Regulatory competition has a long and honorable history. Beginning with the national chartering of commercial banks in 1863, depository institutions have had the choice of federal or state charters. The consequences have generally been improvements in regulatory flexibility and innovation for depositories.

Unfortunately, the National Credit Union Administration faces a serious conflict of interest, which threatens to strangle this beneficial process of regulatory competition.

Federally insured state-chartered credit unions are the immediate victims, but the NCUA’s actions will eventually have deleterious consequences for all credit unions, federal as well as state-chartered.

The agency is the primary regulator of federally chartered credit unions. It is also the administrator of the National Credit Union Share Insurance Fund, which insures all federal credit unions and almost 90% of state-chartered credit unions, whose primary regulators are the states.

Since a credit union can switch its charter fairly readily, and since both the NCUA and the states prefer to preside over larger domains, the NCUA and the states are effectively engaged in regulatory competition. Each side generally tries to make its charter more attractive, encouraging credit unions to choose its charter.

When combined with regulatory competition, the federal agency’s dual role as the primary regulator of federal credit unions and administrator of the insurance fund creates a conflict of interest. When the NCUA takes actions with respect to the share insurance fund, one has to ask, “Is this being done in the interest of the fund or to benefit federal credit unions and disadvantage state credit unions?”

The immediate manifestation of this conflict has been the reimbursement process for safety-and-soundness regulation.

For federal credit unions, the NCUA has been the sole safety-and-soundness regulator. For state-chartered credit unions, state regulators perform this task, with a modest amount of backup from the NCUA.

Since the late 1970s the federal agency has been transferring funds from the insurance fund to reimburse itself for its claimed safety-and-soundness expenditures. In turn, it has reduced the operating (examination) fees of federal credit unions.

But these transfers have been one-sided. Comparable funds have not been transferred to the states for their safety-and-soundness expenditures.

The immediate consequences are that federal credit unions and federally insured state credit unions suffer a reduction in dividends that would otherwise be paid to them by the insurance fund. But federal credit unions enjoy a more-than-offsetting reduction of their operating fees, at the expense of state credit unions.

In essence, the federally insured state-chartered credit unions are forced to cross-subsidize the federal credit unions.

For the 2002 fiscal year this forced transfer will be about $31 million; in terms of returns on assets, the state credit unions will suffer a net disadvantage of almost 3 basis points vis-a-vis federal credit unions.

The concept of the lopsided transfers is bad enough, but it is exacerbated by the NCUA’s procedures. The agency itself decides what percentage of its expenditures should be included in the “safety and soundness” category. It is this fraction of its budget — its “overhead transfer rate” — that is covered by transfers from the insurance fund.

From the early 1980s until 1985 the overhead transfer rate was 33%. From 1985 until 2000 it was 50%. But last October the NCUA increased the rate to 66.72% for the 2001 fiscal year.

All federally insured state-chartered credit unions must be worrying, “What’s next?” And more than a few must be contemplating a switch to a federal charter.

This forced cross-subsidy does not represent a beneficial form of regulatory competition. Though federal credit unions may be the short-run beneficiaries, they will be losers in the long run if most or all federally insured state-chartered credit unions switch their charters. The cross-subsidy will cease, as will regulatory competition.

Unless the National Credit Union Share Insurance Fund is split off as a separate agency — an idea that has its own problems — the NCUA’s conflict-of-interest problem cannot be solved. But its immediate manifestation can and should be eliminated.

The NCUA should cease making any transfers to itself, except for the pure administration of the fund — that is, the overhead transfer rate should be abolished. (To the extent that the agency is doing backup work for the states, it should send them a bill directly). The insurance fund would consequently disburse larger dividends to all of it members. The forced cross-subsidy would cease; the state and federal credit unions would be on a level playing field.

The NCUA has commissioned Deloitte & Touche to examine the overhead transfer rate process. Though the terms of Deloitte’s task have not been made public, let us hope that they encompass an examination of the basic logic of the lopsided transfer itself.

The sooner the overhead transfer rate is abolished, the sooner healthy regulatory competition will return. All credit unions and their members, as well as the American economy generally, will be the beneficiaries.

Mr. White is a professor of economics at the Stern School of Business at New York University.

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