####### Comparing Credit Unions with

####### Other Depository Institutions

![](media/image1.png){width="3.171527777777778in"
height="3.357638888888889in"}

**[United States Department of the Treasury]{.smallcaps}**

January 2001

The Honorable Paul S. Sarbanes

Chairman

Committee on Banking, Housing,

and Urban Affairs

U.S. Senate

Washington, D.C. 20510-6075

Dear Mr. Chairman:

I am pleased to transmit the Department of the Treasury's report on
credit union regulation and taxation, and on preserving the growth and
viability of small banks. We prepared this report as required by
sections 401 and 403 of the Credit Union Membership Access Act of 1998.

In preparing this report, we compared the safety and soundness
regulations governing credit unions with those governing all other
federally insured depository institutions. We also compared the
application of regulatory enforcement authority and federal consumer
protection laws across credit unions and all other federally insured
depository institutions. Finally, we compared the product offerings of
these various institutions.

We reviewed the history of credit unions' exemption from the federal
corporate income tax and estimated the potential revenue that could be
raised were Congress to remove the exemption.

We also reviewed the steps taken during this Administration to promote
the viability of small banks, and discuss the tax policy principles that
govern any expansion of Subchapter S eligibility.

The report contains no recommendations.

Sincerely,

Lawrence H. Summers

Enclosure

\[Identical letters sent to the Honorable Phil Gramm, the Honorable Max
Baucus, and the Honorable Charles Grassley\]

The Honorable Michael G. Oxley

Chairman

Committee on Financial Services

U.S. House of Representatives

Washington, D.C. 20515-6050

Dear Mr. Chairman:

I am pleased to transmit the Department of the Treasury's report on
credit union regulation and taxation, and on preserving the growth and
viability of small banks. We prepared this report as required by
sections 401 and 403 of the Credit Union Membership Access Act of 1998.

In preparing this report, we compared the safety and soundness
regulations governing credit unions with those governing all other
federally insured depository institutions. We also compared the
application of regulatory enforcement authority and federal consumer
protection laws across credit unions and all other federally insured
depository institutions. Finally, we compared the product offerings of
these various institutions.

We reviewed the history of credit unions' exemption from the federal
corporate income tax and estimated the potential revenue that could be
raised were Congress to remove the exemption.

We also reviewed the steps taken during this Administration to promote
the viability of small banks, and discuss the tax policy principles that
govern any expansion of Subchapter S eligibility.

The report contains no recommendations.

Sincerely,

Lawrence H. Summers

Enclosure

\[Identical letters sent to the Honorable John LaFalce, the Honorable
Bill Thomas, and the Honorable Charles Rangel\]

Comparing Credit Unions

# with Other Depository Institutions

## 

### 

### SUMMARY

### 

Credit unions are depository institutions that accept deposits and make
loans. As of June 30, 2000, there were 10,477 federally insured credit
unions with \$426.8 billion in assets. Although the average credit union
is small, with only \$41 million in assets, those with more than \$50
million in assets hold more than 79 percent of all credit union assets,
even though they account for only 15 percent of all credit unions.

As a group, credit unions have grown larger in recent years and have
expanded their offerings of financial products and services. According
to an industry survey, more than half of all credit unions accept loan
applications through the Internet. Moreover, more than 10 percent
provide stock brokerage services or sell mutual funds, albeit through a
subsidiary.

Although they provide many of the same products and services as banks
and thrifts, credit unions have certain distinguishing characteristics.
They are member-owned cooperatives, with each member having one vote
regardless of the amount of a member's deposits. Moreover, they do not
issue capital stock; rather, they are non-profit entities that build
capital by retaining earnings. Finally, credit unions may serve only an
identifiable group of customers with a common bond (*e.g.*, the
employees of a particular firm, the members of a certain organization,
or the members of a specific community).

**Federal Laws and Regulations**

Despite their relatively small size and their restricted fields of
membership, federally insured credit unions operate under banking
statutes and rules virtually identical to those applicable to banks and
thrifts. Significant differences have existed in the past, but have been
gradually disappearing. Recently, most of the remaining major regulatory
differences between credit unions and other depository institutions were
removed.

In 1998, Congress established net worth requirements for credit unions
and directed the National Credit Union Administration (NCUA) to
promulgate prompt corrective action (PCA) rules and risk-based net worth
requirements for credit unions. Although the NCUA's final rules mirrored
those applicable to other depository institutions in most respects, a
few differences can be noted. Each of these two rules contains a
placeholder for the role that "regulatory capital" could play should the
NCUA authorizes it. Such "capital" would be uninsured, but would be
viewed as adding to the net worth available to a credit union to absorb
losses. However, history shows that uninsured depositors withdraw their
funds at the first sign of financial difficulty, thus rendering such
funds unavailable to absorb losses and, in some cases, precipitating
runs on institutions. In addition, under the PCA regulation, the NCUA
waived its right to take certain statutorily authorized actions against
undercapitalized credit unions, such as requiring a new election of a
credit union's board of directors.

We have identified only two other important differences. First, the
NCUA's loans-to-one-borrower restriction greatly exceeds the limit
applicable to other depository institutions, which is typically set at
15 percent of capital. The limit for credit unions stands at 10 percent
of net worth *and 10 percent of deposits.* Second, credit unions are
exempt from the Community Reinvestment Act (CRA), which requires that
banks and thrifts serve all customers within their geographic area.
However, the NCUA recently promulgated a regulation requiring that any
credit union seeking to expand, convert to, or charter a community
credit union would have to prepare a written plan for serving its entire
community.

At this time, we do not believe these differences raise any particular
safety and soundness or competitive equity concerns. Therefore, we offer
no administrative or legislative recommendations.

**The Credit Union Tax Exemption**

Historically, cooperative depository institutions were generally
exempted from the federal corporate income tax. For example, cooperative
banks had always been exempt, whereas state credit unions obtained an
exemption in 1917. Federal credit unions have also always enjoyed an
exemption, one that stemmed from the cooperative character of federal
credit unions and the desire to tax them in a manner consistent with
federal thrift institutions.

In 1951, however, Congress removed the thrift tax exemption because
these institutions had evolved into commercial bank competitors, and had
lost their "mutuality," in the sense that the institutions' borrowers
and depositors were not necessarily the same individuals. Congress
determined that, under these circumstances, their tax exemption afforded
them an unfair advantage over commercial banks. Although it removed the
thrift exemption, Congress left intact the credit union exemption.

In directing the Treasury Department to study this issue, Congress asked
us to analyze "the potential effects of the application of . . . Federal
tax laws . . . on credit unions in the same manner as those laws are
applied to other federally insured financial institutions." Thus, we
analyzed how much revenue might be raised by removing the exemption. We
estimated that between \$13.7 billion and \$16.2 billion would be raised
over a ten-year period if all credit unions were taxed.

**Preserving Small Banks**

The Administration has, throughout its tenure, taken substantial steps
to preserve the growth and viability of small banks. The Credit
Availability Program (CAP), for example, was unveiled by the President
shortly after taking office in 1993. In the midst of a slow economic
recovery, the CAP updated certain important regulations, thereby
curtailing regulatory burden on banks and improving the availability of
credit, particularly to small and medium-sized businesses, farms, and
low-income communities. Other initiatives included streamlining
compliance with the Bank Secrecy Act, reducing regulatory burden,
streamlining CRA rules, and simplifying small bank capital standards.
Believing that we have taken those actions best tailored to preserving
the growth and viability of small banks, we recommend no new policy
initiatives at this time.

Small banks have also benefited from the tax benefits of Subchapter S
status. By the end of 1999, more than 1,260 banks were operating as S
corporations. These institutions represent over 15 percent of U.S.
banks, but only about 2 percent of banking assets, suggesting that
smaller institutions have been among the first to elect S corporation
status. This strong response by smaller banks suggests that Subchapter S
offers considerable advantages in terms of more favorable tax treatment
and lower compliance burdens. If further policy changes are considered,
they should satisfy two broad requirements. First, any additional
measures to simplify the tax treatment of small banks must be crafted
with a recognition that small businesses electing Subchapter S status
play a vital role in the U.S. economy, and that only a small number of
these firms are banks. Second, proposed modifications to Subchapter S
must be evaluated with respect to potential effects on the competitive
environment faced by smaller banks.

### CHAPTER 1

#### Introduction

### 

The Credit Union Membership Access Act of 1998 (CUMAA) directed the
Treasury to study several depository institution issues.[^1] Most of
these concerned credit unions, but one addressed the viability of
community banks. This report presents the results of our study with
regard to sections 401 and 403 of CUMAA. A report on section 203, which
required a study of credit union member business lending, will be
submitted under separate cover.

Section 401 requires the Treasury to evaluate:

> the differences between credit unions and other federally insured
> financial institutions, including regulatory differences with respect
> to regulations enforced by the Office of Thrift Supervision, the
> Office of the Comptroller of the Currency, the Federal Deposit
> Insurance Corporation, and the Administration; and
>
> the potential effects of the application of Federal laws, including
> Federal tax laws, on credit unions in the same manner as those laws
> are applied to other federally insured financial institutions.

Under section 403, Congress directed Treasury to submit:

> recommendations for such legislative and administrative action as the
> Secretary deems appropriate, that would reduce and simplify the tax
> burden for insured depository institutions having less than
> \$1,000,000,000 in assets; and banks having total assets of not less
> than \$1,000,000,000 nor more than \$10,000,000,000; and
>
> any other recommendations that the Secretary deems appropriate that
> would preserve the viability and growth of small banking institutions
> in the United States.

#### I. Credit Union Characteristics

Like banks and thrifts, credit unions are depository institutions that
accept deposits and make loans.[^2] Also like banks and thrifts, their
member deposits are insured by the federal government up to
\$100,000.[^3] As of June 30, 2000, 10,477 federally insured credit
unions with

\$426.8 billion in assets served 76.3 million members.[^4] Thus, the
average credit union asset size is \$41 million. As Table 1-1 shows, the
vast majority of credit unions is small and holds a relatively small
share of credit union assets. About 57 percent of all credit unions hold
less than \$10 million in assets. Moreover, credit union assets are
concentrated within the largest institutions. Credit unions with more
than \$50 million in assets comprise less than 15 percent of all credit
unions, but they hold over 79 percent of total federally insured credit
union assets.

####### [Table 1-1: Number of Federally Insured Credit Unions and Total Assets by Size Category]{.underline}

(Dollars in billions; data as of June 2000)

+-------------+-------------+-------------+-------------+-------------+
| Asset Size  | Number of   | Percent of  | Total       | Percent of  |
| Category    | I           |             | Assets      | Total       |
|             | nstitutions | All Credit  |             | Assets      |
|             |             | Unions      |             |             |
+-------------+-------------+-------------+-------------+-------------+
| \< \$2      | 2,537       | 24%         | \$2.2       | 0.5         |
| million     |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| \$2 -\$10   | 3,457       | 33%         | \$17.9      | 4.2         |
| million     |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| \$10-\$50   | 2,939       | 28%         | \$68.0      | 15.9        |
| million     |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| \> \$50     | 1,544       | 15%         | \$338.7     | 79.4        |
| million     |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| Total       | 10,477      | 100%        | \$426.8     | 100.0       |
+-------------+-------------+-------------+-------------+-------------+

Source: Sheshunoff Information Services, Inc., *BankSearch* (Austin, TX:
2000).

Credit unions have grown larger in recent years. As of year-end 1994, 67
percent of all credit unions had less than \$10 million in assets,[^5]
compared with 57 percent as of June 30, 2000. Of this 10 percent
difference, credit unions with more than \$50 million in assets account
for half of this change.[^6]

Although credit unions have certain characteristics in common with banks
and thrifts, (*e.g.*, the intermediation function), they are clearly
distinguishable from these other depository institutions in their
structural and operational characteristics. Many banks or thrifts
exhibit one or more of the following five characteristics; but only
credit unions exhibit all five together.

First, credit unions are member-owned,[^7] and each member is entitled
to one vote in selecting board members and in certain other
decisions.[^8] Although other mutual institutions are

also member-owned, voting rights are generally allocated according to
the size of the mutual member's deposits, rather than being "one member,
one vote."[^9]

Second, credit unions do not issue capital stock. Credit unions create
capital, or net worth, by retaining earnings. Most credit unions begin
with no net worth and gradually build it over time.[^10]

Third, credit unions rely on volunteer, unpaid boards of directors whom
the members elect from the ranks of membership.[^11]

Fourth, credit unions operate as not-for-profit institutions, in
contrast to shareholder-owned depository institutions. All earnings are
retained as capital or returned to the members in the form of interest
on share accounts, lower interest rates on loans, or otherwise used to
provide products or services.

Fifth, credit unions may only accept as members those individuals
identified in a credit union's articulated field of membership.[^12]
Generally, a field of membership may consist of a single group of
individuals that share a common bond; more than one group, each of which
consists of individuals sharing a common bond; or a geographical
community.[^13] A common bond may take one of three forms: an
occupational bond applies to the employees of a firm; an associational
bond applies to members of an association; and a geographical bond
applies to individuals living, working, attending school, or worshiping
within a particular defined community.[^14]

Table 1-2 shows the number of federal credit unions and their total
assets for each type of field of membership category. A multiple common
bond credit union holds more than one occupational or associational
common bond or a combination of both types of common bonds. (Community
common bonds may not be part of a multiple common bond federal credit
union.) Note that 49 percent of federal credit unions have multiple
common bonds, but they hold 71 percent of federal credit union assets.
Of the institutions organized around a single common bond, most serve
particular occupational groups. Occupational bonds account for 31
percent of all federal credit unions and 16 percent of federal credit
union assets.

[Table 1-2: Federal Credit Unions by Type of Membership]{.underline}\*

(Dollars in billions; data as of December 31, 1999)

+-------------+-------------+-------------+-------------+-------------+
|             | Number      | Percent of  | Total       | Percent of  |
|             |             | all Federal | Assets      | all         |
|             |             | Credit      |             |             |
|             |             | Unions      | (\$ in      | Federal     |
|             |             |             | billions)   | Credit      |
|             |             |             |             | Union       |
|             |             |             |             | Assets      |
+-------------+-------------+-------------+-------------+-------------+
| Single      | 3,317       | 51.3%       | \$71.7      | 29.3%       |
| Common Bond |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| O           | 1,978       | 30.6%       | \$40.2      | 16.4%       |
| ccupational |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| As          | 666         | 10.3%       | \$3.8       | 1.6%        |
| sociational |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| Community   | 649         | 10.0%       | \$26.4      | 10.8%       |
+-------------+-------------+-------------+-------------+-------------+
| Other\*\*   | 24          | 0.4%        | \$1.3       | 0.5%        |
+-------------+-------------+-------------+-------------+-------------+
| Multiple    | 3,149       | 48.7%       | \$172.6     | 70.7%       |
| Common Bond |             |             |             |             |
+-------------+-------------+-------------+-------------+-------------+
| Total       | 6,466       | 100.0%      | \$244.3     | 100.0%      |
+-------------+-------------+-------------+-------------+-------------+

\* Data on state chartered credit unions were not available.

\*\* Common bonds in this category consist of atypical common bonds that
have been grandfathered.

Source: National Credit Union Administration

**II. Organization of the Report**

This report is divided into four chapters. Chapter 2 analyzes the
differences between federally chartered credit unions and other
federally chartered depository institutions generally and compares the
different statutory and regulatory requirements applicable to all
federally chartered depository institutions. Chapter 3 examines the
revenue implications of eliminating the federal income tax exemption
currently applicable to federally insured credit unions. Finally,
Chapter 4 describes actions taken by this Administration to preserve the
viability and growth of small banks. The report also contains an
Appendix containing a detailed comparison of the statutes and
regulations applicable to banks, savings associations, and credit
unions.

### CHAPTER 2

#### Comparing the Differences between 

#### Federally Insured Credit Unions 

#### and other Federally Insured Depository Institutions

Pursuant to section 401 of CUMAA, this chapter identifies the major
statutory and regulatory differences between federally insured credit
unions and other federally insured depository institutions. In preparing
this chapter, Treasury drew upon its 1997 credit union study.[^15] In
that report, we enumerated several important characteristics that
differentiate credit unions from banks and thrifts.[^16] We also
compiled a table comparing both the enforcement and the safety and
soundness laws and regulations applicable to federally chartered
depository institutions, that is, those depository institutions
supervised by the National Credit Union Administration (NCUA), the
Office of the Comptroller of the Currency (OCC), and the Office of
Thrift Supervision (OTS).[^17]

Given the mandate of section 401, we updated and expanded that table
(see Appendix). The updated table compares rules applicable to federally
insured depository institutions as implemented by all six federal
depository institution regulators, including the Federal Reserve Board
(FRB) and the Federal Deposit Insurance Corporation (FDIC). Where
applicable, meaningful divergences between state and federal rules are
noted. Moreover, the updated table augments the previous one by
summarizing the safety and soundness rules recently implemented by the
NCUA and by comparing the basic consumer protection laws and regulations
across depository institutions. It also identifies the major powers
enjoyed by national banks, federal savings associations, and federal
credit unions.[^18]

Our 1997 report included several safety and soundness
recommendations.[^19] Most of these have been enacted in the CUMAA,
including credit union net worth requirements, risk-based net worth
requirements, prompt corrective action, and updated audit standards.
This chapter examines the NCUA's regulations implementing these
statutory requirements.

Given the important structural and operational differences between
credit unions and other depository institutions highlighted in Chapter
1, one would expect credit union rules to differ in some respects from
those applicable to banks and thrifts. For example, credit unions'
cooperative character precludes them from issuing stock to raise
capital, but also excludes them from the myriad rules governing stock
issuance and the payment of dividends. On the other hand, banks and
thrifts may serve any customer and need not limit their operations to
pre-established fields of membership, whereas credit unions may only
serve those who fall within their fields of membership. This chapter
examines whether the most important statutory and regulatory
requirements applicable to depository institutions differ in any
significant respect for credit unions.

This chapter has been divided into three sections. Section I evaluates
the recent safety and soundness rules promulgated by the NCUA pursuant
to statutory mandates. Section II compares the banking statutes and
regulations under which depository institutions operate. Section III
summarizes our conclusions.

## I. NCUA Implementation of Mandated Safety and Soundness Rules

Treasury's 1997 report, *Credit Unions*, noted that credit unions
operated under less rigorous and formal safety and soundness rules than
did banks and thrifts even as "a growing number of credit unions evolve
into larger and more complex financial institutions."[^20] Contending
that "\[s\]afety and soundness regulation must keep pace with expanding
credit union operations,"[^21] our report recommended, among other
things, that credit unions be subject to statutory net worth
requirements, including: a risk-based net worth requirement; prompt
corrective action; and independent audit requirements for larger
institutions.[^22]

Congress incorporated these three recommendations into the CUMAA.[^23]
These requirements and the NCUA's proposed and final regulations
implementing them are discussed and evaluated below.

#####  Net Worth Requirements for Credit Unions

Prior to CUMAA, NCUA regulations did not impose any net worth
requirement on credit unions. In other words, credit unions were not
required to maintain a given ratio of net worth to total assets for
safety and soundness purposes. Instead, credit unions were required only
to add to their reserves a specified percentage of current earnings. If
reserves reached a certain threshold, credit unions were no longer
required to add to reserves, but no law or regulation stipulated that
credit unions were required to reach that level.[^24] The major
differences between the capital requirements of credit unions and those
of the other depository institutions are delineated below. The Appendix
contains a more detailed comparison.

In contrast, banks and thrifts are required to meet two capital
requirements in order to be adequately capitalized: (1) a minimum ratio
of total capital to total assets, generally 4 percent of Tier 1
capital,[^25] which includes common stock and non-cumulative perpetual
preferred stock;[^26] and (2) a risk-based capital ratio of 8 percent
capital to risk-weighted assets.[^27] Half of the 8 percent risk-based
capital requirement may consist of Tier 2 capital, which may include
cumulative perpetual preferred stock, the allowance for loan and lease
losses, and hybrid instruments that combine debt and equity
features.[^28]

CUMAA's net worth requirements direct federally insured credit unions to
maintain at least 6 percent net worth to total assets to be considered
adequately capitalized.[^29] Note that this exceeds the 4 percent Tier 1
leverage ratio applicable for banks and thrifts (and is statutory, as
opposed to regulatory). Congress determined that a higher ratio was
appropriate because credit unions cannot quickly issue capital stock to
raise their net worth as soon as a financial need arises. Instead,
credit unions must rely on retained earnings to build net worth, which
necessarily takes time. Moreover, Congress established a capital level
two percentage points higher, a level recommended by Treasury, because
one percent of a credit union's capital is dedicated to the National
Credit Union Share Insurance Fund and another one percent of the typical
credit union's capital is dedicated to its corporate credit union.[^30]

Congress also directed the NCUA to develop risk-based net worth
requirements for complex credit unions.[^31] The NCUA was directed to
both define what attributes cause a credit union to be considered
complex,[^32] and design a system for complex credit unions that
accounts for any material risks not adequately addressed by the 6
percent leverage requirement.[^33] To be adequately capitalized, a
complex credit union must meet the higher of the 6 percent leverage
requirement and the risk-based net worth requirement.[^34]

The risk-based capital system for banks and thrifts assigns each class
of assets a risk weight that varies from 0 percent to 100 percent. The 0
percent category includes assets such as cash, the 20 percent category
includes assets such as securities issued by government-sponsored
enterprises, the 50 percent category includes mortgage loans, and the
100 percent category consists of typical commercial loans.[^35] These
rules stemmed from a 12-country effort to develop internationally
uniform capital standards.[^36] As such, this system best serves larger,
internationally active commercial banks, but it would not likely serve
credit unions as well. In this case, credit unions should operate under
different rules, but rules aimed at the same goal of requiring capital
to account for risks not adequately covered by the leverage ratio.

*1. NCUA's Risk-Based Net Worth Requirement*

The NCUA's risk-based capital rule applies to any credit union with more
than \$10 million in assets and whose risk-based net worth requirement
exceeds 6 percent.[^37] A credit union's risk-based requirement is the
sum of eight standard components, as depicted in Table 2-1. Each of the
eight components constitutes a "risk portfolio," which is a portfolio of
assets, liabilities, or contingent liabilities expressed as a percentage
of total assets. A risk-weighting is applied to each component, and all
are summed to determine the credit union's requirement. A credit union
is undercapitalized if its net worth is less than the applicable
risk-based net worth requirement.

[Table 2-1: Standard Calculation of Risk-Based Net Worth
Requirement]{.underline}

+------------------------+---------------------------+----------------+
| ### Ri                 | Allocation of Risk        | Multiplying    |
| sk Portfolio Component | Portfolios                | Factor         |
|                        |                           |                |
|                        | (as % of total assets)    |                |
+------------------------+---------------------------+----------------+
| Long-term real estate  | 0 to 25                   | .06            |
| loans[^38]             |                           |                |
|                        | over 25                   | .14            |
+------------------------+---------------------------+----------------+
| Outstanding member     | 0 to 12.25                | .06            |
| business loans         |                           |                |
|                        | over 12.25                | .14            |
+------------------------+---------------------------+----------------+
| Investments            | 0 to 1 year               | .03            |
|                        |                           |                |
|                        | \> 1 year to 3 years      | .06            |
|                        |                           |                |
|                        | \> 3 years to 10 years    | .12            |
|                        |                           |                |
|                        | \> 10 years               | .20            |
+------------------------+---------------------------+----------------+
| Low risk assets[^39]   | All                       | .00            |
+------------------------+---------------------------+----------------+
| Average-risk           | All                       | .06            |
| assets[^40]            |                           |                |
+------------------------+---------------------------+----------------+
| Loans sold with        | All                       | .06            |
| recourse               |                           |                |
+------------------------+---------------------------+----------------+
| Unused member business | All                       | .06            |
| loan lines of credit   |                           |                |
+------------------------+---------------------------+----------------+
| Allowance for loan     | Limited to the equivalent | (1.00)         |
| losses                 |                           |                |
|                        | of 1.5% of total loans    |                |
|                        |                           |                |
|                        | (expressed as a % of      |                |
|                        | assets)                   |                |
+------------------------+---------------------------+----------------+

Source: NCUA. *See also* 65 Fed. Reg. 44,969.

The final rule offers an alternative method of calculating the
requirement, which a credit union may use if it results in a lower
risk-based net worth requirement. Three of the above-mentioned "risk
portfolios"−long-term real estate loans, member business loans, and
investments−are weighted according to their remaining maturity. If the
alternative results in any component generating a lower requirement, the
credit union may substitute the lower determination for the standard
calculation of that component.[^41]

2.  *Assessment of the NCUA's Risk-Based Net Worth Requirement*

In general, the NCUA implemented the risk-based net worth requirements
as Congress intended. However, the rule contains a placeholder for the
role that "regulatory capital" might play as "a criterion in evaluating
net worth restoration plans" if regulatory capital is approved by the
NCUA.[^42] Under CUMAA, only retained earnings calculated according to
generally accepted accounting principles (GAAP) may count as net
worth,[^43] which means that no form of uninsured regulatory capital may
count as net worth. Nevertheless, the NCUA finds such capital valuable,
believing that it would be available to absorb losses. Specifically, the
NCUA will take regulatory capital, which may be established by NCUA
regulation or authorized by state law and recognized by NCUA, into
account when evaluating a credit union's net worth restoration plan.

A credit union with regulatory capital would likely be permitted to have
lower net worth targets in its net worth restoration plan than a
similarly situated credit union without regulatory capital, on the
theory that regulatory capital would be available to absorb potential
losses. However, depository institution experience with uninsured
depositors shows that these account holders tend to withdraw their funds
at the first sign of financial difficulty, thus rendering such funds
unavailable to absorb losses and, in some cases, precipitating runs on
institutions.

###### B. Prompt Corrective Action for Credit Unions

In response to the large number of bank and thrift failures in the late
1980s and early 1990s, Congress enacted a regulatory structure known as
prompt corrective action (PCA). PCA consists of a set of statutory and
regulatory provisions aimed at resolving capital deficiencies before
they grow into larger problems.[^44] This system classifies depository
institutions into five categories, according to their capital holdings:
well-capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized, and critically undercapitalized.[^45] An
institution that becomes undercapitalized faces progressively more
stringent regulatory restrictions and requirements. Depending on how
undercapitalized an institution becomes, and how long the institution
remains undercapitalized, the primary federal regulator may direct the
institution to issue capital stock or to refrain from increasing its
asset size. Regulators also have the authority to require a new election
of the board of directors and to dismiss managers. Ultimately, an
institution may be placed into receivership if it remains critically
undercapitalized for a long period of time and shows no ability to
recover.[^46]

Treasury's 1997 report determined that prompt corrective action would
benefit credit unions. At that time, we found that the:

> relevant statutes, regulations, and policies fall short of providing a
> system of prompt corrective action for credit unions. The NCUA has no
> regulations or even formal guidelines for taking corrective action
> regarding a troubled credit union, and once a credit union depletes
> its net worth, the NCUA's response may be to provide assistance from
> the Share Insurance Fund rather than to close the institution.
> Although this approach may sometimes turn around a troubled
> institution, it also has risks. In particular, regulatory forbearance
> may delay the actual recognition and correction of serious
> deficiencies. When this occurs in a general downturn with many
> institutions getting into difficulty, what might otherwise have
> produced small losses to the insurance fund could produce much larger
> losses. The breakdown in regulatory discipline and management
> discipline becomes difficult to correct. Unstructured regulatory
> discretion may also promote unfairly disparate treatment of similarly
> situated credit unions.[^47]

Based on Treasury's recommendation, Congress directed the NCUA to
implement a system of PCA for credit unions.[^48] Recognizing the
differences between credit unions and other depository institutions,
Congress did not simply apply the then-existing PCA system to credit
unions; rather, it adapted that system to the characteristics of credit
unions.[^49] For example, given that credit unions can only increase net
worth through retained earnings and that credit unions are generally
chartered with little or no net worth, the statute directed the NCUA to
promulgate separate PCA rules for newly chartered credit unions.[^50]
Similarly, the legislation grants the NCUA more time to allow a
critically undercapitalized credit union to build net worth and return
to financial health than generally permitted for banks and thrifts.[^51]

In addition to tailoring specific statutory PCA provisions to credit
unions, the legislation directs the NCUA to develop a PCA system that is
"comparable" to the PCA rules applicable to banks and thrifts.[^52]
According to the Senate Banking Committee report, "comparable" means
"parallel in substance (though not necessarily identical in detail) and
equivalent in rigor."[^53]

*1. NCUA's Prompt Corrective Action Rule*

PCA consists of two primary components: (1) a framework of mandatory
actions prescribed by statute together with discretionary actions
developed by the NCUA; and (2) an alternative system of PCA that applies
to "new" credit unions. With regard to the first component, CUMAA
mandated a set of required actions, corresponding to five statutory net
worth categories. Those actions that would trigger conservatorship or
liquidation are prescribed in CUMAA. Discretionary actions were left for
the NCUA to devise, provided they are "comparable" to those devised by
the federal banking agencies for banks and thrifts.

New credit unions are those that have been in operation less than ten
years and have \$10 million or less in assets.[^54] Pursuant to CUMAA,
the NCUA devised a completely different system of PCA for these
institutions, taking into account the fact that new credit unions begin
with no net worth and can only build it slowly over time. The final rule
expanded the net worth categories from five to six and delineated how
long it would normally take a new credit union to work its way from
uncapitalized, on the day it is chartered, to higher levels of net
worth. For example, the NCUA anticipates that it would require five
years to accumulate 2 percent net worth and about 10 years to become
adequately capitalized, with at least 6 percent net worth.

The NCUA promulgated its final PCA rule on February 18, 2000,[^55] and
it became effective on August 7, 2000.

2.  *Assessment of the NCUA's Prompt Corrective Action Rule*

As with its approach to devising a risk-based net worth requirement, the
NCUA has generally implemented its PCA rule as Congress intended,
including the congressional mandate that PCA for credit unions be
"comparable" to PCA for banks and thrifts. To the extent there are
differences, for the most part they derive from the structural
distinction between credit unions and other depository institutions.

We found, however, that the rule differs unnecessarily from the bank and
thrift PCA rule in two respects. First, the NCUA has decided explicitly
to forego its right to take certain discretionary actions against
undercapitalized credit unions. For example, the NCUA has decided not to
use its authority to require a new election of an undercapitalized
credit union's board of directors, although it will retain its authority
to do so in the case of a significantly or critically undercapitalized
institution. With regard to an undercapitalized credit union, the NCUA
believes that a wholesale election of the board of directors may be an
overreaction when a credit union's net worth falls below six percent.
Although this may be true in many, or nearly all such situations, there
may well be exceptions. Treasury believes that it would have been more
appropriate for the NCUA to articulate its perspective in the preamble
and in guidance, while at the same time retaining the authority.

Second, as with the proposed risk-based net worth rule, the final PCA
rule contains a placeholder for the role that "regulatory capital" could
play in the PCA system if the NCUA authorizes it. As noted previously,
only GAAP calculated retained earnings count as net worth.[^56]
Recognizing this, the NCUA states in the preamble that "the final rule
is revised to establish as a criterion in evaluating net worth
restoration plans the type and amount of any forms of regulatory capital
as may be established by NCUA . . . . "[^57] The prospect of new forms
of regulatory capital raises concerns, as mentioned in the discussion of
the NCUA's proposed risk-based net worth requirement rule.

###### C. Independent Audits

All federally insured banks and thrifts must complete annual reports on
their financial condition and management.[^58] Moreover, all banks and
thrifts with at least \$500 million in assets must establish an
independent audit committee and obtain an annual independent audit of
its financial statements by an independent public accountant in
accordance with generally accepted accounting standards.[^59]
Furthermore, the OTS requires any savings association with an
unsatisfactory supervisory rating (3, 4, or 5) to obtain an independent
audit.[^60]

Credit unions have traditionally followed much different audit
procedures. First, a credit union's volunteer board of directors must
appoint a supervisory committee from among the credit union's
membership.[^61] The supervisory committee must then conduct, or hire a
competent party to conduct, an annual audit of the credit union. The
supervisory committee must also verify that the institution's financial
statements accurately and fairly represent the institution's financial
condition and that management practices and procedures sufficiently
protect member assets.[^62] NCUA regulations require that a credit
union's financial statements provide full and fair disclosure of all
assets, liabilities, and member equity.[^63]

In our 1997 report, we noted that with the "rise of large, financially
complex credit unions, the audit becomes increasingly more difficult for
unpaid volunteers to carry out personally."[^64] At that time, the NCUA
required that supervisory committee audits be performed by "persons
having adequate technical training and proficiency as an auditor
commensurate with the level of sophistication and complexity of the
credit union under audit," but did not require that even the largest,
most complex credit union hire a professional accountant.[^65]

Therefore, we recommended that the NCUA require each large federally
insured credit union to obtain an annual audit from an independent
certified public accountant, in a manner comparable to that required by
the FDIC.[^66]

CUMAA modified the audit requirements as recommended in our report.
First, all financial reports and statements required to be filed with
the NCUA must be uniform and consistent with GAAP, although credit
unions with less than \$10 million in assets are exempt.[^67] The NCUA
may substitute its own accounting principles for GAAP, provided that (1)
GAAP is found to be inappropriate for credit unions, and (2) the
substitute principles are "no less stringent" than GAAP.[^68]

Like banks and thrifts, all insured credit unions with at least \$500
million in assets must now obtain an annual independent audit of their
financial statements, performed in accordance with GAAP by an
independent certified public accountant or public accountant licensed to
perform these services by the appropriate jurisdiction.[^69] Certain
audit requirements also apply to insured credit unions with more than
\$10 million in assets, but less than \$500 million, that voluntarily
choose to be audited by an independent auditor who is compensated for
the service.[^70]

**II. Depository Institution Rules Compared**

This section compares the basic statutory and regulatory rules applied
to depository institutions across four broad categories: institution
powers, safety and soundness, regulatory enforcement authority, and
consumer protection. The Appendix contains a detailed table summarizing
these findings.

**A. Institution Powers**

In general, federal credit unions have more limited powers than national
banks and federal savings associations. Most notably, federal credit
unions face stricter limitations on their commercial lending and
securities activities. In addition, a usury ceiling prevents them from
charging more than 18 percent on any loan, and the term of many types of
loans may not extend beyond 12 years. At the same time, however, federal
credit unions have ample authority to offer most other consumer products
and services, whether directly or through an affiliate. Table 2-2
identifies the major products and services available from credit unions
and shows the proportion of credit unions offering such products and
services by asset size.

[Table 2-2: Credit Union Products and Services by Asset
Size]{.underline}

(Percent of credit unions; data as of December 31, 1999)

+------------------+-------+--------+--------+--------+---------------+
| Asset Size (in   |       |        |        |        |               |
| millions)        |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
|                  | \     | \      | \$5    | Over   | All Credit    |
|                  | $1-2m | $5-10m | 0-100m | \$500m | Unions        |
+------------------+-------+--------+--------+--------+---------------+
| Loans:           |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Unsecured        | 98.4  | 99.7   | 100.0  | 100.0  | 98.8          |
+------------------+-------+--------+--------+--------+---------------+
| First Mortgage   | 8.6   | 33.9   | 84.6   | 100.0  | 41.2          |
+------------------+-------+--------+--------+--------+---------------+
| Guaranteed       | 3.7   | 14.5   | 35.7   | 52.3   | 18.4          |
| Student          |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Used Auto        | 96.4  | 99.0   | 100.0  | 100.0  | 96.1          |
+------------------+-------+--------+--------+--------+---------------+
| New Auto         | 96.4  | 99.2   | 100.0  | 100.0  | 95.3          |
+------------------+-------+--------+--------+--------+---------------+
| Auto Leasing     | 1.9   | 8.0    | 27.8   | 45.2   | 11.6          |
+------------------+-------+--------+--------+--------+---------------+
| Plane/Boat/RV    | 71.6  | 88.4   | 94.5   | 97.7   | 80.6          |
+------------------+-------+--------+--------+--------+---------------+
| Credit Cards     | 3.6   | 45.1   | 92.0   | 97.7   | 46.3          |
+------------------+-------+--------+--------+--------+---------------+
| Member Services: |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Stock/Bond       | 0.3   | 3.5    | 32.7   | 73.8   | 10.8          |
| Brokerage\*      |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Mutual Funds\*   | 0.4   | 2.5    | 32.6   | 78.6   | 10.3          |
+------------------+-------+--------+--------+--------+---------------+
| Safe Deposit     | 0.0   | 2.9    | 49.0   | 66.7   | 14.5          |
| Boxes            |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Loan Application | 2.1   | 5.4    | 36.4   | 66.3   | 12.8          |
| Through Audio    |       |        |        |        |               |
| Response         |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Loan Application | 0.8   | 12.2   | 67.4   | 80.2   | 23.4          |
|                  |       |        |        |        |               |
| Through a PC     |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Loan Application | 0.0   | 48.3   | 72.5   | 78.9   | 62.6          |
|                  |       |        |        |        |               |
| Through the      |       |        |        |        |               |
| Internet         |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| ATM Cards        | 2.8   | 53.4   | 94.1   | 100.0  | 49.1          |
+------------------+-------+--------+--------+--------+---------------+
| Deposit          |       |        |        |        |               |
| Ac               |       |        |        |        |               |
| counts/Services: |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| CDs              | 38.3  | 75.5   | 94.7   | 97.7   | 66.6          |
+------------------+-------+--------+--------+--------+---------------+
| Traditional IRAs | 18.5  | 61.6   | 93.2   | 98.8   | 56.1          |
+------------------+-------+--------+--------+--------+---------------+
| Business         | 5.9   | 37.8   | 58.2   | 48.3   | 31.9          |
| Checking         |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+
| Personal         | 13.8  | 74.8   | 96.1   | 100.0  | 60.7          |
| Checking         |       |        |        |        |               |
+------------------+-------+--------+--------+--------+---------------+

Source: Credit Union National Association, *Credit Union Services
Profile 1999.* (Data consists of responses from 68 percent of the 11,012
credit unions in existence at the end of 1999).

\* Institutions may not provide these services themselves, but may offer
them if another entity actually provides the services.

One of the most apparent differences between federal credit unions and
other federally chartered depository institutions stems from the
restrictions federal credit unions have regarding their customer base.
Whereas banks and savings associations may offer products and services
to anyone, federal credit unions may serve only their members.[^71] In
addition, federal credit unions may accept only individuals as members,
although community credit unions may also serve qualified
businesses.[^72] Despite these restrictions, a federal credit union may
extend its offerings to non-members through an affiliate known as a
credit union service organization (CUSO). CUSOs may be owned as a
subsidiary or jointly with other depository institutions, including
banks and thrifts.[^73]

Below we compare the activities in which federal credit unions may
engage to those in which national banks and federal savings associations
may engage. A more complete comparison is provided in the Appendix.

1.  *Deposits and Trust Accounts*

Like national banks and federal savings associations, federal credit
unions may offer checking and savings accounts, although the Federal
Credit Union Act (FCUA) refers to them as share accounts.[^74] Unlike
banks and savings associations, however, credit unions may pay interest
on business checking accounts. Whereas federal credit unions may only
offer trust accounts through a CUSO, national banks and federal savings
associations may offer them directly.

2.  *Customer Services*

Generally, federal credit unions may provide the same financial products
and services as national banks and federal savings associations,
including travel and foreign exchange services, insurance, securities
brokerage, investment advice, and real estate brokerage. However, while
national banks may offer these directly, federal credit union customers
may only obtain these from a CUSO. A federal savings association may not
offer these products directly, unless registered as a broker/dealer or
investment advisor.

3.  *Derivatives*

Federal credit unions have very limited authority to purchase or sell
derivatives, even for the purpose of hedging risk,[^75] unlike national
banks and federal savings associations. Also in contrast to other
federally chartered depository institutions, a federal credit union may
not directly securitize its assets through its own trust. Furthermore,
neither federal savings associations nor federal credit unions may
underwrite securities, whereas national banks, through financial
subsidiaries, may underwrite any security under certain conditions.

4.  *Lending*

Federal credit unions may offer residential mortgage loans, but such
loans may not extend beyond 40 years, and any second mortgage may not
extend beyond 20 years. In addition, national banks and federal savings
associations must obtain a certified appraisal of such properties only
when the loan amount exceeds \$250,000,[^76] whereas federal credit
unions must generally obtain a certified appraisal if the loan exceeds
\$100,000.[^77] Similarly, federal credit unions must obtain a certified
appraisal for any business loan in excess of \$50,000,[^78] while other
federally chartered depository institutions need only obtain such
appraisals for loans in excess of \$1 million.[^79]

Federal credit unions may not make unsecured residential construction
loans, whereas national banks and federal savings associations face only
limited restrictions on such lending. On the other hand, federal credit
unions may make other types of unsecured loans without specific
additional limitations.

Federal credit unions' member business (commercial) lending may not
exceed the lesser of 1.75 times net worth or 12.25 percent of total
assets, unless the credit union is either chartered to make such loans,
has a history of concentrating on making such loans, is a low income
credit union, or participates in the Community Development Financial
Institutions program. In contrast, national banks face no specific
restrictions on this type of lending, and federal savings associations'
commercial loans may not exceed 20 percent of their total assets.

5.  *Investments*

NCUA regulations limit a federal credit union's investments to those
specifically listed in the Act, such as government and agency
securities, which may be purchased without limitation. Aside from the
issuances of certain government sponsored enterprises, federal credit
unions may not invest in residential mortgage-backed securities, such as
strips; residual interests in collateral mortgage obligations or real
estate mortgage investment conduits; or commercial mortgages and related
securities. Moreover, unlike national banks and federal savings
associations, federal credit unions may not invest in securities backed
by non-residential assets, such as credit cards or automobiles, unless
issued by certain government sponsored enterprises. Furthermore, subject
to certain restrictions, national banks and federal savings associations
may invest in corporate debt securities, but federal credit unions lack
such authority.

##### B. Safety and Soundness Rules

As the table in the Appendix shows, credit unions face nearly the same
safety and soundness rules as other depository institutions, with one
notable exception: the NCUA's loans-to-one-borrower regulation.
Currently, a credit union may lend to one borrower up to 10 percent of
its "unimpaired capital and surplus,"[^80] which the NCUA defines as
retained earnings *plus* deposits (or shares). Relying on the FCUA,
which refers to shares as "equity,"[^81] NCUA regulations permit any
federal credit union to lend to any borrower an amount up to 10 percent
of the institution's capital plus 10 percent of the institution's
deposits.[^82] This greatly exceeds the limits on other depository
institutions, which is typically 15 percent of capital.[^83]

##### 

##### C. Regulatory Enforcement Authority

When comparing enforcement authority across federal depository
institution regulators, few differences are found. As the Appendix
shows, credit unions in fact operate under almost identical enforcement
rules as banks and thrifts. For example, the NCUA may issue
cease-and-desist orders and impose civil money penalties under the same
rules as the other federal depository institution regulators.

**D. Consumer Protection**

Credit unions are also subject to the same consumer protection rules as
other depository institutions. The Truth in Lending Act, the Truth in
Savings Act, the Real Estate Settlement Procedures Act, the Home
Mortgage Disclosure Act, and the Expedited Funds Availability Act, for
example, apply uniformly to all depository institutions. However, the
Community Reinvestment Act (CRA)[^84] applies to all depository
institutions except credit unions.[^85]

The CRA established an obligation on the part of federally insured
depository institutions to help meet the credit needs of their entire
communities, including low- and moderate-income neighborhoods and
individuals, consistent with safe and sound banking practices. An
inadequate record under CRA may be grounds for denying or conditioning
an application, for example, to merge with or acquire another depository
institution, or to open or close a branch.

Although the CRA does not apply to credit unions, the NCUA recently
promulgated a regulation requiring that any credit union seeking to
expand, convert to, or charter a community credit union would have to
prepare a written plan for serving its entire community.[^86] Existing
community credit unions would be expected to develop a plan, which would
have to be in place by December 31, 2001.

**III. Conclusion**

Federal credit unions generally operate within the same legal framework
as other federally insured depository institutions. Most differences
between credit unions and other depository institutions derive from the
structure of credit unions. We found this to be most likely in the case
of safety and soundness rules, where credit union operations interact
directly with the operation of the rules. With regard to enforcement and
consumer protection rules, few differences exist. Credit unions have
fewer powers available to them than do banks and thrifts, but, through
CUSOs, credit unions may provide their members with a panoply of
sophisticated financial services and products that rivals the offerings
of banks and thrifts.

### CHAPTER 3

#### The Potential Revenue Effects 

#### of Applying Federal Tax Laws to Credit Unions 

#### 

Section 401 of the Credit Union Membership Access Act requires the
Treasury to study and report on "the potential effects of the
application of federal laws, including federal tax laws, on credit
unions in the same manner as those laws are applied to other federally
insured financial institutions."[^87] Under current law, credit unions
are exempt from federal income taxation, unlike all other federally
insured depository institutions.[^88]

In general, depository institutions are taxed under varying rules
depending on the structure of the institution. The revenue model applied
below assumes that, in the absence of an exemption, the appropriate
rules for taxing credit unions are those applicable to mutual thrifts
(*i.e.*, mutual savings associations, mutual savings banks, cooperative
banks, and domestic building and loan associations). Mutual thrifts are
the federally insured depository institutions most similar in structure
to credit unions, because like credit unions, mutual thrifts generally
do not have corporate stock, are not-for-profit entities, and are owned
by their depositors, or members, rather than by shareholders.

This chapter is organized as follows. Section I describes corporate
taxation generally. Section II describes the manner in which depository
institutions are taxed specifically. Section III relates the history of
the federal income tax exemption for credit unions. Section IV explains
the model used to estimate the revenue effect of taxing credit unions
like mutual thrifts. Because a critical assumption underlying our
revenue estimates is the forecasted growth rate for credit unions, two
series of revenue projections, using both higher and lower growth rates,
are presented.

**I. Taxation of Corporations**

Corporations are generally taxed under one of two sections of the
Internal Revenue Code: Subchapter C (rendering the corporation a "C"
corporation)[^89] and Subchapter S (rendering the corporation an "S"
corporation).[^90]

Most corporations, including depository institutions, are C
corporations.[^91] Under Subchapter C, income is taxed at both the
corporate level and at the shareholder level. Distributions of corporate
income, in the form of dividends, which have already been taxed at the
corporate level constitute taxable income at the individual level to
stockholders. At the corporate level, such entities are generally taxed
at a 35 percent tax rate on taxable income. To compute taxable income, a
C corporation deducts its business expenses, such as employee
compensation, depreciation, and interest paid. However, a deduction is
not allowed for dividends paid. When deductions exceed income, the
corporation has a net operating loss for the taxable year. Carryover
rules permit corporations to use the net operating loss to offset
taxable income in preceding or succeeding taxable years. In general, a
corporation can carry a net operating loss back two years and forward 20
years.[^92]

Some corporations may elect to be taxed under Subchapter S. Eligibility
criteria include, among other things, a requirement that an S
corporation have no more than 75 shareholders and that it not use the
reserve method of accounting for bad debts. Unlike C corporations, the
income of S corporations is allocated for tax purposes to shareholders
and then taxed at their applicable rates; the entity itself does not pay
federal income tax. Prior to 1997, depository institutions were
ineligible to elect S corporation status.

**II. Tax Treatment of Depository Institutions**

**A. General Provisions**

In addition to the rules applicable to corporations generally, special
rules apply to depository institutions.[^93] These special rules reflect
the fact that the income of depository institutions is primarily derived
from taking deposits and making loans. Thus, depository institutions,
unlike taxpayers generally, are allowed a bad debt deduction for
securities that become worthless.[^94] Similarly, sales or exchanges of
debt obligations held by a depository institution result in ordinary
income or loss, rather than capital gain or loss.[^95] Depository
institutions are also subject to a special *pro rata* allocation rule
for purposes of determining the amount of interest expense that is
nondeductible as an expense relating to tax-exempt interest income. With
very limited exceptions, a depository institution is not allowed a
deduction for interest expense allocable to tax-exempt obligations
acquired after August 7, 1986.[^96]

Special rules also apply to small depository institutions (those with
assets of \$500 million or less). In general, taxpayers are required to
use a specific charge-off method to account for bad debts. Under this
method, a deduction for a bad debt is allowed only when a loan becomes
wholly or partially worthless. Depository institutions (other than small
depository institutions) are required to use this method.[^97] Small
depository institutions, however, are permitted to use either the
specific charge-off method or the reserve method of accounting for bad
debts. Under the reserve method, a depository institution establishes a
reserve for bad debts, charges actual losses against the reserve, and is
allowed a deduction for annual additions to restore the reserve to its
proper balance. The reserve method thus allows loss deductions to be
taken before the year in which the loss actually occurs and can be
viewed as equivalent to an interest-free loan from the government to the
taxpayer in an amount equal to the reserve balance multiplied by the tax
rate.[^98]

A taxable depository institution that grows too large no longer
qualifies for the reserve method and must use the specific charge-off
method of accounting for bad debts. To prevent the duplication of
deductions, first as a reserve addition and then when the loan is
specifically charged off, the institution must recapture its existing
bad debt reserve (*i.e*., include the amount of the reserve in income)
unless it elects to use the "cut-off" method.[^99] A depository
institution that voluntarily changes its method of accounting to the
specific charge-off method (*e.g.*, so that it can become an S
corporation) must also recapture its existing bad debt reserve.[^100]

**B. Tax Treatment of Mutual Thrifts**

The tax treatment of a depository institution depends, in part, on
whether the institution is a stock or a mutual company. In a stock
company, the shareholders and the depositors are not necessarily the
same individuals. The equity of the corporation is derived from amounts
paid by shareholders to purchase stock from the corporation and from
earnings retained by the corporation, rather than distributed to
shareholders. In general, the corporation's net income is taxed at the
corporate level, whether it is retained or distributed to shareholders.
Income that is distributed to shareholders as dividends is also taxed at
the shareholder level.

In contrast, mutual corporations are owned by their depositors, and the
equity of a mutual corporation is derived solely from retained
earnings.[^101] Because depositors are the owners, payments to
depositors can include both interest and an equity return to depositors
in their role as owners. While depository institutions are generally
permitted to deduct interest paid on deposits, mutual thrifts are also
allowed a deduction for amounts paid or credited to their depositors as
dividends on their accounts, including amounts that represent an equity
return, if such amounts

may be withdrawn on demand subject only to customary notice of intention
to withdraw.[^102] These dividends, whether representing interest or a
return on equity, are thus taxed only at the depositor level. In effect,
mutual thrifts, unlike other taxable depository institutions, are taxed
only on retained earnings, and not on earnings distributed to owners.

**III. The History of Credit Unions' Tax Treatment**

The first credit unions that appeared in the United States at the
beginning of the previous century were state chartered. When the federal
income tax was first enacted, state chartered credit unions were not
specifically exempt. In 1917, however, an administrative ruling by the
U.S. Attorney General exempted these credit unions from federal income
taxation. The Attorney General ruled that the credit unions closely
resembled cooperative banks and similar institutions that Congress had
expressly exempted from taxation in 1913 and 1916.[^103]

Congress first established a federal charter for credit unions in
1934.[^104] However, that Act did not exempt federal credit unions from
the federal taxation of their income, although they were exempt under
the previous administrative ruling. A statutory exemption was not
provided until 1937.[^105] Two reasons were given for granting this
exemption: (1) that taxing credit unions on their shares, much as banks
are taxed on their capital shares, "places a disproportionate and
excessive burden on the credit unions" because credit union shares
function as deposits; and (2) that "credit unions are mutual or
cooperative organizations operated entirely by and for their members . .
. . " [^106] Thus, the tax exemption was based primarily on the
organizational form of credit unions and ensured consistent treatment
with federal thrift institutions, including mutual savings banks.

In 1951, thrift institutions lost their tax exemption, but the credit
union exemption was retained.[^107] The Senate report to the Revenue Act
of 1951 stated that mutual savings banks and savings and loan
associations were losing their tax exemption because they had evolved
into commercial bank competitors. In addition, thrifts had evolved from
mutual organizations to ones that operated in a similar manner to banks.
Finally, the exemption had given thrifts a competitive advantage over
taxable commercial banks and life insurance companies.

> At the present time, mutual savings banks are in active competition
> with commercial banks and life insurance companies for the public
> savings, and they compete with many types of taxable institutions in
> the security and real estate markets. As a result your committee
> believes that the continuance of the tax-free treatment now accorded
> mutual savings banks would be discriminatory.[^108]
>
> In the early days of \[savings and loan associations\], the
> transactions of the associations were confined to members, and no one
> could participate in the benefits they afforded without becoming a
> shareholder . . . The fact that the members were both the borrowers
> and the lenders was the essence of the "mutuality" of these
> organizations. Although many of the old forms have been preserved to
> the present day, few of the associations have retained the substance
> of their earlier mutuality . . . More and more, investing members are
> becoming simply depositors, while borrowing members find dealing with
> a savings and loan association only technically different from dealing
> with other mortgage lending institutions in which the lending group is
> distinct from the borrowing group . . . The grounds on which your
> committee's bill taxes savings and loan associations on their retained
> earnings . . . are the same as those on which mutual savings banks are
> taxed under the bill.[^109]

**IV. Estimating the Revenue Effects of Taxing Credit Unions**

**A. General Issues**

To evaluate the effect on federal revenues of applying the present tax
rules for mutual thrifts to credit unions, we developed a model to
forecast taxable credit union income for fiscal years 2000 through 2009.
The model is based upon a number of income and balance sheet items
available from the Call Reports database. These are then forecast into
the future, with their growth a function of certain macroeconomic
aggregates and the size, measured in assets, of each institution.
Assumptions concerning the behavior of relevant macroeconomic aggregates
are taken from the Administration's fiscal year 2000 budget
forecast.[^110]

Credit union consolidation is also addressed. Between 1992 and 1997, the
number of credit unions declined by an average of 2.7 percent. Our model
assumes that trends observed over this time period continue through
2009, and makes appropriate adjustment to the composition of the
industry with respect to asset base, income and other measures.

The exact response of credit unions to imposition of a corporate tax is
unclear. Our model therefore considers two alternate scenarios: A higher
growth rate assumes that credit unions can absorb the corporate income
tax without any effect on asset growth. A lower growth rate assumes that
credit unions will pay the tax out of their retained earnings on a
dollar-for-dollar basis, thereby reducing their available capital and
opportunity for growth.[^111] The two alternative rates thus serve as an
upper and lower bound on the model's estimation of credit union asset
growth in the absence of a tax exemption.

Credit unions are assumed to modify their behavior to lower their
taxable income without lowering their "true" income in order to reduce
their tax liability. For example, credit unions are assumed to alter
their investment portfolios to hold more tax-exempt securities in order
to lower their tax liability.

**B. Estimating the Revenue Derived from Taxing Credit Unions**

The estimated revenue raised by applying the federal corporate income
tax to credit unions, subject to a high and low asset growth rate, as
shown in Tables 3-1 and 3-2, respectively.

Under the high growth rate assumption, we estimated that taxing credit
unions would raise \$6.8 billion over a five-year period (fiscal years
2000 through 2004) and \$16.2 billion over a ten-year period (fiscal
years 2000 through 2009). The vast majority of the revenue raised would
come from larger credit unions. For example, Table 3-1 suggests that
credit unions with at least \$100 million in assets would account for
more than 75 percent of the revenue, while comprising just over 10
percent of the number of credit unions.

The estimated tax revenue from large credit unions increases relatively
more than for small credit unions over time, primarily because credit
unions with at least \$10 million in assets have higher growth rates.
This differential growth rate reflects historical patterns. As a result,
over time the income and assets of large credit unions, as well as their
number, increase faster than those of small credit unions. Moreover,
consolidation results in there being fewer small credit unions over
time. Finally, the total tax liability estimated includes the
alternative minimum tax which, because of exemptions for small
corporations, generally would affect only larger credit unions.

Similarly, the tables illustrate the revenue effects of exempting
smaller credit unions from the imposition of any federal corporate
income tax. For example, credit unions with less than \$10 million in
assets account for 2 percent of the revenue, although they comprise
roughly 50 percent of all credit unions. Using the tables, the revenue
effects of other potential thresholds may be determined.

[Table 3-1: Estimated Tax Revenue of Applying Mutual Thrift Tax Rules to
Credit Unions: High Growth Rate Assumption]{.underline}

(Dollar figures are in millions)

  ----------------- ----------- ------------ -------------- ----------- ------------ --------------
  Asset Size        Fiscal                                  Fiscal                   
  Category          Years                                   Years                    
                    2000 - 2004                             2000 - 2009              

                    Estimated                Estimated      Estimated                Estimated
                    Tax                      Percentage of  Tax                      Percentage of
                                             Average Number                          Average Number
                                             of                                      of
                                             Institutions                            Institutions

                    Amount      Percentage                  Amount      Percentage   

  Less than \$5     \$49        1%           38%            \$86        1%           35%
  million                                                                            

  \$5 - 10 million  \$89        1%           15%            \$163       1%           14%

  \$10 - 20 million \$186       3%           12%            \$329       2%           12%

  \$20 - 50 million \$630       9%           17%            \$1,281     8%           17%

  \$50 - 100        \$696       10%          8%             \$1,569     10%          10%
  million                                                                            

  \$100 - \$500     \$2,474     36%          9%             \$5,559     34%          11%
  million                                                                            

  Greater than      \$2,688     40%          2%             \$7,211     45%          2%
  \$500 million                                                                      

  Total             \$6,811     100%         100%           \$16,200    100%         100%
  ----------------- ----------- ------------ -------------- ----------- ------------ --------------

Source: Treasury estimates using Credit Union Call Report data obtained
from Sheshunoff Information Services *One Source*. *See* text for
information about the model and underlying assumption used to generate
these estimates.

Revenue estimates using the lower growth rate are shown in Table 3-2. In
this case, credit union tax revenues are estimated to be \$6.1 billion
between fiscal years 2000 and 2004, or approximately 10 percent less
than with the higher growth rate. For fiscal years 2000 to 2009 the
estimated tax revenue would be approximately \$13.7 billion, or 15
percent less than when using the higher growth forecast. The tax revenue
gap between the high and low growth scenarios widens over time because
the growth rate for large credit unions, which has a disproportionate
effect on overall industry growth rates, is approximately one-third less
than under the high growth rate scenario. As with the high growth rate
estimate, the vast majority of revenue raised comes from larger credit
unions.

[Table 3-2: Estimated Tax Revenue of Applying Mutual Thrift Tax Rules to
Credit Unions: Low Growth Rate Assumption]{.underline}

(Dollar figures are in millions)

  ----------------- ----------- ------------ -------------- ----------- ------------ --------------
  Asset Size        Fiscal                                  Fiscal                   
  Category          Years                                   Years                    
                    2000 - 2004                             2000 - 2009              

                    Estimated                Estimated      Estimated                Estimated
                    Tax                      Percentage of  Tax                      Percentage of
                                             Average Number                          Average Number
                                             of                                      of
                                             Institutions                            Institutions

                    Amount      Percentage                  Amount      Percentage   

  Less than \$5     \$49        1%           39%            \$89        1%           36%
  million                                                                            

  \$5 - 10 million  \$90        2%           15%            \$165       1%           14%

  \$10 - 20 million \$209       3%           14%            \$387       3%           13%

  \$20 - 50 million \$609       10%          16%            \$1,262     9%           17%

  \$50 - 100        \$662       11%          8%             \$1,418     10%          9%
  million                                                                            

  \$100 - \$500     \$2,236     37%          8%             \$4,989     36%          9%
  million                                                                            

  Greater than      \$2,222     37%          2%             \$5,410     39%          2%
  \$500 million                                                                      

  Total             \$6,078     100%         100%           \$13,719    100%         100%
  ----------------- ----------- ------------ -------------- ----------- ------------ --------------

Source: Treasury estimates using Credit Union Call Report data obtained
from Sheshunoff Information Services *One Source*. *See* text for
information about the model and underlying assumption used to generate
these estimates.

#### V. Conclusion

#### 

In laws enacted in 1913 and 1916, Congress expressly exempted mutual
thrifts from federal corporate income tax. Congress extended that
exemption to credit unions in 1937, although an administrative ruling in
1917 gave credit unions an effective exemption from taxation. In 1951,
Congress decided that mutual thrifts had evolved into direct competitors
with banks and removed the tax exemption in order to provide greater
competitive equity between banks and mutual thrifts.

If Congress decided to remove credit unions' tax exemption, credit
unions would receive the same treatment under the federal corporate
income tax code as do mutual thrifts. We estimate that removing the
exemption would raise between \$6.1 billion and \$6.8 billion over five
years, and between \$13.7 billion and \$16.2 billion over ten years.

### CHAPTER 4

#### Preserving the Growth and Viability

#### of Small Banks

Section 403 of the Credit Union Membership Access Act directed the
Treasury Department to submit a report to Congress containing:

-   recommendations, as the Secretary deems appropriate, that would
    reduce and simplify the tax burden (1) on insured depository
    institutions with less than \$1 billion in assets and (2) on banks
    with assets equal to or in excess of \$1 billion, but not greater
    than \$10 billion; and

-   any other recommendations that the Secretary deems appropriate that
    would preserve the growth and viability of small banks.[^112]

The Administration has, throughout its tenure, taken meaningful steps to
preserve the growth and viability of small banks. Its first efforts came
during the first weeks of the Administration and additional efforts
continue to this day. Many of these actions have reduced the regulatory
costs and improved the quality of bank regulation. We believe that we
have taken those actions best tailored to furthering these aims. Thus,
we recommend no new policy initiatives in this area at this time.

We highlight below some of the ways in which the Administration has
implemented policies that promote the growth and viability of small
banks, and then address issues surrounding the taxation of small
depository institutions under Subchapter S of the Internal Revenue Code.

###### I. Administration Accomplishments 

######### **A. The Credit Availability Program**

On March 10, 1993, shortly after taking office, the President unveiled
the Credit Availability Program (CAP), which created a better climate
for bank lending. At that time, the country was in the midst of a slow
economic recovery, and the CAP improved the availability of credit,
particularly to small- and medium-sized businesses, farms, and
low-income communities. Largely in place within 90 days of the
President's announcement, the CAP addressed: (1) real estate lending and
appraisals; (2) appeals of examination decisions and complaint handling;
and (3) examination processes and procedures.

At that time, some were concerned that costly formal appraisals may have
been rendering otherwise sound loans uneconomical. Three significant
changes resulted. First, the bank regulatory agencies increased from
\$100,000 to \$250,000 the threshold level at or below which certified
or licensed appraisals would not be required for a real estate-related
transaction. They identified additional circumstances, particularly for
small business lending, in which appraisals are not required. Finally,
they permitted renewals and refinancings without an appraisal if there
had been no deterioration in market conditions.

The agencies also revamped their appeals processes to ensure that
bankers had a fair and prompt review of examination disagreements. The
OCC and the OTS have each created an Office of Ombudsman, which manages
the appeals process. The OCC has also revamped its procedures for
handling the nearly 15,000 general complaints it receives annually. For
example, it has established a toll-free number and improved its
complaint tracking system.

Third, the regulators have begun to coordinate many of their
interactions with the industry. For example, they have determined that
examinations will be conducted by the primary federal regulator.
Moreover, the OCC and the FDIC share examination schedules to better
coordinate the supervision of holding companies with both national and
state-chartered banks, and coordinate enforcement actions.

**B. Streamlining Compliance with the Bank Secrecy Act**

Treasury and the federal banking regulators promulgate regulations to
implement the Bank Secrecy Act, which Congress passed to combat money
laundering. Proper enforcement requires adequate recordkeeping on the
part of financial institutions to support federal prosecutions of money
launderers. Working with a Bank Secrecy Act Advisory Group, composed of
30 representatives of financial institutions and federal and state
regulatory and enforcement officials, Treasury pared down the amount of
required recordkeeping. Treasury eliminated the requirement that
institutions record and retain for five years special records of all
cash purchases of travelers checks, bank checks, and cashier's checks
over \$3,000. Proposed regulations that would have required mandatory
electronic filing of currency transaction reports (CTRs), and would have
established a mandatory system to "aggregate" cash transactions, were
withdrawn. Treasury also streamlined by 30 percent the CTR, a form long
criticized as too cumbersome by bankers.

**C. A-to-Z Review of Regulations**

Pursuant to a Presidential directive, each regulatory agency within the
government undertook a line-by-line review of its regulations with the
goal of eliminating redundant and unnecessary requirements, streamlining
procedures, and rewriting rules to be more easily understood. The OCC
and OTS have both completed this review and are in the process of
putting their regulations into plain English.

There are concrete examples of the burden-reducing benefits resulting
from this intense review. The OCC and OTS reduced, by six times, the
number of lending limit calculations institutions must perform,
requiring quarterly, rather than daily, analyses. The OCC has also
reduced some of its fees and its national bank assessment rate, which
covers the cost of examination and supervision. For example, the fee for
establishing a shared automated teller machine has been reduced from
\$1,500 to zero, corporate application fees have been reduced by 50
percent, and the national bank assessment rate has been reduced by six
percent.

**D. Refocusing Supervision**

Our nation's thousands of depository institutions vary greatly in size,
complexity, and financial strength. Yet, regulations often ignore these
differences by treating all institutions alike, and relying on generally
applicable procedures. This provides institutions with little regulatory
incentive to reduce risk or increase their capacity to manage risk. It
also creates needless regulatory burden and costs when rules are
inappropriate, irrelevant, or even counterproductive as applied in
certain instances.

The OCC and OTS have been working diligently to make appropriate
differentiations in their regulations. For example, both bureaus have
streamlined the examinations process for smaller, well-capitalized,
well-managed institutions. Materials requested for noncomplex small
national bank examinations have been reduced by nearly 600 percent, from
some 200 items (or more at the examiner's discretion) to 35 standardized
items. Moreover, the streamlined nature of such examinations is
evidenced from the OCC small bank examination handbook, which has been
reduced from 1,216 pages to just over 30 pages. In addition, small,
well-capitalized, well-managed savings associations need no longer
automatically obtain a costly annual independent audit.

The difficulty of supervising a diverse banking industry has also led
regulators to focus on eliminating and streamlining procedures. The
Administration has worked to refocus supervision on results instead, and
to thereby provide institutions with the incentive to perform well,
rather than simply to avoid criticism or follow needless procedures. In
this vein, the OCC revised its examination guidelines to emphasize
operational results, such as default rates, rather than operational
procedures, such as loan underwriting.

**E. Streamlining CRA Rules**

Responding to complaints about how the CRA has been implemented over the
years, the President, in 1993, called on the federal banking agencies to
rewrite their CRA rules to stress performance, not paperwork. In 1995,
after one of the most comprehensive joint rule-making efforts the
regulators have ever conducted, the agencies promulgated final
regulations, culminating a lengthy process in which they sought and
obtained the input of thousands of interested parties, including banks,
savings associations, trade associations, customers, and community
groups. The regulators received over 6,700 comments in 1993 and over
7,200 in 1994. The new rules provide real incentives for depository
institutions to serve all our communities, and a streamlined,
straightforward process for assessing their success.

**F. Regulatory Burden Relief Legislation**

In 1996, the Administration worked with Congress on regulatory burden
relief legislation and supported the final passage of the Economic
Growth and Paperwork Reduction Act. The Act included nearly 300 pages of
regulatory burden relief legislation. Among other things, the 1996 Act
streamlined the home mortgage lending process and eliminated numerous
unnecessary regulatory requirements, such as eliminating the need to
file a branch application to establish an ATM.

G.  **Simplifying Small Bank Capital Standards**

Most recently, the federal banking agencies published an interagency
advance notice of proposed rulemaking that will lead to simplified
capital requirements for small banks.[^113] The purpose of the proposal
is to develop a simplified capital framework that will reduce the
regulatory burden on smaller non-complex banks and thrifts.

**II. Eligibility of Depository Institutions for Taxation Under
Subchapter S**

In general, U.S. tax law treats corporations and their investors as
separate taxable entities. Corporate earnings are taxed first at the
corporate level and again at the shareholder level, as dividends if the
corporation distributes earnings to shareholders, or as capital gains
from the sale of stock. In contrast, the earnings of S corporations are
taxed only once at the shareholder level, whether or not the income is
distributed. Corporations that elect Subchapter S status are subject to
certain restrictions on the number of shareholders and capital
structure. For example, an S corporation may not have more than 75
shareholders, all of whom must be U.S. resident individuals (except for
certain trusts and estates) and may issue only one class of stock. Prior
to 1996, banks and other depository institutions could not elect S
corporation status. A provision of the Small Business Job Protection Act
of 1996 repealed this prohibition.

By the end of 1999, more than 1,260 banks were operating as S
corporations. These institutions represent over 15 percent of U.S. banks
but only about 2 percent of banking assets, suggesting that smaller
institutions have been among the first to elect S corporation status.
This strong response by smaller banks suggests that Subchapter S offers
considerable advantages in terms of more favorable tax treatment and
lower compliance burdens.

In view of a continuing, and perhaps even accelerating, election of
Subchapter S status by small banks, additional modifications intended to
reduce or simplify the tax burden of smaller banks may be premature at
this time. In addition, they may raise tax policy concerns with respect
to their effect on S corporations in other industries and concerns about
their potential effect on the competitive position of all S
corporations, including small banks. If policy changes are considered,
however, they should satisfy two broad requirements:

First, any additional measures to simplify the tax treatment of small
banks must be crafted with a recognition that small businesses electing
Subchapter S status play a vital role in the U.S. economy, and that only
a small number of these firms are banks. In fact, banks and depository
institutions account for less than one percent of all entities electing
Subchapter S status. Thus, any changes to Subchapter S in order to
accommodate small banks must not complicate or otherwise disrupt the
broader effect of Subchapter S to benefit a small number of firms in one
specific industry.

In addition, proposed modifications to Subchapter S must be evaluated
with respect to potential effects on the competitive environment faced
by smaller banks. As noted above, the first firms to elect Subchapter S
treatment have been disproportionately smaller banks. The expressed
intent of the Small Business Job Protection Act of 1996 was to protect
the viability of such institutions; further modifications to Subchapter
S that would permit larger banks with greater access to capital to elect
simplified treatment may be inconsistent with this aim. Unfortunately,
some proposals offered in recent years are intended specifically to
facilitate the election of Subchapter S status by larger depository
institutions.

[^1]: Pub. L. No. 105-219, §§ 203, 401, and 403, 112 Stat. 913, 922 and
    934-935 (1998) (codified at 12 U.S.C. §§ 1752a note and 1757a note).

[^2]: For a thorough analysis of credit unions, their business
    operations, and how they compare to banks and thrifts as financial
    service providers, *see* U.S. Dept. of the Treasury, *Credit Unions*
    (Wash., DC: 1997), pp. 15-27. Congress directed the Treasury to
    conduct this study in section 2606 of the Economic Growth and
    Regulatory Paperwork Reduction Act of 1996. Pub. L. No. 104-208, §
    2606, 110 Stat. 3009-473 (Sept. 30, 1996) (codified at 12 U.S.C. §
    1752a note).

[^3]: 12 U.S.C. § 1787(k)(1).

[^4]: Sheshunoff Information Services, Inc., *BankSearch* (Austin, TX:
    2000). Note that this figure will overstate membership, because some
    people belong to more than one credit union.

[^5]: *Ibid.*

[^6]: ^?^ *Ibid.*

[^7]: 12 U.S.C. § 1752(1) (defining a federal credit union as "a
    cooperative association organized . . . for the purpose of promoting
    thrift among its members and creating a source of credit for
    provident or productive

    purposes . . . . "). Mutual thrifts are also owned by their
    depositors, but the other credit union characteristics do not
    necessarily apply to these depository institutions.

[^8]: ^?^ 12 U.S.C. § 1760.

[^9]: 12 C.F.R. § 544.1 (presenting the federal mutual charter, section
    6 of which provides that "each holder of an account shall be
    permitted to cast one vote for each \$100 . . . . "). Federal mutual
    institutions may set the number of votes per member anywhere from 1
    to 1,000. 12 C.F.R. § 544.2(b)(4).

[^10]: 12 U.S.C. § 1790d(b)(2)(B)(ii) (requiring credit union prompt
    corrective action regulations "to recognize that credit unions (as
    cooperatives that do not issue capital stock) initially have no net
    worth, and give new credit unions reasonable time to accumulate net
    worth . . . . "). This contrasts with banks and thrifts, which will
    be chartered only if they have sufficient capital with which to
    begin operations. 12 C.F.R. § 5.20(h)(4)(national banks);

    12 C.F.R. § 552.2-1(b)(3)(ii)(federal savings associations). Even
    federal mutual associations must have a minimum amount of capital
    with which to begin operations. 12 C.F.R. § 543.2(g)(2)(ii).

[^11]: *See* 12 U.S.C. § 1761. Nevertheless, federal credit unions do
    have the authority to permit a specified number of paid credit union
    employees to serve as directors. *See* NCUA, *The Federal Credit
    Union Bylaws*, art. VI, § 2. Also, some state chartered credit
    unions may have paid boards of directors.

[^12]: ^?^ 12 U.S.C. § 1759(b). Such requirements for state credit
    unions vary from state to state.

[^13]: 12 U.S.C. § 1759(b).

[^14]: NCUA, *Chartering and Field of Membership Manual* (Alexandria,
    VA: 1999), 63 Fed. Reg. 71,998 (Dec. 30, 1998), as amended, 65 Fed.
    Reg. 37,065 (Jun. 13, 2000).

[^15]: Treasury, *Credit Unions, op. cit.* footnote 2.

[^16]: ^?^ *Ibid.*, pp. 17-19.

[^17]: ^?^ *Ibid.*, pp. pp. 131-143.

[^18]: ^?^ State depository institution powers vary by state and will
    not be considered in this report. Moreover, a federally insured
    state bank (or its subsidiary) or savings association (or its
    subsidiary) may not engage in any activity impermissible for a
    national bank (or its subsidiary) unless the FDIC finds that it
    poses no significant risk to the appropriate deposit insurance fund
    and the institution complies with all applicable capital rules. 12
    U.S.C. § 1831a(a)(1)(state banks); 12 U.S.C. § 1831e(a)(state
    savings associations).

[^19]: ^?^ Treasury, *Credit Unions, op. cit.* footnote 2, p. 128.

[^20]: Treasury, *Credit Unions*, *op. cit.* footnote 2, pp. 82-83.

[^21]: ^?^ *Ibid.*

[^22]: ^?^ *Ibid.*

[^23]: ^?^ Pub. L. No. 105-219, 112 Stat. 913 (Aug. 7, 1998).

[^24]: For example, a credit union operating for more than four years
    and having at least \$500,000 in assets had to transfer annually 10
    percent of its gross income to a reserve account until that account
    reached 4 percent of outstanding loans and assets. Other credit
    unions had to transfer the same proportion of gross income until
    they reached 7.5 percent. At that point, their transfer requirement
    declined to 5 percent until the reserve reached 10 percent. 12
    U.S.C. § 1762 (repealed 1998).

[^25]: 12 C.F.R. § 6.4(b)(2)(iii) (OCC); 12 C.F.R. § 565.4(b)(2)(iii)
    (OTS); 12 C.F.R. § 325.103(b)(2)(iii) (FDIC); and 12 C.F.R. §
    208(b)(2)(iii) (FRB). Savings associations must meet capital
    requirements as stringent as those applicable to banks. 12 U.S.C. §
    1464(t)(1)(C).

[^26]: ^?^ 12 C.F.R. part 3, app. A (OCC); 12 C.F.R. part 325, app. A
    (FDIC); and 12 C.F.R. part 208, app. A (FRB). In the case of savings
    associations, Tier 1 capital also includes certain non-withdrawable
    accounts and pledged deposits. 12 C.F.R. part 567 (OTS).

[^27]: ^?^ 12 C.F.R. § 6.4(b)(2)(i) (OCC); 12 C.F.R. § 565.4(b)(2)(i)
    (OTS); 12 C.F.R. § 325.103(b)(2)(i) (FDIC); and 12 C.F.R. §
    208(b)(2)(i) (FRB). The risk-based capital requirements for savings
    associations may deviate from those applicable to national banks to
    account for interest rate risk or other risks, but any deviations
    may not result in materially lower levels of capital for savings
    associations. 12 U.S.C. § 1464(t)(2)(C).

[^28]: ^?^ 12 C.F.R. part 3, app. A (OCC); 12 C.F.R. part 325, app. A
    (FDIC); 12 C.F.R. part 208, app. A (FRB); and 12 C.F.R. part 567
    (OTS).

[^29]: ^?^ 12 U.S.C. § 1790d(c)(1)(B)(i).

[^30]: Treasury, *Credit Unions*, *op. cit.* footnote 2, pp. 58 and
    70-71.

[^31]: 12 U.S.C. § 1790d(d)(1).

[^32]: *Ibid.*

[^33]: 12 U.S.C. § 1790d(d)(2).

[^34]: ^?^ 12 U.S.C. § 1790d(c)(1)(B)(ii).

[^35]: ^?^ 12 C.F.R. part 3, app. A (OCC); 12 C.F.R. part 325, app. A
    (FDIC); 12 C.F.R. part 208, app. A (FRB); and 12 C.F.R. part 567
    (OTS).

[^36]: ^?^ William A. Lovett, *Banking and Financial Institutions Law*
    (St. Paul, MN: 1997), pp. 127-128.

[^37]: ^?^ 65 Fed. Reg. 44,950, 44,966 (Jul. 20, 2000) (to be codified
    at 12 C.F.R. part 702).

[^38]: Long-term real estate loans consists of all real estate loans and
    lines of credit−excluding member business loans−that will not
    reprice or mature within five years. 65 Fed. Reg. 44,966 (to be
    codified at 12 C.F.R. § 702.104(a)).

[^39]: ^?^ Low risk assets consist of cash on hand and the one percent
    deposit held by credit unions in the National Credit Union Share
    Insurance Fund. 65 Fed. Reg. 44,966 (to be codified at 12 C.F.R. §
    702.104(d)).

[^40]: ^?^ Average risk assets equals total assets minus the sum of
    long-term real estate loans, outstanding member business loans,
    investments, and low risk assets. 65 Fed. Reg. 44,966 (to be
    codified at 12 C.F.R. § 702.104(e)).

[^41]: *See* 65 Fed. Reg. 44,969 (to be codified at 12 C.F.R. §
    702.107).

[^42]: 65 Fed. Reg. 8,607 (Feb. 18, 2000). Net worth restoration plans
    will be codified at 12 C.F.R. § 702.206(e). The NCUA's approach
    relies in part on the standards applicable to low-income credit
    unions, which may accept uninsured secondary capital accounts that
    count towards meeting net worth requirements. Although CUMAA
    specifically permitted these credit unions to count such capital as
    net worth, it did not permit its use in any form by other credit
    unions.

[^43]: ^?^ 12 U.S.C. § 1790d(o)(2).

[^44]: ^?^ 12 U.S.C. § 1831o. Regulations implementing these statutory
    requirements can be found at 12 C.F.R. part 6 (OCC); 12 C.F.R. part
    325, subpart B (FDIC); 12 C.F.R. part 208, subpart D (FRB); and 12
    C.F.R. part 565 (OTS).

[^45]: ^?^ 12 U.S.C. § 18310(b)(1). Although created by statute, these
    terms are defined only in regulation. 12 C.F.R. § 6.4 (OCC); 12
    C.F.R. § 565.4 (OTS); 12 C.F.R. § 325.103 (FDIC); 12 C.F.R. § 208.43
    (FRB).

[^46]: 12 U.S.C. § 1831o(h)(3)(C)(i) (directing the regulator to appoint
    a receiver for an insured depository institution has remained
    "critically undercapitalized on average by the calendar quarter
    beginning 270 days after the date on which the institution became
    critically undercapitalized"). Subject to certain stringent
    restrictions, the FDIC and the critically undercapitalized
    institution's federal regulator may spare the institution from
    receivership if it "is viable and not expected to fail." 12 U.S.C. §
    1831o(h)(3)(C)(ii)(II).

[^47]: ^?^ Treasury, *Credit Unions*, *op. cit.* footnote 2, p. 76.

[^48]: ^?^ Pub. L. No. 105-219, § 301, 112 Stat. 913, 923-931 (codified
    at 12 U.S.C. § 1790d).

[^49]: ^?^ For example, CUMAA directed the NCUA to design a system of
    prompt corrective action "to take into account that credit unions
    are not-for-profit cooperatives that do not issue capital stock,
    must rely on retained earnings to build net worth, and have boards
    of directors that consist primarily of volunteers."

    12 U.S.C. § 1790d(b)(1)(B).

[^50]: CUMAA required the NCUA to "prescribe a system of prompt
    corrective action that shall apply to new credit unions in lieu of
    this section \[which must\] recognize that credit unions (as
    cooperatives that do not issue capital stock) initially have no net
    worth and give new credit unions reasonable time to accumulate net
    worth . . . . " 12 U.S.C. § 1790d(b)(2)(B).

[^51]: For example, the NCUA may, under certain conditions, decide not
    to liquidate a critically undercapitalized credit union, but it must
    revisit that decision every six months. 12 U.S.C. § 1790d(i)(2). In
    contrast, the other federal depository institution regulators must
    revisit such a decision every three months. 12 U.S.C. §
    1831o(h)(3)(B). The NCUA must generally liquidate a credit union
    that has remained critically undercapitalized on average during the
    calendar quarter beginning 18 months after the date on which the
    credit union initially became critically undercapitalized. 12 U.S.C.
    § 1790d(i)(3)(A). For the other federal regulators, the comparable
    time period is nine months. 12 U.S.C. § 1831o(h)(3)(C)(i).

[^52]: ^?^ 12 U.S.C. § 1790d(b)(1)(A)(ii).

[^53]: ^?^ [S. Rep. No.]{.smallcaps} 193, 105^th^ Cong., 2^nd^ Sess. p.
    12 (1998).

[^54]: 12 U.S.C. § 1790d(o)(4).

[^55]: ^?^ 65 Fed. Reg. 8,560 (Feb. 18, 2000).

[^56]: 12 U.S.C. § 1790d(o)(2).

[^57]: ^?^ 65 Fed. Reg. 8,560, 8,564 (Feb. 18, 2000).

[^58]: 12 U.S.C. § 1831m(a).

[^59]: ^?^ 12 C.F.R. part 363, implementing 12 U.S.C. § 1831m(d) and
    (g)(1).

[^60]: 12 C.F.R. § 562.4(b)(1).

[^61]: 12 U.S.C. § 1761b(5).

[^62]: 12 C.F.R. part 715, implementing 12 U.S.C. § 1761d.

[^63]: 12 C.F.R. § 702.3.

[^64]: Treasury, *Credit Unions,* *op. cit.* footnote 2, p. 80.

[^65]: ^?^ *See* 12 C.F.R. § 701.12(c)(2)(i) (superseded).

[^66]: ^?^ Treasury, *Credit Unions,* *op. cit.* footnote 2, p. 80.

[^67]: 12 U.S.C. § 1782(a)(6)(C)(i) and (iii).

[^68]: *Ibid*., § 1782(a)(6)(C)(ii)

[^69]: 12 U.S.C. § 1782(a)(6)(D)(i).

[^70]: 12 U.S.C. § 1782(a)(6)(D)(ii).

[^71]: 12 U.S.C. § 1759.

[^72]: 63 Fed. Reg. 71,998, 72,037 (Dec. 30, 1998).

[^73]: Federal credit unions may only invest up to one percent of their
    total paid in and unimpaired capital and surplus in CUSOs. 12 U.S.C.
    § 1757(7)(I).

[^74]: Federal credit unions are member-owned cooperatives. 12 U.S.C. §
    1752(1). Therefore, the FCUA refers to member deposits as member
    shares, whether the share represents a demand deposit, time deposit,
    or certificate of deposit. 12 U.S.C. § 1752(5).

[^75]: Federal credit union may use derivatives to manage the risk of
    loss through a decrease in value of its commitments to originate
    real estate loans at specified interest rates by entering into long
    put positions on securities issued by the Government National
    Mortgage Association, the Federal National Mortgage Corporation, and
    the Federal Home Loan Mortgage Corporation. 12 C.F.R. §
    701.21(i)(2).

[^76]: 12 C.F.R. § 34.43(a)(1) (national banks); 564.3(a)(1) (federal
    savings associations).

[^77]: 12 C.F.R. § 722.3(a)(1).

[^78]: *Ibid.*

[^79]: 12 C.F.R. § 34.43(a)(5)(i) (national banks); 12 C.F.R. §
    564.3(a)(5)(i) (federal savings associations).

[^80]: 12 U.S.C. § 1757(5)(A)(x); 12 C.F.R. § 701.21(c)(5).

[^81]: 12 U.S.C. § 1757(6).

[^82]: 12 C.F.R. § 701.21(c)(5).

[^83]: 12 U.S.C. § 84 (national banks); 12 U.S.C. § 1464(u) (federal
    savings associations). The following example illustrates how much
    greater the limit on loans to one borrower is for credit unions than
    for other depository institutions. Assume that a federal credit
    union and a national bank each have \$100 million in assets and \$8
    million in net worth (8 percent). The national bank's lending limit
    is 15 percent of \$8 million−or \$1.2 million. By contrast, a
    federal credit union's statutory lending limit is keyed to the sum
    of its deposits and its net worth, a sum roughly equaling the credit
    union's total assets. Thus, the credit union's lending limit is 10
    percent of approximately \$100 million−or \$10 million. The credit
    union therefore has a lending limit over eight times larger than
    that of the bank. Treasury, *Credit Unions,* *op. cit.* footnote 2,
    p. 65.

[^84]: Pub. L. No. 95-128, 91 Stat. 1111, 1147-48, title VIII (Oct. 12,
    1977) (codified at 12 U.S.C. § 2900 *et seq.*).

[^85]: 12 U.S.C. § 2902(2) (referring to the definition of "insured
    depository institution" in 12 U.S.C. § 1813(c)(2), which includes
    only those banks and thrifts insured by the FDIC).

[^86]: 65 Fed. Reg. 64,512 (Oct. 27, 2000).

[^87]: Pub. L. No. 105-219, 112 Stat. 913, 934-935 (Aug. 7, 1998).

[^88]: 26 U.S.C. § 501(c)(14)*.*

[^89]: 26 U.S.C. §§ 11,301-305*.*

[^90]: ^?^ 26 U.S.C. §§ 1361-1379.

[^91]: ^?^ Internal Revenue Service, Statistics of Income Division,
    *1997 Corporation Source Book,* Publication 1053 (March 2000).

[^92]: C corporations are also subject to the alternative minimum tax
    (AMT), which applies only if their minimum tax exceeds their regular
    tax liability. 26 U.S.C. § 55.

[^93]: 26 U.S.C. § 585.

[^94]: 26 U.S.C. § 582.

[^95]: 26 U.S.C. § 1221.

[^96]: 26 U.S.C. § 265.

[^97]: Under Treasury regulations, banks and other corporations subject
    to federal or state regulatory supervision may treat debts as
    worthless for tax purposes when they are treated as worthless for
    regulatory purposes. This often allows the losses to be recognized
    earlier than would be the case under generally applicable standards.
    For supporting analysis, *see* Dept. of the Treasury, *Report to The
    Congress on The Tax Treatment of Bad Debts by Financial
    Institutions* (Wash., DC: 1991).

[^98]: For a discussion of when reserves may lower taxes for financial
    institutions, *see* Treasury, *The Tax Treatment of Bad Debts*, *op.
    cit.* footnote 101.

[^99]: The recapture is generally spread over four years. In the first
    year, 10 percent of the reserve is recaptured unless the taxpayer
    chooses to recapture a higher percentage. The reserve remaining
    after the first year is recaptured 2/9ths in the second year, 3/9ths
    in the third year, and 4/9ths in the fourth year.

[^100]: ^?^ The recapture after a voluntary change is also generally
    spread over four years, but 25 percent of the reserve is recaptured
    in each year.

[^101]: As of June 30, 2000, there were 730 mutual savings institutions
    with \$141 billion in assets. Federal Deposit Insurance Corporation,
    *FDIC Quarterly Banking Profile Graph Book* (Wash., DC: second
    quarter 2000),

    p\. 45.

[^102]: 26 U.S.C. § 591.

[^103]: *See* General Accounting Office, *Credit Unions: Reforms for
    Ensuring Future Soundness* (Wash, DC: 1991) (providing a brief
    history of the tax exemption for credit unions).

[^104]: Federal Credit Union Act, Pub. L. No. 467, c. 750, 48 Stat. 1216
    (Jun. 26, 1934).

[^105]: Pub. L. No. 416, c. 3, § 4, 51 Stat. 4 (Dec. 6, 1937).

[^106]: [H.R. Rep. No.]{.smallcaps} 1579, 75^th^ Cong., 1^st^ Sess. p.
    2.

[^107]: Revenue Act of 1951, Pub. L. No. 183, § 313, 65 Stat. 490 (Oct.
    18, 1951).

[^108]: [S. Rep. No.]{.smallcaps} 781, 82^d^ Cong. 1^st^ Sess. 25.

[^109]: *Ibid.*, pp. 27-28.

[^110]: The model forecasts credit union tax revenues in two steps.
    First, the total assets for the entire credit union industry are
    projected into the future based on the Administration's forecast for
    the fiscal year 2000 Budget from February 1999. Based on this
    forecast, projected annual growth rates are generated and then
    adjusted to take into account historical differences in the growth
    of small and large credit unions. Because larger credit unions with
    assets in excess of \$10 million have been growing faster than
    smaller credit unions, the growth rate for large credit unions is
    adjusted upwards and the one for small credit unions downward.
    Second, to reflect the variation in income growth rates in the
    model, the previous year's net charge-offs are increased by the
    asset growth rate and then randomly adjusted to allow the net
    charge-off growth rate to be positive or negative.

[^111]: The assumption of efficient operation implies that credit unions
    may not obtain the funds necessary to pay federal income taxes on a
    given book of business simply by lowering their operating expenses.
    Instead, paying taxes would result in lower after-tax earnings,
    which would lower the rate at which credit unions retained earnings.
    Lower retained earnings, in turn, means that credit unions' net
    worth would grow more slowly, and hence credit unions could
    experience somewhat lower overall growth.

[^112]: Pub. L. No. 105-219, 112 Stat. 913, 935 (Aug. 7, 1998).

[^113]: 65 Fed. Reg. 66,193 (Nov. 3, 2000).