During the NCUA board meeting this Thursday, the credit union industry will learn whether individual board members prefer to engage in real debate or stand behind the rule-making process. Without some fundamental discussion of how board members view the rule, credit unions will have no idea how to comment effectively to influence the decisions of board members later this year.
Why Board Debate Is Critical
NCUA’s proposal to regulate the relative risk weighting of every asset on a credit union’s balance sheet, as well as some off-balance-sheet items, is the most far-reaching authority ever proposed. The danger of the rule extends beyond regulatory burden, however. Based on the banking sector’s experiences with its own risk-based capital rule, Basel, the NCUA’s proposed RBC rule could undermine the safety and soundness of the entire cooperative system.
Prior to the 2008 financial crisis, two of the “safest risk-weighted classes” under the Basel banking capital formulas were sovereign debt (government guaranteed or issued debt) and real estate backed securities. These two asset classes were at the core of the latest market meltdown and contributed to significant banking failures in the United States and around the world.
Thomas Hoenig, vice chairman of the FDIC, summarized Basel’s failure in a September 2012 speech:
“It turns out that the Basel capital rules protected no one: not the banks, not the public, and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded the bailouts. The complex Basel rules hurt, rather than helped the process of measurement and clarity of information.”
But the failure wasn’t just getting the risk weightings wrong or misunderstanding asset classes. The failure was more fundamental. Risk-based capital presumes someone can predict the future with sufficient certainty to prescribe specific numerical risk evaluations. These evaluations are about not only how asset categories will perform in multiple environments but also the relative riskiness among them.
In the global financial marketplace, no firm or individual would claim to predict the future with a formula to fit all circumstances and possibilities. Real life is full of uncertainty, confusion, and chaos. Models are tools that attempt to clarify interconnections; they rarely, if ever, claim future certainty. But that is the underlying premise of the national uniform risk-based capital model that NCUA intends to impose on every credit union with $50 million or more in assets. This model will have the force of law. It is not a modeling tool; it is a legal rule.
An Incorrect Analogy Undermines The System’s Portfolio Diversity
Many credit unions have approached the issue from their individual experience. Specifically, their logic is that they assess their capital today using RBC or Basel standards, so why wouldn’t this approach work at the system level? After all, isn’t it obvious that some assets carry more risk than others — a short-term investment versus a consumer loan, for example?
This logic misapplies institutional risk decision-making to an entire financial system. At the local level, credit union boards and managers make numerous decisions about the composition of their balance sheet and capital adequacy based on multiple factors. Diverse business priorities, pricing, and growth objectives as well distinct member needs drive thousands of local decisions that result in varied portfolio strategies, which, because of their diversity, enhance the system’s overall soundness. A single, uniform, nationwide standard of capital risk management might fit some circumstances some of the time, but it would rarely, if ever, fit the portfolios of all institutions all of the time.
It would be unusual for any credit union to think that its formula for risk assessment should be mandated for every credit union in the country, no matter how confident it was in its own processes. However, NCUA is proposing this approach — a single, government-regulated standard for every credit union in every area of the country.
What works locally does not translate into a system standard. A single formula compromises and undermines the diversity of individual credit union judgments. In the extreme, as in the recent experiences of the banking industry, the entire system can be pulled over a cliff.
The cooperative model works because people stand side by side with an understanding that their ability to govern their own concerns means they can morph, adapt, and endure situations far greater than when everyone is locked in step. System soundness is not based on conformity; it is based on the ability of participants, bonded in common purpose, to apply creative solutions when required. These autonomous decisions create collective strength.
Credit unions cannot assess balance sheet risk and determine the appropriate levels of capital based on a set formula or a programmable, software-like exercise. They must use a process of dynamic judgments that require constant adjustments as the real world changes and organizational plans evolve.
What Will The NCUA Board Debate?
The banking industry and its regulatory overseers, relying on the Basel capital formulas, created a global capital model that contributed to, and certainly did not prevent, a worldwide economic meltdown. The mistake was not in incorrectly rating asset classes; it was in thinking there is a systematic way to forward judge risk evidence.
An example closer to home is NCUA’s failure to accurately evaluate the potential losses on the legacy assets it seized from five conserved corporates in 2010. NCUA hired the most experienced institutions with the most comprehensive, sophisticated models available from Black Rock, PIMCO, and Wall Street investment experts when valuing these private mortgage-backed securities. To date, NCUA’s own projections on this single asset class — one much studied and modeled with data available at the individual loan level — shows an error rate of more than 50%. That is, the losses NCUA projected at $16 billion in 2010 are less than $8 billion in 2014. NCUA used these initial loss projections to impose capital requirements that the five corporates had to expense through their reserves; NCUA then reused the loss projections to justify the liquidations of these corporates. How many other asset errors embedded in the risk-based formulas will remain hidden until it is too late?
An RBC rule will inevitably distort asset allocation decisions versus what individual management and boards would determine. Moreover, an RBC rule, as the Basel precedent, will require a never-ending set of formula changes or examiner overrides to keep up with changing soft spots in the economy.
The Debate Outcome: A Better Grasp Of The Cooperative Model
The proposed RBC rule has encouraged a great deal of debate and controversy. This discussion can be helpful, if the final outcome is to make RBC a tool and not a rule. To impose the regulator’s judgments over the ongoing market-based decision-making credit unions follow today will sooner or later compromise systemic soundness. Currently, thousands of boards and managers make their capital decisions based on their circumstances and needs, which is how they make all their other business decisions.
The result is the most resilient financial system in America today. The data from the latest crisis proves this point. Moreover, the three banking regulatory agencies unanimously adopted in 2014 the cooperative capital leverage ratio requirement as their response to the failures of the Basel approach to capital adequacy.
Imposing Basel requirements on cooperative credit unions would be a serious systemic error. Basel was developed for the for-profit banking industry to mitigate the inevitable conflicts between consumers, regulators, and shareholders as well as to harmonize banking regulations around the world. It presumes a “stock of capital” available to underwrite an institution. Credit union capital has always been generated from a flow of income set aside in retained earnings.
What keeps credit unions safe and sound is not that they invented or discovered a better formula for capital. Rather, in a world full of uncertainty, confusion, change, and constant competition, what keeps credit unions safe and sound is their knowledge of who they serve and why. It is this sense of purpose, embedded in cooperative design, that brings order and common sense to an unpredictable future.
What Does RBC Mean For You?
Explore the changes to NCUA's proposed risk-based capital rule and the potential impact it will have on the credit union industry during this webinar with Callahan chairman Chip Filson and senior analyst Andrew Bolton.