CUNA Comment Letter

These comments discuss how a Safe Harbor System could work in a manner that: complies with the statute; promotes increased net worth at undercapitalized credit unions, thus protecting the National Credit Union Share Insurance Fund; and removes a legitimate PCA-related concern of well-managed, adequately capitalized credit unions with a membership base that provides significant growth opportunities.

The purpose of PCA is to ensure that credit unions maintain sufficient net worth ratios so that losses to the Share Insurance Fund are minimized. There are, in principle, two ways that a credit union’s net worth ratio can fall, that are related to the behavior of either the numerator or the denominator of the net worth ratio.

First, a credit union can have poor or negative earnings brought on by a number of possible causes such as excessive loan losses, poor expense management, faulty interest rate risk management, inappropriate balance sheet pricing, or a shock which results from an event affecting a credit union’s field of membership (such as a plant closing, etc.) When net income becomes very small or negative, the net worth ratio can fall even if asset growth is modest. All of these causes are "problems;" most result from poor management; and they appropriately require prompt corrective action in the form of a customized net worth restoration plan designed to treat the specific problem(s) at hand.

The other general way for a credit union’s net worth ratio to fall is for it to have healthy net income (for example in the CAMEL Code 1 or 2 range) and for it to experience such strong asset growth that its net worth ratio falls, despite the strong earnings. Vigorous growth can occur because of overly competitive pricing on share and deposit accounts. This condition is readily treatable by rationalizing dividend rates. Absent aggressive dividend rates, strong savings inflows can be caused by concern on the part of members about current and future economic conditions, by a change in the perceived attractiveness of alternate household investments (as has recently been the case with equities), by changes in the economic conditions of members, or by changes in offerings or operations at other local financial institutions. We will refer to such episodes of strong savings inflows that are not incented by substantially above-market dividend rates at the credit union as "uninduced" growth.

The effect of uninduced savings growth on a credit union’s net worth ratio can be just the same as induced growth (paying too much on savings) or net income problems of the type discussed above. However, unlike the other causes of net worth ratio deterioration, uninduced growth is not an indication of poor management or external problems that require solutions. Indeed uninduced growth reflects the fact that members find the credit union a safe, attractive place in which they wish to entrust funds. Instead of corrective action, uninduced growth simply requires sufficient net income to capitalize that growth so that further net worth ratio declines are slowed and reversed.

Otherwise healthy and well-managed credit unions that become undercapitalized because of uninduced growth need to increase net income sufficiently to restore net worth ratios. However, under PCA they are subjected to the uncertainly of a Net Worth Restoration Plan (NWRP) and potentially face an extensive list of mandatory and discretionary supervisory actions (DSAs), many of which could seriously disrupt the operations of a well-managed, but rapidly growing credit union. Credit union management (senior staff and boards) are concerned about the risks of falling under NWRPs and some of these DSAs simply because their members find them an attractive place to save.

Indeed this concern extends beyond credit unions that have only modest cushions above the net worth levels required to be classified as adequately capitalized. Based on conversations with many very well capitalized credit unions, it appears that a number of credit unions with net worth ratios of over 10% are concerned that a surge of growth might push them near the range of PCA. Some of these credit unions are actually taking steps to retard growth today so as to minimize any chances of falling under PCA/DSAs in the long-term future. This sort of behavior was doubtless not envisioned by the drafters of the PCA legislation. It is brought about by the fact that credit unions are indeed not-for-profit cooperatives without access to external sources of capital, and credit unions’ tendency to long-term conservative management.

It is to currently well or very well capitalized credit unions that a "safe harbor" net worth restoration plan would be most valuable. Again, the primary effect of PCA on these credit unions stems from fear of the unknown nature of a net worth restoration plan and its DSAs. In addition, there are the disruptive effects of restricting asset growth pending plan approval. A safe harbor plan would work as a pre-announced, pre-approved net worth restoration plan. It would contain a set of prescribed earnings retention requirements, depending on the credit union’s net worth ratio. So long as a credit union with a net worth ratio of less than 6% met these net income requirements, and restricted increases in member business loans outstanding, the credit union would be deemed to be in compliance with an approved net worth restoration plan. A credit union in compliance with the prescribed earnings retention requirements would thus be shielded from all DSAs, and any other consequences of non-submittal of or non-compliance with a net worth restoration plan.

The idea of imposing earnings retention requirements when fixed net worth targets are not met is consistent with the CUMAA’s mandate to establish a system of prompt corrective action that recognizes and accounts for the unique nature of credit unions as not-for-profit, cooperative financial institutions. Because most credit unions cannot currently access additional sources of capital, earnings retention is the only form of capital acquisition. A scaled earnings retention system, with greater earnings rates required for lower net worth ratios, harkens back to the tried and tested system of regular reserve requirements that predates PCA, with the notable exception that under the suggested plan earnings would have to be generated as opposed to simply transferred from some other reserve or undivided earning account. The suggested safe harbor system also bears some functional similarity to the proposed earnings retention requirement for corporate credit unions under Reg 704.

CUNA suggests the following system of earnings retention requirements as a safe harbor net worth restoration plan:

SUGGESTED EARNINGS RETENTION REQUIRMENTS

The first requirement, 10 basis points a quarter for credit unions with net worth ratios between 6% and 7%, is as it currently exists under CUMAA. The subsequent requirements, for lower and lower net worth ratio ranges, increase the quarterly earnings requirement by 10 basis points upon first becoming undercapitalized (net worth ratio under 6%) and then increase the quarterly requirement by 5 basis points for each half a point decline in the net worth ratio.

A credit union that meets these earnings retention requirements will of course not automatically generate an increase in its net worth ratio. That would depend on the credit union’s asset growth rate. The table below shows the maximum growth rates that a credit union could experience while meeting only the minimum required net income requirements if it began the period at the bottom of the 50 basis point net worth ratio brackets. For example, a credit union starting out with a net worth ratio of 5.5% and earning exactly 20 basis points of average assets each quarter would end the year with a ratio of net worth to trailing four-quarter average assets above 5.5% unless its asset growth during the year exceeded 27%. Considering the ratio of net worth to assets as measured at the end of the year, the ratio would be greater than 5.5% unless the credit union’s growth exceeded 16%.

ASSET GROWTH RATES BELOW WHICH NET WORTH RATIOS WOULD INCREASE

A Credit Union Starting at the Indicated Net Worth Ratio that Meets the Relevant Earnings Requirement Would Experience an Increase in its Net Worth Ratio So Long as it Grows no Faster than the Indicated Rates

The information in the preceding table shows that the suggested net income requirement levels would generate actual net worth ratio increases as a credit union initially falls under the 6% standard for capital adequacy unless the credit union was experiencing very rapid growth. However, even if that happened, the resulting increases in the net income requirement would quickly cause net worth increases in all but the most remarkable cases of asset growth. For example, if a credit union’s net worth ratio should fall to 4.5%, the 120 basis point annual requirement would cause the net worth ratio to rise unless asset growth exceeds 57% in the first year using average assets, or 31% using period ending assets. In addition, in practice, credit unions would likely earn at least several basis points above the minimum levels required to maintain a sufficient cushion to continue to qualify for the safe harbor net worth restoration plan.

There is a self correcting dynamic built into the relationship between asset growth, required net income rates, and net worth ratios in the suggested plan. If a credit union should face extremely strong uninduced savings growth so that its net worth ratio fell into the next lower 50 basis point band, it would be required to increase it’s net income. Doing so would require some combination of increasing fees, increasing loan rates, reducing operating expenses, or lowering dividend rates. In the short run, the most immediate and effective of these levers is likely to be cutting dividend rates. Thus, a credit union facing such very strong uninduced savings growth would likely find itself successively reducing the incentive for members to deposit more funds in the credit unions the lower the net worth ratio became.

Another advantage of the suggested safe harbor system is that it would take the NCUA and the state supervisory authorities out of the position of having to micro-manage net worth restoration plans. It would be left up to the credit union how it would manage the net income generation so long as the credit union generated net income according to the suggested ranges. The credit would be able to make the best decisions in the interests of its members to generate additional net income.

Because a significant advantage of the safe harbor plan is the protection it provides a credit union from the uncertainly of non-approval of a NWRP, it would be appropriate for the net income requirement to take effect one quarter in advance of the quarter in which a credit union first becomes undercapitalized. In other words, if a credit union experiences rapid growth so that its net worth ratio falls below 6%, it would immediately be considered to be under the safe harbor plan if its net income in the preceding quarter meets the prescribed requirement. (20 basis points if the net worth ratio is between 5.5% and 5.99%.) In this circumstance, the requirement to submit a net worth restoration plan would be met by a notification by the credit union that it is operating under the safe harbor plan. Also, there would be no requirement to restrict asset growth because the credit union would be implementing an approved plan. In subsequent quarters, the credit union’s net income requirement would be based on the net worth ratio as of the beginning of that quarter. If during any quarter any undercapitalized credit union failed to meet its net income requirements it would then be required to submit for approval a NWRP.

A more detailed analysis of how a credit unions net worth ratio would behave under a variety of asset growth conditions is provided in the Appendix (Excel file) to this comment letter.

Bill Hampel
CUNA Chief Economist

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