CUNA Comment Letter

NCUA's Advance Notice of Proposed Rulemaking on Prompt Corrective Action

January 27, 1999

Ms. Becky Baker
Secretary to the Board
National Credit Union Administration
1775 Duke Street
Alexandria, VA 22314-3428

RE: NCUA's Advance Notice of Proposed Rulemaking on Prompt Corrective Action

Dear Ms. Baker:

The Credit Union National Association appreciates this opportunity to comment on the National Credit Union Administration Board's Advance Notice of Proposed Rulemaking on Prompt Corrective Action (PCA), which appeared in the Federal Register October 29, 1998. This letter is the result of the work of CUNA's Examination and Supervision Subcommittee and HR 1151 Advisory Group. By way of background, CUNA represents approximately 90% of the nation's more than 11,400 state and federal credit unions.

Summary of CUNA's Comments

  1. Credit unions that are very well capitalized or do not present a material risk to the Share Insurance Fund should not be considered complex.
  2. Credits unions would be provisionally complex if certain potentially risky activities exceed specified thresholds.
  3. If identified as provisionally complex, a credit union could at its option perform an ALM analysis to determine complexity.

General Concerns

Prompt corrective action is one of the most important aspects of the Credit Union Membership Access Act (the Act). Neither the Board nor credit unions sought the inclusion of PCA in the legislation. When the issue first arose, many felt as did CUNA that sufficient safeguards were already in place. Moreover, the Act made credit unions the only federally insured financial institutions with capital levels specified by statute. Nonetheless, the credit union system supported HR 1151 as amended by the Senate Banking Committee as the only legislative vehicle for achieving relief on field of membership. That said, we believe PCA has the potential for enhancing safety and soundness if implemented with the regulatory flexibility that Congress intended.

The Board has indicated it plans to implement PCA in a fair and reasonable manner, in which case, the vast majority of credit unions should not be affected by the remedial requirements that must be imposed on those that are significantly or critically undercapitalized. Nonetheless, we are concerned that there is but a thin margin for error in developing the PCA regulations, particularly for significant components such as PCA for small credit unions, the definition of a "complex" credit union, and how risk-based standards should apply to such institutions.

While we are aware of the time constraints in the statute for issuing the regulations, we believe NCUA must not rush the development of its PCA rules, particularly those for complex credit unions. We urge NCUA to allow ample time to craft model rules that will benefit safety and soundness without needlessly burdening any credit union.

To that end, CUNA staff has been directed by our Board to meet with academics and recognized experts in the area of asset/liability management to obtain their recommendations on the application of PCA to complex credit unions. We plan to invite Treasury and NCUA staff to participate if they choose. While we will make every effort to arrange those discussions as soon as possible, more time is necessary within the comment period -- given all the other regulatory issues pending at the same time -- to secure this additional input. We hope to be able to provide any additional recommendations to NCUA by mid-March.

CUNA met with NAFCU and NASCUS on several occasions during the course of the comment period in an effort to coordinate our responses and develop common approaches if possible, particularly in the area of "complex" credit unions. While our letters reflect divergent recommendations in several areas, we agree on three standards for the promulgation of PCA rules for complex credit unions, which were first suggested by NAFCU. These standards are: that size alone should not determine complexity; that a credit union should be able to determine for itself whether it is complex; and PCA rules should provide "real protection against real risks." CUNA wholeheartedly endorses these standards and urges NCUA to adopt them. We now turn to our recommendations for how complex credit unions should be defined.

CUNA's Recommendations for the Definition of Complex Credit Unions

In researching the issue of "complex financial institutions," CUNA found just one use of similar terminology in the regulation and supervision of federally insured depository institutions. The Federal Reserve Board defines a "large, complex institution" as:

"those that generally have a functional management structure; a broad array of products, services, and activities; operations that span multiple supervisory jurisdictions; and consolidated assets of $1 billion or more."

If a bank is defined as a "large, complex institution" it becomes subject to an additional track of risk-focused supervision, beyond the supervision applied to banks that are not large and complex. Risk-focused supervision entails such activities as additional examinations of portions of the bank's activities, additional analyses, assessments, plans, and the preparation of corresponding documents.

The Fed's use of the term "complex" is obviously very different from the use intended by the Act. The only reference to a "complex" credit union in the Act is as it relates to whether a credit union will be required to meet a "risk-based net worth requirement."

CUNA is concerned that the use of the term "complex credit union" as defined in the final rule be restricted to the purpose intended in the Act and not be extended to take on any additional meanings of implications, such as those used by the banking regulatory agencies. Therefore, CUNA strongly recommends that the final rule contain an explicit statement of Board policy that the notion of a "complex credit union" as defined in the rule applies solely to the issue of whether a "risk-based net worth requirement" is to be met.

In developing its comments on the definition of a complex credit union, CUNA considered the following factors:

With these considerations in mind, CUNA suggests that the following principles apply in identifying complex credit unions.

* Consistent with the Act, certain credit unions should be excluded from being defined as complex:

  1. Those with net worth exceeding 8% of assets. As suggested later in this comment letter, CUNA believes that the maximum net worth "add-on" for complex credit unions should be no more than 100 basis points. Any credit union with net worth over 8% would therefore be considered "well capitalized" even if it met the definition of a "complex" credit union. Since being classified as complex would have no consequence for credit unions with net worth ratios of over 8%, they should not be so classified.
  2. Credit unions that are not large enough to present a material risk to the Share Insurance Fund. The purpose of PCA is to reduce the chance of significant losses to the Share Insurance Fund. Credit unions with insufficient insured shares to cause a significant loss to the Share Insurance Fund, even in the case of the simultaneous failure of many of them, should not be subject to consideration as "complex" credit unions. The issue of materiality could be determined in reference to the capitalization of the Share Insurance Fund (say credit unions with insured shares equal to less than 1% of the level of the fund.) Or, materiality could be tied to whether a credit union is required to file a quarterly Call Report.

* Credit unions not excluded from complexity would provisionally be classified as complex if ratios calculated from their financial reports exceeded one or more of the four thresholds outlined below. In order to prevent short-term fluctuations in a credit union's circumstances from causing it to frequently come into and out of complexity, CUNA suggests that the values to be compared to the thresholds be the average of the four quarter-ending ratios preceding the determination. The thresholds described below were chosen on the basis of identifying only those credit unions that represent significantly above normal risks to the Share Insurance Fund.

  1. Borrowing. A credit union with unmatched borrowing exceeding 10% of assets would provisionally be classified as complex. Matched borrowing would include: (a) borrowing in the form of reverse repurchase agreements placed in matched investments for arbitrage; (b) long-term fixed rate borrowing matched against long-term, fixed rate mortgages; and (c) any other borrowing that funds a readily identifiable asset or class of assets with a duration similar to that of the borrowing.
  2. Long-term, fixed-rate mortgage lending. A credit union with a portfolio of unmatched fixed-rate, first-mortgages with remaining maturities of more than 12 years which exceeds 35% of assets would provisionally be classified as complex. CUNA suggests twelve years as the determining factor since that is the maximum loan maturity a federal credit union may make other than a mortgage loan. Long-term, fixed-rate first mortgages funding by long-term, fixed-rate borrowing should not be counted toward the 35% threshold.
  3. Investments. A credit union with certain potentially risky investments exceeding 2.5 times net worth would provisionally be classified as complex. The investments in question should be the same as those currently considered for the requirement that a federal credit union undergo a 300 basis point shock test under investment requirement section 703, with the exception that the remaining maturity threshold should be five years instead of three years as under section 703.
  4. Off-balance sheet exposures. A credit union with non-consumer, off-balance sheet commitments and contingencies exceeding 10% of assets would provisionally be classified as complex. Commitments would include outstanding letters of credit, commitments for commercial real estate or construction and land development, and other unused commitments. Contingencies would include loans sold or swapped with recourse.

* A credit union that is provisionally classified as complex should have the option of accepting the identification and meeting whatever risk-based net worth requirement is relevant. However, CUNA believes that a credit union that exceeds one or more of these simple thresholds may be managing its interest rate risk in such a way that it does not present a significantly above-normal risk to the Share Insurance Fund. A credit union provisionally identified as complex should have the option of demonstrating that it has adequately neutralized the apparent risk and therefore, is not complex. A credit union should be permitted to demonstrate that it has sufficiently minimized its interest-rate risk exposure by conducting a standardized ALM shock test according to the following principles.

  1. Basic ranges for all assumptions, including the size and characteristics of interest rate shocks, balance sheet repricing and decay rates of share accounts would be established by NCUA after consultation with other federally insured depository agencies and ALM professionals.
  2. The standardized ALM shock test would calculate the credit union's "after-shock net worth" also referred to as the "market value of portfolio equity." That represents what the credit union's net worth would be after adjusting for the effects on all balance sheet items of the specified change in interest rates.
  3. 3. A provisionally complex credit union would be considered not complex if its after-shock net worth were at least 6%, regardless of how much the credit union's net income might be affected by the specified change in interest rates. The 6% figure is suggested because it is the statutory level of capital necessary for a credit union with normal risks to be considered adequately capitalized. Even a non-complex credit union has a certain amount of interest rate risk. Because the "after-shock" net worth ratio represents the effects of reducing actual capital by the amount of interest rate risk, an "after-shock" level of 6% is considerable.
  4. No credit union would be required to perform this analysis. This analysis would simply be an option for credit unions provisionally identified as complex.

Risk-Based Net Worth Requirements

CUNA has not yet performed an in-depth analysis to determine the "risk-based net worth requirements" for complex credit unions, given the uncertainty of how NCUA would define "complex." However, CUNA recommends the Board consider the following points in developing its proposed risk-based requirements.

PCA for CUs under $10 Million in Assets And Less than 10 Years Old

The Act directs the NCUA Board to develop a PCA system for "new credit unions" (those in operation for less than 10 years and having less than $10 million in assets), which is "in lieu of" the statutory and regulatory PCA provisions that apply to other credit unions. The system must: carry out the purpose of the PCA statutory requirements; recognize credit unions initially have no net worth and give new credit unions reasonable time to accumulate net worth; create adequate incentives for new credit unions to become adequately capitalized by the time they reach 10 years or $10 million in assets; impose "appropriate" restrictions on new credit unions that do not make progress toward becoming adequately capitalized; and prevent the evasion of PCA.

There is little guidance NCUA can turn to regarding how this section should be implemented. The legislative history on these provisions is confined to the Senate Report, which basically restates the Act. While there are aspects of PCA in the FDI Act or banking regulations that we might point to for guidance in other areas, credit unions alone are allowed an alternative system for new institutions. This is no doubt because, among financial institutions, credit unions are alone in beginning their existence without capital. All credit union capital must be accumulated through the retention of earnings.

We believe that in providing an alternative PCA system for these institutions, Congress has once again indicated its support for the growth and development of new credit unions. The language of the Act strives to encourage new credit unions to accumulate capital, without unleashing harsh regulatory penalties if they fall short while making a good faith effort. Also, the language gives NCUA considerable latitude to allow new credit unions to experience asset growth while building reasonable capital levels. We urge NCUA to permit new credit unions to have as much leeway as possible to comply with PCA requirements.

In developing an alternative system for new credit unions, we also urge NCUA to use its own wealth of experience in dealing with these institutions. We encourage NCUA to develop a blueprint for building regulatory capital that is based on the performance of new or small credit unions for the first ten years of their existence. We believe particular latitude should be provided during the first three years of their charter. We also recommend that while NCUA develop guidelines for capital development at new credit unions, that the unique situation of each credit union in this category be taken into consideration when evaluating its progress. We believe the Act allows NCUA to deviate on a case-by-case basis from standard capital guidelines that would otherwise apply generally to any new credit union.

The Act directs NCUA to provide incentives for new credit unions to build capital. Such incentives could include no reduction in a credit union's Capital or Management components of its CAMEL rating if the credit union were making any progress toward accumulating capital. Incentives could also include additional time to meet certain benchmarks while still a new credit union, if any progress in building capital were shown.

The Act requires NCUA to work with new credit unions in developing net worth restoration plans. This letter discusses net worth restoration plans generally in greater detail below. However, we believe a net worth restoration plan for a new credit union must fully recognize the credit union's age and asset level, as well as any additional unique factors that affect the credit union's ability to build capital.

Net Worth Restoration Plans

The FDI Act spells out specific criteria for a bank or thrift capital restoration plan. These requirements include the steps the institution will take to become adequately capitalized; the levels of capital to be attained each year of the plan; how the institution will comply with any restrictions as a result of its capital; the types and level of activities in which the institution will engage; and such information as the regulator may require. The FDI Act also provides that an acceptable plan must be based on realistic assumptions, be likely to succeed, and not appreciably increase the risk to which the institution is exposed.

The requirements for a net worth restoration plan are not enumerated in the Act. However, there is the requirement, as discussed further below, that NCUA's PCA system be comparable to the PCA program required by the FDI Act.

While in general we do not believe the bank regulators' PCA rules should be the template for NCUA's PCA system (particularly in the areas of risked-based requirements), regulatory guidance from these agencies on the contents of a capital plan is useful. Relevant aspects of the Office of Thrift Supervision's Thrift Bulletin, Guidelines for FIRREA Capital Plans Exemptions and Exceptions are also helpful. On page three of the Bulletin, OTS states, "The capital plan should not be merely a budget of projected operations. It must be a comprehensive plan that is the result of strategic, in-depth planning on the part of the [institution's] board ... and management."

We encourage NCUA to consider carefully the requirements of the FDI Act in establishing its parameters for a net worth restoration plan. We believe that, consistent with the FDI Act and the manner in which the other financial institution regulators have implemented capital plans, a net worth restoration plan should be treated as a business plan for achieving specified capital goals within certain time frames.

While the net worth restoration plan should be viewed as a business plan, we do not think it should be needlessly detailed, create unwarranted paperwork requirements or provide NCUA with a unique means to micro-manage a credit union operating under such a plan.

CUNA suggests that the issue of materiality raised earlier in this letter be considered in the development of net worth restoration plans. Smaller credit unions pose relatively small risks to the Fund and often do not have the breadth and depth of management resources to produce detailed documentation and analysis. CUNA in no way recommends that such credit unions, if under capitalized, be exempted from developing net worth restoration plans. However, the Board should consider applying greater flexibility to the required content and timing of such plans from credit unions that do not represent a material risk to the Fund. Further, due consideration must be given to the role of secondary capital for those credit unions eligible to accept secondary capital.

The Act provides NCUA tremendous flexibility to work with a credit union in accepting a net worth restoration plan, more discretion than the FDI Act affords bank regulators. The Act states, "If an insured credit union submits a ...plan... and the Board determines that the plan is not acceptable, the Board shall promptly notify the credit union of why the plan is not acceptable and give the credit union a reasonable opportunity to submit a revised plan" (12 USC 1790d(f)(4)(A)). We urge NCUA to utilize the full extent of these provisions. NCUA should allow affected credit unions ample time and latitude to develop net worth restoration plans that will provide sufficient guidance for both the institution and the agency regarding how the credit union will improve its capital.

When NCUA issues its proposed PCA rule, it should clearly delineate what it intends the net worth restoration plan to include and allow credit unions to comment on the specific details. We also believe that NCUA should include provisions for waiving the requirements of the plan if an affected credit union is merging with another credit union. Also, there should be a deadline by which NCUA must respond regarding a credit union's net worth plan, so the credit union knows as soon as possible whether it should be implementing the plan or developing a new one.

Comparability with the FDI Act

NCUA has asked for comments on the general issue of comparability between PCA provisions for credit unions and those for other financial institutions. The Act requires comparability only with the FDI Act -- not with the bank regulators' rules. The Act states:

The Board shall by regulation, prescribe a system of prompt corrective action for insured credit unions that is consistent with this section and comparable to section 38 of the Federal Deposit Insurance Act (12 USC 1790d(b)(A)).

Because the Act does not require comparability with the bank regulators' rules, we urge the agency to refrain from importing bank regulations, particularly in the area of risk-based requirements. As pointed out above, the other regulators rules and guidelines could be useful resources for NCUA, but we do not believe that NCUA's regulation should be patterned after those of the bank regulators.

While the Act requires comparability as noted above, it also requires NCUA to design its PCA system in broad recognition of the distinct characteristics of credit unions.

The Board shall ... take into account that credit union are not-for profit cooperatives that (i) do not issue capital stock; (ii) must rely on retained earnings to build net worth; and (iii) have boards of directors that consist primarily of volunteers (12 USC 1790d(b)(B)).

While, NCUA must devise a PCA system that is "parallel in substance (though not necessarily identical in detail) and equivalent in vigor" to Section 38, the agency also has tremendous authority to custom-design its system for credit unions (S. Rpt. 105-193 at p. 12). We urge NCUA to use the full scope of its powers to develop a unique PCA system for credit unions.

Conclusion

In conclusion, prompt corrective action is one of the most important aspects of the Act. We urge the NCUA Board to take sufficient time, within the statutory constraints, to develop a PCA system that will enhance safety and soundness but not penalize credit unions that are making every effort to build capital. We have carefully considered the issues raised by the Advance Notice of Proposed Rulemaking, and we have developed a number of principles, precepts and proposals, which we urge the Board to incorporate into its proposed regulations. If NCUA Board members or staff have any questions about this letter, please do not hesitate to call CUNA's General Counsel Eric Richard, Chief Economist Bill Hampel, or Associate General Counsel Mary Dunn at 202-682-4200.

Sincerely,

Daniel A. Mica
President and CEO

cc: Assistant Treasury Secretary Richard S. Carnell
NCUA Board Chairman Norman D'Amours
NCUA Board Member Yolanda Wheat
NCUA Board Member Dennis Dollar
NCUA Deputy Director of Examination and Insurance Herb Yolles