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Credit Union Capital Requirements Stifle Access to Credit

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Credit unions provide essential retail financial services in the form of depository accounts and consumer loan products and services. Perhaps at no point since the Great Depression has the role of credit unions been of greater importance to consumers than the present financial crisis. 

Historically, credit unions provided a countercyclical balance when the economy weakens by offering a ready source of lending to members and as a safe harbor for deposits. However, the current statutory framework for credit union capital introduces a set of unintended consequences that constrain lending and deposit-taking activities while increasing customer costs at the very time that services are needed most.

Under current law, retail credit unions cannot raise capital. Unlike all other federally insured depository institutions that have access to some form of supplemental capital (including low-income credit unions), retail credit unions can only improve their net worth through retained earnings. 

Like all other federally insured depository institutions, credit unions are subject to Prompt Corrective Action rules, a set of capital-based supervisory standards.  The combination of PCA rules and a restrictive statutory definition of net worth, however, create unique challenges for retail credit unions during stress periods and make it more difficult for them to address capital deficiencies should they arise.

In the years following enactment of PCA, credit unions largely enjoyed a favorable economic environment resulting in sustained strong performance. But as the recent financial crisis unfolded, credit unions faced unique challenges.

As markets became volatile and a general uneasiness fell over the investing public regarding the relative safety of instruments traditionally viewed as low-risk, credit unions were viewed as a safe haven. But at the very time consumers were looking to move their money into credit unions to shelter them during a crisis, the influx of deposits was causing a reduction in the net worth ratios of many credit unions.    

As the crisis grew, banks tightened underwriting terms. The result is the credit crunch that has yet to abate. 

Recent evidence from the crisis indicates that several well-capitalized credit unions slowed deposit gathering in apparent response to eroding net worth ratios.  An unintended consequence of PCA for credit unions is that without a mechanism other than retained earnings to raise capital, credit unions are forced to take drastic measures to ensure their capital ratios remain at well-capitalized levels. This is called the "PCA Trap."  

The alternatives faced by credit unions caught in this PCA Trap have the effect of penalizing consumers and sidelining credit unions from helping to do their part to stimulate an economic recovery. 

For example, credit unions may be forced to lower the rates they pay on deposits to limit inflows. Or they may be forced to raise fees on customer services, lending and products offered to members, as well as reduce noninterest operating expenses and member services in order to improve their retained earnings position. This is a problem that must be fixed.

Congress should revisit the issue of credit union capital and explore supplemental forms of capital specifically tailored to credit unions as not-for-profit financial cooperatives. 

The Capital Access for Small Businesses and Jobs Act (H.R. 3993) introduced this year in the House offers one such solution. 

The bill would strengthen the capital and improve the safety and soundness of credit unions by allowing the National Credit Union Administration to authorize qualified credit unions to accept additional forms of capital to supplement their retained earnings.  The legislation would impose two important limitations on this new authority.

First, the bill excludes from consideration any form of supplemental capital that would alter the cooperative nature of credit unions (e.g., by providing voting rights). Second, the measure expressly confines supplemental capital to only those credit unions that the NCUA determines to be sufficiently capitalized and well-managed. Weak CUs won't get a handout, which would promote undesirable behavior, but strong ones will be spared having to throttle back on lending or deposit-gathering.

The NCUA would determine the specific forms of capital that could be offered through a future rulemaking (subordinated debt is one possibility). But in simplest terms, supplemental capital is a tool that could help well-managed credit unions, large and small, meet their members' demand for access to affordable credit. This would benefit consumers, small businesses and the economic recovery by keeping private credit flowing at a time that we need it most.

Clifford Rossi, PhD, is an Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.    

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Comments (16)
Let them raise all the capital they are able to so long as they pay income taxes like the rest of community banks
Posted by hgwahl | Friday, September 07 2012 at 1:44PM ET
Let them raise all the capital they are able to so long as they pay income taxes like the rest of community banks
Posted by hgwahl | Friday, September 07 2012 at 1:44PM ET
If credit unions want to be on equal footing with other federally insured depository institutions, revoke their non-profit status and have them apply for a bank charter. Credit Unions have morphed into something that they were never meant to be. By extending their loans (and membership) beyond a core group, they have exposed themselves to more risk and thus losses/lack of earnings. Now they want to increase their lending ability for commercial credits. When will their requests for more and more meet with reality?

You'll get no sympathy from any knowledgeable person in the financial industry regarding the "drastic" steps credit unions may have to take to address their capital predicaments. Credit unions pay above market rates on deposits and charge below market rates on loans, all because they enjoy non-profit status. Why should they now be able to compete for capital, just because they can't earn their way out of poor management decisions, even without paying taxes.

Their non-profit status alone is a competitive advantage that most other financial entities will never have access to. And the steps outlined by Mr. Rossi are those things financial institutions are confronted with today while still managing to pay taxes on their earnings. Sorry, credit unions shouldn't be exempt from those tough and very real decisions.

It seems to me that Credit Unions want their cake and eat too. Time for a reality check and to to ask the tough question, "is the credit union model no longer viable in the 21st Century?"
Posted by jdrakepbtx | Friday, September 07 2012 at 1:45PM ET
What the credit unions need to do without losing there status is to have Permanent shares. These share are used to capitalize the credit unions and the members can't use them to borrow against or cash them in .
Posted by pman | Friday, September 07 2012 at 1:55PM ET
Mr. Rossi characterizes the problems facing credit unions very well. In effect, credit unions are between a rock and a hard place. They are one of the few financial institutions whose assets and liabilities both are predominantly consumer oriented and yet the capital conundrum facing credit unions is severe. The tax advantage in effect has become a substitute for lack of effective access to the capital markets.

The commenters on taxation make a good point and maybe what the answer is focuses on defining tax exemptions. Credit unions, mutual savings banks and perhaps even mutual insurance firms with a very narrow business line that fall below a maximum asset test (say $200 million or so) and commit to remain mutual could be considered tax exempt. Any institution, regardless of mutuality, that exceeds the maximum asset test would be taxed but allowed to convert and raise capital as necessary.

From the NUCA's standpoint, the option would allow for stock credit unions. As someone who has been around the credit union industry for some time, I recognize this is a culture change for credit unions. But it makes sense to preserve an important focus for local consumer lending and it ensures that well-run, well-managed credit unions will have access to growth. It also underscores the credit union's business of promoting financial knowledge and financial strength.
Posted by helmudt | Friday, September 07 2012 at 2:01PM ET
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