Meanwhile, the capital rule plods toward a final solution.

Capital Quandary Exposes Different Credit Union Evolutions

In the March 3, 2014 issue of CU Times, we reacted to the NCUA's original proposal on risk-based capital, RBC1, by writing: “The proposed changes to credit union capital requirements illustrate the difficulty the NCUA faces in writing regulation and administering the prudential supervision of approximately 6,700 vastly different financial institutions.”

The RBC debate continues to demonstrate the division of interests within the industry. While the vast majority of credit unions with whom we speak are pleased with the revised rule, others long for another tidal wave of dissenting comments and question both the need for a risk-based rule and the legal authority of NCUA to promulgate a “two-tiered system.” Some call for Congress to intervene and revamp the credit union capital rules.

The second risk-based capital proposal, RBC2, is a significant departure (and improvement) from RBC1 and very similar to the bank version, continuing a trend toward standardizing bank and credit union regulation, especially for those with assets greater than $250 million (including NCUA's proposal to calculate insurance premiums matching FDIC's system). Compared to bank regulations, RBC2 is kinder on consumer loans and the allowance for loan and lease losses, but punitive for mortgage balances greater than 35% of assets.

The capital quandary mirrors the NCUA regulatory quandary. Supervising such a disparate group is fraught with challenges. As an example, NCUA recently introduced five regulations, each with a different focus based mostly on (various) asset sizes: The office of small credit unions (<$50M); the office of national examination and supervision (>$10B); the proposed RBC (now >$100M); the liquidity and hedging rules (>$250M); and the additional 1,000+ low-income designation (LID) credit unions. The LID is essentially a distinct charter within a charter giving the LID credit unions access to supplemental capital, no member business lending cap and the ability to accept non-member deposits.

How and why does an industry representing approximately 7% of U.S. deposits require and manage such distinctly different supervisory groups?

NCUA Announces Intent to Modernize CU Regulation

Many successful non-LID credit unions want access to capital and wonder why they can't have it.

NCUA, in public comments, has stated a desire to introduce this option as part of a modernization effort. All three board members appear aligned. Board Member McWatters stated, “I encourage NCUA to undertake true regulatory relief, including, incorporating supplemental (secondary) capital into the final risk-based capital rule, and modernizing the antiquated member business lending regulations … a review of its field-of-membership (FOM) regulations that needlessly restrict the ability of credit unions to serve consumers.”

Access to supplemental capital raises some important questions that we have been asked to discuss with large credit unions. Questions include, but are not limited to:

1. Credit unions continue to lobby for debt capital assuming it will count for tier 1, which defies the overall trend. Tier 1 capital for banks (US and globally) is restricted to retained earnings and equity (stock). Should credit unions be confident that debt capital will be treated as tier 1 both now and long term?
2. What is the cost of debt capital for banks and what would credit unions expect to pay?
3. What experience does the credit union industry have with supplemental capital and what will the capital be used for?
4. Are there any unique disclosure requirements or investor questions to answer for credit unions issuing capital?
5. While many credit unions understandably desire access to capital, will such modernization simplify or further complicate supervision?
6. What are the advantages, disadvantages and covenants of the various forms of capital?

Sandler O'Neill + Partners, L.P. has been the top adviser to banks raising capital over the past 10 years and has been asked to facilitate the “capital discussion” with many large credit unions and their boards.  The discussion includes perspective on all of the above questions. For example, our research indicates that a majority of the debt issued last year by banks or their holding companies carried a coupon (cost to the bank) ranging from 5%-8% for a typical term of 7-10 years. This compares to a 4.74% earning asset yield for CUs in the $1 billion-plus asset group. Almost all of these banks are public companies (meaning they're supervised by the SEC in addition to multiple bank regulators) and rated by a nationally-recognized rating agency. Also, the vast majority of the capital raises were to support mergers where the cost of debt can be leveraged into a larger asset base. The average asset size of a merged credit union over the past 10 years ranges from $8 million to $36 million.

Access to capital and the elimination of restrictions to both FOM and small business lending follows the evolution of larger credit unions and is an overdue public discussion. Many of these credit unions are well managed with a proven track record of prudent growth. Accommodating the better performers makes more sense than continuing to hold them back with regulations and supervision geared to those that have not and are not evolving.   

Peter Duffy is the managing director with Sandler O'Neill & Partners LP. He can be reached at 646-427-1490 or [email protected].