intent that its  risk-based rule be limited in scope and circumstance when applied to credit unions.

The absurdity of this universal, versus particular,  definition is shown in one example. The rule puts $5.6 billion State Farm FCU, a traditional auto and consumer lender with a long-time sponsor relationship, in the same risk-based category as the $15.1 billion Alliant, the former United Airlines Credit Union. Alliant has evolved into a branchless, virtual business model with an active “trading desk” participating commercial and other loans for other credit unions.

NCUA’s “complex” application of the PCA statute is totally arbitrary based on neither reason nor fact.

Capital design: the most important aspect of “Cooperative Character”

The PCA authority additionally requires that the Board, in designing the cooperative PCA system, consider the “cooperative character of credit unions.” The criteria, listed in the law are that NCUA must take into account: that credit unions are not-for-profit cooperatives that:

(i) do not issue capital stock;

(ii) must rely on retained earnings to build net worth; and

(iii) have boards of directors that consist primarily of volunteers.

The single most distinguishing “character” of credit unions is their reserving/capital structure. Virtually all credit unions were begun with no capital, largely sweat equity of volunteers and sponsor support.

The reserves are owned by the members. They are owed to them in liquidation and even partially distributed, in some mergers.

These reserves accumulate from retained earnings, tax exempt, and are available for free in perpetuity-that is, no periodic dividends are owed.  Many members however can receive bonuses and rebates on their patronage from reserves in years of good performance.

Most products and services offered by credit unions are very similar to those of most other community banking institutions. The most distinctive aspect of the cooperative model is its capital structure, not operations.

Cooperative Capital Controlled by Democratic Governance

This pool of member-owner reserves is overseen by a democratic governance structure of one-member one- in elections.  The reserves are intended to be “paid forward” to benefit future generations.  This reserving system has been the most continuous and unique feature of cooperative “character” since 1909.

This collective ownership forms and inspires cooperative values and establishes fiduciary responsibility.  Management’s responsibility for banks is to maximize return to a small group of owners; in coops the goal is to enhance all members’ financial well-being.

This capital aspect of the cooperative charter is so important that if credit union management decides to convert to another legal structure, a minimum 20% of members must approve this change. No other financial firm has the character of a coop charter with its member-users rights and roles. Not even a mutual financial firm.

Bank’s Capital Structure Very Different from Cooperatives

For banks, capital funds are raised up front, usually from private offerings or via public stock. Owners expect to profit from their investments. Dividends are paid on the stock invested as part of this anticipated return. Today shares represent about 50% of total bank capital.  In credit unions, it is zero.

Bank capital stock, if public, can be traded daily on exchanges. The market provides an ongoing response to management’s performance.

This capital is not free as most owners expect a periodic dividend on their investment.  As an example, in the third quarter of 2021, the banking industry distributed 79% of its earnings in dividends to owners.

There is no connection between a bank’s capital owners, and the customers who use the bank, unless customers independently decide to buy shares in the bank. In credit unions, the customers are the owners.

The remaining component of bank capital is retained earnings. However, every dollar of earnings before  added to capital, is subject to state and federal income tax. Credit union retained earnings are the only source of reserves as noted in the PCA act.  These coop surpluses accumulate tax free.

In design, accumulation, use and governance credit union reserves are of a totally different  “character” than bank capital. Their purpose is to support a cooperative financial option for members and their community.

Bank capital is meant to enrich owners through dividends and/or future gains in share value.  Credit unions’ collective reserves are to benefit future generations of members.

Credit unions are not for profit.  Banks are for profit.

In a capitalist, private ownership dominated market economy, the cooperative’s capital structure is the most distinctive aspect of credit unions.  This is not because of its amount or ratio.  It is its “character,” from its origin, perpetual use and  oversight by members.

Nothing in the CCULR/RBC rules recognizes this especial “character” of credit union capital.  By not addressing this issue, the rule ignores this constraint of the  PCA enabling law.

The historical record demonstrates that  credit union reserves are not comparable to bank capital.  Rather they are a superior approach tailored to the cooperative design.

Tomorrow I will look at the third test, whether RBC/CCULR conforms to the PCA’s requirement of comparability.

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