WASHINGTON-A newly released study by the Government Accountability Office concluded that there is "no compelling need" for credit unions to gain a secondary capital option that would count toward their net worth level for the purposes of Prompt Corrective Action. Three arguments that industry officials have been making are that (1) restricting net worth to retained earnings puts credit unions in danger of PCA actions; (2) that PCA stunts credit unions' growth; and (3) that the PCA tripwires are too high. One by one, GAO picked apart and analyzed these arguments while credit union representatives continued to stand behind the assertions. In the first place, GAO found that credit unions have been able to maintain higher than regulatorily necessary capital levels, even through a "flight to safety" over the last few years, where deposits flowed in almost as if by a giant vortex. Additionally, GAO noted that in the three calendar years since credit unions had PCA place upon them, they have grown at a much faster rate than either banks or thrifts. In 2001, the first year for PCA, credit unions grew 14% while others grew at a rate of about 6%. "Despite these concerns," the report read, "available indicators suggest that the credit union industry has not been overly constrained as a result of the implementation of PCA. As a group, credit unions have maintained capital levels well above the level needed to be considered well-capitalized and have grown at rates exceeding those of other depository institutions during the three calendar years that PCA has been in place for credit unions." NAFCU Communications Manager John Zimmerman dismissed this response as "irrelevant." If any thing, he said, that is a compliment to credit unions that more money goes to them than the banks when market investments are sour. They are serving their members, but they could have done more good without the PCA restraints. One also has to put those figures in perspective, Zimmerman claimed. When banks grow more each year than the entire assets of the credit union industry, the numbers tell a different story. GAO noted a number of credit union CEOs and NASCUS advocated that fast-growing and small to mid-size credit unions can be forced to choose between refusing deposits, reducing services, converting to thrift or community bank, or merging with another credit union. "While the constraints noted above may have occurred to some extent in a limited number of credit unions, we did not find evidence of widespread net worth problems for federal insured credit unions during the period PCA has been in place," GAO said. The investigative arm of the Congress continued, "We have not found any evidence that federally insured credit unions are limiting their services to accommodate a rapidly growing deposit base. Moreover, active asset management is a major component of the operations of any financial institution. Credit union members are expected to manage the growth of their institutions so that an influx of member deposits would not cause the credit union to become subject to PCA." In NCUA's comment letter, which is attached as an appendix to the report, the agency countered, "However, the current "one-size-fits-all" PCA system does not permit this, short of turning away deposits after dividend rates have been reduced to below market rates. Under a risk-based system with a lower leverage requirement, credit unions would have greater ability to manage compliance by shifting investment strategies from longer-term, higher credit risk assets to shorter-term, lower credit risk assets resulting in the need to hold less capital on these safer assets with lower risk weights. This would provide credit unions with the ability to manage compliance with PCA by also managing the asset side of the balance sheet." Regarding credit unions' argument that the PCA tripwires are too high, the GAO report cited a Treasury study, which stated that credit unions should have higher levels of capital because of their 1% deposit in the National Credit Union Share Insurance Fund, the usual 1% deposit in a corporate credit union that many natural person credit unions have, and their inability to raise capital stock. Credit unions' net worth ratio requirements were set two percentage points higher than banks and thrifts for these reasons. NAFCU Senior Economist Jeff Taylor simply stated, "We just don't agree with that argument," and pointed to the explanation in NCUA's comment letter. NCUA also disagreed with GAO's argument. The letter, signed by Chairman JoAnn Johnson, points out that under generally accepted accounting principles (GAAP), as mandated for credit unions by Congress, the 1% deposit in the NCUSIF counts as an asset for the credit union. NCUA also stated that those funds are returned when an institution leaves the insurer and is available to absorb losses resulting from a liquidation or purchase and assumption of failed credit union. The agency also said that not all credit unions are members of a corporate and the assumption is unfair. However, the report also noted that there is dissension among credit unions as to whether they should be permitted to issue secondary capital or not. "The credit union industry itself has expressed widely divergent viewpoints on the desirability of additional forms of capital for all federally insured credit unions, with perhaps the most important issue centering on who would purchase the secondary capital instruments," according to the study. Outside investors could lend market discipline, but dilute member-ownership, while inside investors would not provide as much discipline and investor protection concerns arise. Additionally, with inside investors, GAO expressed concern for "the potential that a weaker credit union could pull down a stronger one (systemic risk) because the investment of one credit union would be treated as the capital of another." Aside from "no compelling need," NAFCU Director of Legislative and Political Affairs Brad Thaler said, "One of the main themes running through the report is that there is not enough information out there. GAO said it could not find enough information on how a secondary capital system for credit unions would work. Though low-income and corporate credit unions are permitted alternative forms of capital, their "experiences are too limited or unique for application" to all credit unions. In fact, less than 6% of low-income credit unions issued secondary capital as of year-end 2003, which is equal to less than 1% of all federally insured credit unions. In addition, GAO argued that corporates have a different membership base and there are far fewer of them than natural person credit unions. Taylor said another problem that credit unions have with their argument from a practical standpoint is the market interest in buying into credit union secondary capital. GAO also noted that NCUA has put out a concept for risk-based capital, but has not yet created a detailed enough plan to evaluate. "Risk-based capital is intended to reflect the unique risk profile of individual financial institutions; however, there are other factors that can affect an institution's financial condition that are not easily quantified," the GAO report read. "In recognition of the limitations of risk-based capital systems, bank and thrift regulators use leverage and risk-based capital requirements in tandem." It remains to be decided to what extent risk-based ratios would augment PCA and how risk components would be weighted. NCUA concurred that the case for secondary capital had not been made but the agency's experience with PCA points to need for reform. NCUA's comment letter stated, "[W]e believe there is a need to make adjustments to better achieve its overall objectives. These adjustments should move PCA to a more fully risk-based system, with a lower leverage ratio (ratio of net worth to total assets) required of a credit union to meet the "well-capitalized" level." Though the study was not a glowing review for proponents of secondary capital for credit unions, Congressman Brad Sherman (D-Calif.), who requested the study, commented, "I would like to thank the GAO for this contribution to the ongoing discussion of credit union capital. However, it is by no means the last word on the issue." "Capital is a good thing," the accountant turned lawmaker said. "Capital is what stands between a financial disaster - whether it is bad management or simply bad luck - effecting one credit union, and the insurance fund being hit. It is hard to make an argument against capital. I don't know anyone who says, `Well, financial institutions should be deprived of a tool to be capitalized.'" Thaler agreed: "Those in the credit union community who are supporters of secondary capital are looking at it with an eye to the future." NAFCU's Taylor added that the GAO "should be looking at it in more of a future context" as well. However, he said, "The whole thing comes down to that an inappropriate model is being used." Zimmerman interjected that NAFCU has always argued that "PCA is a bank solution to a bank problem, but it's a reality we have to deal with." He said NAFCU would continue to make a "concerted effort" to make PCA fit credit unions. Sherman pledged to continue working with fellow members of the House Financial Services Committee, as well as the credit union industry, to address credit unions' capital needs. Sherman had previously brought up the issue of secondary capital for credit unions during discussions on H.R. 1375, the Financial Services Regulatory Relief Act. "We appreciate the Government Accountability Office's view and agree that the majority of credit unions are not affected by Prompt Corrective Action (PCA) net worth requirements now," CUNA President and CEO Dan Mica said. "However, upward of 15 percent of well-managed, well-capitalized credit unions are now sufficiently close to the PCA net worth cutoffs to be concerned that they could run into PCA issues in the mid- to near term. Thus, they are right to be looking for some sort of solution to a looming issue. While access to secondary capital could be one way to address the needs of these credit unions, GAO has rightly pointed out that alternative methods exist-such as risk-based capital.The bottom line, however, is that credit unions are in need of some sort of relief in this area." NASCUS Chairman Roger W. Little said the current system of PCA punishes credit unions for their success. "Alternative capital for many state-chartered credit unions is imperative if they are to continue to meet the financial needs of their members such as financing home ownership, providing financial education and credit counseling.The time has come for capital reform." Credit union lobbyists have said that this report should not have much of a bearing on their advocacy on the Hill. CUNA Senior Vice President of Governmental Affairs John McKechnie commented, "It is far too early to tell what the Hill reaction is going to be on that." He added that the increase in congressional awareness of the "unfair capital straight jacket that has been placed upon a lot of credit unions by PCA" is gratifying. "This report, whether it has any impact on the issue of alternative capital or not, I think this report does not in any way interfere with our ability to continue advocating for CURIA and the risk-based solution, keeping in mind of course that CUNA still supports alternative capital," McKechnie said. [email protected]