Proposed Rule Creates New Risk-Based Capital Calculation for Credit Unions
Earlier this year, the National Credit Union Administration (NCUA) published its proposed rule on prompt corrective action – risk-based capital, which is designed to establish a direct relationship between risk exposure and required capital for credit unions. The more risk a credit union assumes, the higher the capital requirement. Conversely, credit unions with lower risk and less complex operations would have a lower capital requirement.
The document not only outlines the new risk-based capital calculation, but provides extensive information regarding NCUA’s methodology and rational for the various risk-weightings. According to the NCUA, the proposed rule is a direct result of the economic recession and related credit union failures that cost the National Credit Union Share Insurance Fund (NCUSIF) millions of dollars. It is not only more consistent with the relatively new rules for corporate credit unions, but also other federal banking regulatory agencies and depository institutions worldwide.
The proposed rule mainly applies to “complex” credit unions or those with total assets greater than $50 million. In order to be considered well-capitalized, complex credit unions would have to maintain a net worth ratio of 7 percent or above and a risk-based capital ratio of 10.5 percent or above. The proposed risk-based capital ratio calculation is somewhat complicated — the information below can help. The NCUA also has a website to help credit unions calculate their risk-based capital under the proposed rule.
Finding net worth ratio
Under the proposed rule, the numerator of the net worth ratio will primarily consist of the same components currently used to calculate a credit union’s net worth, including equity acquired in mergers. It will still exclude accumulated other comprehensive income (loss), which is primarily comprised of unrealized gains and losses on available-for-sale investments.
The credit union’s allowance for loan and lease losses (ALLL), which is limited to 1.25 percent of risk assets, will be added to the numerator. NCUA states that this limitation is designed to provide an incentive for granting quality loans and recording loan losses in a timely manner. The NCUSIF deposit, goodwill, and other intangible assets will be subtracted from the numerator.
The denominator is more complicated and includes risk-weighted on-balance sheet assets, off-balance sheet assets, and derivatives (which is not applicable for most credit unions). Subtracted from the denominator are the same risk-based capital numerator deductions listed in the preceding paragraph.
Lower risk-weightings are established for cash and cash equivalents, short-term investments, and loans guaranteed 75 percent or more by a government agency. Higher risk-weightings are established for long-term investments, higher concentrations of residential real estate (RRE) and member business loans (MBLs), delinquent loans, corporate credit union perpetual capital, investments in credit union service organizations (CUSOs), and mortgage servicing assets.
Finding risk-based capital ratio
The calculation under the proposed risk-based capital rule primarily uses existing information contained in the Call Report.
Under the proposed rule, the risk-weighting for MBLs increases from 100 percent for concentrations less than or equal to 15 percent of assets, to 200 percent for concentrations greater than 25 percent of assets. However, NCUA notes that most credit unions would not be impacted by this, since the industry is limited to MBLs equal to 12.25 percent of total assets — but a small number of credit unions with grandfathered waivers will be negatively impacted.
NCUA’s proposed risk-weighting calculations for longer-term investments, RREs, and MBLs is due to its new rules on interest rate risk.
Mortgage loans flaw
There is an apparent flaw in the proposed rules that probably only affects only a small number of credit unions, but will hopefully be addressed by the NCUA. Mortgage loans sold as part of the Federal Home Loan Bank (FHLB) Mortgage Partnership Finance (MPF) Program are treated as full-recourse, i.e., liable for all loan credit losses, under the proposed rule and are therefore included in the denominator at 75 percent.
However, credit unions are generally safe with the loans sold under this program and the probability that a loss will be recognized is generally considered to be remote.
Concerns about the rule
Some credit unions that are considered to be well-capitalized currently would be downgraded if the proposed rule becomes effective.
However, NCUA estimates that over 90 percent of credit unions would retain the well-capitalized designation.
Another concern is that the proposed rule may allow an examiner to increase the risk-based capital requirement for certain credit unions. However, this provision of the rule only applies to the NCUA Board, and not an individual examiner.
The NCUA does not acknowledge that the rule would potentially reduce the current capital cushion in all credit unions affected by it, although this is an almost certainty. Most credit unions have no access to supplemental capital. Unlike FDIC-insured banks, they are solely dependent upon earning to build capital levels, which puts them in a distinct market disadvantage with other financial institutions.
Many industry executives have suggested that NCUA should grant a much longer implementation period to allow credit unions to grow and acquire the necessary capital.
In addition, industry economists have suggested that the proposed risk based capital rule would not have saved the credit union industry from the corporate credit union collapse, nor saved many of the credit union failures in the past several years.
NCUA accepted comments for the rule until May 28, 2014, and many credit unions voiced their opinions. NCUA plans a phase-in period of 18 months after the final rule is published in the Federal Register.
NCUA versus FDIC rule
The risk-based capital ratio threshold is consistent with the Federal Deposit Insurance Corporation’s (FDIC) interim final rule, which requires FDIC-supervised institutions to maintain an 8 percent total risk-based capital ratio and a 2.5 percent capital conservation buffer. NCUA states that the risk-based capital ratio of 10.5 percent is consistent with the FDIC proposal, while avoiding the complexity of implementing a capital conservation buffer. There are several similarities between the FDIC interim final rule and the NCUA’s proposed rule:
- FDIC-supervised institutions not subject to the advanced approaches rule, which only affects the largest and most complex FDIC-supervised institutions, may make a one-time election to exclude accumulated other comprehensive income (loss) from risk-based capital.
- Both proposals exclude goodwill and other intangible assets.
- The ALLL is limited to 1.25 percent of risk assets.
- Past-due exposures and delinquent loans are risk-weighted at 150 percent.
- Balances with other depository institutions are risk-weighted at 20 percent.
- First lien residential mortgages with prudent underwriting are risk-weighted at 50 percent (this is the same for credit unions with current first mortgage real estate loans less than or equal to 25 percent of total assets).
- Mortgage servicing assets are risk-weighted at 250 percent.
- All assets not specifically assigned a different risk-weight are risk-weighted at 100 percent.
- If management is unable to demonstrate an understanding of an investment, the risk-weight is 1,250 percent. The resulting capital requirement is approximately equal to 100 percent of the investment’s carrying amount (the balance reported in the financial statements).
However, there are some differences between NCUA’s and FDIC’s rules:
- The FDIC assigns a risk-weighting of 20 percent for non-equity exposures to government sponsored enterprises (GSEs). NCUA’s proposed rule increases the risk-weighting based on the weighted average life (WAL) of investment securities.
- While the base calculations are similar, NCUA assigns higher risk-weightings assigned to RRE and MBLs for more significant concentrations of these loans. For example, current first mortgage real estate loans less than or equal to 25 percent of total assets are assigned a risk-weighting of 50 percent. This increases to 100 percent for concentrations greater than 35 percent of total assets.