Risk-Based Prompt Corrective Action For Credit Unions Is Sound Public Policy

Recognizing the billions of dollars in taxpayer losses that resulted from the savings and loan collapses in the 1980s, the need for credit unions to join banks and thrifts with statutory Prompt Corrective Action (PCA) language was addressed by Congress as a part of the legislative give and take which resulted in the far-reaching 1998 Credit Union Membership Access Act (CUMAA). Although certainly based in good public policy, the PCA provisions included by Congress in CUMAA were not sufficiently analyzed prior to their adoption with a realistic eye toward either the future of growing credit unions in a dynamic financial services marketplace or the risk issues that PCA was designed to require credit unions to manage from a safety and soundness perspective. PCA is indeed good public policy in general, but the specifics need a well-reasoned overhaul in order to better accomplish its purpose. PCA for credit unions must be reformed from an unrealistic “one size fits all” approach to one that is risk based in order to be effective as its authors intended in 1998. To say, as the present PCA statute does, that NCUA must require the same 7% reserve for the cash in a credit union’s vault as we do an in-house mortgage loan portfolio filled with 30-year fixed-rate paper is totally unjustifiable from a risk management perspective. The failure to recognize the differing risk profiles in individual credit unions is the single biggest flaw in the PCA statute which, naturally, results in a statutorily mandated flaw in NCUA’s PCA regulations as well. Although Congress extended to NCUA the flexibility to apply PCA remedies in a manner appropriate to a credit union’s individual risk profile, this discretion only kicks in after the credit union has been determined to no longer be well capitalized and therefore subject to some type of corrective action. A risk based standard, similar to that applied to banks and thrifts but recognizing the credit union difference, would enable NCUA to weight the risk on a credit union’s balance sheet before corrective action is required. Risk based PCA would put the “prompt” back into prompt corrective action because it would allow NCUA to take the totality of a credit union’s risk profile into consideration before it requires a remedy and enables the agency to better determine if the risk factors involved require remedy A, remedy B or, in some cases, no remedy at all because of the low risk nature of the balance sheet. Every credit union with 7% capital is not as well capitalized as another with the same ratio. Yet, the present PCA statute gives a blanket label of “well capitalized” to every credit union with 7% or greater net worth, regardless of its risk profile. Likewise, a credit union with 6.9% capital is considered not to be well capitalized, even if it has an extremely low-risk balance sheet. Credit union supervision is inherently risk based. NCUA has implemented a risk focused examination program that is modernizing our approach to supervision and demonstrating impressive results as we major on the majors, rather than majoring on the minors, when it comes to credit union risk. NCUA has found that it is impossible to apply a single standard to every credit union when it comes to determining an individual institution’s safety and soundness position. PCA must be reformed to accommodate this basic fact of supervisory life. A risk based capital system is hardly uncharted waters. Even before their present move to come under the international Basel accords (a for-profit sector application of risk based capital standards that would not be properly applied to credit unions as not-for-profit cooperatives), banks and thrifts have been under a risk based capital system that has recognized marketplace realities and worked well for years in those industries. Within the credit union community, risk based reserving was the standard for federal credit unions prior to the pre-emption of NCUA’s statutory reserve requirement by Congress when enacting the PCA provisions of CUMAA. Prior to 1998, federal credit unions were required by regulation to reserve a percentage of their risk assets – which excluded such low risk assets as cash on hand, short-term government guaranteed securities, guaranteed student loans, certain fixed assets, insured deposits, NCUSIF deposits and certain specified other assets of minimal or virtually no risk. While some weighting of these and other assets would be required to reflect today’s risk components, NCUA could certainly make risk based PCA work more effectively than the present system. Credit union net worth grew at historic rates during the era of the NCUA risk based reserve requirements. For example, the net worth ratio grew from 7.5% to 10.9% in the five-year period from 1993-98. Although net worth remains an impressive 10.72% at the end of 2003 even after several years of dramatic deposit growth which boosted the total asset denominator, the net worth growth rate as a percentage of total assets has obviously been less in the five years since PCA was enacted than in the previous fiv- year period when operating under a more risk based reserve requirement. Basing PCA net worth requirements on total assets, rather than risk assets, distorts the analysis that must be done to determine a credit union’s safety and soundness position. In some cases, using total assets as the denominator in the net worth calculation will make the credit union balance sheet appear to be more at risk than it truly is. In other cases, the total assets denominator gives a picture of less risk than actually exists. Only through a risk based capital system can the true risk profile of a credit union be brought into the supervisory decision making process that PCA was designed to make more effective. Also, in a rapidly changing financial services marketplace, a distorted capital picture driven by a rigid, rather than risk oriented, PCA standard could result in necessary credit union business decisions being either delayed or advanced based upon a timetable driven by a snapshot of applicable risk that is not as accurate as needed for such strategic management decisions. A risk based capital system must be incorporated into a meaningful reform of the “one size fits all” PCA statute that credit unions and NCUA presently operate under. As Congress and the credit union community debate this issue as a part of their analysis of the Credit Union Regulatory Improvements Act (CURIA) recently introduced by Representatives Royce and Kanjorski, it is important to realize that prompt corrective action will be neither “prompt” nor “corrective” unless it is based on the proper risk triggers. Risk based capital is an idea whose time is coming for credit unions, both natural person and corporates. It is necessary for PCA to be effective as it was intended. And it is sound public policy.