The Limits of Safety & Soundness

In a well-functioning system, regulators and the regulated shouldn’t always agree; in fact, if they do, it’s a sure sign that something is wrong.

Chairman Harper’s comments before the Brookings Institution detailed an expansive view of regulatory authority that signals that, for the industry, we can expect to see more friction between the NCUA and industry stakeholders. The second consequence is the extent to which this change in regulatory tone impacts the oversight of credit unions on the micro level.

Speaking to Brookings moderator Aaron Klein following his speech, the chairman explained, “There is this myth within the credit union system that because credit unions are owned by their members, they’re always going to do right by their members. Generally, that can be true. I do think that most credit unions seek to do that, but there’s this little issue in between … and it’s that the people who manage the credit union, their interest doesn’t always align with that of the members, and it’s our job to make sure that there’s an alignment there.”

This got me ruminating on what exactly is a regulator’s responsibility when it comes to identifying and reacting to an unsafe and unsound practice, and wondering, is there a way to delineate the precise scope of this thing we call “safety and soundness?” In a strictly legal sense, the answer is no, but there are some rules of the road that should be taken into account.

First, the NCUA, like other financial regulators, does and should have an enormous amount of power that comes along with its authority to prevent unsafe and unsound practices. 12 USC 1786 allows the NCUA to remove any individual or board that engages in such activity.  Furthermore, when examiners decide to use this removal power, courts will almost always defer to the agency’s determination unless they find their actions to be arbitrary and capricious (see Gully v. Nat’l Credit Union).

What makes the term “unsafe and unsound” so challenging from a legal standpoint is that it has to be broad enough to encompass scenarios that have not yet occurred. For example, is it an unsafe or unsound practice for a community bank to aggressively grow its assets by offering accounts to companies that work with cryptocurrency? Now we know the answer is a resounding yes, but up until recently, regulators moving too aggressively against Silicon Valley Bank would have been roundly criticized for squelching financial innovation.

But I would hope the one aspect of unsafe and unsound practices that everyone can agree on is that, for a practice to come under that rubric, it must be a practice that has a direct impact on the financial stability of the institution. For example, the FDIC’s enforcement manual explains that:

An unsafe or unsound practice is any action or lack of action that is contrary to generally accepted standards of prudent financial institution operation that, if continued, would result in abnormal risk of loss or damage to an IDII (insured depository, its shareholders, or the DIF (Depository Insurance Fund).

In the context of a not-for-profit industry, does this definition include the authority to question the choices made by financially sound institutions?

The NCUA’s upcoming scrutiny of overdraft practices will provide the first example of how this expansive view of regulatory authority could impact the industry. A credit union’s overreliance on overdraft fees can raise legitimate safety and soundness concerns, as can any single practice or source of income upon which a financial institution becomes too reliant.

Conversely, simply because a regulator doesn’t like a certain practice such as an overdraft fee, doesn’t make it an unsafe or unsound practice. After all, directors have an obligation to work in the best interests of the membership “as a whole.” Could not a board member believe it is not in the interest of the entire membership to absorb the costs of individual members’ desire to access their protections?

Just as too legalistic a view of regulatory powers could dangerously straitjacket an industry’s ability to quickly react to practices that put financial stability at risk, too expansive a view can be used to rationalize virtually any product or practice with which regulators might disagree for policy reasons wholly unrelated to the safety and soundness of the financial institution they are charged with overseeing. For example, just how is the NCUA going to determine when a board’s policies are not in the best interest of the members of the credit union in those circumstances in which the credit union’s policies do not threaten and may in fact increase the safety and soundness of the credit union and comply with the law?

Henry Meier is the former General Counsel of the New York Credit Union Association, where he authored the popular New York State of Mind blog. He now provides legal advice to credit unions on a broad range of legal, regulatory and legislative issues. He can be reached at (518) 223-5126 or via email at henrymeieresq@outlook.com.