Year-End Data Shows RBC Tackles Phantom Foe

Chair Debbie Matz leaves the NCUA board on April 30 after seven years of leading the regulator, leaving behind a new set of regulations her agency argues preserves the safety and soundness of the credit union system, but in reality threaten to undermine its core purpose.

It is critical that the missteps of the Matz era be documented and doors opened for reversals. Exhibit A is risk-based capital. As outlined below, RBC is a case study of why agency budgets are exploding and not just due to work on this ill-conceived effort.

Whenever the agenda of NCUA is off track, too broad, or misplaced, it simply creates the need for more people while adding no value. But more broadly, the RBC exercise is just one more example of the entire system’s resources being required to focus on something without a return.

Burgeoning budgets, chest-pounding over winning settlements from big banks but not returning the money to credit unions, liquidating tiny credit unions without so much as a shred of due process, and as a final gift to the cooperative financial system: the risk-based capital rule.

Passed by a 2-1 vote by last September and due to take effect on Jan. 1, 2019, RBC is a solution in search a problem, imposing potentially crushing, overly complicated capital requirements unprecedented in our movement’s regulatory history.

The target? Less than 10 of the 1,521 credit unions of more than $100 million that an analysis of 5300 Call Report data show would fall beneath the safety threshold. See tables below.

Matz’s departure was announced in a statement that credits the NCUA with saving the industry, with nary a mention of the movement’s own resiliency. This cooperative strength is built on member relationships from decades of sound lending and exceptional service that withstood the failures of the agency itself and the corporate credit unions whose investments it was supposed to be monitoring.

Here’s what Matz says of the 2009 crisis that led to where we are now: We worked around the clock to prevent the collapse of the credit union system, when the outcome was really in doubt. My top priority was to save as many credit unions as we could, minimize total losses, rebuild the insurance fund and stabilize the credit union system. We then focused on shoring up gaps in supervision, regulations, policies, and procedures that threatened safety and soundness, and put new safeguards in place to stop the hemorrhaging and prevent the system from failing.

RBC is a linchpin of these safeguards, passed by a 2-1 vote last September despite thousands of comments opposing the rule and even raising questions in Congress.

The extended rule-making process, three years for NCUA implementation, potentially hundreds of detailed calculations and look-through requirements plus the need for a standalone agency Resource Center all together show this to be the most intrusive, burdensome legal constraint ever imposed on credit unions.

And, as shown below, credit unions over $100 million are virtually 100% compliant today.

The extended rule-making process, three years for NCUA implementation, potentially hundreds of detailed calculations and look-through requirements plus the need for a standalone Resource Center all together show this to be the most intrusive, burdensome legal constraint ever imposed on credit unions.

Get Ready For The Rule

The printed final rule stretches 424 pages. Because of its length, the NCUA issued two summary documents, an FAQ summary, and an RBC risk-estimator spreadsheet. There’s so much here that the agency created a Risk-Based Resource Center on its homepage to help credit unions adapt to the rule.

The rule takes effect more than three years after the board acted. This was to give credit unions time to generate more capital or otherwise take actions to reduce risk. And to get itself ready.

The NCUA said it also needed the three years to get its staff and processes ready. This includes:

• Revising the existing 25-page quarterly call report eight categories such as investments will need to be expanded or added;
• Updating AIRES to use new data and the work papers;
• Modifying off-site risk reporting systems;
• Issuing examiner guidance;
• Performing examiner training on the rule and supervision tools;
• Educating credit unions on the rule.

In the sample risk weighting spreadsheet with the rule, there were 86 categories of risk weights from 0% to 1,250%. The theory is that all risks are weighted relative to each other. Cash on deposit has 0% risk whereas if a current loan secured by a second lien, and is less than 20% of assets, it is rated at 100%; but if over 20% of assets, then it receives a 150% weighting.

The 86 categories of risk weights do not include the credit conversion factors for off-balance sheet items nor the contingent weighting variables. For example, goodwill is weighted at 100% but phased out of the net worth by 2025; goodwill through mergers after the rule’s publication is subtracted 100% from the numerator. CUSO investments and corporate capital are weighted at 100% or 150% depending on whether the total of all such investments exceeds 10% of the RBC numerator.

As repeatedly critiqued in public comments, this detailed risk weighting is a one-size-fits-all model for every credit union, no matter its operational experience, geographic location, or economic and market dependencies. It overrides individual judgments, local member needs, and a credit union’s business plans.

So the question is, do the ends justify the means? What does December 2015 data for all credit unions over $100 million say about these safety and soundness rationales for the rule?

Already In Full Compliance: No Outliers Identified

Our analysis of 5300 Call Report data as of Dec. 31, 2015, show that these sweeping new, uniquely burdensome rules would address a problem that does not exist.

Here’s what the data tells us:

1. Using the same estimation process that NCUA followed in its FAQ listing, 1,512 credit unions over $100 million (the complex standard set in the rule) exceed the 10% RBC standard. Nine (.6%), do not.
2. More credit unions (17) fail the well capitalized net worth test of 7%; however, 13 of these meet the RBC 10% well capitalized standard;
3. Of the nine estimated to fall below the 10% RBC well capitalized, four are also below the 7% standard. So that only five potential new problem situations are identified.

So the traditional net worth test uniquely identifies 13 credit unions, versus just five from the complex RBC calculations, that may have capital adequacy issues.

More Confusion, Not Clarity

The issue is more complicated when there are two capital standards and two different ways of calculating the amount of adequate capital. Two balance sheet accounts are treated completely opposite in these two measurement systems.

In the RBC formula, the full allowance account is added to the net worth numerator. This is not done in the traditional 7% ratio. Only five now are below that well capitalized standard adding back the allowance.

The most dramatic change is with Montauk Credit Union in New York moving from a net worth ratio of 1.7% to a total capital ratio including allowance of 15.3%. Montauk was recently merged with Bethpage even with this total capital ratio.

Similarly, if each credit union’s share insurance account with the NCUSIF is added to the RBC numerator (it is not excluded in the 7% net worth test) only two credit unions would be short of 10%.

How can two completely contradictory ways of using the same asset for capital ratio purposes create a more meaningful and responsive metric. Requiring two capital tests results in confusion and uncertainty. For example, why would Montauk with 15% capital be merged or Texans Credit Union with 10.1% RBC need NCUA assistance?

More than 99.4% of the 1,521 credit unions over $100 million meet the RBC rule. That’s even more than pass the traditional 7% well capitalized standard. No real outliers have been identified with the RBC test; in fact, all but two of those fall below that threshold because of the $0 value given to the 1% NCUSIF deposit. This is an asset that all CPA and accounting rules have certified as proper to carry on credit unions’ books.

No Correlation To Actual Risks

Finally, the rule asserts that it correlates capital to risk. The average RBC ratio of the credit unions subject to the rule is 19.2% at year’s end. How does a single formula equating loan underwriting and credit risk everywhere in the country with the same relative weights better correlate capital to risk?

All RBC does is show how closely a credit union conforms to the NCUA’s singular risk profile. All models, especially algorithms are not neutral. They reflect the values of their creators and programmers. The fact that there is almost 100% excess RBC capital using NCUA’s new assessment model suggests one of two possibilities:

1. Credit unions are way over-capitalized using this risk model
2. The single model is useless when comparing relative risks.

RBC’s Damage To The Cooperative Model

If today virtually all credit unions comply what is the harm in more regulatory burden? Isn’t that just the overhead of having a regulator, even if a misguided one? However, the harm is far greater than more regulatory tax.

The harm is to the core of the cooperative system. Firstly, the NCUA never pretends that the RBC is a cooperative tool. It says it’s a banking model; it compares its risk weights to the FDIC model and even invokes the Basel banking agreements to justify this exercise in rule making.

Never mind that Basel was primarily intended to create a common way to measure capital adequacy for major international banking firms so that these institutions did not move their operations to more favorable jurisdictions that would undermine an individual country’s regulatory requirements.

Basel was never intended to apply to credit unions.

In addition to this misapplication of Basel, there is increasing consensus that RBC is too complex to understand, and at the worst, does not work at all for banks. On April 12, 2016, following the issuance of the Basel’s annual Global Capital Index comparing capital levels of the world’s major international banks using risk-based formulas, FDIC Vice Chairman Thomas Hoenig had this assessment:

This international risk-based measure is misleading and overstates the strength of these firms’ balance sheets. No other industry is allowed to make these kinds of (asset-weighting) adjustments. In contrast to risk-based calculations, the tangible leverage ratio accurately measures bank risk and prices it correctly. It has done a reliable job of aligning a firm’s risk appetite with its loss-absorbing capacity, providing more direct insight into the amount of loss-absorbing capital available to a firm and providing a consistent and comparable measure across firms.

The 7% net worth standard is the equivalent to Hoenig’s tangible leverage ratio. It has worked successfully for more 100 years in the cooperative system.

The Most Profound Error

The NCUA’s most serious error is not understanding and thereby acting to sustain the cooperative model. Cooperatives ask people (members and leaders) to think a certain way, for the people first and the common good. Rule making and prompt corrective actions are a binary form of thinking.

A credit union meets a capital test or does not. A rule is either right or wrong, 1 or 0. Credit unions were formed as analog. They’re institutions required to set aside a flow of income from revenue to be safe. This allows for a continuum of outcomes and possibilities.

Managing To A Formula Not Member Needs

Cooperative design and business practices are distinct from banks. Their purpose is to serve member needs, the outcome is to improve their well-being; and the intent is to respond to local circumstances not the macro environment or even direct market pressures.

The RBC rule compromises the first rule of safety and soundness, which is that no firm, let alone an industry, put all its eggs in a single basket. Credit union diversity in size, business models, product priorities, geographic focus and growth ambitions have been a source of strength and system learning.

The record, the data, and the public explanation show the only reason this formulastic rule exists is to promulgate the NCUA’s pride and power. Can this be reformed from the inside with new leadership or must it take an external event to correct this profound error in cooperative regulatory design? 

The RBC rule imposes a single relative risk model on every credit union and its asset allocations. At the extreme in a crisis this rule could push the cooperative model over a cliff when what were once perceived as relatively risk-free assets such as AAA-rated mortgage investments are found to be toxic. There is no certain way to predict future risk; rather credit unions must be empowered with the flexibility and tools to respond as events may require.

Managing to a formula meets neither member needs nor common-sense adjustments to market realities. Risk-based capital is designed to encourage management decisions in favor of lower-risk assets, such as cash and investments. In a crisis this means that members loan needs will become secondary.

So the RBC rule is not just burdensome and ineffective. It provides no meaningful improvements and it will just push cooperatives to become more like their banking counterparts: an intention at odds with both legislative intent and the country’s economic needs.

The record, the data, and the public explanation show the only reason this formalistic rule exists is to promulgate the NCUA’s pride and power.

Bad ideas can take a long time to die, so maybe in the time till Jan. 1, 2019 ,new leadership can correct this significant misapplication of regulatory authority. Will this occur from the inside with new renewed agency vision or must it take an external event to correct this profound error in cooperative regulatory design?

CREDIT UNIONS >$100M IN ASSETS WITH SUB-10% RBNW
Data as of 12.31.15

CREDIT UNIONS > $100M IN ASSETS WITH SUB-7% NW
Data as of 12.31.15

Sources: Peer-to-Peer Analytics by Callahan & Associates

Senior Writer Marc Rapport and Director of Industry Analysis Sam Taft contributed to this article.