Because of its importance to the credit union system, NCUA's recently proposed rule to update risk-based capital regulations has appropriately garnered much attention.
You may not know that NCUA is required by law to update credit unions' risk-based capital standards as financial regulatory capital standards evolve. The Federal Credit Union Act requires NCUA's prompt corrective action (PCA) requirements be comparable with other federal banking agencies. Maintaining effective capital standards is an essential element of the regulatory frameworks for all financial institutions.
Two updates to Basel have occurred in the regulatory sphere since NCUA first put the risk-based capital requirement in place more than a decade ago. In addition, a 2012 Government Accountability Office report to Congress following the financial crisis recommended NCUA update and improve credit union capital requirements. To maintain comparability with the other federal banking agencies, NCUA must now modernize capital standards as applicable for credit unions.
While NCUA used FDIC's updated capital rule based on Basel III that was finalized in July 2013 as a general baseline, NCUA's proposal does adapt those capital standards to account for CUs' assets and risk profiles. The Federal Credit Union Act specifically requires NCUA's risk-based requirement to account for all material risks, not just credit risk. So while Basel and FDIC's rule focus primarily on credit risk, NCUA's proposed rule factors in interest rate and concentration risks, and is designed to improve the correlation between minimum required capital and risk.
While the credit union system as a whole came through the financial crisis relatively well, many individual CUs did not. A key lesson of the crisis is that capital standards must be well-correlated to risk. As evidence that the current risk-based capital requirement is not sufficiently capturing risk in the system, today only two credit unions are required to hold more capital under the current risk-based capital requirement — as opposed to 199 credit unions that would be required to hold more capital under the proposed rule.
As a reflection of the overall strength of the system, under the proposal 94% of CUs would maintain well-capitalized capital levels.
However, the remaining 199 credit unions, which hold more than $80 billion in assets, would need to choose to either reduce some of their balance sheet risk or add about $700 million in additional capital in the aggregate to reach the well-capitalized level defined by the risk-based proposal. While some published reports suggest the risk-based proposal would require billions in new capital, the actual new capital requirements for the affected CUs is on average less than 1% of their assets (and that assumes they choose not to sell riskier assets instead). It is important to note that holding capital levels above those required by the proposed regulation would be a strategic risk management choice made by CUs and not a regulatory obligation created by the proposal.
When CUs fail by taking excessive risks without commensurate capital to back them up, federally insured credit unions pay for those losses through the National Credit Union Share Insurance Fund. If the riskiest CUs were required to either choose to hold more capital or to shed risky assets in order to comply, then all other well-capitalized credit unions under this proposal face less of a future threat to their own capital.
Under the proposed new risk-based requirement, CUs would also gain further options to manage their balance sheet mix to remain well capitalized for risk-based purposes. For example, if an influx of member deposits occurs, a CU can invest those funds in lower risk-weighted assets (like zero-weighted Treasuries) and therefore not dilute its risk-based capital ratio.
The more calibrated the proposal is to risk, the less there is a perceived or real need for capital levels above the minimum regulatory requirement. NCUA carefully evaluated each rationale behind the different risk-weights in the proposal, including calibrating the risk weights within the context of available data, evaluating comparability as appropriate to the risk-based system for banks, and recognizing cost-benefit trade-offs.
While striving for general comparability with FDIC's risk weights, NCUA did make risk-weighting adjustments — such as weighting consumer loans at 75% in comparison to the banking system's risk weight of 100%. We retained the tiered risk-weight approach from our current risk-based rule, to account for higher concentrations in member business loans and mortgages, as the 2012 GAO report to Congress specifically recommends NCUA address concentration risk.
We were mindful of the trade-offs between precision and additional complexity, and between automated calculations and burdensome information reporting. If the rule is finalized, we intend to amend NCUA's call report program so that a new risk-based capital ratio will be calculated automatically for each credit union.
While the proposal is more calibrated to risk than the current system, it is nevertheless a high-level approach intended for broad applicability. To determine its optimum level of capital, each CU will be encouraged to perform more precise capital modeling and planning relative to its unique market, risk profile, and strategic plans.
NCUA will continue to explore ways to improve the rule, and the 90-day comment process will undoubtedly provide very beneficial input for stakeholders. Your input on how to improve the proposal is welcomed and encouraged.
Larry Fazio is NCUA's director of examination and insurance.
