Why Risk Based Capital Requirements Fail in Practice

We’ve already seen that the risk based approach does not work. It’s obvious that neither man nor model can adequately assess a given asset’s risk under all circumstances before the fact. It doesn’t make sense to spend a lot of time trying. It does make sense to have a minimum leverage ratio but it should be the same for banks of all sizes.”

(Thomas Brown, A Loss of liquidity, not inadequate capital, is what often dooms banks. Bankstocks.com, April 22, 2014)

The leverage, net worth ratio, is the current credit union model. Risk based capital formulae should be tools, not a rule. The real vulnerability for the credit union system at this time is the loss of the CLF-Corporate liquidity safety net.

The End of Risk Based Capital for America’s Community Banks

On September 17, the FDIC board eliminated risk based capital (RBC) requirements for community banks with assets of less than $10 billion.

It replaced the international banking BASEL-inspired approach with a simple leverage ratio. A community bank will be considered well-capitalized under required prompt corrective action (PCA) regulations if the tier 1 leverage ratio is 9%.

Banks will not be required to report or to calculate a risk-based capital according to the FDIC’s press release.

The FDIC Chairman Jelena Williams said the new rule ensures that the regulatory framework is commensurate with the operational reality of these institutions.

“The final rule. . .supports the goals of reducing regulatory burden for as many community banks as possible. . .and will allow community banks to significantly reduce the regulatory reporting associated with capital adequacy on the call report.”

The rule was also supported by all the other banking regulators,  the comptroller of the currency and the Federal Reserve.

An Example for the NCUA Board

The final RBC rule passed by the NCUA board was over 400 pages and requires all of the regulatory and reporting burdens cited by the FDIC as the reason for eliminating this requirement.

Surely the NCUA can learn from this experience! There is no better time or precedent to cancel this ineffectual, burdensome and deeply flawed approach to capital measurement. For if such a rule had been effective, it would have stayed. The FDIC’s experience shows RBC doesn’t work in practice.

The simple to understand leverage ratio, now in effect, has served credit unions well since deregulation and the imposition of PCA in 2008.

Don’t be misled by the 9% well-capitalized FDIC level versus the credit union’s 7% well-capitalized PCA standards into thinking cooperatives need to raise their capital. All of the capital reserves in credit unions are “free.” More than half of bank capital is in equity shares, whose owners are expecting a return on their investment.  Free cooperative reserves do not have this performance burden..

There is no better time for NCUA board to withdraw this misguided rule. Will the board show the leadership demonstrated by the FDIC?

All credit unions would give a great sigh of relief to have this burden removed from the horizon.

The Only Threat to Credit Unions

At a time when many credit union leaders see NCUA board members announcing new regulatory agendas in virtually every speech, it is helpful to remember this counsel from a former NCUA Chairman:

“The only threat to credit unions is the bureaucratic threat to treat them for convenience sake, the same as banks and savings and loans.  This is a mistake, for they are made of a different fabric.  It is a fabric woven tightly by thousands of volunteers, sponsoring companies, credit union organizations and NCUA-all working together.”

 Source:  Chairman’s letter: NCUA 1984 Annual Report

A Credit Union Member Takes a Stand After a $40 Million Loss

In an 18-page complaint filed August 7, Victor Webb filed suit against the board and supervisory committee of the failed CBS Employees FCU seeking over $40 million in recoveries for members.

According to press reports the loss was first discovered on March 6, by an employee who raised questions about a $35,000 check the CEO, Rostohar, had made out to himself.

NCUA’s audit as of February 28, 2019 said the loss could be as high as $40.5 million for an embezzlement scheme that Rostohar admitted carrying out over two decades. In the credit union’s last call report as of December 31, 2018, it reported $21 million in assets, $2.6 million in capital and 2,798 members.

A Member Acts

The federal credit union was chartered in 1961 to serve CBS employees and related companies. In the complaint Webb stated he joined the credit union in 1970 while a CBS employee. He remained a member until the credit union was liquidated in March, although he retired from CBS in 2014.

His suit names the board and supervisory committee members at the time of liquidation and prior members who served in similar capacities during the two decades of defalcations.

As a class action, Webb seeks damages of $40 million on behalf of all members, by stating that the benefits of membership were devalued by this amount which should have been available so members could benefit from lower fees and loan rates or higher dividends—that is the lost benefits of credit union ownership.

“A Fiduciary Relationship”

The core argument for suing the Board and supervisory committee members is summarized as follows:

“By reason of Individual Defendants’ positions with CBS Employees (FCU) as members of the Board of Directors, they are or were, at all times herein relevant, in a fiduciary relationship with Plaintiff and other CBS Employees (FCU) members and owe them a duty of highest good faith, fair dealing, loyalty, as well as a duty to maximize member value.” (Page 3)

The fiduciary responsibility of directors and committee members is well documented in NCUA regulations and letters, but rarely is their conduct formally challenged by a member. But this is a case of extraordinary loss equal to almost 10% of the last reported assets, or $2 million per year, for over two decades. Both the amount and length suggest a complete breakdown in both internal and external, regulatory oversight.

How Could This Happen?

This suit focusing on the fiduciary duties of the Board and Supervisory committee could be a very important milestone in cooperative governance and oversight.

How NCUA’s reported audited shortfall of $40.5 million in a $21.3 million asset size credit union could occur is hard to fathom.

The credit union’s December 2018 call report shows $18.4 million in shares for 2,798 members, resulting in an average share balance of $6,576. The credit union’s assets consisted of $14.7 million of investments and $6.1 million in loans with a reported delinquency of only 0.33%.

The credit union’s $18.4 million in member shares would seem to be more than adequately covered by the $21.2 million (with $2.6 million net worth) in easily verifiable assets if a liquidation were ever necessary.

Internal processes to monitor the credit union’s management are mandated in both bylaws and by rule and reg.

Every federal credit union is required to complete an annual audit under the auspices of its Supervisory Committee. Such an audit, whether internally conducted or outsourced, would entail a verification of member accounts, selected confirmations of investments and loans, and a review of internal controls. The results are reported to the Board.

The Regulatory Review

Additionally, NCUA has conducted annual audits of every FCU since the 2008-09 financial crisis. This review would review the credit union’s own supervisory committee’s audits, including member confirmations, plus a complete examination of investments and loans. In addition, the examiner would review all settlement accounts against the latest bank statements to ensure up to date postings and that the credit union’s general ledger is in agreement with external financial confirmations.

If the assets reported by the credit union are correctly reported, then that would mean the total loss caused by the CEO’s fraudulent activities would be the $40.5 million shortfall plus the $2.6 million in net worth for a total of $43.1 million.

NCUA’s obligation to member shareholders is to pay up to the $250,000 per account insured limit. A $43.1 million payment on top of the $18 million in reported shares would mean that over 6,500 more accounts (using the average share balance from reported members) would have been kept in a second set of off-the-book records.

There are only two explanations for NCUA’s reporting a $40.5 million loss after its February 28,2019 audit:

  1. The reported asset values were widely inaccurate, which raises the question, what kind of annual regulatory examination was done; or
  2. The assets are properly recorded, which means that from $40.5-$43.1 in off balance sheet shares were being managed by the corrupt CEO.

If the second option is the explanation, this suggests the CEO was running a shadow credit union with almost three times the number of members and shares as the reporting credit union. How could this activity be hidden from employees, the directors or supervisory committee, since these members must have received statements and conducted business transactions regularly with the credit union?

If the reported assets are phony, which would account for half of the loss, the only question is what type of annual exam had NCUA conducted over the two decades that this theft occurred?

Time for a Real Accounting

I salute member Webb for standing up and asking that responsible parties be held to account. This is more than sending the former CEO to jail and then covering the tens of millions shortfall out of NCUA’s “rainy day insurance fund.”

All the public evidence suggests that the problems are much more extensive than a corrupt CEO and a hoodwinked and a deleterious board and supervisory committee. The regulatory oversight that is supposed to assure the industry’s safety and soundness through onsite examinations would appear to have been negligent as well.

When a member takes a stand against ineptness, self-serving conduct and dereliction of duty, the whole democratic movement will benefit. Cooperative governance requires that fiduciary duty have real meaning, not just good intentions. Hopefully this suit will bring out the full story and create a much-needed precedent along with a correction of examination shortfalls.

I salute Victor Webb and say with him, “Enough is Enough.” Stop paying out losses, let’s correct the problems letting these occur.

The Cost of Not Learning from Our Brethren’s Mistakes

Over the past twelve months the credit union community is on the hook or paid the bills for the following situations:

  1. A $1 billion cash payout for the Melrose CU and LOMTO FCU liquidations;
  2. An estimated $40.5 million shortfall for a two decade embezzlement by the CEO at CBS Employees FCU;
  3. A $125 Million write off at Municipal Credit Union at June 30, while under NCUA conservatorship.

In each situation there has been no objective, public discussion of what happened. No lessons have been taken away from these extraordinary losses and how they might be eliminated or mitigated in the future.

Specifically:

  • NCUA has said nothing about its Municipal Credit Union conservatorship as the credit union reported the largest loss ever at June 30.
  • In Melrose’s case the primary publicity has been about suing the former CEO for accepting vendor’s trips and other self-interested actions.
  • For CBS Employees FCU’s extraordinary embezzlement, the throw away characterization has been that the CEO was a former NCUA examiner and therefore knew how to hide his two decade defalcation based on his examiner experience.

No Return for Casting Judgment

When a loss occurs, there is a rush to judgment. What went wrong? Who screwed up? Why did this happen, again?

The natural response is to point fingers, blame someone for the problem. Then punish or banish wrongdoers from ever working at a credit union. And resolve the loss by paying for the shortfall out of the NCUSIF—and move on.

While indicting possible malfeasance may be necessary, it can miss entirely the lessons to be learned. The result is that there is no return on the money expended. Credit union monies are swallowed up in a regulatory “black hole.”

Discernment: A Powerful Form of Judgment

For informed judgement is about discernment, understanding the circumstances of what happened and identifying the possibly numerous opportunities to have done something about the situation much earlier.

Judgement is much more than holding people accountable. In the cooperative community, all members pay for the individual losses via the NCUSIF. Therefore the most important benefit should be corrective actions or processes that can prevent similar circumstances from getting “out of hand” in the future.

For example, NCUA says correctly that it sent a letter about potential problems in the taxi medallion industry to all examiners in 2014. The letter did not identify the possible disruption of the entire industry by Uber and Lyft, but it did reinforce proper underwriting including the ability of borrowers to service the debt.

But somehow the problem grew and grew and no one knew how to manage through a cyclical decline in asset values. This is not a new situation for credit unions. Loans secured by real estate, autos and leases, and/or commercial properties and farm land will all have changes in the value of security during the term of the loan.

But somehow these inevitable fluctuations in value cause reactions as if the problem has never occurred. Before. This panic often exacerbates the situation, freezing new responses and resulting in irreversible financial decisions at the lowest point of value for the security.

A Responsibility to and for the Community

Cooperatives are interdependent on each other for market success. The most consequential connection is via the shared capital pool created in the NCUSIF. While the temptation may be to approach difficult situations with an eye to eliminating the problem, that not only may be the least desirable outcome for members of the credit union, but more importantly, it may not be the positive example needed by the whole cooperative community.

Credit unions were created to solve problems especially for members and in circumstances when normal market options were unavailable or too expensive. When problems are just done away with and all circumstances swept under the rug because of sufficient resources to do so, everyone loses. Other credit unions facing similar loan challenges as the taxi medallion example, those with concerns about the adequacy of their internal and external audits; or credit unions with underfunded pension or other liabilities could all benefit from a thorough knowledge of the above cases.

Every credit union board and CEO any CPA or auditing firm and every DP, bonding and any vendor connected to the credit unions above, has an interest in knowing what happened. That knowledge is necessary if there is to be a common commitment to do better in the future. NCUA has to lead by example. The three circumstances above would be excellent places to start with full public reviews. Credit unions have received nothing for the $1.25 billion spent so far. The buck has to stop somewhere before credit unions run out of bucks.

Why the Appeals Court Ruling on NCUA’s FOM Rule Is Irrelevant

According to the US Census Bureau’s population clock, the estimated 2018 United States population (February 2018) is 327.16 million.

This is a bit lower than the 329.06 million estimated by the United Nations.

As reported in Pentagon FCU’s June 30, 2019 quarterly call report, every one in the US is eligible to become a member. The data submitted by  the credit union is as follows:

MISCELLANEOUS INFORMATION NUMBER ACCT
2. Number of current members (not number of accounts) 1,788,610 083
3. Number of potential members 329,152,485 084

 

The Credit Union-Regulator Relationship

“The relationship between credit unions and the regulatory agency is one founded on mutual self-respect, and on the realization that both sides share equally in the responsibility for the survival and future development of credit unions.”

(NCUA 1984 Annual Report, Page 14)

588,000 Members About to Lose Their Credit Union

On June 12 I described NCUA’s May 17, 2019 conservatorship of Municipal Credit Union in New York City. The critical point was who will be the conservator? What will be the plan? Will NCUA’s chosen leader knock the place down or build it up? We now have an answer.

In less than two months on the job, the conservator recorded a June 30, second quarter loss of $125 million. This results in a reduction of net worth from 7.60% (well-capitalized) at March 30 to 3.41% (under-capitalized) at June 30.

Municipal’s 2-Year Report

The conservatorship was initiated by New York regulators in June 2018 by removing the full board and appointing an administrator, who was then let go earlier this year. New York then appointed NCUA conservator.

In late June several “unnamed sources” placed a leak in a CUToday story saying the credit union had a large underfunded defined benefit plan in an amount of over $100 million. NCUA declined to comment on the story, continuing a pattern of silent neglect throughout the entire conservatorship.

But the loss was a lot more than a benefit funding issue for a credit union which had reported a $3 million net income in the 2019 first quarter. The conservator’s total expenses in the quarter of $168.6 million were more than three times the first quarter total of $49 million. Of this increase, $130 was added to personal expenses, $19.1 quarterly increase in office operations, $8.9 million spent on professional services and $9.3 million in loan loss provision. This loss provision increased the coverage ratio from 147% to 177% even though there was no increase of delinquency at .76% of loans.

Who is Acting in the Members’ Best Interest?

The clear answer is nobody. For any so called expert to come in and wipe out half of a credit union’s net worth in less than 45 days on the job shows an inability to look at options, identify alternatives and develop a plan to sustain operations. An underfunded pension obligation is not a new situation for both public or private organizations. Defined benefits are paid out in decades to come and funding plans similarly are long term. Multiple options are available to manage underfunding which is why actuarial assessments are a normal part of a plan’s annual review. The only time cash in full is required is if the plan is to be terminated immediately which can result in every plan member being 100% vested in full whatever the plan’s actuarial cash requirements might be.

The lack of any explanation, public discussion or consideration of alternatives plus the abruptness of the action, suggests kick-the-barn-down strategy to justify a merger of this $3.0 billion credit union chartered in 1916. For cashing out the plan, if that is the reason for the expense, would leave any subsequent leader with no options and with having to develop a new retirement benefit for employees.

Silence and quiet leaks to the press are not patterns of accountability. NCUA board members may make speeches about all sorts of future risks and opportunities but fail to speak to the immediate needs of 588,000 members who have seen a complete breakdown of regulatory responsibility and accountability.

Every year NCUA and the state have examined the credit union. The credit union must have a CPA annual audit which would include an actuarial assessment of the benefit plan. And yet no action was taken until the CEO was found to have embezzled money. Compounding the failure to address the defined benefit funding (if it was an exam issue) is choosing a conservator with no ability to develop a plan for sustainability. Conservatorship becomes nothing more than preparation for a fire sale.

The members have no voice, they have been denied any role in their CU’s future. The credit union has a 22 branch network and a sound and diverse $2.0 billion loan portfolio and over $660 million in cash. Shares are up 6% and loans over 8% from June 2018, during a full year of conservatorship. And the reward for their loyalty and patronage is to be tossed aside as the regulators attempt to cover with silence their repeated failures to address issues that were clearly disclosed previously.

The Cooperative Advantage

Two factors provide credit unions a major advantage when problems occur. The first is the member relationship, loyalty and trust. The second, derived from the first, is patience when resolving problems.

There is no public pressure on stock price to divest of problems and move to new markets. With the right leadership in place credit unions have survived the most severe crises.

In the June 12 article of NCUA’s actions, a line from Hamilton states, “you have no control, who lives, who dies, who tells your story?” There are only two sources for help—can the members mobilize to assert their rightful role? Will credit unions demand accountability from a regulator whose absence from the fray is a stunning dereliction of duty?

A Modest Proposal for Secondary Capital

NCUA’s June delay in implementing a new risk based capital (RBC) rule was in part explained by the need to examine whether a secondary capital option should be part of the new capital model.

Cooperative design and history suggest there is an immediate and straightforward additional capital option. This solution can be implemented regardless of the outcome of the RBC discussions.

The 1934 Federal Credit Union Act mandated that the par value “shall be $5 per share,” an amount in the law based on twenty five years of state-chartered credit union practice.

Credit unions had no share insurance funds, state or federal, until the 1970s.  Prior to that all member shares were at risk, that is equity for the institution.   An ongoing consequence of this financial structure, even in the era of deregulation, is that credit union shares are second in payment priority in event of liquidation to all other liabilities. This means that third party lenders to credit unions, such as the FHLB system or banks, know that equity is more than a credit union’s retained earnings. In the event of failure, the insurance fund must pay lenders’ outstanding loans ahead of shares.

The $5 Par Share Value Today

The historical par value of  $5 was often purchased on an installment plan, for example,  25 cents a week. This par value, now a variable amount, was the foundation for all funding and was at risk should the credit union not succeed.  Virtually all FCUs and state charters still active today, were financed with this membership shares-at-risk model. This shared fate meant that the cooperative model was indeed based on common values and purpose.

The value of the $5 initial member share purchase requirement today depends on which index one uses to analyze changes in economic value.   There are at least seven choices from the consumer price index to various efforts that track the cost of labor, to nominal GDP per capita. The range of results from these various indexes shows that the value of the $5 share in 1934 would range from $62.70 (CPI) to $373 (GDP per capita) in 2019.

Reengaging Members in the Cooperative Model

The option to ask members to purchase one at risk (uninsured) capital share with specified minimum par value would provide additional equity but more importantly signify once again the uniqueness of the cooperative model. It would be available only to members, limited in individual amounts, and subject to terms and conditions set by the boards.

There is no need to invent multiple plans for secondary capital sold to third parties creating a potential conflict with member’s returns. Instead the original design that successfully launched tens of thousands of charters could become today’s solution for capital flexibility when that is in the members’ best interest.

NCUA Board has a Unique Opportunity to Eliminate the Flawed Risk Based Capital Proposal

This Thursday (June 20) the NCUA Board has only one topic on the agenda: the Risk Based Capital Rule (RBNW). Rodney Hood will be the 4th Chairman to address the issue.

He and fellow board member McWatters will have the chance to set a whole new direction for regulatory policy if they choose to do the obvious and cancel outright this deeply flawed rule-making effort.

Not only would such an action align with the administration’s policy priorities, it would also end a regulatory approach that is problematic. All other financial regulators have moved away from the belief that future risk can be both predicted and modeled so accurately so as to require specific and relative levels of capital more than sufficient for any future crisis.

The Proposal’s Flawed Foundation

In the post 2008/2009 financial crisis, FDIC and bank regulators reduced reliance on risk-based approaches in favor of a simple leverage capital ratio. Tomas Hoenig, the former Vice Chairman of the FDIC, championed this clearly understood and easily calculated capital ratio. At the same time, he repeatedly documented the flawed premises and historical errors of modeling future risk relativities among myriad categories of bank assets.

However, NCUA under Chairman Matz introduced this flawed approach that was so lacking in factual foundation that the initial draft had to be withdrawn; but then it was reintroduced a second time.

This revised proposal drew significant dissent from new board member McWatters who was in the minority 2:1 board vote to approve the regulation.

“Based upon my thirty plus years of experience as an attorney who has worked in many intricate issues of statutory and regulatory interpretation, I am of the view that NCUA does not possess the legal authority under the NCUA to adopt a two-tier RBNW regulatory standard.

NCUA staff did not undertake a formal estimate of the recurring compliance costs of the proposed regulations… Regrettably this additional burden falls on a financial services sector that is not too-big-to-fail and was in manner responsible for the recent financial crisis.”

Kicking the Can Down the Road

The objections and complications of the rule were so great that NCUA delayed the final implementation until 2019 to allow time for the agency to expand its call report and internal software to be able to monitor the new rule.

When there were two board members only, Metzger and McWatters, they agreed to postpone implementation another year, til 2020. Congress has even proposed a law to delay this proposal further, a traditional political tactic when a flawed policy cannot be ended outright.

In the meantime, credit unions reported continually rising levels of capital, ending at over 11% collective net worth as of March 31.  This is 400 basis points over the well-capitalized regulatory requirement of 7%.

Taking a Cue from Bob Dylan

In 1966 the folk singer Bob Dylan faced a circumstance which he memorialized in the song 4th Time Around.  It starts with these words:

When she said, “Don’t waste your words, they’re just lies.” I cried she was deaf.

This is the 4th NCUA Board to consider imposing a detailed capital model when the credit union system was the only one to navigate the last crisis relatively intact under no risk-based rule. The RBNW rule is not only flawed but potentially dangerous to the future of credit unions. It rates certain categories of assets as risk free versus other assets.

This approach could induce credit unions to make decisions that could end up pushing all credit unions into the same risk profiles. As FDIC Vice Chairman Hoenig pointed out, the lowest rated risk categories before the Great Recession were sovereign debt and real estate collateralized securities. Both asset classes were at the center of the declines in asset values in the 2008-2009 crisis.

As the woman in Dylan’s song pleads, “Don’t get cute.” The circumstances and history of this wrong-headed regulatory effort suggest that it is time for the board not to get cute once again. Rather it should reject this approach to determining credit union capital adequacy. Or will the Board be deaf to the lessons provided by the last sixty years of this misguided effort?