NCUA Unveils 2005 Risk-Based Capital, PCA Reform Proposal

After extensive review and in-depth analysis of prompt corrective action and capital standards, the NCUA released last week its draft report entitled, “Prompt Corrective Action Proposal for Reform.” This report is a significant step forward in NCUA’s efforts to support an effective and solid risk-based capital system for the nation’s federally insured credit unions. In 2003, NCUA initiated the concept for a risk-based capital structure and sought input from the credit union industry. NCUA received substantial input from all segments of the credit union community. As agency staff further analyzed capital issues, NCUA called for a Summit on Credit Union Capital. Credit union leaders from across the nation participated in the forum, which covered issues relating to the impact of capital and prompt corrective action for natural person credit unions and the corporate credit union system. The summit was a very important and integral step in moving forward as we continued to focus on and evaluate a much needed approach to improve the capital structure for federally insured credit unions. The crux of an institution’s viability is capital. Real progress is being made in working in concert with Congress, the Department of Treasury, and the credit union industry on producing meaningful PCA reform. While the Credit Union Membership Access Act of 1998 established a statutory system of capital standards and prompt corrective action (PCA) for federally insured institutions, NCUA has supported bipartisan legislative efforts in Congress for creating a new risk-based capital standard that reflects the individual risk factors in conjunction with a lowered leverage ratio for each bracket of PCA. Toward this end, the NCUA’s report aiming for prompt corrective action reform, would remove credit unions from a “one size fits all” capital standard, to a standard that incorporates both a leveraged and risk-based component, thereby preserving the integrity of capital standards. The guiding principle behind PCA is to resolve problems in federally insured credit unions at the least long-term cost to the National Credit Union Share Insurance Fund (NCUSIF). This principle is consistent with our fiduciary responsibility to the insurance fund. However, because of the significantly higher leverage requirements placed upon credit unions, the current statutory net worth structure results in a system based largely on net worth to total assets. This creates inequities for credit unions with low-risk balance sheets and limits NCUA’s ability to incorporate behavioral incentives related to higher risk activities. Credit unions manage risk everyday. However, a risk-based capital standard as proposed by the NCUA will provide the opportunity for credit unions to more effectively manage risk. Coupled with considering the dynamic financial marketplace in which America’s credit unions operate today, and the risks that PCA was designed to mitigate, a risk-based capital standard will go a long way to enable future growth for credit unions and expansion of member service. This reform proposal is consistent with NCUA’s steadfast support of PCA as sound public policy. The report is the culmination of over a year’s worth of work reviewing and analyzing various alternatives to the current mandated statutory prompt corrective action. After considering the views of the credit union industry, the General Accountability Office, Congress, and the Department of Treasury, NCUA finalized the draft proposal. If adopted, it would result in a balanced and credible approach to making credit unions’ PCA system aptly robust, yet not unduly burdensome or constraining. The report details recommended statutory changes and provides details as to how NCUA would design a new risk-based system for federally-insured credit unions. As credit unions and banks maintain their structural differences, parity with the PCA system will provide sufficient protection for the NCUSIF and provide federally insured credit unions the ability to better manage their balance sheets. Highlights of the report include the following: * A recognition of the inherent limitations in any risk-based capital system. Consequently, the report advocates a system involving complementary leverage and risk-based standards working in tandem; * For the leverage requirement, NCUA proposes a reduction in the standard net worth (i.e., leverage) ratio requirements for credit unions to a level comparable to what is required of FDIC-insured institutions. In order to achieve comparability between the federal insurance funds, it is necessary to factor in the NCUSIF’s deposit-based funding mechanism. However, the NCUSIF deposit’s treatment for purposes of regulatory capital standards in no way alters its treatment as an asset under generally accepted accounting principles, or NCUA’s support of the mutual, deposit-based nature of the NCUSIF; and * The draft risk-based proposal tailors the risk-asset categories and weights of BASEL II, as well as related aspects of the FDIC’s PCA system, to the operation of credit unions. This approach and the timing of the proposal is consistent with the federal banking regulators’ recent announcement to issue proposed rules this year incorporating BASEL II into their capital standards. The draft proposal is consistent with BASEL II and the FDIC’s PCA system, addressing credit and operational risks under the risk-based requirement and acknowledging other forms of risk, like interest rate risk. NCUA’s reform proposal includes recommendations to address these other forms of risk under the second pillar of the supervisory framework, a robust supervisory review process. Through the examination and supervision process, NCUA will continue to analyze each credit union’s capital position in relation to the overall risk of the institution, which may at times reflect a need for capital levels higher than regulatory minimums. Meaningful capital standards are important in protecting the federal insurance funds, taxpayers, and the stability of America’s credit union system. NCUA also recognizes the importance for institutions in managing capital levels to ensure the efficient use of capital in the economy, to optimize the performance of an institution with appropriate leveraging, and to achieve strategic objectives in providing affordable services for members. Capital is a paramount priority for NCUA. We look forward to maintaining an open dialogue with Congress and serve as a resource, as the policymakers consider these needed reforms to the PCA system.