One thing the savings and loan debacle of the 1980s taught us is the importance of a financial institution's capital in limiting risk exposure for the federal deposit insurance funds and for taxpayers.
As former regulators, we have seen up close the critical need for a meaningful, established capital floor for every insured institution.
Some credit union lobbyists are seeking to dramatically lower the reasonable capital standards adopted by Congress just six years ago. We believe this would be very bad public policy. We sincerely hope the lessons of the savings and loan fiasco have not been so soon forgotten.
Congress passed the Credit Union Membership Access Act in 1998, establishing minimum capital to asset standards, or leverage ratio, for credit unions similar to those imposed years earlier on banks and thrifts. The intent was to ensure continued financial stability in credit unions and to protect taxpayers.
Under the 1998 law, credit unions must maintain a leverage ratio of at least 7% to be considered well capitalized and 6% to be considered adequately capitalized. Below 6%, a credit union is subject to regulatory enforcement actions and is mandated to rebuild capital. In addition, the law imposes a "risk-based" capital standard on credit unions that are defined as "complex" by their federal regulator.
The leverage ratio requirement is slightly higher than the parallel standard for banks and thrifts.
Congress recognized the need for a somewhat higher leverage ratio because credit unions are not stock institutions-and therefore have almost no ability to raise new capital in times of stress-and because they count in their capital the money they "invest" in their deposit insurance fund instead of writing off deposit insurance premiums as banks and thrifts do.
Language designed to weaken these standards is embodied in the proposed Credit Union Regulatory Improvements Act. This bill would amend the 1998 law and replace the leverage ratio with a risk-based capital requirement to be defined by NCUA.
Most regulators would agree with the notion that riskier financial institutions should hold more capital than those with less risk. While we applaud any improvement in measuring risk, this bill falls far short of that goal. Indeed, the proposed bill would increase risks dramatically by reducing the leverage ratio to a meaningless level.
The Credit Union Regulatory Improvements Act proposes to eliminate the current 7% and 6% leverage ratios for well and adequately capitalized institutions and replace them with a leverage ratio of 2% and an undefined risk based ratio. A leverage ratio of 2% of assets would be virtually worthless as a supervisory tool.
By dropping the leverage ratio to 2%, the Credit Union Regulatory Improvements Act would seriously diminish the NCUA's ability to take regulatory actions before credit unions become critically undercapitalized. Indeed, research into bank failures indicates that when the leverage ratio falls to 2%, the economic value of an institution's capital is most likely negative.
In other words, the institution is probably "market value" insolvent when it reaches the 2% level, at which point capital enhancements will be very difficult to arrange and failure the most likely outcome. This is particularly troublesome in the context of credit unions, which are cooperatives without the ability to issue stock to raise capital.
Moreover, the risk-based capital standard proposed in the Credit Union Regulatory Improvements Act is wholly inadequate.
The standard proposed in the bill measures only credit risk and does not take into account interest rate, liquidity, and operational and reputation risks. In contrast, a meaningful leverage ratio provides a strong base of capital to protect against losses arising from any source.
The failure of Capital Corporate Federal Credit Union in 1995 is illustrative of the limitations of risk-based capital standards. Before its failure, CapCorp operated with a thin margin of capital as it had very little credit risk on its books. Corporate credit unions at that time were subject to risk-based capital standards and did not have to meet a leverage ratio requirement.
Weak internal controls, a mismatched asset-liability portfolio, and rapidly rising interest rates in 1994 forced NCUA to place CapCorp into conservatorship. If CapCorp had been subject to a meaningful leverage ratio requirement, it probably would not have been allowed to sink into insolvency.
If the Credit Union Regulatory Improvements Act moves forward, Congress needs to be careful about granting too much discretion to the NCUA to define risk assets, as the bill currently proposes, History has shown that regulators have at times been hesitant to impose tough standards on the industry they regulate.
Finally, as noted above, the NCUA already has the authority to impose risk-based capital standards on any credit unions it regards as "complex." This fact makes us wonder if there is any real purpose behind the Credit Union Regulatory Improvements Act, beyond lowering the leverage ratio to a grossly inadequate 2% level.
If Congress finds it appropriate to mandate risk-based capital for credit unions, the leverage ratio requirement enacted in 1998 should be maintained alongside the risk-based measure.
Norm D'Amours is the former chairman of NCUA and a principal at Capital partners Inc. William Isaac is the former chairman of the Federal Deposit Insurance Corp., and is the chair of Secura Group LLC. This piece originally appeared in The American Banker.
