Congressional Research Service Report: 'Credit Union System – Developments in Lending & Prudential Risk Management' (Part 2 of 2)
Targeted News Service
WASHINGTON, Nov. 30 -- The Congressional Research Service issued the following report (No. R46360) on Nov. 29, 2021, entitled "The Credit Union System: Developments in Lending and Prudential Risk Management":
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(Continued from Part 1 of 2)
Developments in the Credit Union System's Prudential Risk Management
Congress created the NCUSIF in 1970 to be the insurance fund for all federally regulated credit unions./71 The NCUA manages the NCUSIF, which is completely funded by insured credit unions. The NCUSIF's primary income source is the premiums collected from credit unions,/72 which pay the fund's operating expenses, cover losses, and build reserves. Premiums were originally set at one-twelfth of 1% of the total amount of member share accounts, but P.L. 98-369 required each federally insured credit union to maintain a fund deposit equal to 1% of its insured share accounts./73 Examination fees and any penalties NCUA collects from insured institutions are also deposited into the NCUSIF. Fund portions not applied to current operations can be invested in government securities, and the earnings also generate fund income. The NCUSIF's reserves consist of the 1% deposit, plus the fund's accumulated insurance premiums, fees, and interest earnings.
Prudential safety and soundness regulation, which includes holding sufficient capital reserves, may reduce the financial institutions' insolvency (failure) risk and promote public confidence in the financial system. Although higher capital requirements may not prevent adverse financial risk events from occurring, more capital enhances the financial firms' ability to absorb greater losses associated with potential loan defaults. The enhanced absorption capacity may strengthen public confidence in the soundness of these financial institutions and increase their ability to function during periods of financial stress. For this reason, the NCUA has proposed enhanced net worth (capitalization) requirements for credit unions, which is intended to increase the credit union system's resilience to insolvency risk and to minimize possible losses to the NCUSIF and ultimately to taxpayers. These prudential issues are discussed in this section.
Increased Exposure to Mortgage Credit Risk and Recent NCUSIF Management Initiatives
Credit unions were granted the authority to increase their participation in the mortgage market during the late 1970s and 1980s./74
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71 An insurance fund provides deposit insurance to protect members' accounts in the event of a credit union failure.
72 These arrangements are similar to those of the FDIC'sDeposit Insurance Fund (DIF).
73 July 18, 1984, 98 Stat. 494. The 1% is carried on each individual institution's books as an asset.
In light of the savings and loan (S&L) crisis, discussed in the text box below, the credit union system was also granted more powers to mitigate interest rate risk stemming from exposure to mortgage market risk. The following list highlights some of these authorities:
* After the Mini Bill of 1977 was passed, the NCUA adopted regulations on August 7, 1978, permitting credit unions to sell mortgage loans in the secondary market--specifically to Fannie Mae, Freddie Mac, and Ginnie Mae (government-sponsored enterprises, or GSEs) as well as to federal, state, and local housing authorities./75 On August 16, 1978, federal credit unions were also granted the authority to sell their members' federally guaranteed student loans./76
* The Garn-St. Germain Act, as mentioned, eliminated limits on the size and maturity of first lien mortgages, permitted refinancing of mortgage loans, and extended the maturity limit to 15 years for all second mortgages. The CEBA amended the FCU Act to authorize the NCUA to allow second-mortgage, home-improvement, and mobile home loans beyond 15 years.
* The Garn-St. Germain Act also amended the FCU Act to allow credit unions to issue and sell securities, which are guaranteed pursuant to Section 306(g) of the National Housing Act./77 In other words, federal credit unions were given the authority to participate in activities that would allow them to securitize assets.
* In 1988, the NCUA allowed credit unions to invest in mortgage-backed securities (MBS)./78 Rather than hold, for example, 30-year mortgages, the ability to hold MBS of shorter (e.g., 10 year) maturities reduces asset duration risk (discussed in the text box below).
* In 1989, credit unions were allowed to use financial derivatives to purchase insurance against declines in GSE-issued MBS values that would occur after a rise in interest rates, thus protecting the overall value of their asset (loan) portfolios./79 (NCUA noted that the credit union system had experienced a 48% increase in real estate lending in 1987.)
Consequently, as credit unions and other financial intermediaries increased their participation in the mortgage market, they also grew more susceptible to the financial risks linked to this market./80 Rising interest rates was a major risk factor in the S&L crisis during the 1980s, whereas rising mortgage defaults or credit risk was a major factor in the financial crisis that occurred in 2008. Because of the greater exposure to mortgage credit risk, the credit union system along with numerous financial entities in 2008 experienced distress after a sharp rise in the percentage of seriously delinquent mortgage loans in the United States./81
79 See NCUA, "Loans to Members and Lines of Credit to Members," 53 Federal Register 19748-19752, May 31, 1988. The final rule specifically discusses the use of purchasing financial put options, which would allow credit unions to sell any MBS holdings to a counterparty at their initial prices prior to an interest rate increase.
80 See CRS Report R40417, Macroprudential Oversight: Monitoring Systemic Risk in the Financial System, by Darryl E. Getter.
Financial institutions were generally provided with more tools to manage their interest rate risk exposures following the S&L crisis of the 1980s. Similar to credit unions, S&Ls were nonprofit, member-owned financial institutions specializing in taking savings deposits to facilitate residential home mortgage lending. Between 1980 and 1983, 4853 S&Ls, which were holding portfolios consisting primarily of traditional fixed-rate mortgages, failed after the short-term interest rates paid to depositors rose to historic levels./82 Regulation Q interest rate ceilings, which stemmed from the Banking Acts of 1933 and 1935, imposed interest rate ceilings on time and savings deposits. Depositors were subsequently incentivized to withdraw funds from accounts with interest rate restrictions and deposit them in unregulated accounts, such as money market mutual funds. Many S&Ls became insolvent when they were unable to maintain enough depositors to fund loans after deposit rates soared (with accelerating inflation).
The Garn-St. Germain Act granted financial institutions more tools to manage their interest rate risks./83 For example, the ability to sell loans allows financial institutions to dampen their balance sheet losses should an interest rate spike reduce the value of portfolio assets. In addition to hedging against a potential decline in asset values, various interest rate derivatives may also be used to manage the mismatch between asset and liability maturities, specifically the risk that arises when their asset portfolio duration (i.e., the length of time it takes borrowers to repay their longer-term loans) exceeds their liabilities duration (i.e., the length of time financial institutions must repay their short-term borrowings).
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According to the NCUA chairman, corporate credit unions faced increasing liquidity pressures during 2008 after a significant portion of their MBSs--following a deterioration of the underlying real estate collateral--lost value and were subsequently downgraded below investment grade./84 Corporate credit unions operate as wholesale credit unions, meaning that they provide financing, investment, and clearing services for the retail credit unions that interface directly with customers. The corporates accept deposits from, as well as provide liquidity and correspondent lending services to, retail credit unions. This reduces the costs that smaller institutions would bear individually to perform various financial transactions for members./85 Given that retail credit unions are cooperative owners of corporate credit unions, they are also federally insured by the NCUSIF. The NCUA placed two corporate credit unions into conservatorship in March 2009 and three additional corporates in September 2010. The five corporates under conservatorship at the time had represented approximately 70% of the entire corporate system's assets and 98.6% of the investment losses within the system./86
84 See Statement of Deborah Matz, chairman, NCUA, "The State of the Credit Union Industry," p. 3, at http://www.ncua.gov/News/Documents/SP20101209Matz.pdf, which was given in U.S. Congress, Senate Committee on Banking, Housing, and Urban Affairs, 111th Cong., 2nd sess., December 9, 2010.
86 See Statement of Deborah Matz, chairman, NCUA, "The State of the Credit Union Industry," p. 3, at http://www.ncua.gov/News/Documents/SP20101209Matz.pdf, which was given in U.S. Congress, Senate Committee on Banking, Housing, and Urban Affairs, 111th Cong., 2nd sess., December 9, 2010.
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The share equity ratio--the ratio of total funds in the NCUSIF relative to the estimated amount of share deposits held by credit unions--is an indicator that represents the adequacy of reserves available to protect share depositors and maintain public confidence.87 The NCUA annually determines the normal operating level for the share equity ratio, which statutorily must fall between 1.2% and 1.5%./88 The 2006 equity ratio was 1.30% and fell below the statutory minimum to 1.18% by August 2010. The NCUA board may assess a premium when the ratio falls between 1.2% and the declared operating level; however, it is required to assess a premium if the equity ratio falls below 1.2%. Similarly, the NCUA board may declare a dividend if, at the end of the calendar year, the equity level exceeds the normal operating level; it is required to do so if the equity ratio exceeds 1.5%.
Rather than deplete the NCUSIF, Congress in May 2009 established a Temporary Corporate Credit Union Stabilization Fund (TCCUSF) to accrue and recover losses from the corporates./89 The TCCUSF borrowed from Treasury to help cover conservatorship costs, and the NCUA also raised assessments on all federally insured credit unions, including those that did not avail themselves of corporate credit union services./90 The premium assessment reflected a plan to restore the NCUSIF equity ratio to 1.3%, which happened by December 2011.
After achieving a positive net position of $1.9 billion as of May 2017, the NCUA, in July 2017, proposed closing the TCCUSF and providing credit unions with a Share Insurance Fund distribution in 2018, estimated to be between $600 million and $800 million./91 The TCCUSF officially closed on October 1, 2017; its assets and obligations were transferred to the NCUSIF./92 The NCUA reduced the share equity ratio from 1.39, which had previously been set in September 2017, to 1.38,/93 administering an equity distribution (rebate) of $160.1 million to member institutions./94
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87 Similarly, the designated reserve ratio (DRR) is the ratio of total funds in the FDIC's DIF relative to the estimated amount of insured bank deposits.
88 FCU Act (12 U.S.C. 1782(h)(4)). For comparison, the Dodd-Frank Act requires the DRR to be a minimum of 1.35% of total insured deposits. See P.L. 111-203, Sec.334.
89 Helping Families Save Their Homes Act of 2009 (P.L. 111-22, 123 Stat. 1632, Division A).
90 In January 2011, the authority to assess premiums on the credit union system to repay Temporary Corporate Credit Union Stabilization Fund (TCCUSF) advances was clarified by P.L. 111-382, the National Credit Union Authority Clarification Act. See "NCUA 2013 Financial Statement Audits for Temporary Corporate Credit Union Stabilization Fund," at http://www.ncua.gov/about/Leadership/CO/OIG/Documents/2013-FSA(OIG-14-05)-TCCUSF.pdf; and "NCUA Board Gets TCCUSF Report, OKs Joint Agency Appraisal Rule," at http://www.nafcu.org/News/2014_News/ March/NCUA_Board_gets_TCCUSF_report__OKs_joint_agency_appraisal_rule/.
On January 23, 2014, the NCUA announced increases in capital requirements for a subset of natural person credit unions designated as complex./95 NCUA initially defined a complex credit union to have at least $50 million in assets./96 On January 27, 2015, the NCUA revised the initial proposed rule, amending the definition as having at least $100 million in assets./97 On October 29, 2015, the NCUA finalized the risk-based capital rule./98 Some of the rule's specific requirements included the following:
* A new asset risk-weighting system was introduced that would apply to complex credit unions, which would be more consistent with the methodology used for U.S. federally insured banking institutions./99
* A new risk-based capital ratio (defined using the narrower risk-based capital measure in the numerator and total risk-weighted assets, which are computed using the new risk-weighting system, in the denominator) of 10% would be required for complex credit unions to be well-capitalized under the prompt corrective action supervisory framework./100 The risk-based capital ratio was designed to be more consistent with the capital adequacy requirements commonly applied to depository (banking) institutions worldwide.101 Compliance of complex credit unions with the risk-based capital ratio requirements as well as the existing statutory 7% net-worth asset ratio would have been effective by January 1, 2019, to avoid NCUA supervisory enforcement actions.
96 The Credit Union Membership Access Act of 1998 (CUMAA; P.L. 105-219) required the NCUA to develop the definition of a complex credit union. The Regulatory Flexibility Act (RFA; P.L. 96-354) requires federal agencies to consider the impact of their proposed and final rules on small entities. Consequently, the NCUA currently defines a complex credit union as a natural person credit union with at least $50 million in assets. This definition became effective on February 19, 2013, reflecting an increase from the 2003 definition that used the asset threshold of at least $10 million. See National Credit Union Administration, "Prompt Corrective Action, Requirements for Insurance, and Promulgation of NCUA Rules and Regulations," 78 Federal Register 4032-4038, January 18, 2013.
97 See NCUA, "Part II: Risk-Based Capital; Proposed Rule," 80 Federal Register 17, January 27, 2015.
98 See NCUA, "Risk-Based Capital," 80 Federal Register 66626-66723, October 29, 2015, at http://www.gpo.gov/ fdsys/pkg/FR-2015-10-29/pdf/2015-26790.pdf.
99 See "Summary of the Risk Weights" in the NCUA final rule, which includes an NCUA and FDIC risk weights comparison. The Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency adopted the risk-weighting-assets system on July 2, 2013; the Federal Deposit Insurance Corporation adopted it on July 9, 2013. See "Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule," at https://www.govinfo.gov/content/pkg/FR-2013-10-11/pdf/2013-21653.pdf. The risk-based capital measure primarily accounts for credit (default) and concentration risk; NCUA will address interest rate risk via alternative regulations and supervisory processes.
100 Under the prompt corrective action supervisory framework, regulators examine whether credit unions and banks meet the requirements to be considered well-capitalized, adequately capitalized, under-capitalized, significantly undercapitalized, and critically undercapitalized. The level of scrutiny, restrictions, and penalties imposed by regulators increases as the financial health of a depository institution deteriorates.
101 See CRS Report R42744, U.S. Implementation of the Basel Capital Regulatory Framework, by Darryl E. Getter.
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* Non-complex credit unions with assets below $100 million would not have been required to comply with the new risk-weighting system, and they would no longer be required to risk-weight their assets. Instead, non-complex credit unions must comply with the existing statutory 7% net-worth asset ratio./102
* Credit unions with a concentration in commercial lending in excess of 50% of their total assets would be required to hold higher amounts of net worth to abate the higher levels of concentration risk./103
On December 17, 2019, the NCUA issued a final rule to move the effective date to January 1, 2022./104 The NCUA also amended the complex credit union's definition by increasing the asset threshold level from $100 million to $500 million. Nevertheless, the delays have prompted some Members of Congress to monitor the implementation progress of the risk-based capital rule for credit unions./105
Complex Credit Union Leverage Ratio
On July 22, 2021, the NCUA released a proposed rule that would allow eligible complex credit unions to opt into a complex credit union leverage ratio (CCULR) framework, which is comparable to the optional Community Bank Leverage Ratio framework./106 Under the CBLR framework, banks with less than $10 billion in average total consolidated assets that meet certain risk-profile criteria may elect to maintain a leverage ratio of greater than 9% to satisfy both the risk-based and leverage capital requirements to be well-capitalized./107 Likewise, rather than calculate risk-based capital requirements, the CCULR framework would require complex credit unions to meet a minimum net worth ratio initially established at 9% by January 1, 2022, that would gradually increase to 10% by January 1, 2024. The comment period ended on October 15, 2021.
103 A risk weight of 150% will be applied to commercial loans should the total amount exceed 50% of total assets. For more information on NCUA risk weights, see "Risk-Based Capital Proposal Comparison: 2015 Revised Proposal Changes Compared to 2014 Original Proposal," at http://www.ncua.gov/Legal/Documents/RBC/RBC-ProposalComparison.pdf.
104 See NCUA, "Delay of Effective Date of the Risk-Based Capital Rules," 84 Federal Register 68781-68787, December 17, 2019.
107 See FDIC, "Community Bank Leverage Ratio Framework, FIL-66-2019, November 4, 2019, at https://www.fdic.gov/news/news/financial/2019/fil19066.html; and CRS Report R45989, Community Bank Leverage Ratio (CBLR): Background and Analysis of Bank Data, by David W. Perkins. In addition, the NCUA issued a final rule in April 2018 that amended its regulations regarding capital planning and stress testing for federally insured credit unions with $10 billion or more in assets. See, NCUA, "Capital Planning and Supervisory Stress Testing," 83 Federal Register 17901-17910, April 25, 2018. Because of Section 4012 of the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136), the CBLR was temporarily lowered to 8%. The initial CBLR at greater than 9% will be phased in and fully re-established effective on January 1, 2022. See Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Department of the Treasury, FDIC, "Agencies Announce Changes to the Community Bank Leverage Ratio," April 6, 2020, at https://www.federalreserve.gov/newsevents/pressreleases/ bcreg20200406a.htm.
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Because credit unions do not issue common stock equity, they do not have access to capital sources beyond retained earnings. If alternative sources of capital, referred to as supplemental capital, were to be used in addition to net worth, then credit unions would be able to increase their lending while remaining in compliance with their safety and soundness net worth requirements. The proposal discussed below to adopt supplemental capital requirements would enhance the credit union system's lending capacity and introduce a new prudential risk management tool.
An NCUA working group has developed three general sources of supplemental capital, all of which would be repaid after reimbursement of the NCUSIF following liquidation of an insolvent credit union./108 Credit unions could raise
* voluntary patronage capital (VPC) if (noninstitutional) members were to purchase "equity shares" in the organization./109 VPC equity shares would pay dividends; however, a VPC investor would not obtain any additional voting rights, and no investment would be allowed to exceed 5% of a credit union's net worth.
* mandatory membership capital (MMC) if a member pays what may be conceptually analogous to a membership fee. MMC capital would still be considered equity for the credit union but, unlike VPC, it would not accrue any dividends.
* subordinate debt (SD) from external and institutional investors. SD investors would have no voting rights or involvement in a credit union's managerial affairs. SD would function as a hybrid debt-equity instrument, meaning the investor would simply be a creditor with no equity share in the credit union while it is solvent and would not be repaid principal or interest should the credit union become insolvent. SD investors must make a minimum five-year investment with no option for early redemption.
A credit union's net worth is defined in statute; therefore, congressional legislative action would be required to permit other forms of supplemental capital to count toward their net worth prudential requirements.
109 In discussions of supplemental capital, the term equity shares is used to help distinguish from share deposits, which is the term generally used in discussions about credit unions' deposits.
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Credit union industry advocates argue that lifting lending restrictions to make the system more comparable with the banking system would increase borrowers' available pools of credit. Community banks, which often compete with credit unions, argue that policies such as raising the business lending cap, for example, would allow credit unions to expand beyond their congressionally mandated mission and could pose a threat to financial stability. By amending the FCU Act several times to expand permissible lending activities, Congress arguably had recognized that the credit union system has evolved into a more sophisticated financial intermediation system. Congress has also emphasized prudential safety and soundness concerns.
Following the 2008 financial crisis, the federal bank prudential regulators implemented prudential requirements to enhance the U.S. banking system's resiliency to systemic risk events. The NCUA initially proposed in 2014 to increase capital requirements particularly for large credit unions (those with $500 million or more in assets); however, the proposal has been revised, delayed, and is currently scheduled to become effective in January 2022. In the meantime, the NCUA has implemented and proposed rules to support expanding lending activities that would increase financial transactions volumes (economies of scale), thus possibly generating greater cash flows and profitability for the credit union system. The adoption of enhanced prudential net worth requirements for the credit union system, however, arguably may facilitate mitigating the financial risks that typically accompany increases in lending.