Category: Risk Based Capital

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RBC/ CCULR: “The Fruit of a Poisonous Tree”

One commentator on the rule which went into effect on January 1, wrote me:

“Regulatory net worth is a tax on asset growth. It requires resources be directed to reserves held idle on the balance sheet, instead of being used for investment in credit union products and services. . .

Increasing the regulatory capital erodes competitive positioning opportunities and makes it harder for credit unions to fulfill their chartered mission.

The other factor is the low interest rate environment.  You can’t accrete capital fast enough by just growing assets anymore. . .   This regulation is a death warrant for credit unions between $400 million and $1 billion.  . . .”

How much is this initial tax to be CCULR compliant?

Between $30-40 billion  of sequestered existing reserves or required new capital to be at 9%.  That assumes no capital buffer is added.  This total will be approximately double the industry’s total net income in 2021.

Two others wrote after reading Three Strikes a RBC/CCULR Should be Out:

Why didn’t someone sue?

I’m not hearing a peep out of CUNA or NAFCU over this change.

The Grass Roots Effort in 2015

The December 2021 RBC/CCULR rule was the fifth formal rule-making effort spanning an eight-year period.  The initial proposal was so badly put together the agency concluded that: After carefully considering the comments of stakeholders, Chairman Matz in September (2014) announced that the agency would make significant structural changes to the proposal and issue a revised proposed rule for a second comment period.” (NCUA 2014 Annual Report pg 12)

The final rule was proposed in January 2015.  At that year’s GAC convention, credit unions were urged to Raise Their Voice in opposition to the rule.

With a booth encouraging action:

Despite widespread, continued credit union opposition, the Board approved RBC in a 2 to 1 vote  in September 2015 with McWatters opposed.  Ironically, NCUA’s 2015 Annual Report’s theme, “The Year of Regulatory Relief” was a PR fantasy.

So onerous was the rule that implementation was deferred  for more than three years until January 1, 2019 to: “provide ample time for affected credit unions to choose to generate more capital while continuing to maintain their current portfolios, reduce risk, or execute some strategic combination of the two.”

In October, 2018, the Board approved a one year further delay in implementation. It raised the definition of complex in the rule from $100 to $500 million in assets, removing 1,026 credit unions from its requirements.

In 2019 the Board passed another delay of two years until January 1, 2022, described as a “win for credit unions.”

The fifth time was the charm.  By a vote of 3-0 in December, 2021, the board passed RBC and CCULR with only a nine-day lead time before becoming effective on January 1, 2022.

The Illusory Truth Effect

One of the realities of public discourse is that when something is repeated often enough, people begin to think it is true.  Especially if the misstatements are by persons in authority.

Credit unions filed 2,056 comments in opposition to the 2014 proposal. They filed just 21 responses to the new CCULR/RBC rule.

Was the low response due to regulatory fatigue?  Did NCUA just outlast the widespread industry opposition? Perhaps.

I believe the pattern of reissuing, modifications and extensions all created the impression that the rule was both necessary and legal.  It was neither.

It is an example of an “illusory truth effect” created by NCUA’s off and on again eight-year rule making campaign.

The agency had five different chairs in these eight years with no consistent policy process. This elongated effort created a regulatory “myth” distorting credit unions’ true capital adequacy and  full compliance with  PCA requirements.

Under 22 years of RBNW guidance, the agency summoned credit unions’ self-determined capital management,  The  result was a 3.5% average net worth ratio above the 7% minimum.  RBC/CCULR imposed a new, higher 9% standard by fiat.

The New Rule’s Failings

  • The agency provided no “substantial objective evidence” that the system’s capital levels were inadequate under RBNW. Staff admitted that only one failed credit union in the past ten years would have been subject to RBC’s additional capital.
  • The agency wrongly used the “comparable” standard to implement a clone of bank regulations. This approach clearly contradicted the statutory intent that RBNW cover only a select small group of credit unions that represented unusual risks. As staff stated in its board memo: A special note that most, if not all, of the components of the CCULR are similar to the federal banking agencies’ CBLR.
  • There was no statutory authority for a CCULR option.
  • Nine days for implantation violates the “reasonable period of time” requirement for a change in PCA capital levels.
  • Harm to members will be real. Over 500 credit unions will now be burdened with immediate RBC compliance.  They must limit asset growth or charge members more to take the so-called CCULR “off ramp.”
  • The compliance burden is immense. Completing the final five pages of information in the revised 32 page quarterly call report is required to compute this one RBC ratio.

Who Will Raise the Issue Now?

Credit unions’ initial response could be to give up any effort to change.  Just attempt to live with it.  Or merge.  The reporting and tracking burden is so intense that NCUA has launched a 90-day period of  industry webinars, examiner training and printed guidance.  It has waived late filing fees for March.

At a time of rising interest rates, inflation, cyber worries, members’ economic uncertainty and continued technology disruption, credit unions are learning to fill out a new form.  Five pages of data to calculate a single ratio.

Once this one ratio result is known, credit unions must then decide how to conform all of their decisions to this rule that rates the risk of every asset choice they make.

This rule was a leadership failure from the top down. To change will require action from the grassroots up.

First Stop: GAC

A rule promulgated  to enhance the future viability of the credit union system will have just the opposite effect.  It reduces competitive options immediately.

Every credit union attending GAC can inform and rally peers, trade spokesmen, congressional contacts and the press about this unwarranted burden.  Examples are critical; do the homework. Know your ratio and the choices you now must make to counter the rhetorical myths others may use to support the rule.

Press your case publicly-see the booth picture above.  Privately, ask NCUA board members to see the consequences and change the rule before more harm is done. Board members Hood and Hauptman stated their responsibility for the rule’s consequences:

Hauptman: The Board intends to monitor the impact of CCULR and RBC on credit unions and the Share Insurance Fund going forward. I look forward to working with my Board members next year and the year after on quantitative analysis on a cost and benefits of our current approach to RBC and CCULR.

Why not begin this year?

Why This Matters

One of the unique features of credit unions is their democratic governance. Whether in the oversight of the credit union via the board or in interactions with the regulator, democracy is fragile.  It requires constant practice, renewal and involvement.

This rule is so obviously wrong from  many perspectives that it is hard to understand how it got this far.  But the internal appeal of governmental authority is strong, especially clothed with good intent.

The authority asserted in this rule is total, every asset and maturity decision now comes with a regulators’ risk rating.  NCUA staff and board seem blissfully unaware of how this will impact credit unions.  Somehow it is supposed to make the insurance fund stronger!

Changing this outcome will require an all hands and all voices effort.  But then democracy was never meant to be a spectator sport.

And I will continue to do so!

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Three Strikes and RBC/CCILR Should Be Out: Failing the Test of Comparability

My earlier posts described how NCUA ignored two of the three explicit criteria in the PCA law when imposing RBC/CCULR rules on credit unions.

Before looking at the third constraining feature, “comparability,” there is a procedural violation in NCUA’s actions. The agency’s Federal Registration filing for CCULR and amended RBC was December 23,2021; the act took full effect on January 1, 2022.

The PCA act directs how these changes are to occur:

Adjusting net worth levels -Transition period required

If the Board increases any net worth ratio under this paragraph, the Board shall give insured credit unions a reasonable period of time to meet the increased ratio.

Credit unions were given 9 days to comply with CCULR’s 29% increase (from 7% to 9%)  to attain a well-capitalized rating.

The Third Criteria for PCA Implementation

At its core, NCUA has only one explanation for its new RBC/CCULR joint rules:

Harper: The final rule is a balanced approach that gives complex credit unions a risk-based capital framework comparable to those developed by other federal banking agencies.  

The combined rules’ minute details and hundreds of risk weightings are explained with multiple variations of one idea: “to ensure comparability with the banking industry.”

Nowhere is comparable defined.

If comparable means “the same as,” credit unions’ 10.6% net worth ratio at December 2021 already exceeds either banks’ core capital leverage ratio of 8.86% or equity capital ratio of 10.06% as reported by FDIC in their September 30 quarterly report.

Must credit unions now reduce their capital level to be comparable to banks’ average?

Obviously not.   NCUA’s intent is that credit union net worth be measured with the exact same accounting details as the bank’s follow.  Except banks have many more capital options for the numerator.

The rule’s 70+ risk weighting formulas, and multiple variations, applied to credit union assets were lifted directly from the banking model.

The rule duplicates bank regulations at every point even though the asset composition and financial roles of the two systems are drastically different.

This literal interpretation of comparable accomplishes one goal—NCUA now controls credit unions with the same power bank regulators enjoy.  This should be no surprise as Chairman Harper has repeatedly praised FDIC bank regulation as the de facto standard he intends for credit unions and the NCUSIF.

This approach was followed ignoring the two system’s different histories, legislative purpose, financial design and most importantly, financial performance.

What did comparable mean when Congress mandated this new cooperative capital standard in 1998?

For 90 years credit union capital adequacy was based on a flow concept, setting aside a required percentage of total income before dividends, rather than a balance sheet, net worth ratio, measured at points in time. This  new ratio standard was significantly different from credit unions’ prior practice of building reserves over time as a percentage of total income.

The Act explicitly required NCUA to “design the system, taking into account” the not-for-profit  cooperative structure which cannot issue capital stock and relies only on retained earnings for reserves. When requiring a balance sheet ratio test versus a set aside from revenue, NCUA’s process must consider the listed differences in reserve structure and even the board volunteer composition.

The second change under PCA for credit unions  is in a different section of the act:

d) Risk based net worth requirement for complex credit unions.

The agency is directed to include ” a risk-based net worth requirement for insured credit unions that are complex.”

Banks have no call out for complex.  Risk based weightings are universal for all banks.

The new coop PCA  model required a risk-based factor (weighting) for a defined set of complex situations which “take account any material risks against which the net worth ratio . . . may not provide adequate protection.”

These words clearly establish a different PCA model for credit unions than required of banks.

Cooperative PCA standards are clearly intended to be different.  To assert that comparable means to duplicate, copy or be the same as banks practice is a misinterpretation of the Act.

Twisting a Law Reducing Burden to Impose a New Regulation

The most recent example of this misinterpretation of NCUA’s authority is Chairman Harper’s description justifying the CCULR option  proposed by NCUA in July 2021, five months earlier.

Harper: We must, however, also recognize several legislative, regulatory, and marketplace developments since the NCUA Board approved the final Risk‑Based Capital Rule in 2015. For example, in 2018, Section 2001 of the Economic Growth Regulatory Relief and Consumer Protection Act directed the other federal banking agencies to propose a simplified alternative measure of capital adequacy for certain federally insured banks. The result of that effort became known as the Community Bank Leverage Ratio framework which became effective in January 2020.

There is a supreme irony citing President Trump and the Republican-sponsored Main Street Relief Act, to reduce regulation burden.  Then to expand its application to NCUA’s rule making authority over credit unions.

Here is a summary of the reference Harper cited:

Title II Regulatory Relief and Protecting Consumer Access to Credit

Section 201. Capital Simplification for Qualifying Community Banks. This section requires that the Federal banking agencies establish a community bank leverage ratio of tangible equity to average total consolidated assets of not less than eight percent and not more than 10 percent. Banks with less than $10 billion in total consolidated assets who maintain tangible equity in an amount that exceeds the community bank leverage ratio will be deemed to be in compliance with capital and leverage requirements.

There is no mention of NCUA anywhere. NCUA had not even implemented RBC when the bill was signed in May 2018.  There was no basis for credit unions to ask for regulatory relief from a rule not in effect and deferred three times at that point.

The congressionally enacted CCULR option was a banking industry effort for an alternative to a flawed and burdensome RBC rule.   FDIC’s  vice chair Thomas Hoenig had been a long standing vocal critic of RBC.

Further evidence that this section 201 did not include NCUA is that NCUA is specifically named in two other parts of the bill that explicitly provide regulatory relief for credit unions:

Section 212. Budget Transparency for the NCUA. This section requires the National Credit Union Administration to publish and hold a hearing on a draft budget prior to submitting the budget.

Section 105. Credit Union Residential Loans. This section provides that a 1- to 4-family dwelling that is not the primary residence of a member will not be considered a member business loan under the Federal Credit Union Act.

To claim NCUA’s authority for CCULR, Harper refers back to the 1998 PCA bill.  He then uses the “comparability” reference to presume authority in a bill passed twenty years later and in a section specifically omitting any reference to NCUA .

The result of this newly found authority is to increase credit unions’ restricted capital. As stated in the Board memo:  ”The Board believes that a CCULR of nine percent is appropriate because most complex credit unions would be required to hold more capital under the CCULR framework than under the risk-based capital framework.”

A False Narrative

NCUA was not given CCULR authority.  It is a false narrative permeating RBC/CCULR that credit unions’ rules can exactly copy bank rules.

This duplication-interpretation overlooks the two-decade reality that credit unions were fully compliant with their PCA risk based net worth (RBNW) model and repeatedly surpassing banks in financial performance under it.

The staff perpetuates this duplicating justification in its board memo: A special note that most, if not all, of the components of the CCULR are similar to the federal banking agencies’ CBLR.

The Consequences of Unconstrained Regulation

There are immediate and long-term unfortunate consequences when authority is improperly interpreted and asserted.  This erroneous RBC/CCULR precedent will undermine the credit union system’s unique role and diversity, directly contrary to PCA’s intent to respect cooperative character.

It sets an example of agency interpretation independent of fact, statutory language and prior compliance precedent.

Board Member Hood pointed out this long-term risk in his December board comments:

We now have (PCA compliance) with our risk-based network requirement. This law gives this board serious responsibilities which we must faithfully uphold, but this does not mean that since the bank regulators established a risk-based capital regime, we must follow them.

I actually worry that once we decree that 7% may no longer be adequately capitalized, then whether it’s this board or a future board that settles on an 8%, 9%, 10% net worth in the complex credit union ratio, as some say in North Carolina, the barn door is now open to that interpretation or that change.

I worry that we may have set an arbitrary standard above the law that a future board can easily change at any time.

There is much more at stake from RBC/CCULR than approximately  $30-40 billion of forced sequestration and newly required credit union capital. And the rule’s faulty legal standing.

The central issue is whether the NCUA board is willing or able to support the continuing evolution of a unique cooperative financial system in its regulatory actions.

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NCUA’s Apocalyptic New Year’s Surprise for Credit Unions

On December 23, 2021, NCUA filed a new rule, RBC/CCULR, in the federal register. It took full effect just 9 days later on January 1, 2022. This rule is the most consequential ever passed by NCUA, and the most damaging.

The change immediately affects 83% of 2021 yearend credit union assets.

Using a purported rationale of improving the safety of the system, the rule will result in the opposite outcome. It significantly handicaps the ability of credit unions to make decisions about how best to serve their members using their own experiences and judgments.

This catastrophic new burden will accelerate the merger of sound, well-run credit unions approaching the $500 million starting line for CCULR/RBC.  It will  energize this culling of hundreds of successful medium-sized local institutions now facing an overnight  fundamental change in compliance burden.

The New Year Shock

Credit Union 1, Rantoul, Illinois, wins the award for the first credit union to publish its full 2021 Annual Report including year-end financial data and ratios.

The President’s Report  by Todd Gunderson, CEO, contains the following upbeat assessment:

CU 1 loan portfolio growth was 15% as we extended $ 916 million in loans to our members throughout the year—an increase of 43%–and $276 million from the 2020 year.  The additional loan interest income helped CU 1 achieve a record net income amount for the 2021 year, bringing net capital rate or our rainy-day fund up to 8.71% of assets.  This keeps CU 1 well in excess of what regulators call a well-capitalized credit union, defined as 7% net capital.   

CU 1’s total assets had increased to $1.226 billion or by 4.8%.  At the same time, it raised its net worth ratio from 8.21% in 2020 to 8.71%.

Chair Bob Eberhert was equally proud of CU 1’s regulatory standing:   “. . . our future . . .is about having the trust of membership by being a sound member-oriented financial institution that propels CU 1 to be awarded the highest rating that can be bestowed upon a bank or credit union by  banking supervisory regulators.

These statements were accurate for exactly one day, December 31, 2021, when the books were closed.

CU 1 is the first of hundreds of credit unions that entered the New Year believing their past performance was at the highest standard.  They will now find they are in a literal regulatory net-worth “no-man’s land” where no coop has ever been.

Enter Three Capital standards

Every credit union over $500 million in assets saw their minimum ratio for “well capitalized” raised from 7% to 9%, a 29% increase, on January 1, 2022.

No phase in, no transitions, no analysis of the consequences, and imposed despite no demonstrated need at the individual credit union or system level by NCUA.

From one simple, easy to compare century-long standard, these institutions are now subject to three interlocking capital requirements.  These rules entail multiple options for calculating the numerator for “capital reserves” under the three standards.

The denominator, or “total assets,” now requires hundreds of specific math calculations as well as evaluating alternative methods. These factors include whether the asset is on and off the balance sheet, multiple time periods for determining “average” assets, and every asset’s relative risk calibrated precisely to a government mandated and calibrated formula.

The chart below presents this new tri-part capital era. The system has gone from the left column of clearly understood and applied net worth of 7% with five gradations, to the completely open-ended 500+ page-RBC/CCULR formulas and criteria.

Capital Options Table

A Direct Member Tax

The rule handicaps credit unions from spending money to lower fees (eg. overdraft charges), offer better savings or loan rates or even initiate critical programs such as cyber security or ESG initiatives.

Instead, this income must now be put into reserves where the amounts already set aside have proven more than sufficient through every previous financial crisis.

Every one of the 100 million plus members in a credit union subject to, or nearing this rule’s reach, will pay the direct costs of this regulatory tax in higher fees, lower savings or higher loan rates.

The members most affected will be those at the margin, with lower credit, just starting out after leaving school, or returning to the labor force; that is those traditionally perceived as higher risk.

Hundreds of Credit Unions Impacted

Hundreds of credit unions like CU 1 now find their “well-capitalized” regulatory standing downgraded overnight.  From understanding and complying with a capital standard proven over 100 years, they are immediately thrown into  a regulatory purgatory.

RBC/CCULR is a purgatory of changeable definitions and formulas in which every asset decision is now subject to a government-dictated risk rating.

Every credit union over $500 million in assets (83% % of total assets) can now be whipsawed between two different capital standards.  NCUA reserved the authority to impose the capital model they want,  regardless of the credit union’s choice.

No more respect for credit unions’ four-decade track record of demonstrated risk management honed in the marketplace since deregulation.

These two draconian rules of 500 pages are in effect now. No phase in, no transitions, no analysis of the consequences, and implemented with no reference to the actual capital soundness of the industry.

It is a regulator taking an action because it can. The traditional due processes and institutional checks and balances, at the board level, failed.

Uncertainty  About Cooperative Soundness Undermines Public Confidence

The agency gave itself the authority to micro-manage every asset decision made daily by 5,000 credit unions.  It is the most extreme example of an independent regulator asserting control over every aspect of a credit union’s operations.

This rule is  the worst kind of regulatory putsch possible. It is an assumed authority run amok.

It throws the credit union system into a public relations debacle.  For credit union leaders it creates a compliance wonderland of uncertainty about the rules of the game.

Will all CAMEL 1 rated credit unions below 9% now become CAMEL 2?

Will this incentivize the sale of subordinated debt with members paying the added cost of capital to be compliant?

How does anyone– the regulator, the members, the public– compare credit union performance with three very different ways of measuring “well capitalized”?

Will this intrusive regulatory grading of every asset decision override credit unions’ learned experience? And inhibit serving members and making investments required to stay competitive?

In upcoming posts I will show why RBC/CCULR is “the fruit of a poisonous tree.”

 

 

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Asset Bubbles and Credit Unions

During his time as Vice Chair of the FDIC, Thomas Hoenig challenged the agency’s implementation of risk-based capital requirements.  He questioned both the theory and practice, pointing to the lending distortions which contributed to banking losses during the Great Recession.

I became aware of  his views when in 2014 NCUA began the process of imposing the same flawed system on credit unions.   Hoenig believed the best capital indicator was  a simple leverage ratio, the credit union model for 110 years, until December 2021.  Then NCUA dictated a complex, three-part capital structure, CCULR/RBC, to replace this century long capital standard.

Hoenig’s Other Regulatory Dissent

Hoenig was a career regulator.  He began as an economist in bank supervision at the Kansas City District Federal Reserve Bank an area of the country where he had grown up. In the 1970’s during a period of unprecedented double-digit inflation, he saw first-hand the impact on lenders and their borrowers whose relationships were underwritten with collateral-based loans.   The security was believed to be ironclad during this decade of ever-rising prices for farmland and commercial real estate.

Hoenig’s story is told in a new book, The Lords of Easy Money,  and a summary article in Politico. The article describes how he became the lone dissenting vote in November 2010 on the Federal Reserve’s Open Market Committee.  He opposed extending the monetary policy called quantitative easing beyond the Great Recession to jump start the economy.

His opposition was based on his early Midwestern regulatory experience, as the Fed tried to get inflation under control. From Politico:

“Under Volcker, the Fed raised short-term interest rates from 10 percent in 1979 to 20 percent in 1981, the highest they have ever been.

“You could see, Hoenig recalls, that no one anticipated that adjustment.” More than 1,600 banks failed between 1980 and 1994, the worst failure rate since Depression.”

But the banking failures and borrower bankruptcies were not the primary reason for Hoenig to  oppose Fed Chair Bernanke’s continued quantitative easing.

The “Allocative Effect” of Asset Bubbles

When borrowing rates are effectively negative, as now, this fuels inflation with surplus liquidity looking for places to go.   Too many dollars chasing too few goods. With funding costs near zero, any reasonable investment looks like a sure thing.

As asset prices rise quickly, a feedback loop develops. Higher asset prices today drive tomorrow’s asset prices ever higher. Especially when those assets are pledged to support more borrowing.

For Hoenig, his greatest concern with this low interest rate policy is the distortion or  “allocative effects”  of the additional wealth created by this monetary stimulus.

As summarized in Politico:

“Quantitative easing stoked asset prices, which primarily benefited the very rich. By making money so cheap and available, it also encouraged riskier lending and financial engineering tactics like debt-fueled stock buybacks and mergers, which did virtually nothing to improve the lot of millions of people who earned a living through their paychecks.

Hoenig was worried primarily that the Fed was taking a risky path that would deepen income inequality, stoke dangerous asset bubbles and enrich the biggest banks over everyone else. He also warned that it would suck the Fed into a money-printing quagmire that the central bank would not be able to escape without destabilizing the entire financial system.”

The Economic Consequences Hoenig Warned About

Those distortions are here now.  One need only look general stock market levels as well as individual company valuations that are unhinged from  performance to see examples that don’t compute.

In a January 7 essay “A Stock Market Crash is Coming and Everyone Knows It” the writer notes wild stock valuations: The price earnings ratio for the S&P index of stocks historically averages 15.  Today the ratio is 29 times;  Amazon’s ratio is 60 and Tesla’s 330.

This disconnect between stock prices and a company’s financials is most visible in meme stocks, IPO’s and SPAC’s often with no history of positive net income.  These new offerings and crypto-currency  asset hype are explained as harbingers of  a  newly emerging digital-metaverse economy.  Predictions of these asset bubbles bursting go back at least two years.  Because it hasn’t happened yet, doesn’t mean the Fed’s changed policy won’t be disruptive.

The Credit Union Impact

Credit unions are creatures of the market. Co-ops whether by design or neglect that have become distant from their members, are even more dependent on market sourced opportunities.

Approximately 80% of all credit union loans are secured by autos, first and second mortgages, or commercial assets. Before asset bubbles burst, decisions about new loans and investments look straightforward, easy to project future returns.

The most frequent example today of this financial euphoria is credit unions buying whole banks, frequently in new markets.  When the cost of funds is .25- .50 basis points, paying a premium of 1.5 to 2.0 times book value for a bank looks like a can’t lose opportunity.   Even when the bank’s financial performance is being supported by the same low cost of funds and its underwriting  secured by commercial loans with continuously appreciating assets.

GreenState Credit Union in Iowa, Hoenig’s home state, is so eager to take advantage of these current opportunities that it is buying and absorbing three banks simultaneously, all operating outside its core markets.

In North Carolina, Truliant  Federal Credit Union announced in December that it had raised $50 million in an unsecured  subordinated term note at a fixed rate of 3.625%, The purpose reported in the press: “Truliant has primarily grown the credit union’s loan portfolio organically, however management is open to acquisitions in the $500-$750 million asset range.” 

The announcement is a public invitation for brokers to bring their deals to Truliant’s table.

When funding looks inexpensive and asset values stable or rising, what could go wrong?

The short answer is that  the Fed’s inflation response will disrupt all asset valuations and their expected returns.  The larger question is whether buying businesses whose owners believe now is the time to cash out, and whose results were created by a very different model and charter, will even match a credit union’s capabilities.

In an earlier analysis of credit union whole bank purchases I raised these issues:

As credit unions pursue whole bank acquisitions, are they buying “tired” business models built with different values and goals? Are these credit unions giving up the advantages of cooperative design and innovation attempting to purchase scale? Will combining competitors’ experiences (and customers) with the credit union tax exemption create an illusion of financial opportunity that fails to prove out when evaluated years down the road.

The Discipline Required of the Co-op Model

The co-op member-owner model protects credit unions from some of the rough and tumble accountability of constantly changing stock market valuations.  This difference requires strong management and board discipline to remain focused on the people (members) who respond to and need a credit union relationship.

Buying into new markets and customers through financial leverage, versus winning them in competition, is a new game for credit unions.  Organic growth builds on known capabilities and experiences, not externally purchased originations.

Hoenig’s critiques offer a third lesson relevant for these leveraged buyouts.  The financial consequences of public policy changes can take years  for their consequences to be found out.

It took seven years for the FDIC to recognize there was no cost-benefit outcome with RBC. And eleven years to understand the full economic impacts from when he first opposed quantitative easing as the primary tool for the fed to keep the economy growing.

Credit union success is not because they are bigger, financially more sophisticated, or even led by superior managers versus banks.   They win when their capabilities  align with member needs.  Members join based on their choice, not because their account was bought from another firm.

The beginning of a significant economic pivot, long forecast by the Fed, seems a very suspect time to use member capital to pay out bank owners.   The bank owners are asking for members’ cash, not the stock that other bank purchasers would offer, to protect these sellers from valuation uncertainties.

Credit union leaders buying banks are betting (paying premiums) that they can  manage the bank’s assets and liabilities for a higher future return than their for-profit managers were able to do.

Rather than compete with a superior business design, buying banks intending to run them more effectively, feels like surrendering to the opposition.

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“No Wonder We All Are Bored with NCUA Board Meetings”

This week I asked my good friend Randy Karnes for his perspective  on the upcoming NCUA board meeting (12/16/21). Here’s what he had to say:

Chip hoped that I might inspire the NCUA board to consider its agenda differently; to move away from the agenda’s details and towards activities that would craft a new expectation for us all.   

NCUA and its governance needs to focus on bigger issues. Issues that inspired owners. Issues that made business fun for those who derive  meaning from their efforts. Issues that extended value so that the everyday owners, and professionals reporting to them, would care about board meetings and NCUA’s  oversight functions.

He hoped the three politically selected directors would consider that we need more from the regulator.  We want a group that cares about our professions, our ideas for governance,  and our safety nets.  That the credit union-funded institutions at NCUA are still there to back our plays, our efforts, and our belief in the work ahead.

So I read Chip’s 12/13 blog as the inspiration for my comments, but only found the inspiration to declare I understand why no one gives a sh*t anymore.

Here’s what we’re looking at for Thursday; an agenda that claims we should be paying attention:  Got to wonder?

Multiple issues with the RBC/CCULR capital regulation, a topic of great concern that will affect the CU industry for years to come – a bureaucratic press headline and a staff that cries wolf.

    1. Lots of numbers (NCUA/FDIC) – far from any consequence for those locally looking for numbers that will sustain them.
    2. CU’s have already maintained enough dollars for last few “so called crises” – but who would waste a crisis yet to come?
    3. Is it credit unions  or the NCUA Board  who is focused on “change for change” to their own ends – we see no need for any capital change.
    4. Why trust their “ends” at all, no wonder we all are bored with NCUA board meetings, they are not for us and we hear no mention of us in their words or declarations.
    5. More reg burden for the sake of burden. Another option for NCUA to leverage their situational control of our members’ futures. These new tools are ineffective and simply clutter other work that screams for action.
    6. Confusing stats for the sake of stats, oil and water displays, confusion just to take our eyes off the ball – member value.
    7. Member faith in NCUA thinking is muddled by over wrought academic complexity.  No workman’s simplicity in this group, that would take experience; a care for the work.

Now shift to the budget item.

The next budget is just another edition off  an assembly line of budgets – cranking out ugly babies with no mirrors in sight. More spending wanted, when less would send a message of hope and clarity.

    1. Planners who expect a rising  curve of more money in this to the next year, to every year – void of awareness from past exploits or value adds.
    2. More people to pad our importance, to enhance processes now un-manned, and with no plans for when needed. We need more people without recognizing there are none to be had.
    3. The budget is not about the flow of our industry and the requirements for its sustainability.  It is simply to ensure the NCUA outlasts its ward, that the NCUA is the last group standing.
    4. The industry’s funds are always there to direct, and NCUA will always be  quicker, slicker, and quietly positioned to direct those funds from members’ activities to a bureaucratic engine fueled by money.
    5. Just give us more, we are hungry.

These are the “minutes” for the 12/16 NCUA Board meeting,  ahead of time, a template of expectations from a bored audience of the industry’s CU members – customer-owners who wonder why the value of ownership has lost its punch.

But the funny thing is we all really do still give a sh*t! We are hungry to believe, follow, and to give homage to the NCUA’s efforts if they would simply find the heart to sell us that they still have the will to deliver value to our members. The heart to simply believe in the work of cooperatives. The heart to inspire us with the simplicity of a local community’s effort to lift itself up by work well done.

I know that Chip wants me to declare that 12/16 is a day for us to rally our voices and take on these tactics from the agenda – to shout we give a damn about RBC/CCULR or the board’s broken budget processes, but I can’t.

The only goal I have for the NCUA’s board and bureaucrats is to work harder, and work smarter to bring back those days when we waited in earnest to read the press reports of an NCUA board meeting. To read the reports ready to smile with the effort and the intent that made us believe we had a valuable ally for our futures.

It’s not that America has given up on its institutions that ensure our success; rather we simply forgot how to promote  leaders for these institutions whose roles are to guard and foster our efforts. We need to change how NCUA board members rise to the occasions ahead.

Too many times these directors have started out as lame ducks….and it has nothing to do with their terms. Lame work is becoming the standard.

Tell Me Why I’m Wrong.

 

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Tomorrow’s NCUA Board Challenge:  A Turning Point of Just More of the Same?

Most individuals and organizations  realize at some point in their journeys,  that money does not guarantee success.  Nor happiness.

Thursday’s NCUA Board is, at first glance, all about money.  Tens of millions.  And how it is to be raised, allocated and spent.

Since all NCUA’s funds are from credit union members, it behooves we all pay attention. For NCUA has no other revenue. It is the steward of almost $400 million in annual costs paid by members.

The Board’s financial decisions on Thursday  include:

  • The size of NCUA’s annual and capital budget spending;
  • How these costs are allocated (OTR) between the CLF, NCUSIF and Operating Fee;
  • The limit, or cap, on the maximum relative size of the NCUSIF via the NOL, after which a dividend must be paid;
  • The disposition of the approximately $100 million in surplus retained in the Operating Fund from excess FCU annual fees collected over recent years.
  • Even the proposed CCULR/RBC rule is about money, not just burden. It would require credit unions to retain from revenue initially as much as $26 billion more in reserves that would otherwise be available for greater  member value and service.

All About Money, or Is It?

The justifications for the amounts NCUA is seeking, is that the regulator’s financial resources are what sustains a safe and sound movement.  More financial resources enables more effective supervision.

This leadership approach is a fallacy.  It is often used to explain NCUA’s and even many  credit union decisions.  Institutional strength or capability is measured by asset size, by net worth ratio or for NCUA, the annual spend or dollars on hand.

Resilience Not Resources

However, over and over again especially this year, events have shown that resilience is a leadership characteristic, not the amount of resource an organization controls.   Credit unions with double digit net worth, managing hundreds of millions, even billions, are routinely merging saying they lack the resources to cope with future challenges.  That is a leadership failing, not a resource gap.

Every credit union in existence today was started with no financial capital.  They survived, prospered, and thrived because of volunteer sweat equity, sponsor support, member self-help and shared belief in their purpose.  In other words, leadership.

These critical intrinsic motivations are being replaced with an assumption that more and more dollars are the key to survival.   The thought that resilience depends on more dollars cuts against the grain of what a coop financial system is and can be.

This reasoning is used by some CEO’s who end their tenure with mergers accompanied with large added retirement or financial bonuses.  Greed not gratitude becomes the hallmark career-end.

Who Will Credit Unions Become?

How the Board decides the issues before it tomorrow will send a clear message who they believe credit unions are today and what they will become in the future.  Will it be about more money for NCUA or an effort to inspire credit unions through careful stewardship of their resources and decisions based on objective data?

During the past two years of the pandemic credit unions have shown their best side.  Waving fees, making loan adjustments, lowering charges, and being with members or in person no matter the severity of the epidemic.   The growth in member savings and bottom lines have resulted in back-to-back record setting outcomes and zero NCUSIF insurance losses.

Daily credit unions are announcing bonus dividends to members to share their success in the millions.

The board’s decisions on resources will communicate their view of whether credit unions are special kind of financial service provider that warrants further inspiration, or just a minor-league version of banking.

Will the board present made up worries and projects lacking outcomes to support funding?  Will it succumb to temptation to offer unknowable future risks to retain unneeded reserves?  Will it affirm the idea that every credit union must stand on its own bottom—no system safety nets or mutual support in the event of problems?

All for One and One for All?

Credit union’s manage people’s money to promote other member’s financial opportunity. The well-being of one is linked to the well-being of all.   The same approach has, in the past, applied to credit union’s intra-dependent cooperative system design.

The result is credit unions are much stronger than individual numbers alone would ever indicate.  The member relationships, based on a premise that this financial community will help ones neighbors, creates goodwill and loyalty creating value that far exceeds  financial ratios.

Credit unions are a classic example of American innovation with leaders that have attracted  tens of millions of adherents or fans, called members.  It is self-help, self-financed and self- governed, formed from the grass roots and built on community respect.

A Contradictory Stance On Credit Union’s Role

The NCUA board has represented a different portrait of the system.  In the past decade, NCUA’s priorities suggest credit union’s meaning and value is measured primarily by how many dollars are on the  balance sheet and in net worth.

The whole theme is to get more.  There is no underlying recognition about the practical life of the members or their credit union’s role.  Such a world view cannot inspire the movement let alone feed the soul of  members.

NCUA’s increasingly dystopian views augmented by faulty analysis and misleading numbers blinds them to see what they can’t see.  NCUA no longer see credit unions as they are, because NCUA see things as they are.  They no longer seek information that would change their approach;  rather they look for a story that confirms what they already have in mind.

NCUA’s decisions rest on a simple falsehood that more is necessary rather than a more  complex reality.  Resilience and credit union success is not built on financial performance, but by leaders imbued with purpose and community well-being.

Inverting Common Sense

Even worse is the proposed RBC/CCULR rule.  It inverts the legal maxim that bad cases make bad law. In NCUA’s  view a bad loss requires an ever more complex rule.

When NCUA approves a generally applicable rule like RBC to counter an extreme outcome or circumstance, the risk is that all credit unions’ freedoms are now restricted by the behavior of a very few.

The burden of the RBC/CCULR rule will fall directly on the membership, in the initial proposal by at least $26 billion.

Will the NCUA board respond to the incredible credit union performance during the pandemic for members.  Will it say, “Job well done?”  Or now is our time to get more funds?  Will they respect and recognize the documented track record of the industry since 2008 (reported yesterday) or will they continue to present misleading analysis and mythical future outlooks?

Whatever the outcome, it will set the tone and direction for years to come.  It is unlikely there will be a better time or circumstance for the NCUA board to affirm its faith in the credit union system, the performance of cu leadership during COVID,  and to restrain the never ending instinct  to acquire more resources.

 

 

 

 

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Why the RBC/CCULR Should Be Dropped

The following observations ares from an expert who has worked financial institutions for years.   This academic-style analysis uses  NCUA and FDIC data.

The author sent this summary comment along with the charts:

Any increase in net worth regulatory requirement is a tax on asset growth. Credit unions must grow to maintain market relevance (i.e., they need income to invest in technology, security, regulation, product development, etc.). Adding to the burden just makes it more difficult for credit unions to fulfill their mission. This is a statement of fact.

The corporate credit union collapse was really a double-whammy to credit unions. Not only did they need to replace reserves due to loan losses, but they had to shoulder the burden of NCUSIF and TCCUSF expense/assessments. Had the system been only holding 7% net worth in the aggregate, it would have been able to overcome economic fallout from the Great Recession without falling below 6%. (see the stress test observation #3)

In any system outliers exist. There will always be a few that engage in activities that put themselves at risk (fraud, credit risk, concentration risk, interest rate risk, etc.). The role of the examiner is to identify those activities and enforce policy to make sure they don’t happen.

Asking everyone to hold more capital, because of a handful of outliers, does not fix the root problem; rather, it allows it to propagate knowing a safety net is in place. At the end of the day, it would be a lot cheaper (and more effective) to increase  examinations instead of asking credit unions to hold more reserves.

Observation #1: Sound underwriting protected credit unions during the Great Recession years.

The biggest threat to credit union reserves is loan losses because of the speed and magnitude in which they can occur.

The bars on the chart are net charge-offs as a percent of assets (to facilitate comparison with reserves which are also measured as a percent of assets).

In the five years prior to 2008 and the nine years following 2012, loan losses averaged 0.33% of assets with a small standard deviation, a sign of consistent and sound underwriting.

During a five-year stretch from 2008 through 2012, credit unions reserves were hit the hardest, due to economic fallout from the Great Recession. Loan losses averaged 0.62% of assets (almost double the normal rate). However, credit union losses were 37% lower than FDIC insured banks which averaged 0.99% of assets.

Observation #2: Credit unions added to reserves during the Great Recession years and the economic fallout resulting from COVID 19.

The line on the chart is income before net charge-offs as a percent of average assets. It represents the surplus available to offset loan losses and add to overall reserves (loan loss reserve or net worth). The bars on the chart are net charge-offs, also as a percent of average assets.

The difference between the line on the chart and the bars is the amount added to reserves. This chart includes NCUSIF and TCCUSF expense, to demonstrate the impact of the corporate credit union failure on the system.

Despite elevated loan losses and NCUSIF/TCCUSF expense, credit unions added to reserves every year, including the Great Recession years and during the COVID 19 aftermath.

Observation #3: A stress test shows that at 7% net worth, adequate reserves were present to weather the Great Recession and subsequent corporate credit union collapse.

The line on the chart is income before net charge-offs as a percent of average assets. It represents the surplus available to offset loan losses and add to overall reserves (loan loss reserve or net worth). The bars on the chart are net charge-offs, also as a percent of average assets.

The dots with data labels are the result of a stress test that set net worth at exactly 7% of assets prior to the onset of the Great Recession and subsequent corporate credit union collapse.

Under this real-world stress test, credit union reserves would have dipped below 7% well capitalized but would have exceeded 6% adequately capitalized, even after absorbing just over $8.4 billion in TCCUSF and NCUSIF expense from 2009 through 2013 – the equivalent of 0.89% of credit union assets.

Furthermore, credit unions would have built up ample reserves to absorb the shock to net worth in 2020 and 2021 due to stimulus activity that inflated the liability side of the balance sheet (not the riskier asset side via loans).

Observation #4: Credit unions have consistently maintained excess reserves beyond 7% well capitalized.

The line on the chart is net worth as a percent of assets. The dashed line is net worth plus loan loss reserve as a percent of assets (i.e., total reserves).

Credit unions have consistently maintained excess reserves beyond 7% well capitalized – and those reserves have been sufficient to offset loan losses resulting from the Great Recession, the subsequent corporate credit union collapse and the rush of stimulus dollars injected into the economy in 2020 and 2021.

Observation #5: An impact assessment shows that increasing the capital requirement would affect up to 651 credit unions greater than $400 million in assets requiring an additional $26.5 billion in net worth.

Proposed regulation would impact credit unions exceeding $500 million in assets. Credit unions approaching that threshold would also be impacted as they must prepare for crossing it. The impact assessment looks at the 808 credit unions who currently have more than $400 million in assets as of 2021 Q3.

The bars on the chart to the left represent a distribution of credit unions by net worth strata. There are currently 349 credit unions with net worth below 9.5%. The line on the chart represents the cumulative number of credit unions across the strata. There are 651 credit unions with less than 11.5% net worth.

Credit unions will always hold a buffer above the regulatory net worth requirement. System-wide, credit unions currently have a 3.2% net worth buffer (10.2% 2021 Q3 net worth minus 7.0% well capitalized equals 3.2% buffer). To evaluate the impact of an increase in regulatory net worth, an assumption that credit unions will hold a buffer of 1.5% is used. So, if the definition of well capitalized increases to 10.0%, then a credit union would hold 11.5%, a buffer of 1.5%.

The chart on the right shows the amount of additional net worth dollars required to reach a target net worth ratio. If the regulatory requirement increased to 10% then credit unions would hold 11.5%, requiring an additional $26.5 billion of net worth.

Regulatory net worth is a tax on asset growth. This is a statement of fact. It requires resources be directed to reserves held idle on the balance sheet, instead of being used for investment in credit union products and services, technology, security, wages to provide employees with a fair standard of living, DEI (diversity, equity, and inclusion) and community impact initiatives. Increasing the regulatory requirement erodes competitive position and makes it harder for credit unions to fulfill their chartered mission.

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Wise Reflections on Two Topics:  RBC and the Inflation Outlook

Two experienced bank regulators on risk-based capital:

Comment by  leo.sammallahti@coop.exchange:

What banks perceive as safe is more dangerous to the financial system than what banks perceive as risky. Financial crises are not caused by banks engaging too much in activities deemed risky, but by activities deemed to be safe turning out to be riskier than thought.

Per Kurowski is a former Executive Director of the World Bank for Costa Rica, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Spain and Venezuela who has been on a decade long crusade against risk weighted capital requirements. Recommend googling him – if you come across a YouTube channel with covers of Latin American pop songs don’t be mistaken to think that is not him. It is him, and the channel includes also videos about his thoughts on banking. He also has a blog.  A recent memo on RBC.

As Paul Volcker, the former head of the federal reserve said:

“Over time, the inherent problems with the risk weighted bank capital-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011.”

The Inflation Tax-an Excerpt

“… So, yes, inflation is here. It’s real. And it’s slowing the economy. It’s like a giant new tax on households and businesses, and wage hikes aren’t a panacea. And now you have a Fed that has partly caused the problem, by overstimulating demand relative to the preparedness of the supply side, and ends up with an economic slowdown anyway. What’s worse, these resulting high food and energy prices hurt low-income households the most–the very contingent that the Fed’s super-easy-monetary policy was supposed to help by letting things “run hot” this time around.

And finally, on the fiscal side, the situation doesn’t look much better. Politico has a piece today about how the stimulus checks and child tax credits aren’t delivering for Democrats; “whatever political benefits were supposed to accrue…have seemingly faded,” they write. “Giving people money may not be the dispositive political winner that they imagined.”

It may simply be that voters are smart enough to connect the dots and realize what all this cash and Fed stimulus has done to the economy–and how little it can fix of the lingering Covid challenges.”

From: Kelly Evans, kelly@cnbc.com, The Inflation Tax, October 11, 2021

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Experts Views on Why Risk Based Capital Fails

Following the 2008/9 Great Recession and financial crisis,  many commentaries and studies asked why the risk-based capital requirements did not prevent severe losses in banks.

The following are the conclusions from several regulators and studies.

 

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Risk Based Capital’s Basic Flaw

Credit unions were very critical of both NCUA’s risk based capital proposed rules  in 2014 and 2015.   Among the major objections were:

  • Failing to document any objective need for the rule
  • Creating multiple shortcomings and inconsistencies in asset risk weightings
  • Establishing a competitive disadvantage  versus bank capital options
  • Undermining member value in  both costs to implement and higher capital levels
  • Providing open ended examiner authority to interpret circumstances and override the rule
  • Imposing a one-size-fits-all national formula for risk and capital adequacy for over 5,000 diverse institutions serving thousands of different  markets
  • Ignoring banking regulators’s experiences which led them to drop RBC in favor of a simple leverage ratio
  • Overlooking the negative impact of  RBC on the corporate system’s ability to serve members

The concept of RBC can be useful at an institutional level because decisions and reserves are based on specific experiences (delinquencies and returns) for an asset’s known historical performance.

However, what works locally does not scale up to a single national formula.

The Fundamental Flaw of The RBC Concept

No team in any sport would try to win a contest by only playing defense. To compete in any activity, an organization must have both offense and defense.

But a one-sided approach to financial soundness is what RBC mandates. It requires credit unions to reserve based on a formula for risk and ignores all factors for income or return.

Every cooperative succeeds by pursuing,  sometimes seizing, opportunity. Credit unions were begun as a solution for consumers that were not well-served by existing choices.

A formula that attempts to measure only risk means examiners and credit unions will be inhibited or even restricted in  responding to individual or unusual circumstances.   Especially members in a crisis.

Every credit union monitors risk daily when it prices loans or evaluates investment yields.  The projected return is balanced with an asset’s risk whether duration or credit, and in the context of the balance sheet’s overall ALM position. Using a single formula to evaluate these decisions distorts everyday business practice and experience.

Risk for an individual credit union is more nuanced than a simple formula that assigns  relative risk weightings for almost 100 asset classes. As any board or manager knows,  such an approach is not how asset strategies are developed.

RBC does not reflect pricing  to pursue market opportunities.  It imposes a single national risk profile to replace the accumulated financial experiences and judgments which managers now use in each of their  institutions.

Risk is not a bad thing. Risk is considered whenever a credit union makes a loan, a CUSO or other investment, or a fixed-asset purchase. The judgment in the decision is the opportunity to help a member or enhance the credit union’s financial management,  not how it conforms to a one-size-fits-all  rule.

Risk Based Capital Is A Tool, Not A Rule

The risk based capital rule is a mistake.

If there is any benefit in a single formula to assess a cooperative’s financial soundness, then NCUA should validate that  by using the risk-based analysis as a tool in examinations.

Imposing  a one-size-fits-all rule denigrates the knowledge and experience of credit union managers across the country. It is contrary to the purpose of the cooperative model.

If risk analysis were as simple as a single formula, then there would be no need for cooperatives — just one financial charter license, one common set of rules, and one way to serve the market.

Credit unions were started because the existing financial frameworks and ways of doing business did not meet the needs of member-owners or of their communities.

For more than 100 years, credit unions have used a reserving-capital process that requires they  set aside an amount or percentage of income as a cushion for difficult times and to meet minimum well-capitalized targets.

This approach has worked. It has well served  members, the regulators, and the American economy. Reserving  is a holistic judgment that balances opportunity and member need with the uncertainties inherent in any market economy.

RBC plays defense only by focusing on one very narrow factor in managing safety and soundness.   It adds nothing to the evaluation of specific opportunities or individual credit union business situations.

More importantly, if the complex formulas are wrong overall, or in respect of any asset category, that mistaken judgment could push credit unions over a cliff who followed the letter of the law.

Reserving beyond meeting the well-capitalized minimum leverage ratio of 7% is best done by the boards and managers who are directly accountable for their judgment, not government bureaucrats.