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entitled 'Credit Unions: Available Information Indicates No Compelling 
Need for Secondary Capital' which was released on September 07, 2004.

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Report to Congressional Requesters: 

August 2004: 

CREDIT UNIONS: 

Available Information Indicates No Compelling Need for Secondary 
Capital: 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-849]: 

GAO Highlights: 

Highlights of GAO-04-849, a report to congressional requesters

Why GAO Did This Study: 

Since the passage of the Credit Union Membership Access Act of 1998 
(CUMAA), many in the credit union industry have sought legislative 
changes to the net worth ratio central to prompt corrective action 
(PCA). The current debate centers on the issue of allowing federally 
insured credit unions to include additional forms of capital within the 
definition of net worth. In light of the issues surrounding the debate, 
GAO reviewed (1) the underlying concerns that have prompted the credit 
union industrys interest in making changes to the current capital 
requirements, (2) the issues associated with the potential use of 
secondary capital in all federally insured credit unions, and (3) the 
issues associated with the potential use of risk-based capital in all 
federally insured credit unions.

What GAO Found: 

The credit union industrys interest in making changes to the current 
capital requirements for credit unions appears to be driven by three 
primary concerns: (1) that restricting the definition of net worth 
solely to retained earnings could trigger PCA actions due to conditions 
beyond credit unions control; (2) that PCA in its present form acts as 
a restraint on credit union growth; and (3) that PCA tripwires, or 
triggers for corrective action, are too high given the conservative 
risk profile of most credit unions. Despite these concerns, available 
indicators suggest that the credit union industry has not been overly 
constrained as a result of the implementation of PCA. As a group, 
credit unions have maintained capital levels well above the level 
needed to be considered well-capitalized and have grown at rates 
exceeding those of other depository institutions during the three 
calendar years that PCA has been in place for credit unions.

Allowing credit unions to use secondary capital instruments to meet 
their regulatory net worth requirements would raise a number of issues 
and concerns, with perhaps the most important issue centering on who 
would purchase the secondary capital instruments. While outside 
investors would provide market discipline, this would raise concerns 
about the potential impact on the member-owned, cooperative structure 
of credit unions. Inside investors, however, could impose less 
discipline and raise systemic risk concerns if it resulted in a 
situation where weaker credit unions could bring down stronger credit 
unions due to secondary capital investments. Other issues relate to the 
specific form of the capital instruments for credit unions. The credit 
union industry itself appeared divided on the desirability or 
appropriate structure of secondary capital instruments.

Conceptually, the use of risk-based capital to address the concerns 
some in the credit union industry expressed about PCA is less 
controversial. Though two risk-based capital proposals were put 
forward, neither has garnered industry consensus and both lacked 
details of key components upon which to base any assessment of their 
merits. Risk-based capital is intended to reflect the unique risk 
profile of individual financial institutions; however, there are other 
factors that can affect an institutions financial condition that are 
not easily quantified. In recognition of the limitations of risk-based 
capital systems, bank and thrift regulators use leverage and risk-based 
capital requirements in tandem. GAO is aware that NCUA is constructing 
a more detailed risk-based capital proposal that incorporates both 
risk-based and leverage requirements; however due to the lack of 
formalized details, GAO could not perform a meaningful assessment of 
the proposal.

What GAO Recommends: 

GAO observes that the general favorable economic climate for credit 
unions experienced during the relatively short time that PCA has been 
in place for credit unions precluded sufficient testing of the current 
system of PCA and that additional time and greater experience are 
needed to determine what, if any, changes to PCA are warranted. In 
comments on this report, the National Credit Union Administration 
(NCUA) concurred that a case for introducing secondary capital has not 
been made but believed that adjustments to PCA were needed to make it 
more fully risk based.

www.gao.gov/cgi-bin/getrpt?GAO-04-849.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Richard J. Hillman at 
(202) 512-8678 or hillmanr@gao.gov.

[End of section]

Contents: 

Letter: 

Results in Brief: 

Background: 

Concerns about PCA Appear to Drive Industry Interest in Secondary 
Capital: 

Potential Use of Secondary Capital in the Credit Union Industry Poses 
Many Unanswered Questions: 

While Many View Risk-Based Capital as an Enhancement to PCA for Credit 
Unions, Key Structural Issues Remain Unresolved: 

Observations: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Definitions of Risk Portfolios and Weighted-Average Life 
of an Investment, and a Risk-Based Standard Calculation Example: 

Appendix III: Items in Use by NCUA in Developing Its Risk-Based Capital 
Proposal: 

Appendix IV: Comments from the National Credit Union Administration: 

Appendix V: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Acknowledgments: 
Tables: 

Table 1: Summary of PCA Capital Requirements for Credit Unions: 

Table 2: NAFCU Board's Seven Principles for a Viable Alternative Capital 
Model: 

Table 3: Risk Portfolios Defined: 

Table 4: Weighted-Average Life of Investments: 

Table 5: Example of the Standard Calculation of the Risk-Based Net Worth 
Requirement: 

Figures: 

Figure 1: Federally Insured Credit Unions' Total Shares, Total Assets, 
and Capital Ratios, 1994-2003: 

Figure 2: Asset Growth of Other Depository Institutions Compared with 
Credit Unions, 1994-2003: 

Figure 3: Summary of FDICIA Capital Categories and Ratio Requirements: 

Abbreviations: 

CEO: chief executive officer: 

CRA: Community Reinvestment Act: 

CUMAA: Credit Union Membership Access Act of 1998: 

CUNA: Credit Union National Association: 

FCUA: Federal Credit Union Act: 

FDIC: Federal Deposit Insurance Corporation: 

FDICIA: Federal Deposit Insurance Corporation Improvement Act of 1991: 

GAAP: generally accepted accounting principles: 

NAFCU: National Association of Federal Credit Unions: 

NASCUS: National Association of State Credit Union Supervisors: 

NCUA: National Credit Union Administration: 

NCUSIF: National Credit Union Share Insurance Fund: 

NWRP: Net Worth Restoration Plan: 

PCA: prompt corrective action: 

RBNW: risk-based net worth: 

ROAA: return on average assets: 

Treasury: Department of the Treasury: 

Letter August 6, 2004: 

The Honorable Michael G. Oxley: 
Chairman: 
The Honorable Barney Frank: 
Ranking Minority Member: 
Committee on Financial Services: 
House of Representatives: 

The Honorable Brad Sherman: 
House of Representatives: 

Credit unions, which have approximately 82 million members across the 
United States, historically have occupied a unique niche among 
depository institutions.[Footnote 1] Credit unions are member-owned 
cooperatives that are exempt from federal income taxes. They do not 
issue capital stock; rather, they are not-for-profit entities that 
build capital by retaining earnings. Recent debate about and support 
for changes to the existing capital requirements for credit unions--
which establishes the percentage of net worth to total assets that they 
must maintain--has raised concerns about potential safety and soundness 
implications. These implications derive from the many important 
purposes a depository institution's capital serves. From a regulatory 
perspective, capital acts as a buffer against unexpected operating 
losses or other adverse financial results. From a depository 
institution's perspective, capital serves as a basis to generate long-
term growth. Capital is also commonly viewed as a measure of financial 
strength.

Prior to 1998, the National Credit Union Administration (NCUA), which 
regulates federally chartered credit unions and certain aspects of 
federally insured state-chartered credit unions, did not impose any net 
worth requirement on federally insured credit unions.[Footnote 2] 
Instead, as noted by NCUA, Section 116 of the Federal Credit Union Act 
(FCUA) required credit unions to make a periodic reserve transfer until 
reserves reached 6 percent of risk-assets (10 percent for credit unions 
with under $5 million in assets). Then in 1998, the Credit Union 
Membership Access Act (CUMAA) established a capital-based supervisory 
framework called prompt corrective action (PCA) that requires NCUA to 
classify federally insured credit unions into five categories--well-
capitalized, adequately capitalized, undercapitalized, significantly 
undercapitalized, and critically undercapitalized--based on net-worth-
to-total-assets ratios. Under PCA, credit unions that are less than 
well-capitalized must take actions prescribed by statute and 
discretionary actions developed by NCUA based on the institutions' 
capitalization category.[Footnote 3]

Since the implementation of PCA for credit unions, some sectors of the 
credit union industry have been calling for changes to the capital 
requirements for credit unions. The changes called for generally 
include (1) amending the definition of net worth to include alternative 
forms of capital, such as unsecured subordinated debt instruments--
known as secondary capital instruments; (2) moving to risk-based 
capital standards; and (3) some combination of the changes discussed 
above.[Footnote 4]

As agreed, you asked us to describe (1) the underlying concerns that 
have prompted the credit union industry's interest in making changes to 
the current capital requirements, (2) the issues associated with the 
potential use of secondary capital in all federally insured credit 
unions, and (3) the issues associated with the potential use of risk-
based capital in all federally insured credit unions.

To identify and describe concerns regarding the current capital 
requirements for credit unions, we interviewed credit union industry 
groups, several credit union chief executive officers, credit union 
regulators and two banking regulators. Additionally, in these 
interviews we gathered information on the issues and concerns 
associated with the potential use of secondary capital and risk-based 
capital by credit unions. We also conducted a literature search to 
identify studies on the potential use of secondary capital by credit 
unions and spoke with academics and other industry observers. Appendix 
I provides additional details on our scope and methodology. We are 
aware that NCUA is constructing a more detailed risk-based capital 
proposal that incorporates both risk-based and leverage requirements; 
however due to the lack of formalized details, we could not perform a 
meaningful assessment of the proposal. We conducted our work in 
Washington, D.C., from November 2003 through July 2004 in accordance 
with generally accepted government auditing standards.

Results in Brief: 

The credit union industry's interest in making changes to the current 
capital requirements for credit unions appears to be driven by three 
primary concerns: (1) that restricting the definition of net worth 
solely to retained earnings could trigger PCA actions due to conditions 
beyond credit unions' control; (2) that PCA in its present form acts as 
a restraint on credit union growth; and (3) that PCA tripwires, or 
triggers for corrective action, are too high given the conservative 
risk profile of most credit unions. First, the argument most often 
advanced for allowing all federally insured credit unions to use 
additional forms of capital is that events such as a rapid inflow of 
funds, as occurred in recent years because of adverse conditions in 
investment markets, might result in otherwise well-managed credit 
unions experiencing a rate of share (deposit) growth that exceeds their 
ability to accumulate retained earnings. Consequently, this would 
decrease credit unions' net worth ratio and trigger PCA actions. 
However, we did not find evidence that the inflow of member share 
deposits resulted in widespread net worth problems for federally 
insured credit unions during the period that PCA has been in place. 
Second, some industry representatives have argued that PCA acts as a 
restraint on growth because credit unions are not able to retain 
earnings quickly enough to avoid a decline in net worth ratios during 
periods of sustained growth. While PCA is intended to curb aggressive 
growth, our analysis of credit union and bank data indicates that 
credit unions have been able to grow at a higher rate than banks during 
the 3 years that PCA has been in place for credit unions. Third, some 
industry representatives have also contended that PCA trigger points 
for credit unions are higher than for banks and thrifts despite the 
generally more conservative risk profile of credit unions. It should be 
noted that Congress established the capital standards to take into 
account that credit unions do not issue capital stock and must rely on 
retained earnings to build net worth, which necessarily takes time. 
Moreover, the Department of the Treasury (Treasury) stated that 
Congress established the leverage capital level 2 percentage points 
higher than banks and thrifts because 1 percent of a credit union's 
capital is deposited in the National Credit Union Share Insurance Fund 
(NCUSIF) and another 1 percent of the typical credit union's capital is 
invested in a corporate credit union.

The credit union industry itself has expressed widely divergent 
viewpoints on the desirability of additional forms of capital for all 
federally insured credit unions, with perhaps the most important issue 
centering on who would purchase the secondary capital instruments. 
Allowing investors outside of the credit union industry to hold the 
instruments would bring increased market discipline, but there are 
concerns that this would be more costly than the usual sources of funds 
and change the member-owned, cooperative nature of the credit union 
industry. Alternatively, allowing investors from within the industry 
may alleviate these concerns; however, in-system investors could impose 
less discipline than out-of-system investors, raising concerns about 
investor protection--adequacy of disclosure regarding the uninsured, 
subordinated status of the investment--and the potential that a weaker 
credit union could pull down a stronger one (systemic risk) because the 
investment of one credit union would be treated as the capital of 
another. Other concerns relate to the specific form of the capital 
instruments, and how they would be incorporated into the regulatory net 
worth requirement for credit unions. We could not identify proposals on 
the use of secondary capital by credit unions that were specific enough 
to facilitate our assessment of these key issues. While two types of 
specialized credit unions--low income and corporate--can currently use 
alternative capital instruments to meet their regulatory capital 
requirements, their experiences are too limited or unique for 
application to the bulk of the industry. One industry group, however, 
has developed a list of principles, or minimum set of criteria, to 
consider for any proposal.

A number of key structural issues regarding the potential use of risk-
based capital for all credit unions remain unresolved, including (1) 
the extent to which risk-based ratios would be used to augment, versus 
replace, the current PCA net worth (leverage) requirements; and (2) how 
key risk components and weights that are appropriate to the unique 
characteristics of credit unions would be defined. In contrast to most 
credit unions, all banks and thrifts are required to meet both a 
leverage ratio and a risk-based capital ratio in order to be 
"adequately capitalized." Bank and thrift regulators recognized the 
limitations of a solely risk-based capital requirement and continued 
the leverage requirements to address factors a risk-based ratio does 
not address but that can affect an institution's financial condition, 
such as liquidity and operational risks. Under CUMAA, the few credit 
unions that must meet risk-based net worth requirements are called 
"complex" credit unions, generally those with total assets at the end 
of a quarter exceeding $10 million and with a risk-based net worth 
calculation exceeding 6 percent; they represent approximately 8 percent 
of all federally insured credit unions as of December 2003. Though a 
credit union trade association has put forward two risk-based capital 
proposals, neither has garnered industry consensus. Moreover, each 
proposal lacked key components such as a clear definition of risk 
assets, risk weights, and asset classifications appropriate for credit 
unions. As a result, these proposals did not contain sufficient details 
upon which to assess their merits. In addition, NCUA officials told us 
they are developing, but have not yet finalized, a risk-based capital 
proposal to augment the current PCA for all credit unions that they 
believe acknowledges the unique nature of credit unions and 
incorporates the relevant and material risks credit unions face.

We provided a draft of this report to the Chairman of the National 
Credit Union Administration and the Secretary of the Treasury for 
review and comment. We received written comments from NCUA that are 
reprinted in appendix IV. NCUA agreed with this report's assessment 
that a case for secondary capital has not been made due to key 
unresolved issues and the lack of industry consensus on the need for 
and appropriate structure of secondary capital instruments. However, 
NCUA stated that its experience gained to date with the PCA system for 
federally insured credit unions indicates a need to make adjustments to 
better achieve its overall objectives. Specifically, NCUA stated that 
these adjustments should move PCA to a more fully risk-based system, 
with a lower leverage ratio (ratio of net worth to total assets). 
However, we believe that the generally favorable economic climate for 
credit unions experienced during the relatively short time that PCA has 
been in place for credit unions precluded sufficient testing of the 
current system of PCA for credit unions to determine if significant 
changes, such as that proposed by NCUA, are warranted. In addition, GAO 
believes that any proposal to move to a more risk-based system should 
provide for both risk-based and meaningful leverage capital 
requirements to work in tandem.

Background: 

The current U.S. bank risk-based capital regulations implement the 1988 
Basel Accord on risk-based capital.[Footnote 5] The Basel Accord 
established the widespread use of capital ratios that bank and thrift 
regulators could use as a starting point for assessing the financial 
condition--that is, safety and soundness--of internationally active 
banks and thrifts. In the United States, U.S. bank regulators applied 
the Basel Accord to all banks, rather than just internationally active 
ones. In 1991, GAO recommended a tripwire approach--incorporating 
capital and safety and soundness standards, or levels at which 
supervisory actions would be triggered--based on our findings that 
regulatory discretion and a common philosophy of trying to resolve the 
problems of troubled institutions informally and cooperatively resulted 
in enforcement actions that were neither timely nor forceful enough to 
prevent or minimize losses to the deposit insurance fund.[Footnote 6] 
Moreover, acting in response to the large number of bank and thrift 
failures in the late 1980s and early 1990s, Congress enacted the 
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), 
which included a capital-based regulatory structure known as 
PCA.[Footnote 7] Specifically, FDICIA categorizes depository 
institutions into five classifications on the basis of their capital 
levels and imposes increasingly more severe restrictions and 
supervisory actions as an institution's capital level deteriorates.

CUMAA required NCUA to adopt a system of PCA comparable with that of 
FDICIA for use on federally insured credit unions, which NCUA initially 
implemented in 2000.[Footnote 8] CUMAA defined the net worth ratio for 
PCA purposes as net worth to total assets.[Footnote 9] Under CUMAA, net 
worth is defined as the retained earnings balance of the credit union 
at quarter end, as determined under generally accepted accounting 
principles (GAAP).[Footnote 10] NCUA regulations provide four 
alternative methods that credit unions can use to calculate total 
assets for use in the net worth ratio: (1) average of quarter-end 
balances of the current and three preceding calendar quarters, (2) 
average of month-end balances over the three calendar months of the 
calendar quarter, (3) average daily balance over the calendar quarter, 
or (4) quarter-end balance of the calendar quarter as reported on the 
credit union's call report.[Footnote 11] NCUA regulations state that 
for each quarter, a credit union must elect a measure of total assets 
from these four alternatives to apply for all PCA purposes, except for 
the risk-based net worth requirement.[Footnote 12]

CUMAA prescribes three principal components of the PCA system for 
credit unions: (1) a comprehensive framework of actions, including 
actions prescribed by statute and discretionary actions to be developed 
by NCUA, for credit unions that are less than well-capitalized; (2) an 
alternative system of PCA to be developed for credit unions that NCUA 
defines as "new"; and (3) a risk-based net worth requirement to apply 
to credit unions that NCUA defines as "complex."[Footnote 13] Table 1 
summarizes the PCA capital requirements for regular and complex credit 
unions.

Table 1: Summary of PCA Capital Requirements for Credit Unions: 

PCA category: Well-capitalized; 
Net worth ratio for all credit unions (percent): > 7; 
Risk-based ratio for "complex" credit unions: And, > applicable risk-
based net worth (RBNW) requirement.

PCA category: Adequately capitalized; 
Net worth ratio for all credit unions (percent): 6 to 6.99; 
Risk-based ratio for "complex" credit unions: And, > applicable RBNW 
requirement.

PCA category: Undercapitalized; 
Net worth ratio for all credit unions (percent): 4 to 5.99; 
Risk-based ratio for "complex" credit unions: Or, < applicable RBNW 
requirement.

PCA category: Significantly undercapitalized; 
Net worth ratio for all credit unions (percent): 2 to 3.99, or less 
than 5 and fails to submit or implement a net worth restoration plan; 
Risk-based ratio for "complex" credit unions: Not applicable.

PCA category: Critically undercapitalized; 
Net worth ratio for all credit unions (percent): < 2; 
Risk-based ratio for "complex" credit unions: Not applicable. 

Source: NCUA Rules and Regulations, 12 C.F.R. 702.102.

[End of table]

CUMAA imposes up to four mandatory supervisory actions--an earnings 
transfer, submission of an acceptable net worth restoration plan, a 
restriction on asset growth, and a restriction on member business 
lending--depending on a credit union's capital classification, as 
determined by net worth ratios. Credit unions that are not well-
capitalized are required to take an earnings transfer.[Footnote 14] 
Credit unions that are undercapitalized, significantly 
undercapitalized, or critically undercapitalized are subject to all 
four actions. In addition, CUMAA requires NCUA to appoint a conservator 
or liquidation agent within 90 days of a credit union becoming 
critically undercapitalized unless the NCUA Board of Directors 
determines that other action would better achieve PCA's purpose. 
Pursuant to CUMAA, NCUA also developed discretionary supervisory 
actions, such as the dismissal of officers or directors of an 
undercapitalized credit union, to complement the prescribed actions 
under the PCA program.

While CUMAA required NCUA to implement a system of capital-based 
tripwires, capital-based safeguards of insurance funds are inherently 
limited because capital does not typically show a decline until an 
institution has experienced substantial deterioration in other 
components of its operations and finances. Deterioration in an 
institution's internal controls, asset quality, and earnings can occur 
years before capital is adversely affected. Financial regulators 
recognize that, though essential, a capital requirement is only one of 
a larger set of prudential tools used to protect customers and ensure 
the stability of financial markets they regulate. For depository 
institutions, the key or critical tool that financial regulators use to 
ensure the adequacy of an institution's capital levels and its safety 
and soundness is the on-site examination process.

Concerns about PCA Appear to Drive Industry Interest in Secondary 
Capital: 

The credit union industry's recent interest in using alternative forms 
of capital appears to be associated primarily with three concerns about 
PCA for credit unions. First, several credit union officials argued 
that secondary capital or other alternatives were needed, given 
concerns that credit unions might trigger PCA restrictions because of 
rapid inflows of deposits due to investors' "flight to safety"; 
however, we have not found widespread evidence to support these 
concerns. To assist credit unions that fall marginally below 
"adequately capitalized" primarily because asset growth has outstripped 
income growth, NCUA proposed the use of an abbreviated net worth 
restoration (NWRP) plan. According to an NCUA official, the proposed 
rule was not pursued further because it was considered too complicated, 
would only benefit a very small number of credit unions, and did not 
appear to provide material relief. Second, other credit union officials 
contended that PCA acts as a restraint on credit union growth. Our 
analysis of credit union and bank data indicates that credit unions 
have been growing faster than banks in the 3 years credit union PCA has 
been in effect. Finally, several credit union officials are concerned 
that the PCA tripwires for credit unions are too high, given the 
conservative risk profile of most credit unions. It should be noted 
that, according to Treasury, Congress established the capital level 2 
percentage points higher because 1 percent of a credit union's capital 
is deposited in NCUSIF and another 1 percent of the typical credit 
union's capital is invested in a corporate credit union.[Footnote 15]

"Flight to Safety" Raised Concerns about PCA, Although Net Worth Ratios 
Generally Remained above Well-Capitalized Levels: 

As investors sought high-quality (that is, safe) investments due to 
weak performance by the stock and other investment markets in the early 
2000s, credit unions experienced significant growth in member share 
deposits. Several credit union industry officials expressed concern 
that this inflow of new shares into credit unions might dilute net 
worth ratios, thus triggering net worth restoration plans and other 
supervisory actions under PCA.

To assist credit unions that fall marginally below "adequately 
capitalized" primarily because asset growth outstrips income growth, 
NCUA introduced the concept of an abbreviated NWRP in June 
2002.[Footnote 16] While no specific proposal was introduced, the NCUA 
board invited public comment on the concept of what was then referred 
to as "safe harbor" approval of a NWRP--that is, notice of certain 
criteria established by regulation that, when met, will ensure 
approval.

In November 2002, NCUA put forth a proposed rule and request for public 
comment on allowing the use of abbreviated NWRP--which NCUA referred to 
as a first-tier NWRP--by qualifying federally insured credit unions 
whose net worth ratio declined marginally below the adequately 
capitalized threshold (6 percent) because growth in assets outpaced 
growth in net worth.[Footnote 17] Under the proposal, a credit union 
would have been eligible to file an abbreviated NWRP if it satisfied 
three criteria: historical net worth, performance, and growth.[Footnote 
18]

There were three principal differences between the content requirement 
of a standard NWRP and the abbreviated NWRP proposed by NCUA. First, 
the proposed abbreviated NWRP would require only 4 quarters of pro 
forma projections of total assets, shares and deposits, and return on 
average assets, while the standard NWRP required complete pro forma 
financial statements covering a minimum of 2 years. Second, the 
abbreviated NWRP would not require a credit union to specify what steps 
it would take to meet its schedule of quarterly net worth targets, 
which is required for a standard NWRP. Finally, a standard NWRP 
requires those steps to extend beyond the term of the plan to ensure 
that the credit union remains at least adequately capitalized for 4 
consecutive quarters thereafter. In contrast, the proposed abbreviated 
NWRP did not address the credit union's net worth after the end of the 
term of the plan. NCUA's proposed rule also detailed the criteria for 
approval of the abbreviated NWRP and the circumstances in which a 
credit union that would otherwise be eligible to file an abbreviated 
NWRP would have been required to file a standard NWRP instead.

According to an NCUA official, the proposed rule was not pursued 
further because it was considered too complicated, would benefit only a 
very small number of credit unions, and did not appear it would provide 
material relief since some form of NWRP (albeit somewhat abbreviated) 
was still required by statute. NCUA officials stated that the credit 
union industry supported the proposal for an abbreviated NWRP but the 
credit union industry was advocating a proposal that would be 
automatically approved if it met a fixed set of objective criteria. 
However, NCUA officials explained that CUMAA requires a case-by-case 
determination by NCUA that a plan "is based on realistic assumptions 
and is likely to succeed in restoring the net worth of the credit 
union."

Although NCUA's proposal to assist certain credit unions that fall 
marginally below "adequately capitalized" was not pursued further, we 
found that despite a recent inflow of member share deposits, the credit 
union industry as a whole has been able to maintain net worth ratios 
well above the PCA threshold for well-capitalized credit unions. 
Moreover, current data suggest that the "flight to safety" may be over, 
as investors appear to be returning to the investment markets. Figure 1 
illustrates that during the period that PCA has been in place for 
credit unions (2001-2003), the net worth ratios for federally insured 
credit unions dropped somewhat initially but stabilized at the close of 
2003.

Figure 1: Federally Insured Credit Unions' Total Shares, Total Assets, 
and Capital Ratios, 1994-2003: 

[See PDF for image] 

[End of figure] 

Note: We analyzed the NCUA Form 5300 database, found at [Hyperlink, 
http://www.ncua.gov/data/FOIA/foia.html].

Groups such as the National Association of State Credit Union 
Supervisors (NASCUS) and several credit union chief executive officers 
(CEO) told us that that the combination of PCA requirements and 
members' flight to safety from the markets could force both fast-
growing credit unions and small to midsize credit unions to choose 
between (1) refusing deposits, (2) reducing services to members in 
order to retard the growth of assets, (3) converting to a savings and 
loan or community bank, or (4) merging with another credit union. While 
some of the larger credit union CEOs with whom we spoke stated that PCA 
is not causing capital constraints currently, they told us the 
potential exists for share growth to outstrip their ability to retain 
earnings, thus triggering net worth restoration plans and other 
supervisory actions under PCA. On the other hand, according to some 
CEOs of small and midsize credit unions, these constraints are 
affecting them currently. While the constraints noted above may have 
occurred to some extent in a limited number of credit unions, we did 
not find evidence of widespread net worth problems for federally 
insured credit unions during the period PCA has been in place. 
Moreover, as of December 2003, less than 3 percent of federally insured 
credit unions have reported a net worth ratio below the well-
capitalized threshold.

PCA Cited as a Restraint on Growth, Although Credit Unions Have Had 
Stronger Growth Rates Than Banks and Thrifts: 

Some credit union industry officials have indicated that the current 
credit union PCA system acts as a restraint on credit union growth, 
because any additional new member shares (deposits) would increase 
their assets and correspondingly reduce their net worth ratios. While 
most credit unions have been well-capitalized during the period that 
PCA has been in place, some industry officials have suggested that the 
capital constraints it imposes will become increasingly difficult to 
manage, forcing credit unions to turn away deposits so as not to dilute 
or decrease their net worth ratios. It should be noted that PCA was 
intended to curb aggressive growth, since uncontrolled growth was one 
of the common attributes of thrifts and banks that failed during the 
banking crisis of the late 1980s and early 1990s.

Credit union industry officials, including NCUA, have stated that some 
credit unions have had to reduce their services to members in an effort 
to satisfy PCA requirements. NCUA officials told us credit unions that 
have decreased services to their members have done so as part of net 
worth restoration plans. However, NCUA officials told us they would 
have no way of determining the number of credit unions considering 
decreasing services in an effort to prevent being subject to regulatory 
actions by NCUA. We have not found any evidence that federally insured 
credit unions are limiting their services to accommodate a rapidly 
growing deposit base. Moreover, active asset management is a major 
component of the operations of any financial institution. Credit union 
managers are expected to manage the growth of their institutions so 
that an influx of member deposits would not cause the credit union to 
become subject to PCA.

Despite the concerns about PCA acting as a constraint against asset 
growth, credit unions have grown at a higher rate than banks and 
thrifts during the period that PCA has been in place for credit unions 
(see fig. 2). This was particularly the case in 2001, the first full 
calendar year in which PCA was in place for credit unions. In that 
year, credit unions achieved an asset growth rate of more than 14 
percent, compared with an approximate growth rate of 6 percent for 
other depository institutions. The disparity in growth rates narrowed 
in 2002 and 2003.

Figure 2: Asset Growth of Other Depository Institutions Compared with 
Credit Unions, 1994-2003: 

[See PDF for image] 

[End of figure] 

Industry Has Contended That PCA Triggers Are Too High: 

The credit union industry has consistently criticized PCA triggers 
(that is, capital thresholds) as being too high. Some credit union 
officials have noted that PCA encourages credit union managers to hold 
more capital than is necessary, which does not allow them to maximize 
shareholder value. In addition, they said that PCA tripwires for credit 
unions are higher than those of banks and thrifts despite the more 
conservative risk profile of credit unions.

Banks and thrifts are required to meet two capital requirements in 
order to be adequately capitalized: (1) a minimum tier 1 leverage 
ratio--that is a minimum ratio of total capital to total assets, which 
is generally 4 percent of tier 1 capital; and (2) a risk-based capital 
ratio of 8 percent capital to risk-weighted assets.[Footnote 19] Under 
CUMAA's net worth requirements, federally insured credit unions must 
maintain at least 6 percent net worth to total assets to be considered 
adequately capitalized. This exceeds the 4 percent tier 1 leverage 
ratio applicable for banks and thrifts (and is statutory, as opposed to 
regulatory). In its 2001 report, Treasury stated that 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, 
Treasury stated that Congress established the capital level 2 
percentage points higher, a level recommended by Treasury in its 1997 
report on credit unions, because 1 percent of a credit union's capital 
is deposited in NCUSIF and another 1 percent of the typical credit 
union's capital is invested in a corporate credit union.[Footnote 20] 
Effective July 3, 2003, a federally insured credit union is allowed to 
invest up to 2 percent of its assets in any one corporate credit union 
and, in the aggregate, up to 4 percent of its assets in multiple 
corporate credit unions.[Footnote 21]

Potential Use of Secondary Capital in the Credit Union Industry Poses 
Many Unanswered Questions: 

Though some in the credit union industry seek use of alternative forms 
of capital, little information exists that would allow us to assess the 
implications of using these instruments. We found that the credit union 
industry lacks consensus on the desirability of these instruments, with 
one of the key issues in the current debate over secondary capital 
centered on who would purchase these instruments and their resulting 
impact on the unique nature of credit unions--member-owned, not-for-
profit cooperatives. Also, we could not identify a definitive proposal 
that specifically addressed other critical issues relating to the use 
of secondary capital instruments, such as pricing and market demand. 
While low income credit unions are allowed to use secondary capital 
instruments and corporate credit unions are allowed to use secondary 
capital instruments and count it toward their net worth requirements, 
their experiences are too narrow to offer insight into the value of 
such an instrument for all federally insured credit unions.[Footnote 
22] However, one industry group has developed a list of principles, or 
minimum set of criteria, to consider for any proposal.

Industry and Other Experts Disagree on the Merits of Using Secondary 
Capital: 

The credit union industry is divided on the merits and potential 
effects of using alternative capital. Credit union industry officials 
have expressed concerns that credit unions may find their rate of share 
(deposit) growth exceeding their ability to accumulate retained 
earnings, triggering net worth restoration plans and other supervisory 
actions under PCA. According to one trade association, the Credit Union 
National Association (CUNA), building net worth through earnings 
retention is a time-consuming process, and being able to use 
alternative capital instruments would allow a credit union to quickly 
build its capital levels. Additionally, some credit union officials 
believe that the current credit union capital system encourages 
managers to overcapitalize their credit unions (that is, hold excessive 
capital), which is not always the best alternative for financial 
institutions. Some officials have stated that secondary capital would 
allow credit union managers the flexibility to be more proactive in 
managing their capital.

One credit union CEO, whose institution is one of the largest federally 
insured credit unions, stated that three of the five largest federally 
chartered credit unions were against allowing credit unions to acquire 
secondary capital. He countered arguments for changing PCA by citing 
his credit union's experience with a dramatic influx in shares 2 years 
ago. He noted the influx did not trigger PCA because his institution's 
capital was aggressively managed. The CEO added that the dividends paid 
to the credit union's members, along with other services, were not 
limited or reduced as a result of this aggressive management. He 
explained that the excess capital (which was built over time through 
returns on investments at higher interest rates) in concert with 
diligent capital management kept the credit union from triggering PCA.

Industry Debate Centers around Key Issue of Outside Versus In-System 
Investors: 

Debate over secondary capital centers around who should be allowed to 
purchase these instruments. Some in the credit union industry argue 
that allowing outsiders to invest in the credit union industry would 
increase market discipline, but there are concerns that outside 
investment would be more costly and change the structure of the credit 
union industry. Opponents of secondary capital suggest that allowing 
voting, or even nonvoting, secondary capital from investors outside of 
the credit union industry would dilute the ownership structure of 
credit unions--not-for-profit, member-owned cooperatives. For example, 
one credit union CEO asserts that secondary capital would allow outside 
investors "a place at the table," whether the subordinated debt 
instruments carry voting or nonvoting rights. He explained that the 
outside investors could demand returns on investments through changes 
in interest rates or another form of return, or a right of first 
refusal if the credit union should ever adopt a for-profit model. Other 
credit union managers, including those in favor of secondary capital, 
told us that if done carelessly, secondary capital for credit unions 
could be disastrous; however, they will continue to promote the use of 
secondary capital provided it does not change the credit union's 
ownership rights.

To alleviate these concerns, others suggest allowing investors from 
within the industry (in-system investors). This approach, however, 
raises concerns about investor protection and other systemic risks. 
Moreover, in-system investors could impose less discipline than out-of-
system investors. According to one academic expert, the credit union 
industry is divided on the topic of alternative capital; the academic 
stated that at least 55 percent of credit unions want to avoid the 
capital markets, while the remainder would be more open to entering the 
capital markets and become increasingly banklike. He cautioned that 
alternative capital should not be used to sustain credit unions that 
were not already solvent. He explained that secondary capital from 
investors within the credit union system--that is, credit union members 
and other credit unions--might introduce systemic risk, wherein the 
risks of the issuing credit union were inherently spread to the credit 
union holding the debt instrument. For example, if Credit Union A 
purchased subordinated debt from Credit Union B and Credit Union B 
failed and was forced to liquidate its assets, Credit Union A would 
then be financially affected, possibly resulting in two failed credit 
unions.

Additionally, some officials in the credit union industry suggested 
that with appropriate disclosure, individual credit union members could 
invest in secondary capital instruments offered by credit unions. 
However, even with these disclosures (recognizing that alternative 
capital instruments are uninsured, nonvoting, and subordinated to other 
shares), it is possible that credit union members may not fully 
understand and appreciate the subordinated nature of their investments.

Industry Has Not Produced Detailed Proposals; Other Literature on 
Secondary Capital Also Limited: 

We identified one proposal and one academic study that suggest how 
secondary capital could be utilized by all federally insured credit 
unions; however, these lacked sufficient detail and did not address 
critical issues. Specifically, the proposal and academic study did not 
address the specific form of the capital instruments, criteria 
governing its issuance (including how it would be incorporated into the 
regulatory net worth requirement for credit unions), market viability 
and demand (including in-system or out-of-system investors), and 
pricing analysis to effectively discuss its potential benefits and 
implications. As a result of the lack of detail, we were unable to 
fully assess the issues associated with the potential use of secondary 
capital by all credit unions.

The secondary capital proposal--"Capital Notes"--was developed by the 
CUNA Mutual Group, a company that offers health insurance and financial 
services to credit unions. CUNA Mutual Group believes the Capital Notes 
program, slated for two phases, could help credit unions meet their 
capital needs. CUNA Mutual Group is piloting this secondary capital 
mechanism to low income credit unions, which are already permitted 
under NCUA regulations to count secondary capital toward their PCA 
requirements. The Capital Notes program allows low income credit unions 
to issue unrated subordinated debt in a private placement with flexible 
terms and rates.[Footnote 23] CUNA Mutual Group purchases the notes 
issued by the low income credit unions to hold in its investment 
portfolio.

According to CUNA Mutual Group, if the PCA definition of net worth is 
changed to include secondary capital, the subsequent planned phase of 
the Capital Notes program will allow all federally insured credit 
unions to issue unrated, unsecured notes that would be purchased by a 
trust. The trust would then go through a ratings process and issue its 
own notes that institutional investors such as corporate credit unions, 
CUNA Mutual Group, and other insurance companies could purchase. CUNA 
Mutual Group representatives stated that corporate credit unions would 
then purchase the highest-rated notes and CUNA Mutual Group, or other 
insurance companies, would most likely hold the lower-rated or first-
loss notes. According to CUNA Mutual Group, the advantages of its 
Capital Notes program are that it: 

* allows fast-growing and low-capitalized credit unions to secure 
additional needed capital;

* provides additional protection to NCUSIF, the share insurance fund;

* allows credit unions access to capital sources already available to 
other depository institutions, such as banks;

* maintains members' governance rights; and: 

* avoids potential abuses in sales of the notes by restricting 
purchasers to qualified (institutional) investors.

Because the Capital Notes program began its pilot phase in December 
2003, insufficient time has passed to allow for an assessment of the 
effectiveness of the program for low income credit unions. In addition, 
the motivation of secondary capital investors in low income credit 
unions is likely significantly different from that of investors in 
other federally insured credit unions. Consequently, the pricing 
analysis, market viability, and demand (in-system as well as out-of-
system) of the first phase of Capital Notes may not be applicable to 
the proposed second phase of the program.

We identified an academic study regarding the potential use of 
alternative capital instruments by credit unions.[Footnote 24] This 
study, issued by the Filene Research Institute and the Center for 
Credit Union Research, concluded that allowing credit unions to sell 
subordinated debt to parties outside of the credit union industry to 
meet their capital requirements could provide the following advantages: 

* In terms of market discipline, the higher interest costs associated 
with debt of riskier credit unions would reduce the temptation of 
excessive risk taking by credit union managers and would send a 
forward-looking signal to regulators if credit unions' risk taking 
increased.

* In terms of transparency and disclosure, marketing of subordinated 
debt, directly or via a pool arrangement, would require increased 
transparency and disclosure about the condition of credit unions.

* In terms of maintaining a larger cushion for the share insurance 
fund, the holders of subordinated debt would be compensated only after 
NCUSIF was fully compensated out of sales of existing assets, thereby 
reducing the risk to the insurance fund.

* In terms of increasing the incentives for prompt action by 
supervisors, holders of subordinated debt would encourage regulators to 
act promptly if credit unions became excessively risky or troubled.

However, while presenting a framework for using secondary capital, the 
authors of the study did not provide a specific proposal. In addition, 
they did not address market demand for secondary capital, pricing or 
the ultimate cost of these instruments to credit unions or assess the 
impact of the external subordinated debt holders on the member-owned 
and member-operated structure of credit unions.

Few Credit Unions Have Experience with Secondary Capital Instruments: 

NCUA first authorized the issuance of secondary capital instruments by 
low income credit unions in 1996.[Footnote 25] According to NCUA, it 
granted the authority in recognition of the special needs of these 
credit unions to raise capital from sources outside of their low income 
communities. Under NCUA regulations, credit unions with a low income 
designation can (1) receive nonnatural person, nonmember deposits that 
are not NCUSIF-insured; (2) offer uninsured secondary capital accounts 
and include these accounts on the credit union's balance sheet for 
accounting purposes; and (3) include these secondary capital accounts 
in the credit union's net worth for PCA purposes.[Footnote 26] However, 
investment in low income credit unions does not offer a template for 
the industry because the motivations of secondary capital investors in 
low income credit unions may be different from investors in other 
federally insured credit unions. For example, banks may obtain credit 
under the Community Reinvestment Act (CRA) for their investment in low 
income credit unions.[Footnote 27] In addition, many foundations and 
philanthropic organizations also are involved in providing secondary 
capital to low income credit unions in an effort to ensure that the 
credit unions are able to provide needed financial services to areas 
traditionally underserved by mainstream financial institutions.

Moreover, as of December 31, 2003, less than 6 percent of all low 
income credit unions had secondary capital accounts. Additionally, low 
income credit unions that had secondary capital accounts represented 
less than 1 percent of all federally insured credit unions. Thus, in 
addition to the different incentives for investment, the limited 
experience of low income credit unions with secondary capital 
instruments also provides little insight into the potential market 
demand and pricing of secondary capital instruments for all federally 
insured credit unions.

Corporate credit unions--whose members are credit unions, not 
individuals--also can issue forms of secondary capital.[Footnote 28] 
According to NCUA, corporate credit unions have been allowed to use 
secondary capital instruments to meet their regulatory capital 
requirements since 1992 in recognition that the ability of corporate 
credit unions to build capital is limited by the combined effects of 
(1) conservative investment standards imposed by NCUA and (2) the 
competitive markets in which corporate credit unions vie for credit 
unions' investment funds. Capital for corporate credit unions is 
defined as the sum of a corporate credit union's retained earnings, 
paid-in capital (both member and nonmember), and membership capital. 
NCUA refers to this paid-in capital and membership capital as corporate 
credit union secondary capital; among other things, these two types of 
capital are not insured by NCUSIF and are generally longer-term 
investments.[Footnote 29] As of December 31, 2003, 18 out of all 31 
corporate credit unions had member paid-in capital accounts, 30 out of 
31 had membership capital accounts, and none had nonmember paid-in 
capital accounts. However, taking into account that (1) corporate 
credit unions and natural person credit unions are not comparable given 
their member base, and (2) there are far fewer corporate credit unions 
compared with the total number of federally insured credit unions, 
those 18 corporate credit unions with member paid-in capital and 30 
with membership capital do not provide a representative or sufficient 
sample that can be used as a model to demonstrate how secondary capital 
could be used for all federally insured credit unions. Thus, the 
limited experience of corporate credit unions with member paid-in 
capital, coupled with the lack of experience with nonmember capital 
sources, provides little insight into the potential demand and pricing 
of secondary capital instruments for all federally insured credit 
unions.

Although the Credit Union Industry Lacks Consensus on Proposals, One 
Industry Group Has Developed a Set of Principles: 

The credit union industry as a whole has neither endorsed secondary 
capital nor put forth a specific secondary capital proposal; however, 
several officials with whom we spoke referred to the principles of the 
National Association of Federal Credit Unions (NAFCU) board for the 
development of a secondary capital instrument as a set of criteria to 
consider. Listed in table 2 are the NAFCU board's principles 
recommended for any secondary capital instrument designed for use by 
all federally insured credit unions.

Table 2: NAFCU Board's Seven Principles for a Viable Alternative 
Capital Model: 

1. Preserve the not-for-profit, mutual, member-owned and cooperative 
structure of credit unions and ensure that ownership interest 
(including influence) remains with the members.

2. Ensure that the capital structure of credit unions is not 
fundamentally changed and that the safety and soundness of the credit 
union community as a whole is preserved.

3. Provide a degree of permanence such that a sudden outflow of capital 
will not occur.

4. Allow for a feasible means to augment capital.

5. Provide a solution with market viability.

6. Ensure that any proposed solution applies for PCA purposes (to 
include risk-based capital as appropriate) or changes the definition of 
net worth to include other equity capital balances.

7. Ensure that any proposed solution qualifies as equity capital 
balances under GAAP; and qualifies as an amendment redefining net 
worth.

Source: NAFCU.

[End of table]

While we believe that this list incorporates key factors that should be 
considered for an alternative capital proposal, it should be noted that 
this is not an exhaustive list of all the possible concerns that may 
develop as a result of allowing all federally insured credit unions the 
use of alternative capital instruments. NAFCU officials told us that 
they have not been able to produce an alternative capital proposal that 
satisfies these seven principles because of some of the inherent 
tensions among the principles. For example, were alternative capital 
issued only within the credit union system, the number of investors 
would be more limited than if it were issued to the general public, 
suggesting that a viable alternative capital instrument should be 
issued in the markets--that is, outside of the credit union system. 
However, issuing alternative capital instruments outside of the credit 
union system may create another "class" of owners, thereby changing the 
nature of credit unions.

While Many View Risk-Based Capital as an Enhancement to PCA for Credit 
Unions, Key Structural Issues Remain Unresolved: 

The debate about the potential use of risk-based capital for all credit 
unions revolves around key structural issues, including (1) the extent 
to which risk-based ratios would be used to augment, versus replace, 
the current PCA net worth (leverage) requirements and (2) how key risk 
components and weights that are appropriate to the unique 
characteristics of credit unions would be defined. While all banks and 
thrifts are required to meet both a risk-based capital ratio and a 
leverage ratio to be classified as adequately capitalized, most credit 
unions are required to meet only one--a leverage ratio--to be 
classified as adequately capitalized. Bank and thrift regulators 
recognized the limitations of a solely risk-based capital requirement 
and continued the leverage requirements to address other factors that 
can affect a bank's financial condition, which a risk-based ratio does 
not address. NCUA has adopted a risk-based component of PCA; however, 
it affects only a small percentage of credit unions--those that meet 
NCUA's definition of "complex." Though a credit union trade association 
has put forward two risk-based capital proposals, neither has garnered 
industry consensus. Moreover, each proposal lacked details of key 
components upon which to base any assessment of their merits. NCUA 
officials told us they are developing, but have not yet finalized, a 
risk-based capital proposal to augment current PCA for all credit 
unions that they believe acknowledges the unique nature of credit 
unions and incorporates the relevant and material risks credit unions 
face.

Leverage Ratio Requirements Used to Augment Risk-Based Capital for All 
Banks and Thrifts: 

FDICIA requires all banks and thrifts to meet both a risk-based and a 
leverage requirement.[Footnote 30] Leverage ratios have been part of 
bank regulatory requirements since the 1980s. They were continued after 
the introduction of risk-based capital requirements as a cushion 
against risks not explicitly covered in the risk-based capital 
requirements. According to regulatory guidelines on capital adequacy, 
the final supervisory judgment of a bank's capital adequacy may differ 
from the conclusions that might be drawn solely from the risk-based 
capital ratio. Banking regulators recognized that the risk-based 
capital ratio does not incorporate other factors that can affect a 
bank's financial condition, such as interest-rate exposure, liquidity 
risks, the quality of loans and investments, and management's overall 
ability to monitor and control financial and operating risks.[Footnote 
31] FDICIA also requires bank regulators to monitor other risks, such 
as interest-rate and concentration risks.[Footnote 32]

FDICIA requires the federal bank and thrift regulators to establish 
criteria for classifying depository institutions into five capital 
categories: well-capitalized, adequately capitalized, 
undercapitalized, significantly undercapitalized, and critically 
undercapitalized. Figure 3 illustrates four capital categories and 
ratio requirements of FDICIA's PCA provisions.

Figure 3: Summary of FDICIA Capital Categories and Ratio Requirements: 

[See PDF for image] 

[A] The leverage ratio can be as low as 3 percent if the institution 
has a regulator-assigned composite rating of 1. Regulators are to 
assign a composite rating of 1 only to institutions considered to be 
sound in almost every respect of operations, condition, and 
performance.

[B] An institution cannot be considered to be well-capitalized if it is 
subject to a formal regulatory enforcement action that requires the 
institution to meet and maintain a specific capital level.

[End of figure] 

Although not shown in figure 3, a fourth ratio--tangible equity--is 
used to categorize an institution as critically 
undercapitalized.[Footnote 33] Any institution that has a 2 percent or 
less tangible equity ratio is considered critically undercapitalized, 
regardless of its other capital ratios. The amount of capital held by a 
bank is to be greater than or equal to the leverage ratio. However, if 
the risk-based capital calculation yields a higher capital requirement, 
the higher amount is the minimum level required.[Footnote 34]

Although U.S. bank risk-based capital guidelines address several types 
of risk, only credit and market risk are explicitly 
quantified.[Footnote 35] The quantified risk-based capital standard is 
defined in terms of a ratio of qualifying capital divided by risk-
weighted assets. All banks are required to calculate their credit risk 
for assets, such as loans and securities; and off-balance sheet items, 
such as derivatives or letters of credit.[Footnote 36] There are two 
qualifying capital components in the risk-based credit risk 
computation--core capital (tier 1) and supplementary capital (tier 2). 
In addition to credit risk, banks with significant market risk 
exposures are required to calculate a risk-based capital ratio that 
takes into account market risk in positions such as securities and 
derivatives in an institution's trading account and all foreign 
exchange and commodity positions, wherever they are located in the 
bank.[Footnote 37] The market-risk capital ratio augments the 
definitions of qualifying capital in the credit risk requirement by 
adding an additional capital component (tier 3). Tier 3 capital is 
unsecured, subordinated debt that is fully paid up, has an original 
maturity of at least 2 years, and is redeemable before maturity only 
with approval by the regulator. To be included in the definition of 
tier 3 capital, the subordinated debt must include a lock-in clause 
precluding payment of either interest or principal (even at maturity) 
if the payment would cause the issuing bank's risk-based capital ratio 
to fall or remain below the minimum requirement.

Current Risk-Based Component of PCA for Credit Unions Applies to Few 
Credit Unions: 

NCUA's PCA risk-based capital rule currently applies to relatively few 
credit unions--approximately 8 percent of all federally insured credit 
unions that were designated as "complex" as of December 31, 
2003.[Footnote 38] It should be noted that none of the five largest 
credit unions, and only one of the top 10 credit unions in terms of 
assets, met NCUA's definition of complex. CUMAA mandated a risk-based 
net worth requirement for "complex" credit unions, for which NCUA was 
required to formulate a definition according to the risk level of the 
credit union's portfolios of assets and liabilities.[Footnote 39] These 
credit unions are subject to an additional risk-based net worth 
requirement to compensate for material risks, against which a 6 percent 
net worth ratio may not provide adequate protection. Specifically, the 
risk-based net worth calculation measures the risk level of on-and off-
balance sheet items in the credit union's "risk portfolios."[Footnote 
40]

NCUA uses two methods to determine whether a complex credit union meets 
its risk-based net worth requirement: (1) a "standard calculation," 
which uses specific standard component amounts; and (2) a calculation 
using alternative component amounts.[Footnote 41] A credit union's 
risk-based net worth requirement is the sum of eight standard 
components, which include such items as unused member business loan 
commitments and allowance for loan and lease losses. Appendix II 
provides an example of the standard calculation of the risk-based net 
worth requirement, including the definitions of the risk portfolios and 
weighted average life for investments. Although not shown in appendix 
II, the alternative method of calculating the risk-based requirement 
involves weighting four of the risk portfolio components--long-term 
real estate loans, member business loans, investments, and loans sold 
with recourse--according to their remaining maturity, weighted average 
life, and weighted average recourse, respectively.[Footnote 42] In 
addition, the risk-based net worth requirement allows credit unions 
that succeed in demonstrating mitigation of interest-rate or credit 
risk to apply to NCUA for a risk mitigation credit. The credit, if 
approved, would reduce the risk-based net worth requirement a credit 
union must satisfy to remain classified as adequately capitalized or 
above. According to NCUA, between March 2002 and December 2003 there 
have been 38 credit unions that failed the standard risk-based net 
worth requirement, with two credit unions failing both the standard and 
alternative calculation requirements.[Footnote 43] In addition, toward 
the end of 2003 two credit unions submitted applications for a risk 
mitigation credit.

Existing Industry Proposals Lack Specificity and Consensus: 

The credit union officials with whom we spoke disagreed whether the 
current PCA system should be replaced or augmented by a risk-based PCA 
system. One credit union official--a recognized proponent of secondary 
capital--told us that risk-based capital should be used to augment, but 
not replace, the current leverage-based net worth capital requirements. 
Conversely, two industry groups told us that they see risk-based 
capital requirements serving as a complement to secondary capital, if 
it were allowed to be included as a component of net worth. Many credit 
union officials told us that current PCA is "one size fits all" but 
would not comment further on risk-based capital. In addition, NASCUS 
told us that it has recently endorsed the risk-based language in a 
House of Representatives bill, although it continues to support 
secondary capital for all credit unions.[Footnote 44] However, it 
should be noted that for most credit unions, risk-based assets are less 
than total assets; therefore, a given amount of capital would have a 
higher net worth ratio if risk-based assets were used. And capital 
requirements would likely be reduced if risk-based capital were an 
alternative, rather than a complement, to leverage ratios.

CUNA put forward two risk-based capital proposals that they believe (1) 
would preserve the requirement that regulators must take prompt and 
forceful supervisory actions against credit unions that become 
seriously undercapitalized and (2) would not encourage well-capitalized 
credit unions to establish such large buffers over minimum net worth 
requirements that they would become overcapitalized. However, both 
proposals lacked details of key components that would be needed in 
order to assess their merits. The first CUNA proposal does not provide 
a clear definition of risk assets. The second CUNA proposal does not 
provide specific risk weights and asset classifications appropriate for 
credit unions.

The first proposal would replace the current two-phased PCA system with 
a single system using risk-based and net worth ratio requirements for 
all credit unions.[Footnote 45] This system would incorporate NCUA's 
pre-CUMAA definition of risk assets--all loans not guaranteed by the 
federal government, and all investments with maturities over 5 years--
into the PCA system by modifying the current definition of net worth 
ratio.[Footnote 46] Specifically, the first proposal would lower the 
current net worth ratios for each PCA category to parallel the leverage 
ratio requirement for banks and thrifts and add a risk-based net worth 
ratio requirement using the existing PCA threshold levels for credit 
unions. For example, an adequately capitalized credit union would be 
defined as having a risk-based net worth ratio of 6 percent or greater 
and a net worth ratio of 4 percent or greater. Under this proposal, if 
a credit union's net worth ratio falls into different categories by 
risk and total assets, the lower classification would apply. The 
proposal stated that risk assets could be defined as nonguaranteed 
loans and long-term investments, or NCUA could be instructed to define 
risk assets in a manner consistent with its pre-CUMAA requirements.

The second proposal would incorporate components of both the Basel 
capital framework currently in use by banks and thrifts in the United 
States and the risk-based portion of the current credit union PCA 
applicable to complex credit unions. Specifically, this proposal states 
that net worth requirements could be based on risk weights for assets 
as in place for banks, but with the weights established on the basis of 
both credit and interest-rate risk. Under this proposal, the risk 
weights could be set by NCUA based on the Basel system.[Footnote 47] 
According to the second proposal, it is likely that NCUA could choose 
to adopt some credit-risk weights that are different from those 
currently in use by bank and thrift regulators under the Basel system 
because some of the weights would be assigned on the basis of interest-
rate risk. The proposed risk-based ratio requirements for each PCA 
category would parallel the current total risk-based requirement for 
banks and thrifts. In addition, this proposal states that a credit 
union could also be required to maintain a net worth ratio equivalent 
to the leverage ratio required for banks and thrifts. Similar to the 
first proposal, if a credit union's net worth ratio falls into 
different categories by risk and total assets, the lower classification 
would apply. For example, in order to be adequately capitalized under 
the second proposal, a credit union would have to have a risk-based 
ratio of 8 percent or greater and a net worth ratio of 4 percent or 
greater.

NCUA Suggests Using Risk-Based Capital Requirements for All Credit 
Unions: 

According to NCUA officials, NCUA envisions a risk-based PCA system 
similar in structure to that currently employed in the banking system. 
However, they stated that NCUA would tailor the risk weights and the 
categories into which assets fall, to take into consideration the 
unique nature of credit unions and the loss histories of their asset 
portfolios. In addition, the NCUA officials told us that a risk-based 
credit union PCA system should be designed to address all relevant and 
material risks (for example, interest-rate risk). According to these 
NCUA officials, the credit union PCA system should be robust enough so 
as not to be "one-size-fits-all," but simple enough to facilitate 
administration of the system and be well understood by credit unions. 
NCUA officials told us that they are in the process of developing a 
risk-based PCA proposal that would be used for all credit unions, not 
just complex credit unions. See appendix III for items being used in 
the development of NCUA's risk-based PCA proposal.

NCUA officials emphasized that the CUMAA mandate to take prompt 
corrective action to resolve problems at the least long-term cost to 
NCUSIF is good public policy and consistent with NCUA's fiduciary 
responsibility to the share insurance fund. However, they stated that 
they believe additional flexibility is needed to enable NCUA to work 
with problem institutions. They explained that the additional 
flexibility could be structured to constrain any tendency toward 
regulatory forbearance and preserve the objective of PCA. NCUA 
officials told us that they believe a revised system would alleviate 
most concerns that credit unions have with PCA. They believe changing 
the system would provide credit union management with the ability to 
manage compliance by making adjustments to their asset portfolios, 
maintain ample protection for the system and individual credit unions, 
and preserve NCUA's ability to address net worth problems. NCUA 
officials told us that such a system would likely obviate the need or 
desire for secondary capital for the vast majority of credit unions.

Observations: 

Despite concerns raised by some in the credit union industry, available 
information indicates no compelling need for using secondary capital 
instruments to bolster the net worth of credit unions, or to make other 
significant changes to PCA as it has been implemented for credit 
unions. Available indicators suggest that the credit union industry as 
a whole has not been overly constrained as a result of the 
implementation of PCA. Notably, credit unions were able to maintain 
capital levels well in excess of the PCA requirements during a period 
of rapid share or deposit growth. One of the inherent weaknesses in PCA 
is its focus on capital, which typically is a lagging indicator of a 
financial institution's health. As such, it will be important for NCUA 
to distinguish between capital deterioration that occurs because of 
fundamental weaknesses in the institution's structure or management 
versus temporary capital shortfalls due to constraints beyond a credit 
union's control. While we do not find the arguments for using secondary 
capital instruments to be compelling, to the extent that well-managed 
and -operated credit unions do experience temporary capital 
constraints, NCUA may want to revisit the concept of an abbreviated net 
worth restoration plan for marginally undercapitalized credit unions. 
Consideration of changes such as this seem to be more consistent with 
the notion that the problems some credit unions may be facing are 
temporary and, therefore, best tackled with temporary, not more 
permanent, solutions, such as secondary capital instruments.

Allowing credit unions to use secondary capital instruments to meet 
their regulatory net worth requirements would raise a number of issues 
and concerns. One of the key issues is who would be allowed to invest 
in the secondary capital instruments of credit unions. While allowing 
credit unions to sell secondary capital instruments to investors 
outside of the credit union industry would provide market discipline, 
this would raise concerns about the potential impact on the member-
owned, cooperative nature of credit unions. Some have proposed limiting 
potential investors to credit union members, other credit unions, and 
corporate credit unions; however, in-system investors could impose less 
discipline and raise systemic risk concerns if it were to create a 
situation where weaker credit unions brought down stronger credit 
unions due to secondary capital investments. Other issues relate to the 
specific form of the capital instruments, and how they would be 
incorporated into the regulatory net worth requirement for credit 
unions. The credit union industry itself appeared divided on the 
desirability or appropriate structure of secondary capital instruments.

Conceptually, the potential use of a risk-based capital system for all 
credit unions appears less controversial. Risk-based capital is 
intended to require institutions with riskier profiles to hold more 
capital than institutions with less risky profiles. However, not all of 
the risks that credit unions face, such as liquidity and operational 
risk, can be quantified. In recognition of the limitations of risk-
based capital systems, the bank and thrift regulators use both risk-
based and nonrisk weighted (leverage ratio) capital requirements for 
PCA purposes. The requirements are used in tandem to better ensure 
safety and soundness in banks and thrifts. Among the numerous issues 
that would need to be addressed in a risk-based capital proposal, given 
the unique nature of credit unions, would be the appropriate risk 
weights and categories into which assets fall and the appropriate risk-
based and nonrisk-based capital ratios for each PCA category. We are 
aware that NCUA is constructing a more detailed risk-based capital 
proposal that includes both risk-based and leverage requirements for 
all credit unions and believe that any proposal should be based on the 
premise that risk-based capital be used to augment, but not replace, 
the current net worth requirement for credit unions.

We remain a strong supporter of PCA as a regulatory tool. The system of 
PCA implemented for credit unions is comparable with the PCA system 
that bank and thrift regulators have used for over a decade. The 
concerns raised by the credit union industry appear to reflect the 
inherent tension between credit union managers' desire to maintain the 
optimal amount of capital to efficiently fuel growth and returns to 
credit union members and Congress's desire to protect the federal share 
insurance funds from losses that could have been prevented by early and 
forceful supervisory action. As we stated in our October 2003 report, 
credit unions have been subject to PCA for a short time, and the 
advantages and disadvantages of the current program are not yet 
evident. Additional time and greater experience with the use of PCA in 
the credit union industry would provide greater insight into the need 
for any significant changes to PCA as well as the best options for any 
changes.

Agency Comments and Our Evaluation: 

We provided a draft of this report to the Chairman of the National 
Credit Union Administration and the Secretary of the Treasury for 
review and comment. We received written comments from NCUA that are 
reprinted in appendix IV. In addition, we received technical comments 
from NCUA and Treasury that we incorporated into this report, as 
appropriate.

NCUA concurred with this report's assessment that there is no 
compelling need for secondary capital. For example, NCUA concurred that 
there are key unresolved issues, such as whether secondary capital 
instruments would be commercially viable, to whom these instruments 
could and should be sold (e.g. inside versus outside investors), the 
effects on the member-owned, cooperative structure of credit unions, 
and any safety and soundness and systemic risk implications posed by 
this activity. NCUA also concurred that there is a lack of consensus 
within the credit union system on the need for and appropriate 
structure of secondary capital instruments. Finally, NCUA stated that 
the vast majority of insured credit unions maintain extremely strong 
capital positions, notwithstanding a recent prolonged period of rapid 
share growth.

NCUA stated that it concurred with views expressed by many within the 
credit union industry that the current PCA tripwires were too high. 
NCUA disagreed with Treasury's rationale for the higher limit--1 
percent for the deposit in NCUSIF and another 1 percent for the typical 
credit union's capital invested in corporate credit unions--than that 
imposed on banks and thrifts. NCUA stated that under GAAP, which 
Congress mandated credit unions follow, the NCUSIF deposit is 
considered an asset on the financial statements of a credit union. 
Further, NCUA stated that the NCUSIF deposit is not related to a credit 
union's net worth from either an accounting or financial risk 
standpoint. In addition, NCUA noted that not all credit unions belong 
to corporate credit unions or hold this form of investment; therefore, 
using a "one size fits all" approach to trigger PCA supervisory actions 
based on this assumption is inherently unfair. Finally, NCUA stated 
that PCA tripwires are too high, penalizes institutions with 
conservative risk profiles, and allows higher risk earnings strategies 
without commensurate net worth levels. While we did not perform an 
evaluation of PCA, which would include a discussion of the thresholds, 
we note that the NCUSIF deposit is not liquid and, therefore, not 
immediately accessible for credit unions to use as a capital buffer. 
Though we agree that not all credit unions are engaged in corporate 
credit union investments, we believe that these investments are still 
relevant as a PCA consideration and any risk-based capital standards 
should appropriately recognize these investments.

NCUA stated that based on their experience gained to date with the PCA 
system for federally insured credit unions, adjustments are needed to 
better achieve PCA's overall objectives. Specifically, NCUA stated that 
the adjustments should move PCA to a more fully risk-based system, with 
a lower leverage ratio required of a credit union to meet the well-
capitalized levels. NCUA believes that a well-capitalized leverage 
requirement in the range of 5 percent would be more than sufficient to 
meet the safety and soundness goals of PCA. However, NCUA did not 
provide evidence that the current 7 percent net worth requirement has 
been a hardship to the credit union industry. As noted in this report, 
credit unions cannot quickly raise their capital through the issuance 
of capital stock when a financial need arises, they must rely on 
retained earnings to build sufficient capital--which necessarily takes 
time. Further, we believe that the generally favorable economic climate 
for credit unions coupled with the relatively short amount of time that 
PCA has been in place for credit unions do not provide a sufficient 
testing of the current system of PCA for credit unions to determine if 
changes are warranted.

NCUA stated that it recognized that, as our draft report indicated, the 
efficacy of a risk-based system is highly dependent on the details of 
the risk categories and weights, as well as the complementary 
relationship between the risk-based and leverage requirements. However, 
NCUA stated that the draft report suggested that a risk-based system 
would result in risk assets being lower than total assets for most 
credit unions, resulting in a given amount of capital producing a 
higher net worth ratio. NCUA stated that such a result was not a 
foregone conclusion. NCUA indicated that a proposal under consideration 
included risk categories with weights at and above 100 percent. The 
statement in the draft report was based on our discussion with 
representatives of the credit union industry. As we noted in our draft 
report, no detailed proposals regarding a risk-based system for all 
credit unions was available for our analysis, including that being 
developed by NCUA. In the absence of details, we cannot comment on the 
ultimate effect of a proposal that is in the process of being developed 
on the required capital levels for credit unions. However, we believe 
that, used in tandem with leverage capital requirements, any risk-based 
capital standards should appropriately recognize the risks credit 
unions face.

In response to the statement in our draft report that PCA was intended 
to act as a restraint on growth, NCUA stated that it was important to 
differentiate overly aggressive growth from robust growth, consistent 
with sound business strategy, experienced by healthy credit unions. 
While we agree that there are different types of growth, institutions 
still need to hold sufficient capital regardless of the type of growth 
experienced. As noted in this report, PCA was intended to curb 
aggressive growth, since uncontrolled growth was one of the common 
attributes of banks and thrifts that failed during the banking crisis 
of the late 1980s and early 1990s. Moreover, our analysis of aggregated 
credit union data indicated that credit unions have been able to 
maintain a rate of growth that has exceeded that of banks and thrifts 
in the three full calendar years that PCA has been in place for credit 
unions.

NCUA noted that our draft report suggested that NCUA revisit the 
concept of an abbreviated NWRP for marginally undercapitalized credit 
unions for situations involving temporary capital shortfalls. It noted 
that the statutory language of CUMAA precluded NCUA from providing any 
significant regulatory relief in this regard. NCUA stated that it 
supported a statutory change to provide NCUA the regulatory authority 
to waive the requirement to submit a NWRP for credit unions that have a 
temporary, marginal drop in their net worth ratio below adequately 
capitalized, as determined on a case-by-case basis. While NCUA put 
forth a proposed rule on an abbreviated NWRP, NCUA did not pursue it 
further. We believe it is important that NCUA explore and use all of 
the available options and discretion provided by CUMAA. While an 
abbreviated NWRP may not be viewed by NCUA or the industry as granting 
significant regulatory relief, the experiences gained with an 
abbreviated NWRP would provide NCUA and Congress with additional 
information regarding the need for additional regulatory authorities. 
Moreover, it is important to note that none of the federal bank or 
thrift regulators have similar authority to that being sought by NCUA.

As agreed with your offices, unless you publicly announce the contents 
of this report earlier, we plan no further distribution until 30 days 
from its issuance date. At that time, we will send copies of this 
report to the Chairman and Ranking Minority Member of the Senate 
Committee on Banking, Housing, and Urban Affairs. We also will send 
copies to the National Credit Union Administration and the Department 
of the Treasury and make copies available to others upon request. In 
addition, this report will be available at no charge on the GAO Web 
site at [Hyperlink, http://www.gao.gov].

This report was prepared under the direction of Harry Medina, Assistant 
Director. If you or your staffs have any further questions, please 
contact me at (202) 512-8678 or [Hyperlink, hillmanr@gao.gov], or 
Harry Medina, Assistant Director, at (415) 904-2220 or [Hyperlink, 
medinah@gao.gov]. Key contributors are acknowledged in appendix V.

Signed by: 

Richard J. Hillman: 
Director, Financial Markets and Community Investment: 

[End of section]

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

To identify and describe concerns regarding the current capital 
requirements for credit unions, we interviewed credit union industry 
groups, several credit union chief executive officers, credit union 
regulators, and two banking regulators. Additionally, through these 
interviews we gathered information on the issues and concerns 
associated with the potential use of secondary capital and risk-based 
capital by credit unions, including any documented proposals. We also 
conducted a literature search to identify studies on the potential use 
of secondary capital by credit unions and spoke with academics and 
other industry observers.

To illustrate credit union prompt corrective action (PCA) capital 
levels over time, we conducted research on PCA regulations and reviewed 
the National Credit Union Administration's (NCUA) Form 5300 (call 
report) database for 1994-2003 for federally insured, natural person 
credit unions. We reviewed NCUA-established procedures for verifying 
the accuracy of the Form 5300 database and found that the data 
constituting this database are verified on an annual basis, either 
during each credit union's examination, or through off-site 
supervision. We determined that the data were sufficiently reliable for 
the purposes of this report. In addition, we reviewed capital 
requirements of banks and thrifts for comparison with credit union 
capital requirements.

Credit unions have been subject to PCA programs for a short time, and 
the advantages and disadvantages of the current programs are not yet 
evident. As a result, we did not perform an evaluation or assessment of 
credit union PCA. We are aware that NCUA is constructing a more 
detailed risk-based capital proposal that incorporates both risk-based 
and leverage requirements; however, due to the lack of formalized 
details, we could not perform a meaningful assessment of the proposal. 
Given that none of the secondary capital or risk-based PCA proposals 
provided to us have garnered credit union industry consensus or contain 
sufficient details on which to base an assessment, we did not perform 
an evaluation of these proposals or an analysis of their potential 
benefits and implications.

We conducted our work in Washington, D.C., from November 2003 through 
July 2004 in accordance with generally accepted government auditing 
standards.

[End of section]

Appendix II: Definitions of Risk Portfolios and Weighted-Average Life 
of an Investment, and a Risk-Based Standard Calculation Example: 

Table 3: Risk Portfolios Defined: 

Risk portfolio: Long-term real estate loans; 
Assets, liabilities or contingent liabilities: Total real estate loans 
and real estate lines of credit (excluding member business loans) with 
a maturity (and next rate adjustment period if variable rate) greater 
than 5 years.

Risk portfolio: Member business loans outstanding; 
Assets, liabilities or contingent liabilities: Member business loans 
outstanding.

Risk portfolio: Investments; 
Assets, liabilities or contingent liabilities: As defined by federal 
regulation or applicable state law.

Risk portfolio: Low-risk assets; 
Assets, liabilities or contingent liabilities: Cash on hand and 
National Credit Union Share Insurance Fund (NCUSIF) deposit.

Risk portfolio: Average-risk assets; 
Assets, liabilities or contingent liabilities: 100 percent of total 
assets minus sum of risk portfolios above.

Risk portfolio: Loans sold with recourse; 
Assets, liabilities or contingent liabilities: Outstanding balance of 
loans sold or swapped with recourse, except for loans sold to the 
secondary mortgage market with a recourse period of 1 year or less.

Risk portfolio: Unused member business loan commitments; 
Assets, liabilities or contingent liabilities: Unused commitments for 
member business loans.

Risk portfolio: Allowance for loan and lease losses; 
Assets, liabilities or contingent liabilities: Allowance for loan and 
lease losses limited to equivalent of 1.50 percent of total loans.

Source: NCUA Rules and Regulations, 12 C.F.R. 702.104.

[End of table]

Table 4: Weighted-Average Life of Investments: 

Investment: Registered investment companies and collective investment 
funds; 
Weighted-average life: i. Registered investment companies and 
collective investment funds: As disclosed in prospectus or trust 
instrument, but if not disclosed, greater than 5 years, but less than 
or equal to 7 years; 
ii. Money market funds and short-term investment funds: 1 year or less.

Investment: Callable fixed-rate debt obligations and deposits; 
Weighted-average life: Period remaining to maturity date.

Investment: Variable-rate debt obligations and deposits; 
Weighted- average life: Period remaining to next adjustment date.

Investment: Capital in mixed-ownership government corporations and 
corporate credit unions; 
Weighted-average life: Greater than 1 year, but less than or equal to 
3 years.

Investment: Investments in credit union service organizations; 
Weighted-average life: Greater than 1 year, but less than or equal to 
3 years.

Investment: Other equity securities; 
Weighted-average life: Greater than 10 years. 

Source: NCUA Rules and Regulations, 12 C.F.R. 702.105.

[End of table]

Table 5: Example of the Standard Calculation of the Risk-Based Net 
Worth Requirement: 

Risk portfolio: Quarter-end total assets; 
Dollar balance: $200,000,000; 
Amount as a percentage of quarter-end total assets (percent): 100%.

Risk portfolio: Long-term real estate loans; 
Dollar balance: $60,000,000; 
Amount as a percentage of quarter-end total assets (percent): 30% = ; 
Standard component (percent): 2.20%; 

Risk portfolio: Long-term real estate loans; Threshold amount: 0 to 25 
percent; 
Amount as a percentage of quarter-end total assets (percent): 25%; 
Risk weighting: 0.06; 
Amount times risk weighting (percent): 1.5%; 

Risk portfolio: Long-term real estate loans; Excess amount: over 25 
percent; 
Amount as a percentage of quarter-end total assets (percent): 5%; 
Risk weighting: 0.14; 
Amount times risk weighting (percent): 0.7%; 

Risk portfolio: Member business loans outstanding; 
Dollar balance: $35,000,000; 
Amount as a percentage of quarter-end total assets (percent): 17.5% =; 
Standard component (percent): 1.10%.

Risk portfolio: Member business loans outstanding; Threshold amount: 0 
to 15 percent; 
Amount as a percentage of quarter-end total assets (percent): 15%; 
Risk weighting: 0.06; 
Amount times risk weighting (percent): 0.9%; 

Risk portfolio: Member business loans outstanding; Intermediate tier: 
> 15 to 25 percent; 
Amount as a percentage of quarter-end total assets (percent): 2.5%; 
Risk weighting: 0.08; 
Amount times risk weighting (percent): 0.2%; 

Risk portfolio: Member business loans outstanding; Excess amount: over 
25 percent; 
Amount as a percentage of quarter-end total assets (percent): 0%; 
Risk weighting: 0.14; 
Amount times risk weighting (percent): 0%; 

Risk portfolio: Investments; 
Dollar balance: $50,000,000 =; 
Amount as a percentage of quarter-end total assets (percent): 25% =; 
Standard component (percent): 1.51%.

Risk portfolio: Investments; Weighted-average life: 0 to 1 year; 
Dollar balance: $24,000,000; 
Amount as a percentage of quarter-end total assets (percent): 12%; 
Risk weighting: 0.03; 
Amount times risk weighting (percent): 0.36%; 

Risk portfolio: Investments; Weighted-average life: > 1 year to 3 
years; 
Dollar balance: $15,000,000; 
Amount as a percentage of quarter-end total assets (percent): 7.5%; 
Risk weighting: 0.06; 
Amount times risk weighting (percent): 0.45%; 

Risk portfolio: Investments; Weighted-average life: >3 years to 10 
years; 
Dollar balance: $10,000,000; 
Amount as a percentage of quarter-end total assets (percent): 5%; 
Risk weighting: 0.12; 
Amount times risk weighting (percent): 0.6%; 

Risk portfolio: Investments; Weighted-average life: > 10 years; 
Dollar balance: $1,000,000; 
Amount as a percentage of quarter-end total assets (percent): 0.5%; 
Risk weighting: 0.20; 
Amount times risk weighting (percent): 0.1%; 

Risk portfolio: Low-risk assets; 
Dollar balance: $4,000,000; 
Amount as a percentage of quarter-end total assets (percent): 2%; 
Risk weighting: 0.00; 
Standard component (percent): 0%.

Risk portfolio: Sum of risk portfolios above; 
Dollar balance: $149,000,000; 
Amount as a percentage of quarter-end total assets (percent): 74.5%.

Risk portfolio: Average-risk assets; 
Dollar balance: $51,000,000; 
Amount as a percentage of quarter-end total assets (percent): 25.5%; 
Risk weighting: 0.06; 
Standard component (percent): 1.53%.

Risk portfolio: Loans sold with recourse; 
Dollar balance: $40,000,000; 
Amount as a percentage of quarter-end total assets (percent): 20%; 
Risk weighting: 0.06; 
Standard component (percent): 1.20%.

Risk portfolio: Unused member business loan commitments; 
Dollar balance: $5,000,000; 
Amount as a percentage of quarter-end total assets (percent): 2.5%; 
Risk weighting: 0.06; 
Standard component (percent): 0.15%.

Risk portfolio: Allowance for loan and lease losses; 
Dollar balance: $2,040,000; 
Amount as a percentage of quarter-end total assets (percent): 1.02%; 
Risk weighting: (1.00); 
Standard component (percent): (1.02)%.

Risk portfolio: Sum of standard components: 
Standard component (percent): 6.67%.

Source: NCUA Rules and Regulations, 12 C.F.R. 702, App. A.

[End of table]

[End of section]

Appendix III: Items in Use by NCUA in Developing Its Risk-Based Capital 
Proposal: 

While NCUA has not finalized its risk-based PCA proposal for all credit 
unions, NCUA officials provided us items being used in the development 
of their risk-based PCA proposal: [Footnote 48]

* NCUA supports a statutorily mandated PCA system, with a minimum core 
leverage requirement (hard floor of 2 percent of total assets for 
critically undercapitalized); a statutory definition of net worth (with 
ability through regulation to reduce what qualifies as net worth, not 
increase it); and statutory thresholds based on risk assets defined by 
NCUA for the various net worth categories. NCUA also believes it should 
be provided with the authority to set the remaining elements of the 
risk-based PCA system by regulation.

* With the exception of being able to set by regulation a minimum level 
of net worth in relation to total assets (for example, 4 percent or 5 
percent, tied to the credit union's CAMEL rating) to be considered 
adequately capitalized, NCUA believes the current thresholds (but in 
relation to risk assets) are acceptable and best left established by 
statute.[Footnote 49] However, NCUA wants to keep the parity provision 
in the current statute, which provides the authority to change the 
thresholds by regulation, commensurate with any changes to the banks' 
PCA thresholds.[Footnote 50]

* With regard to the net worth ratio numerator, NCUA also supports a 
statutory definition for net worth, but the current definition should 
be expanded beyond retained earnings under generally accepted 
accounting principles (GAAP). NCUA believes a better definition of net 
worth is equity of the credit union as determined under GAAP and as 
authorized by the NCUA board. NCUA believes this would provide the NCUA 
board with the authority through regulation to subtract from net worth 
balance sheet items (such as goodwill that have no value in the event 
of a payout) the NCUA board deems appropriate. Additionally, NCUA 
believes that this definition preserves the requirement to comply with 
GAAP and limits statutorily what can be included in net worth, while 
providing NCUA with the flexibility to reduce assets that count toward 
net worth for PCA purposes but that do not have value to the insurance 
fund.

* With regard to the net worth ratio denominator, NCUA advocates having 
the regulatory flexibility to set the risk weights for assets and 
adjust them, as it deems appropriate.

* In cases where there is a marginal drop in net worth below adequately 
capitalized, NCUA advocates having the regulatory flexibility to 
temporarily waive a credit union's requirement to submit a net worth 
restoration plan if: (a) the credit union is CAMEL-rated 1 or 2 with a 
net worth ratio in the range of 5 percent to 7 percent, (b) the credit 
union's book of business does not present a safety and soundness issue, 
and (c) the credit union's assets are well managed. In addition, NCUA 
desires the regulatory flexibility to revisit the credit union after a 
specified time to determine if the temporary waiver is still 
appropriate and, if not, require the credit union to submit a net worth 
restoration plan. NCUA believes that this would reduce the burden 
placed on credit unions experiencing a small, temporary decline in the 
net worth ratio due to circumstances such as unsolicited, robust share 
growth that do not pose a safety and soundness concern. Further, NCUA 
believes such a provision would still provide NCUA with adequate 
authority to address any concerns on a case-by-case basis.

[End of section]

Appendix IV: Comments from the National Credit Union Administration: 
National Credit Union Administration:

Office of the Chairman:

July 9, 2004:

Richard J. Hillman, Director:
Financial Markets and Community Investment: 
United States General Accounting Office: 
Washington, D.C.

Re: Draft GAO Report 04-849:

Dear Mr. Hillman:

Thank you for the opportunity to review and comment on the General 
Accounting Office's (GAO) draft report entitled Credit Unions - 
Available Information Indicates No Compelling Need for Secondary 
Capital (the report). On behalf of the National Credit Union 
Administration (NCUA), I would like to express our appreciation for the 
professionalism exhibited by your staff and your careful consideration 
of this important matter.

As the report discusses, questions surrounding the appropriateness of 
authorizing all federally insured credit unions to use secondary 
capital to meet prompt corrective action (PCA) requirements are 
numerous and complex. We agree with your conclusion that there are key 
unresolved issues, such as whether or not secondary capital instruments 
would be commercially viable, to whom these instruments could and 
should be sold (e.g., inside versus outside investors), the effects on 
the member-owned cooperative structure of credit unions, and any safety 
and soundness and systemic risk implications posed by this activity. We 
also agree that there is a lack of consensus within the credit union 
system on the need for and appropriate structure of secondary capital 
instruments. In view of these considerations and the fact that the vast 
majority of insured credit unions maintain extremely strong capital 
positions notwithstanding a recent prolonged period of rapid share 
growth, at this time we accept your conclusion that a case for 
secondary capital has not been made. We fully expect that there will be 
continued debate and study of this issue within the credit union 
system.

The report does, however, discuss what we believe are valid concerns 
with the PCA system established by the Credit Union Membership Access 
Act (CUMAA). NCUA strongly believes the statutory mandate to take 
prompt corrective action to resolve problems at the least long-term 
cost to the National Credit Union Share Insurance Fund (NCUSIF) is 
sound public policy consistent with NCUA's fiduciary responsibility to 
the NCUSIF. However, now that we have gained experience with a PCA 
structure for federally insured credit unions we believe there is a 
need to make adjustments to better achieve its overall objectives.

These adjustments should move PCA to a more fully risk-based system, 
with a lower leverage ratio (ratio of net worth to total assets) 
required of a credit union to meet the "well-capitalized" level. In 
view of the conservative nature of credit unions (driven by their 
cooperative, member-owned structure), the comparatively low loss 
history of the credit union system, and the fact that our experience 
indicates that the great majority of credit unions manage their net 
worth to a level higher than the leverage requirement, we believe a 
"well-capitalized" leverage requirement in the range of 5% would be 
more than sufficient to meet the safety and soundness goals of PCA. 
Some additional details of the risk-based system that we envision are 
discussed below.

The report notes that PCA is intended to act as a restraint on growth 
that outpaces a credit union's ability to generate commensurate 
earnings, especially aggressive growth strategies that have a high 
correlation to problems in financial institutions. However, it is 
important to differentiate overly aggressive growth from robust growth, 
consistent with sound business strategy, experienced by healthy credit 
unions.

When a credit union experiences safe but strong growth that in the 
short term exceeds the ability of a prudent earnings strategy to fund 
net worth at the same pace, NCUA believes the key factor is how the 
credit union invests these funds. Page 17 of the report states "credit 
union managers are expected to manage the growth of their institutions 
so that an influx of member deposits would not cause the credit union 
to become subject to PCA." However, the current "one-size-fits-all" PCA 
system does not permit this, short of turning away deposits after 
dividend rates have been reduced to below market rates. Under a risk-
based system with a lower leverage requirement, credit unions would 
have greater ability to manage compliance by shifting investment 
strategies from longer-term, higher credit risk assets to shorter-term, 
lower credit risk assets resulting in the need to hold less capital on 
these safer assets with lower risk weights. This would provide credit 
unions with the ability to manage compliance with PCA by also managing 
the asset side of the balance sheet.

NCUA also believes that having the ability to waive the requirement for 
a net worth restoration plan (NWRP) under certain circumstances would 
help address the growth issue. The report suggests NCUA revisit the 
concept of an abbreviated NWRP for marginally undercapitalized credit 
unions for situations involving temporary capital shortfalls. We 
considered this initial proposal carefully. However, the statutory 
language of CUMAA precludes NCUA from providing any significant relief 
to credit unions in this regard. Thus, we support a statutory change to 
provide NCUA the regulatory authority to waive the requirement to 
submit a NWRP for credit unions that have a temporary, marginal drop in 
their net worth ratio below "adequately capitalized", as determined on 
a case-by-case basis.

NCUA concurs with the views expressed by many within the credit union 
industry that the PCA tripwires are too high. The current system's high 
leverage requirement, coupled with the underlying psychological factors 
driving credit union officials to have a cushion above the PCA 
requirements, creates a "one-size-fits-all" PCA system. This has the 
effect of penalizing institutions with conservative risk profiles. At 
the same time, it allows higher risk earnings 
strategies without commensurate net worth levels. A well designed risk-
based system with lower leverage requirements would more closely relate 
required capital levels with the risk profile of the institution and 
allow for better utilization of capital.

The report repeats the Department of Treasury's contention that 
Congress determined that a 2% higher limit than that imposed on banks 
and thrifts was necessary due to the 1 % deposit in the NCUSIF and 
another 1 % of the typical credit union's capital invested in corporate 
credit unions. NCUA respectfully disagrees with this rationale.

Under GAAP, which Congress mandated credit unions follow, the NCUSIF 
deposit is considered an asset on the financial statements of a credit 
union. Further supporting its treatment as a credit union asset, it has 
been NCUA's long standing practice to return this deposit when a credit 
union exits federally insured status or converts to another form of 
financial institution. These funds are also available to absorb losses 
in the event of a liquidation or purchase and assumption of a failed 
credit union. The NCUSIF deposit is not related to a credit union's net 
worth from either an accounting or financial risk standpoint. It would 
take a highly improbable massive systemic event to trigger a write-off 
of the NCUSIF deposit and recapitalization of the insurance fund. 
Further, if the NCUSIF equity ratio declines below 1.2%, CUMAA mandates 
that NCUA charge an insurance premium to restore the fund to at least 
1.2%.

Regarding natural person credit unions' investment in capital 
instruments of corporate credit unions, the report acknowledges that 
this was factored into the higher limit because the typical credit 
union holds this form of investment. We note that not all credit unions 
belong to corporate credit unions or hold this form of investment. 
Therefore, using a "one-size-fits-all" approach to trigger PCA 
supervisory actions based on this assumption is inherently unfair. We 
believe natural person credit unions' investments in capital 
instruments of corporate credit unions is best addressed by factoring 
any individual institution's at-risk investments in corporate credit 
unions into a risk-based PCA system.

We recognize, as the report indicates, the efficacy of a risk-based 
system is highly dependent on the details of the risk categories and 
weights, as well as the complementary relationship between the risk-
based and leverage requirements. The report suggests a risk-based 
system will result in risk assets being lower than total assets for 
most credit unions, resulting in a given amount of capital producing a 
higher net worth ratio. In fact, a proposal under consideration 
includes risk categories with weights at and above 100%. Thus, it is 
not a foregone conclusion that the risk-based portion of the PCA system 
would result in significantly lower required capital levels.

We agree with the report's assertion that not all risks that credit 
unions face can be quantified. Thus, although we are still working on 
the details, we envision a risk-based capital structure that works in 
tandem with a leverage component. This can be illustrated as follows:

Figure 1: Example of Possible Parameters for a Risk-Based Capital 
Requirement in Tandem with a Leverage Requirement for Credit Unions:

[See PDF for image]

[End of table]

We appreciate the inability of GAO and others to comment further on 
NCUA's proposal for a more risk-based PCA system until it is fully 
developed. We look forward to the continued dialogue on this issue with 
all parties sharing our common interest in the continued safety and 
soundness of the credit union system. Thank you again for the 
opportunity to comment on the draft report. If you have any questions 
or need further information, please feel free to contact NCUA Executive 
Director J. Leonard Skiles at (703) 518-6321.

Sincerely,

Signed by: 

JoAnn M. Johnson: 
Chairman: 

[End of section]

Appendix V: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Richard J. Hillman, (202) 512-8678 Harry Medina, (415) 904-2220: 

Acknowledgments: 

In addition to those named above, Heather T. Dignan, Landis L. Lindsey, 
Kimberly A. Mcgatlin, Carl M. Ramirez, Barbara M. Roesmann, Paul G. 
Thompson, John H. Treanor, and Richard J. Vagnoni made key 
contributions to this report.

(250168): 

FOOTNOTES

[1] In this report, we use "credit union" to refer to federally 
insured, natural person credit unions--those institutions with a 
membership consisting of individuals. As of December 2003, there were 
9,369 federally insured, natural person credit unions. In contrast, 
corporate credit unions have a membership consisting of other credit 
unions. As of December 2003, there were 31 corporate credit unions. 

[2] Like banks, federally insured credit unions can be federally 
chartered or state chartered. NCUA has oversight authority for 
federally chartered credit unions and requires its credit unions to 
obtain federal share (deposit) insurance, through the National Credit 
Union Share Insurance Fund (NCUSIF), which it administers. 
Additionally, most state-chartered credit unions also have federal 
insurance. Approximately 98 percent of credit unions are federally 
insured. 

[3] See Pub. L. No. 105-219 301 (1998), as amended, 12 U.S.C. 1790d 
(2000 & Supp. 2004). These actions are set forth in NCUA's regulations 
12 C.F.R. Part 702, Subpart B (2004).

[4] Subordinated debt is debt that is either unsecured or has a lower 
priority than that of another debt claim on the same asset. 
Subordinated debt instruments are not backed or guaranteed by the 
federal deposit or share insurance funds.

[5] The document referred to as the Basel Accord is entitled 
"International Convergence of Capital Measurement and Capital 
Standards, Basel Committee on Banking Supervision" (Basel, Switzerland: 
July 1988).

[6] U.S. General Accounting Office, Bank Supervision: Prompt and 
Forceful Regulatory Actions Needed, GAO/GGD-91-69 (Washington, D.C.: 
Apr. 15, 1991).

[7] Pub. L. No. 102-242 131(a), 12 U.S.C. 1831o, as amended.

[8] Pub. L. No. 105-219, Title III (1998), codified at 12 U.S.C. 1790d 
(2000 & 2003 Supp.). The NCUA's initial implementing regulations were 
published at 65 Fed. Reg. 8560 (Feb. 18, 2000).

[9] 12 U.S.C. 1790d(o)(3).

[10] Retained earnings consists of undivided earnings, regular 
reserves, and any other appropriations designated by management or 
regulatory authorities. This means that only undivided earnings and 
appropriations of undivided earnings are included in net worth. As 
discussed elsewhere in this report, CUMAA defines "net worth" for low 
income credit unions to include uninsured, subordinate capital 
accounts. 12 U.S.C. 1790d(o)(2)(B).

[11] 12 C.F.R. 702.2(k)(1) (2004). Call reports are submitted by 
credit unions to NCUA and contain data on a credit union's financial 
condition and other operating statistics.

[12] 12 C.F.R. 702.2(k)(2).

[13] NCUA regulations define a "new" credit union as one that has been 
in operation for less than 10 years and has less than $10 million in 
total assets. 12 C.F.R. 702.301 (2004). Because of the relatively 
small number of "new" credit unions, this report does not focus on 
them. NCUA defines a credit union as "complex" when its total assets at 
the end of a quarter exceed $10 million and its risk-based net worth 
calculation exceeds 6 percent net worth. 12 C.F.R. 702.103 (2004).

[14] An earnings transfer means that a federally insured credit union 
must increase the dollar amount of its net worth quarterly either in 
the current quarter, or on average over the current and three preceding 
quarters, by an amount equivalent to at least 0.1 percent of its total 
assets, and must quarterly transfer that amount (or more by choice) 
from undivided earnings to its regular reserve account until it is 
''well-capitalized.'' See 12 C.F.R. 702.201(a) (2004).

[15] Department of the Treasury, Comparing Credit Unions with Other 
Depository Institutions (Washington, D.C., January 2001).

[16] See 67 Fed. Reg. 38431 (June 4 2002).

[17] See 67 Fed. Reg. 71113 (Nov. 29, 2002).

[18] The historical net worth criterion had two parts: (1) a credit 
union would need a minimum net worth ratio of 5.50 percent as measured 
using the quarter-end balance of total assets. If there was an 
applicable RBNW requirement, the credit union's net worth ratio could 
not be more than 50 basis points (0.50 percent) below the RBNW 
requirement; and (2) for each of the 3 prior quarters, a credit union 
would need to have achieved a net worth ratio of at least 6 percent. In 
contrast to measuring current quarter net worth by quarter-end total 
assets in (1) above, for each of the three prior quarters a credit 
union could elect among any of the four methods of calculating the 
total assets denominator of the net worth ratio. If that credit union 
were subject to a RBNW requirement, it would also need to have met that 
requirement in each of the 3 prior quarters. For the performance 
criterion, NCUA proposed that for the current and each of the 3 
preceding quarters, a credit union would need to have increased the 
dollar amount of its net worth by a 60 basis point (0.60 percent) 
annual return on average assets (ROAA). Finally, the proposed growth 
criterion required that for the period combining the current and 3 
preceding quarters, the credit union's ending total asset growth could 
not exceed 110 percent of the growth in net worth plus shares and 
deposits. See 67 Fed. Reg. 71113 (Nov. 29, 2002).

[19] The total risk based capital ratio is the sum of tier 1 capital 
(core) and tier 2 capital (supplementary) divided by risk-weighted 
assets. Tier 1 includes common stockholder's equity, retained earnings, 
and noncumulative and limited amounts of cumulative perpetual preferred 
stock. Tier 2 includes, among other supplementary capital elements, the 
nontier 1 portion of cumulative perpetual preferred stock, limited-life 
preferred stock and subordinated debt, and loan loss reserves up to 
certain limits. See Department of the Treasury, Comparing Credit Unions 
with Other Depository Institutions (Washington, D.C., January 2001). 
See also Department of the Treasury, Credit Unions (Washington, D.C., 
December 1997). 

[20] Id.

[21] See 68 Fed. Reg. 32958 (June 3, 2003); see also 12 C.F.R. 
703.14(b) (2004).

[22] In this report, we refer to corporate credit unions' additional 
forms of capital as secondary capital per the NCUA description.

[23] Unrated subordinated debt has not been evaluated by a rating 
agency for risk--that is, probability of full repayment. Private 
placement is a sale directly to an institutional investor.

[24] See James A. Wilcox, "Subordinated Debt for Credit Unions" 
(prepared for the Filene Research Institute and The Center for Credit 
Union Research, 2002).

[25] A credit union may be designated by NCUA as a low income credit 
union if it serves predominantly low-income members, a category that 
includes members who either earn less than 80 percent of the average 
for all wage earners as established by the Bureau of Labor Statistics, 
or have annual household income that falls at or below 80 percent of 
the median household income for the nation. The term "low income" also 
includes members who are full-time or part-time students in a college, 
university, high school, or vocational school. See 12 C.F.R. 701.34 
(2004).

[26] NCUA regulations also specify the conditions under which low 
income credit unions can receive secondary capital accounts. For 
example, the maturity of the secondary capital account must be for a 
minimum of five years and must not be redeemable prior to maturity. See 
12 C.F.R. 701.34(b).

[27] The CRA requires all federal bank and thrift regulators to 
encourage depository institutions under their jurisdiction to help meet 
the credit needs of the local communities in which they are chartered, 
consistent with safe and sound operations. See 12 U.S.C. 2901, 2903, 
and 2906 (2000). CRA requires that the appropriate federal supervisory 
authority assess the institution's record of meeting the credit needs 
of its entire community, including low-and moderate-income areas. 
Federal bank and thrift regulators perform what are commonly known as 
CRA examinations to evaluate services to low-and moderate-income 
neighborhoods. Assessment areas, also called delineated areas, 
represent the communities for which the regulators are to evaluate an 
institution's CRA performance.

[28] Corporate credit unions provide credit unions with services, 
investment opportunities, loans, and other forms of credit should the 
credit unions face liquidity problems. See 12 C.F.R. Part 704 (2004).

[29] 12 C.F.R. 704.2. Under this regulation, membership capital means 
funds contributed by members that (1) have an adjustable balance with a 
minimum withdrawal notice of 3 years or are term certificates with a 
minimum term of 3 years, (2) are available to cover losses that exceed 
retained earnings and paid-in capital, (3) are not insured by NCUSIF or 
other share or deposit insurers, and (4) cannot be pledged against 
borrowings. Paid-in capital encompasses accounts or other interests of 
a corporate credit union that (1) are perpetual, noncumulative dividend 
accounts, (2) are available to cover losses that exceed retained 
earnings, (3) are not insured by NCUSIF or other share or deposit 
insurers, and (4) cannot be pledged against borrowings.

[30] 12 U.S.C. 1831o(c)(1). The minimum leverage ratio is a 
requirement that tier 1 capital be equal to a certain percentage of 
total assets, regardless of the type and riskiness of the assets.

[31] Liquidity risk is the potential for financial losses due to the 
inability of an institution to meet its obligations on time because of 
an inability to liquidate assets or obtain adequate funding, such as 
might occur if most depositors or other creditors were to withdraw 
their funds from an institution. Operational risk is the potential for 
unexpected financial losses due to inadequate information systems, 
operational problems, breaches in internal controls, or fraud.

[32] Interest-rate risk is the risk of potential loss arising from 
changes in interest rates. It exists in traditional banking activities, 
such as deposit taking and loan provision, as well as in securities and 
derivatives activities. Concentration risk exists if a bank is heavily 
exposed to certain sectors or countries. It deals with the risks of not 
diversifying assets so that a problem in any one sector or country 
might financially affect the bank.

[33] 12 U.S.C. 1831o(c)3. The tangible equity ratio is the sum of 
common stock, surplus, and retained earnings, net of Treasury stock and 
currency translation adjustments, with intangible assets subtracted 
from both the numerator and denominator.

[34] For additional information on bank capital components and bank 
risk-based capital regulations, see U.S. General Accounting Office, 
Risk-Based Capital: Regulatory and Industry Approaches to Capital and 
Risk, GAO/GGD-98-153 (Washington, D.C.: July 20, 1998).

[35] See e.g. Federal Reserve Board Regulation H, 12 C.F.R. Part 208, 
App. A, E; Office of the Comptroller of the Currency regulations, 12 
C.F.R. Part 3, App. A, B; Federal Deposit Insurance Corporation (FDIC) 
regulations, 12 C.F.R. Part 325, App. A, C. Credit risk is the 
potential for financial loss resulting from the failure of a borrower 
or counterparty to perform on an obligation. Market risk is the 
potential for financial losses due to the increase or decrease in the 
value or price of an asset resulting from broad movements in prices, 
such as interest rates, commodity prices, stock prices, or the relative 
value of currencies (foreign exchange).

[36] Derivatives are financial products that enable risk to be shifted 
from one entity to another. An off-balance sheet item is a financial 
contract that can create credit losses for the bank but that is not 
reported on the balance sheet under standard accounting practices. An 
example of such an off-balance sheet position is a letter of credit or 
an unused line of credit that commits the bank to making a loan in the 
future that would be on the balance sheet and thus create a credit 
risk.

[37] To be considered a significant exposure, this gross market risk 
exposure must exceed 10 percent of total assets or exceed $1 billion.

[38] NCUA Form 5300. Available from www.ncua.gov.

[39] NCUA defines a credit union as "complex" when its total assets at 
the end of a quarter exceed $10 million and its risk-based net worth 
calculation exceeds 6 percent net worth. 12 C.F.R. 702.103.

[40] NCUA's November 2000 report notes that the "risk portfolios" of 
balance sheet assets consist of long-term real estate loans, member 
business loans outstanding, investments, low-risk assets, and average-
risk assets. The "risk portfolios" of off-balance sheet assets are 
loans sold with recourse and unused member business loan commitments.

[41] A credit union may substitute one or more alternative components, 
in place of the corresponding standard components in 12 C.F.R. 
702.106, when any alternative component amount, expressed as a 
percentage of the credit union's quarter-end total assets as reflected 
in its most recent call report, rounded to two decimal places, is 
smaller.

[42] 12 C.F.R. 702.107 (2004).

[43] The majority of these failures have occurred during the latter 
part of 2003.

[44] H.R. 3579--Credit Union Regulatory Improvements Act of 2003.

[45] Two-phased refers to the current PCA system of required net worth 
ratio for most credit unions and an additional risk-based computation 
required for complex credit unions.

[46] Prior to CUMAA, although credit unions were not subject to an 
explicit net worth requirement, they were required to make transfers to 
a regular reserve account based on the current ratio of their regular 
reserves to risk assets.

[47] The risk weights for the four categories in the Basel Accord 
assume all assets within each category have the same level of credit 
risk.

[48] We did not perform an evaluation or assessment of the items 
provided by NCUA. Appendix I provides additional details on our scope 
and methodology.

[49] Regulators use the CAMEL (capital adequacy, asset management, 
earnings, and liquidity) system to rate depository institutions on a 
scale of 1-5: 1 is strong, 2 is satisfactory, 3 is flawed, 4 is poor, 
and 5 is unsatisfactory. 

[50] The parity provision in Credit Union Membership Access Act of 1998 
(CUMAA) states that, in general, if the federal banking agencies 
increase or decrease the required minimum level for the leverage limit 
(as those terms are used in section 38 of Federal Deposit Insurance 
Corporation Improvement Act of 1991), the NCUA board may, by 
regulation, and subject to the determinations set forth in CUMAA 
section 301(c)(2), correspondingly increase or decrease one or more of 
the PCA net worth ratios. See 12 U.S.C. 1790d(c)(2).

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