Corporate Credit Unions: Competitive Environment May Stress Financial Condition, Posing Challenges for NCUA Oversight
Published: 2004-09-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Thousands of credit unions have placed about $55 billion of their excess funds in corporate credit unions (corporates). In a three-tiered system, corporates provide lending, investment, and processing services for their member credit unions. Problems with investments in the past prompted regulatory changes that required higher capitalization and stricter risk management, but allowed for expanded investment authorities. GAO assessed (1) the changes in financial condition of the corporate network and (2) the oversight of corporates by the National Credit Union Administration (NCUA), the federal regulator of credit unions.
section_title: What GAO Found
paragraphs: Corporates face an increasingly challenging business environment that potentially could stress their overall financial condition. In response to the competitive environment, corporates are offering new and more sophisticated products and services, expanding their use of technology, and seeking opportunities to merge or collaborate with other corporates. The corporates' financial condition as measured by profitability and capital ratios remained close to a range that has prevailed since the mid-1990s. However, since 2000, a large influx of deposits, coupled with low returns on traditional corporate investments, has constrained earnings and caused a downward trend in corporates' overall profitability. To generate earnings, corporates increasingly have targeted more sophisticated and potentially riskier investments, but appear to be managing risk by shifting toward more variable-rate and shorter-term investments, providing a potentially better match for the relatively short-term nature of their members' deposits. However, the corporates' changing business environment and utilization of more sophisticated and riskier investments increases the importance of NCUA regularly assessing its oversight processes to ensure that corporates are properly managing these risks. NCUA has strengthened its oversight of corporates by creating a centralized office for oversight, revising regulations, implementing risk-focused supervision, and hiring specialists. However, NCUA faces challenges in identifying networkwide problems on a consistent basis, using specialists effectively, providing relevant guidance on mergers, and assuring the quality of corporates' internal controls. Although NCUA identified deficiencies during its examinations, it has not systematically tracked their resolution or evaluated trends in examination data, which could help anticipate emerging issues facing corporates. NCUA also did not fully consider all risks when allocating resources or assigning specialists to examinations, leading to NCUA overlooking some information system deficiencies. Although corporates continue to consider mergers to remain competitive, NCUA had not developed adequate guidance for submitting and reviewing merger proposals. Finally, NCUA has not ensured that corporates' internal controls have remained consistent with those of similarly sized financial institutions

section_title: Letter
paragraphs: Thousands of credit unions have placed about $55 billion of their excess  funds in corporate credit unions for investment purposes. Under a  three-tiered system, corporate credit unions (corporates) are  member-owned financial cooperatives whose members are credit unions,  not individuals. As the “credit union for credit unions,” corporates provide  deposit, liquidity, investment, and processing services for their members. In  turn, the member credit unions have about 82 million members, to whom  they provide deposit, loan, and some investment services. U.S. Central  Credit Union (U.S. Central), a nonprofit cooperative, is owned by  corporates (serves as the “corporate for the corporates”) and it serves its  members much like corporates serve their credit union members—which  the federal regulator for credit unions, National Credit Union  Administration (NCUA), and the corporate network refer to as natural  person credit unions.
We last conducted a comprehensive review of corporates and their  oversight by NCUA in 1991. In addition, we conducted more targeted  reviews of corporates in 1994 and 1995 in response to the failure of a large  corporate in the mid-1990s. Since that time, assets placed in corporates  have grown, corporate credit union business strategies have changed, and  NCUA has significantly changed its approach to oversight. In light of the  evolution of corporate credit union operations and the change in NCUA’s  supervisory approach, and as part of our overall review of the credit union  industry, you asked us to review a number of issues involving corporates  and NCUA. Based on discussions with your staff, we assessed (1) the  changes in financial condition of corporate credit unions since 1992 and (2)  NCUA’s supervision and oversight of corporates, particularly with regard to  how it identifies and addresses safety and soundness issues.
To assess the changes in the financial condition of corporates, we analyzed  corporate credit union call report data from December 1992 to December  2003, and reviewed internal corporate credit union analyses and  independent studies of the industry from rating agencies. We also  conducted a legislative and regulatory review to determine the key  legislative and regulatory changes affecting corporates since 1992. To  depict the business environment that can affect the financial condition of  corporates, we administered a questionnaire to all 31 currently operating  corporates, and interviewed NCUA and credit union trade organization  officials. To assess how NCUA’s supervision of corporates identified and  addressed safety and soundness issues, we reviewed NCUA documentation  on its risk-focused examination program and reviewed examinations and  NCUA management reports for all corporates from 2001 through 2003. We  also conducted a detailed review of NCUA workpapers for 10 corporates  and interviewed the examiners who were responsible for supervising these  corporates. In addition, we conducted site visits to seven corporates,  selected based on their size, geographic location, and whether they were  state or federally chartered, or were granted expanded investment  authorities. Appendix I provides additional details on our scope and  methodology. Appendix II provides a list of all 31 corporates that were  active as of December 31, 2003, and appendix III contains a copy of the  structured questionnaire. We conducted our work in Alexandria, Virginia,  Washington, D.C., and other U.S. cities from December 2003 to September  2004 in accordance with generally accepted government auditing  standards.
subsections: section_title: Background
paragraphs: Corporate credit unions occupy a unique niche among financial  institutions. They are nonprofit financial cooperatives that are owned by  natural person credit unions (that is, credit unions whose members are  individuals), and provide lending, investment, and other financial services  to these credit unions. For example, corporates offer loans to member  credit unions, which in turn use these loans to meet the loan demands of  their individual members. However, corporates are not the only financial  institutions that provide products and services to credit unions. For  example, some credit unions may also obtain loans from Federal Reserve  Banks or Federal Home Loan Banks. Additionally, corporates offer credit  unions investment products and investment advice, but credit unions can  also obtain these services from broker-dealers or investment firms. Finally,  corporates also offer automated settlement, securities safekeeping, data  processing, accounting, and electronic payment services, which are similar  to the correspondent services that large commercial banks have  traditionally provided to smaller banks. With an emphasis on safety and  liquidity, corporates seek to provide their members with higher returns on  their deposits and lower costs on products and services than can be  obtained individually elsewhere. However, corporates’ limited ability to  generate profits—as nonprofit institutions, owned and controlled by their  primary customers—constrains their ability to build a financial cushion  against adverse financial conditions or unexpected losses.
Since 2000, corporates have experienced deposit inflows from natural  person credit unions that increased corporates’ assets and shares.  Corporates act as a “liquidity sponge” for the underlying natural person  credit union system, and the cyclical rise and fall of corporates’ assets and  shares (deposits) are rooted in the deposit flows of the natural person  credit unions. Thus, these inflows and outflows of deposits, which are  beyond corporates’ control, affect their measures of financial  strength—such as profitability and capital ratios. As we discuss later in the  report, this has exacerbated the stress on their financial condition.
Since 1992, the number of corporates in the corporate network has  decreased, with assets more concentrated in larger institutions. (See fig. 1  for an illustration of the network’s geographic distribution.) Mainly as a  result of mergers, corporates have decreased in number from 44, at the end  of 1992, to 30 as of December 31, 2003, excluding U.S. Central. On average,  corporates also have become larger, with the median asset size (excluding  U.S. Central) increasing from $450.6 million in 1992 to $1.2 billion at the  end of 2003. However, the corporate network still encompasses small and  large institutions, ranging in size from $7.3 million in assets to $25 billion,  as of December 31, 2003. In addition, asset concentration in the network  has become more pronounced since 1992. Excluding U.S. Central, at the  end of 1992 the three largest corporates accounted for approximately 42  percent of the corporates’ total assets. By the end of 2003, these corporates  accounted for roughly half of corporates’ total assets and the largest  corporate accounted for about one-third.
As shown in figure 2, the credit union industry is organized into three  closely connected groupings. At the “top” or retail level, as of December 31,  2003, there were the 9,488 credit unions that served roughly 82 million  individual customers. In the middle are the 30 corporates, which serve  credit unions by investing the cash they have not lent out and by providing  loans and other financial services to the credit unions. Finally, on the  “bottom” or wholesale level is U.S. Central, which provides corporates a  range of products and services, similar to those that corporates provide to  credit unions.
Since their inception, corporates’ primary functions have been to accept  deposits and make loans to their members. In addition, today, they also  provide investments and other financial services to credit unions, and  corporates over time have broadened the types of products and services  they offer. Most corporates offer  electronic services, such as the Automated Clearing House (ACH) and   correspondent services, such as settlements with the Federal Reserve  and other financial institutions;  check services, including collection and settlement of money orders and  traveler’s checks;  credit card settlement; and   education and training.
However, corporates now offer or plan to introduce new products and  services such as online training, electronic bill payment, Internet banking,  asset/liability management (ALM), and brokerage services. For more  detailed information on the products and services corporates offered or  planned to offer, see appendix IV.
While the first credit union in the United States started in 1909, the first  corporate did not start operations until 1968. Many corporates grew out of  the various state credit union leagues and initially served only single states  or regions. Over time, corporates were granted national fields of  membership that allowed them to expand the number of credit unions they  served. While corporate credit union membership can be national,  corporates can have either a state or federal charter. As of December 31,  2003, 18 of the 31 corporates, including U.S. Central, were state-chartered.  In terms of oversight, NCUA has authority for supervision and examination  of federally chartered corporates. Under the dual-chartering system, the  supervisory authorities for those states that have state-chartered  corporates are primarily responsible for supervision of these institutions.  However, since all corporates provide deposit, liquidity, and correspondent  services to federally insured credit unions, NCUA also has regulatory  authority over state-chartered corporates and assesses the risks federally  insured, state-chartered corporates and noninsured, state-chartered  corporates present to the National Credit Union Share Insurance Fund  (NCUSIF). This assessment, which is essentially an examination of the  corporates’ operations, is performed jointly with state supervisory  authorities during their examinations of state-chartered corporates.
Part 704 of NCUA’s regulations, together with the relevant provisions of the  Federal Credit Union Act of 1934, constitutes the primary federal  regulatory framework for both state- and federally chartered corporates.  NCUA first issued Part 704 in 1982. Since our previous report on corporates  in 1991, NCUA made significant revisions to Part 704 in 1998 and 2002  relating to risks, capital, investments, and other areas covered by this  report.
section_title: Corporate Network Faces an Increasingly Challenging Business Environment, Creating Potential Stress on Its Financial Condition
paragraphs: Like other financial institutions, corporates face a challenging business  environment that affects their financial condition and is characterized by  increasing competition, changing product and service offerings, and rapid  technological advances. Moreover, recent pressure from a  low-interest-rate environment and rapid growth in assets has put additional  stress on the corporate network’s profitability and capital ratios. While  net income levels have grown since 2000, corporates’ profitability was  lower in 2003 than in 1993. As rapid asset growth negatively impacts  profitability, it affects corporates’ ability to generate sufficient retained earnings—the primary component of their capital. As overall capital  levels have been rising, corporates have been relying more on less  permanent (relatively weaker) forms of capital. Additionally, rapid asset  growth and the relatively slower growth in retained earnings has put  pressure on corporates’ capital ratios, which could be a cause for concern  since capital ratios are an important indicator of financial strength. Growth  and changes in corporate investments, such as recent shifts of more of the  corporates’ investment portfolios into potentially higher yielding and more  volatile securities, may increase interest-rate risk if the investments are not  managed properly. In particular, the percentage of corporate investments in  obligations of U.S. Central has declined while the percentages of  corporates’ investments in privately issued mortgage-related and  asset-backed securities have increased. Corporates appear to be  managing risk by shifting toward more variable-rate and shorter-term  securities, providing a potentially better match for the relatively short-term  nature of their members’ deposits. However, a regulatory change effective  in 2003 allowed certain corporates to purchase securities with lower credit  quality (more credit risk), raising implications for NCUA oversight since  this activity may lead to increased risk if it is not managed properly.
subsections: section_title: The Challenging Business Environment in Which Corporates Operate May Impact Their Financial Condition
paragraphs: Corporate credit unions are operating in a challenging business  environment characterized by increased competition, pressure to increase  returns on their investments in a low-interest-rate environment, and the  need to invest in technology and personnel to meet the demands of their  credit union members for new and more sophisticated products and  services. To obtain the corporates’ views on their business environment,  we distributed a questionnaire to the entire network and achieved a 100  percent response rate. The corporates reported that they faced competition  from outside the corporate network from entities such as banks,  broker-dealers, the Federal Reserve System, and Federal Home Loan  Banks. About 87 percent of the corporates reported that they also faced  competition from other corporates despite the cooperative nature of the  network. In addition, in recent years (since 2000), corporates have received  a large inflow of deposits from their natural person credit union members,  which had increasing amounts of unloaned funds because of the “flight to  safety” that occurred in the wake of the stock market downturn. These  inflows increased corporates’ assets, pressuring them to ensure that they  received sufficient returns when investing these funds to maintain  adequate capital levels and fund operations. However, over the last several  years, low interest rates have reduced the returns that corporates could  obtain on their investments, which has put stress on their overall  profitability. Finally, the corporates stated that they faced a rapidly  changing marketplace, particularly related to the increased demands from  credit unions for more sophisticated products and services such as  electronic banking.
The strategies corporates have employed to respond to their challenging  business environment can have positive or negative impacts on their  overall financial condition. For example, over time, corporates have  increasingly invested in securities such as privately issued  mortgage-related and asset-backed securities and less so in obligations of  U.S.Central, suggesting that they are seeking to enhance the yields on their  investments. As corporates shift their investments into potentially  higher-yielding securities, the network could face increased risks if  individual corporates do not have adequate infrastructure in place to  manage risks associated with their investments.
Increasing competitive pressures may have encouraged consolidation,  through mergers within the network, as corporates sought to achieve  economies of scale. Consolidation is likely to continue as 7 of the 30  corporates responding to our questionnaire stated that they were likely or  would consider merging in the next 2 years. Industry observers have noted  that mergers are an effective strategy to attain economies of scale  necessary to afford investments in technology and skilled personnel;  however, if poorly implemented, mergers have the potential to impact  operating performance. The recent and expected consolidation activities  within the network could impact the financial condition of the acquiring  corporate, as well as the corporate network.
Finally, based on the responses to our questionnaire, corporates reported  that they have been forming strategic alliances with other corporates to  provide member credit unions with sophisticated products and services  such as online banking and business lending services. Industry observers  have viewed these alliances as an effective approach to meet the demands  of members while distributing the costs among several corporates.  However, as corporates move into new areas to meet the demands of their  members, corporates need to maintain sufficient retained earnings and  capital levels.
section_title: Despite General Growth in Net Income, Corporate Profitability Has Trended Lower Recently
paragraphs: Despite generally rising net income levels since 1995, the profitability of  corporates has declined recently due to the low-interest-rate environment  and large inflows of deposits from natural person credit unions. More  specifically, as shown in figure 3, while net income of corporates generally  fluctuated since 1992, it grew overall since 1995. While profitability  generally remained within ranges prevalent in the industry since the  mid-1990s, it was lower at the end of 2003 than at the end of 1993.
Also, as shown in figure 3, profitability—the net income corporates realize  on their assets—was relatively stable in the mid-1990s, but has been  trending downward since 2001. Effectively, the recent lower-interest-rate  environment has narrowed the difference between what corporates were  earning on their investments and what they were paying to their members.  (Appendix V provides more details on corporates’ income and operating  expenses.) Profitability is an important indicator of financial condition, as  it is a key determinant of the sufficiency of a corporate’s retained earnings.  Retained earnings are the primary component of a corporate’s capital,  representing that corporate’s financial strength and its ability to withstand  adverse financial events. The recent trend downward in corporates’  profitability has slowed growth in their retained earnings and capital  compared with their assets.
section_title: Despite Increases in Overall Capital Levels, Corporates’ Capital Ratios Have Trended Lower Recently
paragraphs: The overall level of capital at corporates has steadily increased since 1998,  in part due to regulatory changes that allowed corporates to use other, less  permanent (or relatively weaker) forms of capital in addition to retained  earnings. Corporates have been increasingly relying on these relatively  weaker forms of capital. However, since 2000 capital ratios have declined  as growth in assets outpaced growth in capital. The increasing reliance on  less permanent forms of capital and corporates’ generally constrained  ability to build capital in periods of stress raises a potential concern about  the financial strength of the corporate network.
subsections: section_title: Capital Levels Have Generally Risen, but Corporates Increasingly Have Relied on Less Permanent Forms of Capital
paragraphs: As shown in figure 4, the overall level of capital at corporates has steadily  increased since 1998. This is due in part to regulatory changes that allowed  corporates to use other, less permanent (or relatively weaker) forms of  capital in addition to retained earnings.
Beginning in 1998, Part 704 of NCUA regulations expanded the definition of  regulatory capital by defining capital as the sum of reserves and undivided  earnings (that is, retained earnings) and permitted corporates to include  two other, less permanent forms—paid-in capital and membership capital.  More specifically, reserves and undivided earnings include all forms of  retained earnings, including regular or statutory reserves and any other  appropriations designated by management or regulatory authorities. NCUA  currently defines “core capital” for corporates in Part 704 as retained  earnings plus paid-in capital. Retained earnings, which are internally  generated, are the most permanent form and the primary component of  corporates’ capital. Both paid-in capital and membership capital, which are  from external sources, are less permanent forms of capital, suggesting they  provide a relatively weaker cushion against adverse financial events. Prior  to July 1, 2003, paid-in capital was defined as a member deposit account  with an initial maturity of at least 20 years. However, NCUA now requires  paid-in capital to be a more permanent form of capital (a perpetual  dividend account), available to cover losses that exceed reserves and  undivided earnings. NCUA had noted that, due to its high cost, paid-in  capital would be used by corporates as a bridge during short periods of  stress, such as rapid growth, and should not be used for long periods. While  NCUA’s redefinition of paid-in capital has increased the relative  permanence of this form of capital, membership capital represents funds  contributed by members that have either an adjustable balance with a  required notice of withdrawal of at least 3 years or are term certificates  with a minimum term of 3 years. As such, membership capital is probably  best thought of as a form of subordinated debt, which can protect the  insurance fund in the event of a corporate failure.
As shown in figure 4, corporate capital rose from $2.9 billion in 1998 to $5  billion at the end of 2003. Retained earnings accounted for 41 percent of  total capital in 1998 but declined to around 36 percent of total capital at the  end of 2003. Paid-in capital increased from around 6 percent of total capital  in 1998 to around 10 percent in 2003. Membership capital shares have  consistently represented the largest percentage of capital, typically around  50 percent, and have been steadily accounting for a greater percentage of  capital since 2000. Thus, while the capital of corporates continues to rise,  corporates have increasingly relied on less permanent (that is, relatively  weaker) forms of capital. While this is a method corporates can use to  increase capital during periods of rapid growth in assets, it does lead to  concerns about the ability of the network to withstand financial shocks,  especially in light of the increasingly challenging business environment  they face.
section_title: Capital Ratios Have Declined Recently but Remain above Current Regulatory Requirements
paragraphs: While the total capital of corporates has steadily increased since the  late-1990s, since 2000 capital ratios have declined as growth in assets  outpaced growth in capital. NCUA currently specifies three capital ratios:  the capital ratio, which includes all forms of capital relative to moving daily  average net assets (DANA); the core capital ratio, which includes core  capital (retained earnings plus paid-in capital) relative to moving DANA;  and the retained earnings ratio, which includes reserves plus undivided earnings relative to moving DANA. As depicted in figure 5, these capital  ratios were lower in 2003 than in 1998 despite generally rising capital  levels.
As assets have increased, corporates have been unable to generate  sufficient capital to maintain capital ratios. In particular, after peaking in  2000, capital ratios declined, as the corporates’ asset base—which  inversely affects the capital ratio—increased by over 80 percent over the  same period. Despite recent declines, at the end of 2003 the capital and  retained earnings ratios remained in excess of their current respective  regulatory requirements of 4 percent and 2 percent. Due to corporates’  role in serving their members, their generally low earnings continue to  present a challenge and a potential weakness—as corporates generally rely  on building permanent capital from retained earnings—and could put a  strain on the profitability of the corporate network in the future. As a  result, corporates’ capital ratios, although above current regulatory  requirements for safety and soundness purposes, are vulnerable to erosion  from factors such as rapid inflows of deposits that corporates may not be  able to control.
section_title: Growth and Changes in Corporates’ Investments May Increase Risks If Not Monitored or Managed Properly
paragraphs: Although assets have grown through the recent influx of deposits,  corporates have continued to allocate them almost exclusively to  investments (rather than other assets that include cash, loans, or fixed  assets). With this growth, the percentage of corporates’ investments in  obligations of U.S. Central has declined somewhat, particularly for the  largest corporates. In response to the low-interest-rate environment,  corporates have moved relatively more of their investments into potentially  higher yielding—and more volatile—securities. The largest corporates also  appear to be managing interest-rate risk by shifting toward more  variable-rate and shorter-term securities, providing a potentially better  match for the relatively short-term nature of their members’ deposits.  However, a regulatory change effective in 2003 allowed certain corporates  to purchase securities with lower credit quality, but few have used this  investment authority. It is not clear, however, to what extent corporates  might use this investment flexibility in the future, raising implications for  NCUA oversight since this activity may lead to increased credit risk if it is  not managed properly.
subsections: section_title: While Corporate Investment Portfolios Have Grown, Larger Corporates Invested Less in U.S. Central
paragraphs: Corporates’ investments have grown with the recent inflows of deposits  from natural person credit unions. Investments, which include  asset-backed securities, commercial debt obligations, mortgage-related  issues, and U.S. government obligations, represent the vast majority of  corporates’ assets—usually 90 percent or more (see fig. 6). At the end of  1992, total investments of corporates stood at $41.1 billion; at the end of  2003, they were reported at $65.3 billion. Since 2000, total investments of  corporates have grown by 84 percent.
Since 1992, corporates’ investments in U.S. Central obligations have  typically accounted for approximately one-half of their total investments,  the largest single investment category. The generally high proportion of  investments in U.S. Central obligations reflects the “pass-through” nature  of many corporates. Historically, U.S. Central has functioned as a conduit  between corporates and the capital markets. Despite growth in the overall  amount of corporates’ investments in U.S. Central obligations, they  declined as a percentage of corporates’ total investments from 1997 to  2003. For example, they went from $15.6 billion (53 percent) at the end of  1997 to $29.2 billion (45 percent) at the end of 2003. This decline indicates  that the largest corporates are investing their funds directly, rather than  through U.S. Central. As shown in figure 7, in general, the largest  corporates have held smaller percentages of their investments in U.S.  Central obligations than smaller corporates.
As investment management has increased in complexity, smaller  corporates may not have had the resources necessary to develop and  maintain investment capabilities internally, and U.S. Central thus was able  to provide smaller corporates with these services by leveraging the  efficiencies gained through its economies of scale. Despite the recent  decline in the percentage of corporates’ investments in U.S. Central  obligations, U.S. Central still provides substantial investment  services—suggesting that the health of U.S. Central remains critically  important for its members and their associated natural person credit  unions.
section_title: Investments Have Shifted Toward Potentially Higher Yielding and More Volatile Securities, but Largest Corporates Appear to Be Managing Interest-Rate Risk
paragraphs: In response to the low-interest-rate environment, corporates have moved  relatively more of their investments into potentially higher yielding—and  more volatile—securities. In particular, corporates have increased their  relative holdings of privately issued mortgage-related and asset-backed  securities, which may offer higher yields for corporates relative to other  investments such as government-guaranteed obligations. As illustrated in  table 1, the percentage of investments in privately issued mortgage-related  securities increased from 0.9 percent of total investments in 1997 to 14.1  percent in 2003. Asset-backed securities also increased relative to total  investments (from 19.5 percent in 1997 to 24.7 percent in 2003). With the  potentially higher yields, the corporates are also potentially increasing  risk—notably interest-rate risk. This shift highlights the importance of risk  monitoring and management by the corporates and NCUA.
However, corporates also have shifted the composition of their investment  portfolios toward more variable-rate and shorter-term securities, a strategy  that tends to reduce adverse exposure to changing interest rates and thus  reduces interest-rate risk. While 41.7 percent of corporates’ asset-backed  securities were classified as fixed-rate at the end of 1997, 18 percent were  so classified at the end of 2003. Since corporates’ call reports do not  include weighted-average life data—the expected time that the principal  portion of a security will remain outstanding—we reviewed materials from  the three largest corporate credit unions that showed these institutions  tended to hold securities with relatively short weighted-average lives, with  most being less than 3 years. As a result, while corporates have moved to  securities that may entail additional investment risk, the largest corporates  in the network appear to be managing interest-rate risk by shifting toward  more variable-rate and shorter-term securities, providing a potentially  better match for the relatively short-term nature of their members’  deposits.
section_title: Expanded Authority to Invest in BBB Rated Securities May Lead to Increased Credit Risk If Not Managed Properly
paragraphs: Due to the revision of Part 704, some corporates have been allowed to  invest in lower-rated securities (down to BBB rated), which might lead to  increased credit risk if these investments were not managed properly.  Investments with lower credit quality tend to provide higher yields but can  also expose investors to the increased likelihood that promised cash flows  will not be paid. While “moving down the credit curve” (that is, investing in  lower credit quality securities) potentially exposes a corporate to increased  credit risk, such a strategy might not increase the overall risk for a  corporate making such investments provided the additional risk was  managed appropriately. According to NCUA, this regulatory change gave  corporates added flexibility with which to diversify their portfolios and reduce investment concentration. In particular, these securities could be  used in an attempt to limit credit risk by lowering concentrations in certain  industries or geographical areas and creating a more diversified portfolio.  Also, lower-rated securities could be purchased because they carried a  particularly attractive return for their credit rating or provided a good mix  of credit risk and interest-rate risk given the other holdings of a corporate.  According to NCUA and corporate officials, the ability to hold such  lower-rated securities in their portfolios (as opposed to having to sell a  security immediately if it were downgraded) might provide these  institutions more flexibility in disposing of an investment that suffered a  rating downgrade. Corporates would be able to hold the investment in an  effort to limit realized losses rather than being forced to promptly liquidate  it. Based on our review of information provided by the three corporates  that have the authority to invest in these securities, as well as discussions  with their officials and risk management staff, corporates either have made  few such investments or none. Further, officials at the three institutions  indicated that they did not plan to use their authority to purchase BBB  rated securities.
However, it is not clear to what extent corporates will take advantage of  this investment flexibility in the future, which has implications for NCUA  oversight that we discuss later in this report. If corporates were to hold or  invest in BBB rated securities to a greater extent, these investments might  create additional risks to the corporate network if not managed properly. In  general, like other financial institutions, a corporate’s vulnerability to risk  depends on its overall portfolio and the amount of capital that is backing it.  Some have suggested that corporates tend to be relatively thinly capitalized  compared with other financial institutions, which may raise concerns over  potential additional exposure to risk. For example, the Department of the  Treasury has raised concerns that allowing corporates to invest in BBB  rated securities could weaken the safety and soundness of the corporate  network because the amount of capital held in the corporatesmight not be  commensurate with the risks associated with these lower credit quality  investments.
section_title: NCUA Strengthened Its Oversight of Corporates, but Could Do More to Anticipate and Address Emerging Network Issues
paragraphs: NCUA has made numerous changes over the last several years to  strengthen its oversight of corporates but faces challenges in such areas as  networkwide assessments, obtaining and utilizing technical staff resources,  developing merger guidance for corporates, and assuring the quality of  corporates’ internal control structures. Specifically, NCUA established a  separate office dedicated to the oversight of corporates, and revised its  corporate regulation (Part 704) to improve corporates’ management of  credit, interest-rate, and liquidity risks. NCUA also adopted a risk-focused  supervision and examination approach, and trained or hired a limited  number of specialists to help oversee increasingly complex operations at  corporates. However, NCUA has not put in place a system to track the  resolution of deficiencies or evaluate trends in examination data and  therefore may not be able to anticipate emerging issues within the network.  Further, NCUA has not systematically considered certain operational risks,  such as weak information system controls, when assigning specialists to  examinations, which may have led to NCUA overlooking certain problems  or not ensuring that problems were corrected in a timely manner. While  continued consolidation of the corporate network appears likely, NCUA  has not developed merger guidance specific to corporates, and its  examiner guidance has not ensured that merger proposals were assessed  consistently. Thus, NCUA’s inadequate guidance has increased the risk that  resulting decisions may not be in the best interests of corporates or their  members, or may negatively affect the safety and soundness of corporates.  Also, as corporates have invested in more complex technologies and added  more sophisticated products and services, the importance of NCUA’s  oversight of corporates’ internal controls has increased. However,  corporates are not subject to the internal control reporting requirements  imposed on other financial institutions of similar size that help to ensure  safety and soundness, as defined under the Federal Deposit Insurance  Corporation Improvement Act of 1991 (FDICIA). This raises a question  about whether NCUA has the necessary information to assess corporates’  internal controls.
subsections: section_title: NCUA Made Several Major Improvements in Oversight Since 1991
paragraphs: Since 1991, NCUA has strengthened its oversight of corporates by  reorganizing staff, revising regulations, and changing examination and  supervisory focus. NCUA established the Office of Corporate Credit Unions  (OCCU) in 1994, partly in response to problems with selected investments  at U.S. Central. Within this new office, NCUA centralized its supervision  of corporates and increased the number of examiners dedicated to  supervision and examination of corporates. According to NCUA officials,  prior to this change, NCUA examiners lacked adequate training and  expertise to examine activities undertaken by corporates, since they spent  most of their time examining natural person credit unions, whose  operations generally are less complex than those of corporates. Further, in  1992, NCUA had 12 examiners dedicated to the oversight of 44 corporates  and U.S. Central. As of June 2004, NCUA had 22 examiners plus three  information systems specialists and one payments system specialist hired  to help oversee the 30 corporates and U.S. Central.
NCUA also revised its corporate regulation (Part 704) in 1998 to increase  measurement and monitoring of interest-rate, liquidity, and credit risk  within the corporate network. The revisions to Part 704 were in response  to the failure of Capital Corporate Federal Credit Union in January 1995  and GAO and other recommendations for NCUA to improve its oversight of  corporates. The 1998 revisions required corporates to measure and report  on the impact of interest-rate and liquidity changes on their net economic  value. Corporates also were required to change the methods used to  calculate their investment concentration limits—moving from a calculation  that used an asset base to one that consisted of core capital (reserves and  undivided earnings and paid-in-capital). Corporates could use this method  to improve their management of credit risk by matching the risks  associated with investment concentrations with capital, which protects  corporates if investment risks lead to losses.
NCUA also implemented a risk-focused supervision and examination  approach in 1999 to concentrate its resources on the high-risk areas within  corporate operations. Similar to the examination approach taken by other  financial institution regulators, the risk-focused approach is intended, in  part, to better employ examiner resources and improve examination  results by emphasizing the areas of greatest risk. Under this approach,  examiners have greater discretion to identify areas that require their  attention and allocate their time accordingly. Further, examiners can  determine when and where to employ the assistance of specialists with  skills tailored to the activities of the institution, as its operations become  more complex. According to NCUA officials, OCCU also began to promote  examiners who had experience in investments and asset/liability  management to the position of capital market specialist. As of August 2004,  OCCU had five capital market specialists. Additionally, NCUA’s Office of  Strategic Program Support and Planning (OSPSP) had three investment  specialists with private-sector financial market experience that could assist  OCCU’s capital markets specialists. For example, OSPSP investment  specialists participate in selected examinations of corporates that have  expanded investment authorities.
section_title: NCUA Identified Deficiencies but Did Not Systematically Track Their Resolution or Evaluate Trends in Examination Data
paragraphs: NCUA’s risk-focused approach has helped it identify weaknesses in  corporates’ operations and require corrective actions at corporates;  however, we found that NCUA did not methodically aggregate and track  the resolution of deficiencies or systematically conduct trend analyses to  identify recurrent or networkwide issues. We have reported that sound  risk-focused examination practices rely on the regulator’s ability to  maintain an awareness of industrywide risk. Other depository institution  regulators, such as the Office of the Comptroller of the Currency, the Board  of Governors of the Federal Reserve System, and the Office of Thrift  Supervision reported that they have mechanisms in place to conduct some  degree of industrywide assessments of their depository institutions.  Further, the Federal Deposit Insurance Corporation (FDIC) tracks and  analyzes trends in examination findings and their resolution in several  ways. For example, after each examination, FDIC reviews, analyzes, and  enters findings and their resolution into various databases. In addition,  FDIC gathers information on its institutions’ internal controls to report on  local, regional, and national trends in bank performance and identify  activities, products, and risks that affect banks and the banking industry.
Based on our review of about 100 risk-focused examinations for all  corporates and U.S. Central from January 2001 through December 2003,  NCUA examiners had identified deficiencies—most frequently in the areas  of asset/liability management, investments, management, funds transfer,  and information systems—but we could not always determine if corporates  had resolved these deficiencies. NCUA also had established time frames for  correcting deficiencies and procedures for corporates to take actions to  address the deficiencies. According to NCUA, corporates must prepare  plans that specify the action needed and identify the corporate official  responsible for implementing the plan. Further, NCUA reported that  examiners typically verify the resolution of deficiencies during an  examination or on-site supervision, actions that examiners were expected  to document in the examination workpapers. Examiners assigned to  subsequent examinations also were to review the deficiencies from the last  examination report to see what corrective action had been implemented.  NCUA reported that based on the severity of the deficiency, as a matter of  practice, resolutions might be noted in the examination report or in the  workpapers.
However, after reviewing these examination reports and other NCUA  oversight documents, we were unable to consistently determine whether  the deficiencies NCUA had identified for individual corporates had been  resolved. The executive summaries included in some examination reports  noted that deficiencies from the previous year had been addressed, but this  practice was not standard for all of the exam reports we reviewed. For  example, 14 of 38 examination reports we reviewed had discussed the  status of deficiencies and whether they were resolved. Moreover, the  corporate examiners’ guide did not stipulate that examiners should  document the resolution of prior deficiencies when preparing the final  examination report. NCUA officials told us that the examiner-in-charge  tracked the status of deficiencies at individual institutions and reported  this information in monthly examiner reports. While these reports  documented the status of deficiencies, information on the status was not  included or consolidated in monthly reports prepared for the OCCU  Director or in quarterly reports to NCUA’s Board. As a result, NCUA  management may have been unaware of issues related to the resolution of  examination deficiencies, as can be seen in the following examples:  In the review of one corporate’s examinations, we noted that its  information system disaster recovery site did not meet NCUA  requirements (for site location and a separate power system) for at least  3 years. The examination documentation we reviewed did not issue a  deficiency finding detailing the weaknesses of the recovery site. After  further review, we found that the disaster recovery site was located at  the chief executive officer’s home for at least 6 years before the  examination report detailed the need to replace the disaster recovery  site.
At another corporate, NCUA acknowledged in the examination that the  institution had not addressed information systems deficiencies related  to information security for 3 years. However, in the prior year’s  examination, NCUA had no mention of recurring problems with  information systems at this corporate.
NCUA issued a deficiency finding in the area of accounting and financial  reporting for a corporate after it had submitted 13 months of data  inaccuracies in its 5310 call reports, exposing the corporate to financial  and reputation risk.
NCUA management believed that its existing examination processes and  available information (such as call reports, examiner reports on  corporates, internal monthly management and quarterly reports, and staff’s  institutional knowledge) provided it with sufficient information to assess  the adequacy and timeliness of corporates’ corrective actions. For  example, NCUA officials stated that OCCU management reviews all  examination reports prior to issuance, including any noted deficiencies. In  the regulator’s view, this practice provides an additional layer of oversight  and evaluation. Additionally, OCCU emphasized that its monthly  management reports serve as a key supervision tool to assess issues,  trends, and corrective action at individual corporates. Despite OCCU’s  practices for coordinating and overseeing individual examinations, these  practices were informal (that is, we did not identify guidance or formal  operating procedures) and appeared to operate independently of one  another. Additionally, these processes and practices did not constitute a  system that would aggregate the number and type of deficiencies occurring  at all corporates.
According to NCUA officials, their current practices kept them abreast of  potential overall issues affecting the network without the need for a  separate system to catalogue the deficiencies. For example, OCCU has  trained three corporate program specialists to support field examiners,  who track issues and trends in their assigned corporates and meet  periodically with OCCU management to discuss issues and trends across  the corporate system. They also noted that the examination review process  had identified a number of issues or trends such as the need to address  Bank Secrecy Act-related issues. However, NCUA officials also said that at  the request of their corporate program specialists, they were developing a  database to track deficiencies identified in examinations to better track  their resolution. They did not specify the planned completion date for this  database.
NCUA’s current system has relied on interaction between the different  offices, examiners, and specialists involved in oversight of corporates. A  tracking system may have helped NCUA to identify, anticipate, or  otherwise address some of the information system weaknesses we noted  above. More specifically, without such a system for tracking examination  findings and their resolution, NCUA’s ability to identify the extent and  duration of a problem at an individual corporate is limited, which may  prevent the timely resolution of deficiencies. Similarly, the lack of a  tracking system that aggregates deficiencies diminishes NCUA’s ability to  identify networkwide problems readily, assist examiners-in-charge in  developing examination plans, and devise strategies to address issues  before they become a significant safety and soundness concern.
section_title: NCUA Did Not Systematically Consider Certain Risks When Allocating Resources or Scheduling Specialists for Examinations
paragraphs: NCUA has not systematically considered corporates’ risk management  (both quality and capacity) when allocating resources and scheduling  specialists for examinations. Federal depository institution regulators,  under the auspices of the Federal Financial Institution Examination  Council (FFIEC)—of which NCUA is a member—had issued guidance on  how to systematically determine when to assign specialists to an  examination. In addition, FDIC and Office of the Comptroller of the  Currency (OCC) have issued specific guidance on the frequency with which  specialty examinations should be conducted. For example, OCC’s guidance  requires that information systems examinations be consistently conducted  at least every 12 to 18 months for community banks with assets of less than  $1 billion, with a minimum objective of assessing the quantity of  transaction risk and the quality of risk management, including staff  capacity and skills. By contrast, NCUA has not established a minimum level  of involvement of specialists in examinations.
Since we noted that NCUA had identified a number of problems in  information systems at the corporates and were concerned that they had  relatively few specialists in this area, we reviewed FFIEC’s Information  Systems Examination Handbook, which also provides a process by which  regulators can determine when and where to employ information systems  specialists. We used this handbook to assess how NCUA deployed  examiners, relative to best practices and guidance as exemplified in the  handbook. According to this handbook, information systems examiners  must judge risk posed by the quantity of transactions and quality of the institution’s risk management. Assessing aggregate risk allows examiners  to weigh the relative importance of both the quantity of transactions and  the quality of risk management for a given institution and direct the  activities and resources for the regulators’ supervisory strategies. Under  this approach, a smaller corporate with a low volume of transactions and  weak risk management could pose a risk to the network equal to that of a  large corporate with a high volume of transactions and a strong risk  management program.
We reviewed examination-planning documents for all 31 corporates to  determine how NCUA evaluated these risks when determining the  frequency at which specialists would be assigned to examinations. We  found that NCUA documented its assessment of operations risk in these  planning documents, but did not explicitly discuss the quality of risk  management for various functions and operations when determining if  specialists should be assigned to examinations. For example, in some  cases, we found that the examination-planning documents only provided a  single line stating that an information systems specialist was not needed on  the next examination and did not document the reason for this assessment.  While the planning documents were not clear about NCUA’s decision  process for assigning specialists to examinations, it also was not clear to us  whether NCUA routinely or consistently considered various operational  weaknesses at these corporates when assigning specialists.
An external review of OCCU in 2002 concluded that NCUA’s complement of  two information systems specialists and one payment system specialist did  not appear to be sufficient to adequately oversee the corporate network  and that OCCU should consider hiring additional specialists in these areas.  NCUA believes it has sufficient specialists to examine the 31 corporates;  however, it has made this determination without fully assessing the  corporates’ business environment and networkwide challenges. NCUA  tended to assign specialists on the examinations of larger corporates or  those implementing newer systems and less so on examinations of smaller  corporates or examinations of established systems at large corporates.  According to NCUA, specialists had limited or no involvement in  examinations at the 12 smallest corporates (with assets of less than $1  billion) from 2001 to 2003. During the same period, specialists were  annually involved in the examination of the eight corporates with assets  above $2.6 billion. While this approach appears reasonable, the limited  involvement of specialists under such circumstances may have contributed  to important information system weaknesses at corporates that were either  not identified by NCUA or not promptly corrected. For example, U.S.  Central’s automated clearing house (ACH) software had deficiencies that  led to a system failure that delayed payments to customers of 2,200 natural  person credit unions for nearly 2 days. According to NCUA, information  systems specialists had reviewed the system’s performance in prior  examinations. However, because the Automated Clearing House (ACH)  software was mature and U.S. Central staff was monitoring its  performance, NCUA did not consider it a high-risk component of U.S.  Central’s operations and had not reviewed it recently. As a result,  weaknesses in their backup procedures and routine maintenance,  insufficient capacity (noted in prior examinations but not satisfactorily  resolved), and other deficiencies that resulted in the outage were not  corrected. NCUA has stated that it is reviewing its procedures to determine  if such systems should receive a minimum level of review. NCUA has also  acknowledged that the ACH delay resulted in financial loss and increased  reputation risk to the corporate network.
NCUA also faces other obstacles to conducting more systematic  evaluations of risk—both in assuring that corporates have the capacity for  managing risks and ensuring that, as a regulator, it has the staff to assess  the quality and operations in corporates’ risk management functions. As  noted previously, corporates have been operating in a challenging  investment environment, with additional authorities to make lower-rated  investments. Consequently, the quality of risk management at corporates  has grown in importance. While the results of our review of the risk  management function at the three largest corporates suggested that these  corporates were taking appropriate steps to assess and mitigate their risks,  these corporates had a relatively small number of staff in their risk  management functions. More specifically, the largest corporates and U.S.  Central were using sophisticated financial models to assess and manage interest-rate, credit, and liquidity risks. But a rating agency and external  auditor have expressed concerns about small staff sizes and how they  affect these corporates’ continued ability to evaluate and manage risks and  undertake succession planning should key staff leave. The loss of any such  staff at a corporate could hamper its ability to undertake the sophisticated  analyses needed to evaluate risks. The thinness of corporates’ risk  management staffs indicates that NCUA should routinely assess  corporates’ investment risk. However, as we noted earlier, NCUA also has a  limited number of specialists to conduct comprehensive evaluations of risk  management at corporates. Given that the risk-focused approach allows  judgment in assigning resources to areas of greatest concern, the thinness  of corporates’ risk management staff, in combination with the limited  number of specialists at NCUA, suggests that continued attention to  corporates’ investment strategies may help to ensure that corporates are  adequately undertaking their risk management functions. Therefore, this  may require NCUA to reassess its staffing levels and consider the costs and  benefits of adding additional examiners or specialists to adequately  monitor and oversee the growing complexity of corporates’ operations.
section_title: As Corporate Network Consolidates, Merger Approval Process Could Be Improved with Better Guidance
paragraphs: As part of its regulatory authority to ensure the safety and soundness of  corporates, NCUA reviews and approves corporate merger applications.  Some corporates, NCUA, and trade-organization officials indicated that  consolidation in the network—as a result of mergers—would likely  continue over the next several years. However, with more mergers likely,  NCUA has not developed specific guidance for corporates preparing  merger proposal packages. In contrast, NCUA has issued guidance for  natural person credit unions that provides step-by-step instructions for  completing the merger process, and NCUA refers corporates to this  guidance. However, NCUA has recognized that this guidance may be  insufficient for corporates. In its guidance to examiners, who are  responsible for evaluating merger proposal packages, NCUA has suggested  that capital ratios unique to corporates, defined in Part 704 of NCUA’s Rules  and Regulations, were more appropriate than the probable asset share ratio applicable to natural person credit unions. However, in the guidance on  mergers available to corporates on its Web site, NCUA has not indicated  that corporates needed to include this information. In our review of five  merger packages recently approved by NCUA, we found that three merger  packages were initially submitted without the corporate capital ratios  defined in Part 704. These merger packages required revision or additional  analysis by the corporate and NCUA before the package could be  approved, encumbering the approval process.
Other regulators such as OCC have provided detailed guidance to banks  applying for mergers that listed specific data needed for evaluation and  described the regulators’ merger review process. OCC has stated that their  approach is intended to avoid misunderstandings and unnecessary delays  in the approval. NCUA officials told us they considered several factors  when approving corporate mergers such as consolidated budgets and  conversion and consolidation plans for information systems that it has not  discussed in the natural person credit union guidance. However, only one  of the five merger proposals we analyzed was submitted with this  additional information. Other corporate’s proposals required revisions or  were approved without additional information being provided. One  corporate stated they believed the merger process could be improved and  made less cumbersome if NCUA provided clearer or more specific  guidance for corporates. Finally, NCUA’s guidance did not explicitly discuss  how the effects of competition should be considered when approving  corporate mergers, which may become more of an issue as the network  continues to consolidate and corporates increasingly compete with each  other or with other financial institutions.
section_title: Corporates Not Subject to Internal Control Reporting Requirements of FDICIA
paragraphs: As corporates react to a competitive environment by investing in  technology and offering more products and services, NCUA’s oversight of  internal controls at corporates becomes even more critical. However,  corporates with assets over $500 million were not required to report on the  effectiveness of their internal controls for financial reporting. Under the  Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)  and its implementing regulations, banks and thrifts with assets over $500  million are required to prepare an annual management report that contains:  a statement of management’s responsibility for preparing the  institution’s annual financial statements, for establishing and  maintaining an adequate internal control structure and procedures for  financial reporting, and for complying with designated laws and  regulations relating to safety and soundness; and  management’s assessment of the effectiveness of the institution’s  internal control structure and procedures for financial reporting as of  the end of the fiscal year and the institution’s compliance with the  designated safety and soundness laws and regulations during the fiscal  year.
Additionally, the institution’s independent accountants are required to  attest to management’s assertions concerning the effectiveness of the  institution’s internal control structure and procedures for financial  reporting. The institution’s management report and the accountant’s  attestation report must be filed with the institution’s primary federal  regulator and any appropriate state depository institution supervisor, and  must be available for public inspection. These reports allow depository  institution regulators to gain increased assurance about the reliability of  financial reporting.
The reporting requirement for banks and thrifts under FDICIA is similar to  the reporting requirement included in the Sarbanes-Oxley Act of 2002.  Under Sarbanes-Oxley, public companies are required to establish and  maintain adequate internal control structures and procedures for financial  reporting. In addition, a company’s auditor is required to attest to, and  report on, the assessment made by company management on the  effectiveness of internal controls. As a result of FDICIA and  Sarbanes-Oxley, reports on management’s assessment of the effectiveness  of internal controls over financial reporting and the independent auditor’s  attestation on management’s assessment have become a normal business  practice for financial institutions and many companies.
While NCUA has issued a letter to corporates indicating that selected  provisions of the Sarbanes-Oxley Act of 2002, including the provision on  internal control reporting standards, may be appropriate to consider,  NCUA has not mandated that corporates adopt this standard. Given that  other depository institutions of similar size are required by FDICIA to  adhere to the internal control reporting requirements to ensure safety and  soundness, NCUA’s lack of such a requirement for corporates raises the  question of whether NCUA has the necessary information to adequately  assess corporates’ internal controls. This assessment has become more  important as corporates’ operations have grown in complexity due to their  changing investment strategies, investments in technology, and  introduction of new products and services.
section_title: Conclusions
paragraphs: Increased competition both inside and outside of the credit union system  has challenged corporates to explore new technologies and introduce more  products and services to retain their members. Increased competition,  large fluctuations in inflows and outflows of deposits, in combination with  low interest rates, have created potential stress on the financial condition  of corporates and U.S. Central. While corporates’ assets have increased  rapidly, their ability to increase earnings remained constrained. As a result,  corporates have increased their investments in privately issued,  mortgage-related and asset-backed securities, which can increase returns  but require more sophisticated analysis and monitoring. The change in  corporates’ investment profile is another indication of the growing  complexity in their operations. Since some corporates have been allowed  to invest in lower-rated securities (although few have), this could introduce  increased risks in the system if not managed properly. With the changing  operating and investment environments, this increases corporates’  potential vulnerability to different financial stresses—and requires that  corporates and their regulator, NCUA, place continued attention on their  risk-assessment and monitoring strategies.
NCUA has made strides in strengthening its oversight of corporates,  particularly with the adoption of a risk-focused approach, certain  regulatory changes, and the hiring or training of specialists in information  and payment systems and capital markets. We believe these actions have  helped NCUA to more effectively oversee corporates. However, based on  issues we identified, we believe NCUA should do more to anticipate and  address emerging network issues. In particular, a tracking system used in  conjunction with other measures, such as information from its  management and call reports, could provide timely and significant  information to NCUA that would help ensure that its risk-focused approach  addressed individual as well as networkwide risks. The relatively small  number of specialists during a time of increased competition and growing  complexity in corporate operations raises additional concerns since NCUA  had not systematically incorporated specialists in planning risk-focused  examinations, or tracked recurring or pervasive issues throughout the  network. We believe this makes it difficult for NCUA to determine the  number and type of specialists that are needed or to anticipate problems to  adequately monitor or oversee the corporate network. Further, with the  continued consolidation in the network, NCUA’s guidance was inadequate  to ensure that examiners consistently evaluate proposed corporate  mergers. Without sufficient guidance for corporates and examiners, NCUA  lacks assurances that decisions on corporate mergers are consistently  being made using appropriate criteria and information or that these  decisions are consistently being made in the best interests of their  members and NCUSIF. We believe that corporates and NCUA examiners  would benefit from better guidance since consolidation, through mergers,  is likely to continue. The growing complexity in operations and the  products that corporates have introduced also raise important concerns  about whether NCUA can ensure that corporates’ internal controls, which  are central to monitoring operations and risk management, are properly  assessed and monitored. However, NCUA has not required corporates to  follow the same internal control reporting requirements (defined under  FDICIA) as other financial institutions that face similar risks. Finally, the  changing profile of the industry introduces both greater opportunities and  greater challenges for NCUA, as the regulator of these institutions, to  achieve a balance that ensures the network’s ability to introduce beneficial  changes and properly manage its risks.
section_title: Recommendations for Executive Action
paragraphs: To promote a more systematic and consistent approach in NCUA’s  oversight of corporates to ensure they are safely providing financial  services to natural person credit unions, we recommend that the Chairman  of the National Credit Union Administration take the following five actions:  Establish a process and structure to ensure more systematic  involvement of specialists in identifying and addressing problems and  developing and consistently applying policies, and reassess whether  there are sufficient specialists to oversee corporates;  Track and analyze examination deficiencies on a networkwide basis to  identify and track recurring and pervasive issues throughout the  network and to ensure that corporates take required corrective actions;  Pay increased attention to oversight of corporates’ risk management  functions to ensure corporates have sufficient capacity and skills to  monitor and manage their risks;  Provide specific guidance to corporates for merger proposal packages  to ensure they are providing sufficient and relevant information, and  improve guidance to examiners to ensure that merger proposals are  reviewed consistently and meet the goals of serving members while not  placing NCUSIF at undue risk; and   Require corporates with assets of $500 million or more to be subject to  the internal control reporting requirements of the Federal Deposit  Insurance Corporate Improvement Act of 1991 to ensure that corporates  are held to the same standards as other financial institutions that face  similar risks.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from the Chairman of the  National Credit Union Administration. We received written comments from  NCUA that are summarized below and reprinted in appendix VIII. In  addition, we received technical comments from NCUA that we  incorporated into the report, as appropriate.
NCUA stated that it concurred with most of our assessments and  conclusions contained in the report and plans to take actions to implement  all but part of one of our recommendations.
Specifically, NCUA concurred with the report’s assessment that corporates  are operating in an increasingly challenging and competitive environment.  In its comments on a draft of this report, NCUA stated that its changes to  the corporate rule, made in response to the dynamic financial marketplace,  functioned as intended, thus permitting the corporates’ balance sheets to  expand and contract, sometimes rapidly, depending on liquidity levels in  credit unions, while not compromising safety and soundness. NCUA agreed  that the influx of deposits, combined with decreasing interest rates had  strained profitability and resulted in lower capital ratios. However, NCUA  did not agree with the report’s assessment that paid-in capital and  membership capital are “weaker forms of capital.” NCUA restated its  requirements for these two forms of capital and, as stated in the report,  believed that both paid-in capital and membership shares are available to  cover losses that exceed retained earnings, and are not insured by either  NCUSIF and cannot be pledged against borrowings. While we agree with  NCUA’s statements, as further discussed in the report, we remain  concerned that both forms of capital are from external sources and are less  permanent than retained earnings, therefore, providing a relatively weaker  cushion against adverse financial events.
In commenting on corporates’ investments, NCUA believed that the slight  potential increase in credit risk exposure due to the 2002 rule change  permitting corporates to purchase securities with lower credit quality is  more than offset by the rule’s decrease in exposure to credit concentration  risk. Additionally, NCUA is of the opinion that the rule’s “modest  expansion” of permissible investment graded securities, combined with its  reduction in credit concentration limits, results in a stronger corporate  network—that corporate management is better positioned to compete,  within prudent safety and soundness thresholds, than under the previous  rule. NCUA also pointed out in its comments that as of June 30, 2004, 97  percent of the network’s rated long-term securities are rated AAA. Based  on the high quality and diversification of the network’s investments, NCUA  believes credit risk is minimal. NCUA stated that it has addressed  controlling interest-rate risk in the corporate rule and its assessment of the  network’s investment portfolio interest-rate risk is minimal. We  acknowledged in our report that corporates either have made few or no  investments in BBB rated securities, and they indicated that they did not  plan to use their authority to purchase such investments. However, it is not  clear to what extent corporates will take advantage of this investment  flexibility in the future, which has implications for NCUA’s oversight,  especially given the thinness of risk-management staff at corporates.  Further, we share Treasury’s concerns that allowing corporates to invest in  BBB rated securities could weaken the safety and soundness of the  corporate network because the amount of capital held in the corporates  might not be commensurate with the risks associated with these lower  credit quality investments.
While NCUA concurred with the report’s recommendation for the need to  provide corporates with specific merger guidance to facilitate the  regulatory review process, NCUA did not concur with the report’s  conclusion that improved guidance to examiners is needed to ensure  mergers meet the goals of serving members while not placing NCUSIF at  undue risk. NCUA stated in its comments that it has adequate procedures  in place, and that every corporate merger package prepared by OCCU is  reviewed by NCUA’s Office of General Counsel prior to being presented to  the NCUA Board for action. As stated in the report, NCUA officials told us  that they considered several factors when approving corporate mergers  such as consolidated budgets and conversion plans for information  systems that NCUA has not discussed in the natural person credit union  guidance. However, we found that only one of the five merger proposals we  analyzed was submitted with this additional information and, therefore, we  do not believe that NCUA’s guidance to examiners was sufficient to ensure  that examiners consistently evaluate corporate mergers. As stated in the  report’s conclusions, without sufficient guidance, NCUA lacks assurances  that decisions on corporate mergers are consistently made using  appropriate criteria and information or that these decisions are made in the  best interests of their members and NCUSIF. While clear criteria and  consistency in review are important, improving examiner guidance for  mergers is also necessary to help protect against forbearance on the part of  NCUA.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from its  issuance. At that time, we will send copies of the report to the Chairman of  the Senate Committee on Banking, Housing, and Urban Affairs; the  Chairman and Ranking Minority Member of the House Committee on  Financial Services; and interested congressional committees. We also will  send copies to the National Credit Union Administration and make copies  available to others upon request. In addition, this report will be available at  no charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions regarding this report, please   contact me at (202) 512-8678 or hillmanr@gao.gov or Debra R. Johnson at  (202) 512-9603 or johnsond@gao.gov. Key contributors are acknowledged  in appendix IX.
section_title: Objectives, Scope, and Methodology
paragraphs: Our report objectives were to (1) assess the changes in financial condition  of corporate credit unions (corporates) since 1992 and (2) assess the  National Credit Union Administration’s (NCUA) supervision and oversight  of corporates, particularly with regard to how it identifies and addresses  safety and soundness issues in the industry.
subsections: section_title: Financial Condition of Corporate Credit Unions Since 1992
paragraphs: To assess the changes in the financial condition of corporates since 1992,  we analyzed corporate credit union call report data, which include balance  sheet and income statement data for corporates. Our analysis, based on  Forms 5300 and 5310 data supplied by NCUA, included calculating  descriptive statistics and key financial ratios and describing trends in  financial performance and the structure of the industry. The information  included Form 5300 data from the end of 1992 through the end of 1996 and  monthly Form 5310 data from January 1997 through December 2003. Our  analysis relied upon selected balance sheet and income statement data  such as assets, shares, investments, capital, net economic value (NEV), and  various income measures and ratios that are commonly used to assess the  financial condition of financial institutions. The transition in 1997 from  Form 5300 (still used by natural person credit unions) to Form 5310, which  is specifically designed for corporates, entailed numerous changes in  reporting. Furthermore, significant regulatory changes, effective in 1998,  also resulted in numerous changes to the information reported on Form  5310 for 1998. Overall, these changes resulted in the deletion of some items  from the financial reports and the addition of others. Subsequently, in some  cases the data were not comparable across time. For example, NEV, which  is a measure of interest-rate risk, was added to Form 5310 in 1998; thus, we  were only able to conduct analysis on this measure from 1998 to 2003. In  our prior report on natural person credit unions, we reviewed NCUA’s  procedures for verifying the accuracy of the Form 5300 database and found  that the data were verified on an annual basis, either during the corporate  credit union’s examination, or through off-site supervision. We determined  that the data were sufficiently reliable for the purposes of this report. We  also performed a data reliability assessment on data from January 1997  through December 2003 for Form 5310, which involved electronic testing of  the data and obtaining information from NCUA on its data verification  procedures. We found that the data were verified for accuracy on a monthly  basis and determined that the data were sufficiently reliable for the  purposes of this report.
To augment our analysis and obtain a more comprehensive assessment of  corporates’ financial condition and risks, we reviewed internal corporate  credit union financial analysis reports from selected corporates,  independent evaluations of corporate risk controls and models, and  external studies of the industry from major rating agencies, such as Fitch,  Moody’s, and Standard and Poor’s. We also met with selected NCUA  examiners and risk management staff at corporates to better assess how  corporates were managing their risks. In addition, we reviewed internal  documents and analyses dealing with risk monitoring and control from  several corporates in order to assess how well these corporates could  assess and manage risk.
section_title: NCUA’s Supervision of Corporates
paragraphs: To assess how NCUA’s supervision of corporates identifies and addresses  safety and soundness issues, we conducted a review of key legislative and  regulatory changes affecting corporates since 1992. We reviewed NCUA  documentation on its risk-focused program, including NCUA examination  reports, their corresponding three-year plans, and the Office of Corporate  Credit Union (OCCU) management reports for all 31 corporates for 2001- 2003. We conducted interviews with OCCU management and with OCCU  examiners-in-charge for 10 corporates. In addition, we visited seven  corporates. We developed a structured questionnaire for all 31 corporates  to solicit their views on what challenges individual institutions and the  collective corporate network faced. We reviewed past GAO and U.S.  Department of the Treasury reports on corporates and NCUA, internal  reviews of OCCU, and an external review of OCCU performed by an  outside auditing firm. We also contacted officials from the Federal Deposit  Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS), the  Office of the Comptroller of Currency (OCC), and the Board of Governors  of the Federal Reserve System. Lastly, we interviewed trade association  officials.
As part of our legislative review, we reviewed the Federal Credit Union Act  to determine the legislative authority for corporates and NCUA’s Part 704,  which is the primary regulation governing corporates. Specifically, we  reviewed the Federal Register for all changes made to Part 704 since 1992  to understand the rationale behind these changes. We also obtained  summaries from NCUA, which provided their rationale for the changes and  brief descriptions of the changes to specific sections of Part 704.
To assess NCUA’s documentation for its risk-focused program, we reviewed  NCUA’s Corporate Examiner’s Guide, which describes the policies and  procedures under which examiners are to implement the risk-focused  program. The guide describes procedures for off-site monitoring, on-site  examinations, information required in an examination report, and  coordination with state supervisory authorities for corporates that have a  state charter.
Also, as part of our assessment of NCUA’s risk-focused examination  program, we reviewed about 100 examinations for the 31 currently  operating corporates, corresponding 3-year plans, and OCCU monthly  management and quarterly reports for the period January 2001 through  December 2003. For the review of examinations, we developed a data  collection instrument (DCI) to collect 3 years’ worth of information for  each of the 31 corporates. The DCI enabled us to aggregate examination  areas appearing in a large number of corporates over the time period  reviewed that could be potential networkwide issues due to their  prevalence or persistence. Examples of findings identified by NCUA in the  various examination areas included errors or problems associated with  5310 reporting, accounting procedures, asset/liability management, Bank  Secrecy Act compliance, contingency planning, corporate governance,  credit analysis, funds transfer, information systems, interest-rate risk,  investment, lending, and management.
The 3-year plans included information on the last examination and financial  profiles—for example, daily average net assets (DANA), capital ratios, and  net economic value (NEV). These plans also contained the supervision type  of the corporate, supervision plans, Corporate Risk Information System  (CRIS) ratings, and in some cases, requests for information system, payment system, or capital market specialists for the next examination or  supervision contact.
The OCCU monthly management reports covered areas such as OCCU’s  administration news, trends in corporates, significant problem case  corporates, other significant program issues, miscellaneous corporate  information, information on internal or external affairs, board action items,  and the next month’s calendar. The quarterly reports provided a brief  update of events since the previous report, a summary of corporate  network trends, the current status of e-commerce in corporates, specific  discussions on 20 percent to 50 percent of individual corporates, and the  future outlook for corporates and OCCU during the next quarter and  beyond.
We met with OCCU management to follow up on questions generated from  our review of the examinations, 3-year plans, and OCCU monthly  management and quarterly reports. We also selected a judgmental sample  of 10 corporates from which to gather additional information about NCUA  oversight. These corporates were selected based on asset size, geographic  location, charter type, level of expanded investment authority, and  significant findings in the examinations. We obtained NCUA’s most recent  examiner workpapers for these 10 corporates to review how NCUA  supported its findings. We also met with the examiner-in-charge and, when  possible, capital market specialists for the 10 corporates to better  comprehend their approach to examining the corporate credit union and to  understand the support and rationale for some examination findings. In  addition, we visited 7 of the 10 corporates to observe and discuss their  operations, risk management practices, and interactions with NCUA. We  selected these 7 based on their asset size, geographic location, type of  charter (state or federal), and whether they had expanded investment  authorities. We interviewed senior management and some board and  supervisory committee members. We asked structured questions of  officials from various departments within the corporates. The departments  included investments, risk management, accounting, internal audit,  external audit, information systems, and product support. We obtained  policies and procedures for various areas within the corporates, including  investments, lending, and risk management. We also obtained  documentation packages, which were submitted to the asset/liability  committees of corporates for some of the institutions we visited, to review  investments and their impact on the risk within the corporates. We also  observed corporates’ physical environment to determine the types of  safeguards that were in place, particularly for information technology.
We developed a structured questionnaire to collect information from the  corporate network that focused on their perspectives about various  components of the industry. We pretested the questionnaire with one of the  largest corporates and received numerous meaningful observations about  our original version and made refinements. We administered the structured  questionnaire to the entire population of active corporates (as of December  31, 2003) as shown in appendix II.
Appendix III includes a copy of our structured questionnaire, and appendix  IV includes responses to the majority of questions in the questionnaire. The  Association of Corporate Credit Unions (ACCU) oversaw the distribution  of our structured questionnaire to its 30 corporate members. We  administered the questionnaire to the one non-ACCU corporate member.  The questionnaires were sent by e-mail at the end of March 2004. We  received all responses to our questionnaire by mid-May 2004 and achieved  a 100 percent response rate. We conducted follow-up telephone interviews  with numerous corporates to obtain clarification on some of their  responses. Our questionnaire covered the following areas:  products and services that corporates offer to their natural person   Credit Union Service Organizations (CUSO),   corporate investments with U.S. Central,  regulatory changes and impacts on corporates’ operations,  the effects of the risk-focused approach on corporates,  corporates’ fields of membership,  challenges corporates face and their responses to these challenges, and  corporates’ immediate and future merger plans.
We analyzed the results by summarizing responses or providing simple  statistics (for example, range, median, and average) to most of the  quantitative questions. Specifically, we conducted quantitative analysis on  questions 1, 3, 4, 5, 7, 7a, 11, 12, 13, 14, 17, and 21. We performed content  analysis on most of the responses to the qualitative questions. Specifically,  we conducted content analysis on questions 8, 9, 10, 16, 19, 20, 21a, and 22.  The results of our analysis for most of the questions are presented in  appendix IV.
To gain a better understanding on the challenges and problems NCUA has  faced in overseeing corporates, we reviewed past GAO and U.S.  Department of the Treasury reports on corporates and NCUA. These  reports also provided recommendations for NCUA to improve its oversight.  Additionally, we reviewed internal NCUA reviews on OCCU. These reviews  are conducted about every 3 years by OCCU’s Director and staff from  outside OCCU, who review OCCU’s operations and suggest improvements.  Similarly, NCUA has contracted for an outside party to review OCCU’s  operations, and this party also has provided recommendations on  improvements in OCCU management and oversight. OCCU’s last external  review was completed in 2002. We interviewed officials from the  Department of the Treasury and academia who had studied corporates.
To obtain information on the experiences of other depository institution  regulators with the risk-focused examination and supervision approach, we  obtained written responses from officials at FDIC, OTS, OCC, and the  Board of Governors of the Federal Reserve System.
Finally, to obtain perspectives on the business environment confronting the  corporate network and their responses to a changing environment, we  interviewed trade association officials from ACCU, the National  Association of Federal Credit Unions, including its board of directors, and  the National Association of State Credit Union Supervisors.
We conducted our work from December 2003 to September 2004 in  Alexandria, Virginia, Washington, D.C., and other U.S. cities in accordance  with generally accepted government auditing standards.
section_title: Corporate Credit Unions Active as of December 31, 2003
section_title: Structured Questionnaire to Corporate Credit Unions on Their Current Makeup and Challenges Facing the Network
paragraphs: We distributed the following questionnaire to the entire network of  corporates in the United States, including both federally and state- chartered institutions, and achieved a 100 percent response rate.  (Appendix II lists the 31 corporates active as of December 31, 2003, and  whether they are federally or state-chartered.) The questionnaire has three  sections: products and services, regulatory changes, and challenges facing  corporates. The first section addresses the types of products and services  offered by corporates to their members, the issues they faced regarding  competition, the type of investment authorities corporates had or sought,  and the extent of their investments with U.S. Central Corporate Credit  Union. The second section addresses various regulatory issues such as  what regulatory changes affected their institution, a description of the  corporate’s field of membership (for example, whether they had a national  field of membership), and their perception of NCUA’s risk-focused  supervisory approach. Finally, the questionnaire solicits the opinions of  corporate managers on what future issues the corporate credit union  industry faces. Appendix IV contains selected responses to the  questionnaire.
The U.S. General Accounting Office (GAO),  an independent agency of the U.S. Congress,  has been asked to review the National  Credit Union Administration’s (NCUA)  oversight of corporate credit unions on  behalf of the Senate Banking committee.  As  part of this review, we are collecting  information from the corporate credit union  network.  We are sending this questionnaire,  via the Association of Corporate Credit  Unions, to each of the 31 corporate credit  unions, in order to reflect corporate credit  unions’ perspective in our study. substantive questions and is largely fact- based for the purpose of allowing the GAO   to accurately describe the current makeup  of the corporate credit union network.
In addition, the survey asks for the opinion  of the management of your corporate credit  union on the future issues that face the  industry.  Those questions are included to  ensure that the issues covered in our report  reflect the perspective of the corporate  network.
The questionnaire should be answered by  the official (or officials) most familiar with  the corporate credit union’s operations.   Specifically, our review is focused on  examining the following three questions: (1) How has the financial condition and  function of corporate credit unions changed  over time and what have been the effects of  that change; (2) To what extent does  NCUA’s supervision of corporate credit  unions identify and address safety and  soundness issues in the industry; and (3)  What challenges do corporate credit unions  face and what actions are they taking to  address these challenges.
Your responses and all company  information you provide will be treated to  protect your privacy and that of the  corporate credit union.  Responses will be  reported in aggregate, and therefore will not  be used in any way that would identify you  or your corporate credit union.
Please return your completed questionnaire  to GAO by April 15, 2004.  The response  should be submitted electronically as a  Microsoft Word file attachment sent to May  Lee at Leem@gao.gov , or if you like, we  could make other arrangements for your  submission.  Please call May Lee at (415)  904-2182 to make such arrangements.
If you have any questions about this survey  or the GAO study, please contact  José R.  Peña, Analyst-in-Charge, at (415)-904-2268.  or email him at penajr@gao.gov.
Thank you for your participation.
I. Products, Services and Investments  1)  Please complete the following table describing the products and services that your corporate credit union  offered?  (Yes or No) five years? in the next   two years?
Yes   Yes   Yes   Yes   Yes    1. Marketing    2. Online Training    3. Rates/Events Updates/News    1. ACH Services    2. Cash Concentration    3. Check Imaging    4. Electronic Bill Payment    5. Funds/Wire Transfers (In & Out)    6. Internet Banking    7. Website Design and Management  (continue on next page.)
Yes   Yes   Yes   Yes   Yes   Yes   Yes  (continuation of Q1.) offered?  (Yes or No) five years? in the next   two years?
F. Funds Management/Financial  Services   1. Account Management & Statements    2. Amortizing Certificates (ACP)    3. Asset/Liability Management    4. Brokerage Services    5. CDs    6. Corporate Checking Accounts    7. Derivatives Hedging    8. Dividend Earning Accounts    9. Investment Advisory  10. Loans/Lending  11. Members’ Business Accounts  12. Members’ Capital Accounts  13. Money Market Accounts  14. Open-End and Term Credits  15. Overnight/Cash Management Accounts  16. Savings Bonds  17. Share Certificates (all kinds)
Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes   Yes    1. Cash Letter Credit     2. CU Service Settlement    3. CUNA Service Group Settlement    4. CUNA Mutual Services    5. Reverse Purchase Program    6. Securities Safekeeping  H. Other (Specify.)
Yes   Yes   Yes   Yes   Yes   Yes    1.     2.     3.     4.     5.
Yes  2)  How are your member capital accounts structured?  3)  By size of assets, how many of your members are NPCUs, CCUs, or Others?  (Enter the number of  your Corporate members in each cell.  If none, enter “0”.) >$10M but <$100M  >$100M but <$1 Billion  4) What percentage of your various lines of business are from the following Natural Person (or Corporate) Credit  Union member size categories?  (Enter percent by size for each line of business. Percentages should total to 100%)
5)  Has your Natural Person (or Corporate) Credit Union members’ use of services increased (I),  stayed the same (S), or decreased (D) since CY1992 , as broken out by member size?  (Select  a letter for each cell in the table using the following indicators; then enter it in the cell.
I = INCREASED use of the service  S = SAME use of the service as before 1992  D= DECREASED use of the service  NA = Not applicable)
6)  What do you think are the reasons for any changes in your members’ use of your services?  7)  How many CUSOs does your corporate credit union have a stake in? (Check one.) 1. 2. 3. 4.
0  (Skip to Question #8.)    1    2    3 or more  7a) If 1 or more, please complete the following table and continue to question 7b.  7b) How do the services that these CUSOs provide differ from the services the corporate  credit union provides?  8)  In what ways does your corporate credit union face competition from outside the corporate  credit union network?  (If no external competition, skip question 8a.)  8a) What are the sources of that competition, and which products services are most  affected? 8b) To what extent do you expect competition to continue to increase in the next several  years? 9)  In what ways have you felt competition from other corporate credit unions increase in the  last five years? 10) To what extent do you expect competition from other corporate credit unions to continue to  increase in the next several years?  11) What investment authorities do you currently have? (Check all that apply.) 1. 2. 3. 4. 5. 6. 7. 8.
Base  Base Plus   Part I   Part II  Part III     Part IV   Part V   Other (Specify.)   12) Do you plan on asking for more authorities in the next two years?  If yes, then which ones?   (Check all that apply.) 1. 2. 3. 4. 5. 6. 7. 8.
Base  Base Plus   Part I   Part II  Part III     Part IV   Part V   Other (Specify.)   13)  What percent of your investments are made through U.S. Central?   = Percent of investments with U.S. Central.  14) Which of the following categories best describes your planned use of U.S. Central for  investment purposes in the next two years? 1. 2. 3. 4.
To do Less with U.S. Central    To do the Same with U.S. Central    To do More with U.S. Central    Do not currently invest in U.S. Central AND do not plan to do so in next two years  15) Which regulatory changes – including changes to Part 704 – have had the most impact on  your corporate credit union?    15a) Please describe how those changes have impacted your corporate credit union’s  operations?    16) Please describe the effect of NCUA’s more risk-based approach of corporate credit union  examination on your corporate credit union?  17) Do you have a national field of membership? Check one.) 1. 2. 18)  How many NPCU members are within your Corporate field of membership in each of the  following states?  (If other than “0”, enter actual number of member NPCUs in each state.)
subsections: section_title: III. Challenges Facing Corporate Credit Unions
paragraphs: 19) What are the primary challenges facing your corporate credit union as it attempts to maintain  and/or grow its membership in the next two years?  20) What is your corporate credit union doing to address these challenges?  21) What is your corporate credit union’s current merger plans?  1. 2. 3. ______________________ 4. 5.
In discussions to merge with another corporate credit union    Likely to merge with another corporate credit union in the next two years     Will consider a merger with another corporate credit union in the next two years    Will not consider a merger in the next two years    Uncertain  21a) If you checked either box 1, 2, or 3 in the previous question (#21), please describe the  factors that contribute to your corporate credit union’s decision to consider a merger?  22)   What are the three major challenges currently facing the corporate credit union industry as  a whole?  1.   2.   3.   23) Please indicate the name, title, and phone number of the person(s) who was mainly  responsible for filling out this questionnaire.
Phone number:   24) Please indicate the name, title, and phone number of the person GAO staff should contact if GAO has follow up questions. 25) Would you like to discuss any of the above questions in further depth, or anything else  related to our review of the corporate credit union industry, with GAO?   1. 2.
If YES, please provide name, title, and phone number of the person to contact to  schedule a follow-up conversation.
Thank you for completing the Survey  (Save your completed survey as an MS Word document and   send it as an attachment to May Lee at Leem@gao.gov)
section_title: Selected Responses to Structured Questionnaire Distributed to Corporate Credit Unions
paragraphs: As noted in appendix III, we distributed a questionnaire to the entire  network of corporates. This appendix provides responses to the majority of  questions posed in the questionnaire (see questions 1, 3-5, 7-14, 16-17, and  19-22). This information was analyzed in the aggregate to prevent specific  responses from being associated with an individual institution.
The information included in this appendix is based on the responses of 31 corporates, unless  otherwise indicated.
Products and Services Corporate Credit Unions Offer  offered? to do so in the  five years? two years?
1. ATM Cards (Issuing)    2. ATM Settlements/Terminal Driving    4. Debit Cards (Issuing)  B. Check Services    2. Check Loss Reduction    3. Money Order Settlement    4. Share Draft Processing    5. Statement Prep and Mailing    7. Travelers Check Settlement  C. Correspondence Services    1. Coin and Currency    2. Federal Reserve Settlement    4. Foreign Check Collection    5. Foreign Currency Conversion  D. Education and Training    3. Rates/Events Updates/News  E. E-Services    4. Electronic Bill Payment    5. Funds/Wire Transfers (In & Out)    7. Website Design and Management    1. Account Management & Statements    2. Amortizing Certificates (ACP)    6. Corporate Checking Accounts  offered? to do so in the  five years? two years?
11. Members’ Business Accounts  12. Members’ Capital Accounts  13. Money Market Accounts  14. Open-End and Term Credits  15. Overnight/Cash Management Accounts  17. Share Certificates (all kinds)  G. Miscellaneous    1. Cash Letter Credit     2. CU Service Settlement    3. CUNA Service Group Settlement    4. CUNA Mutual Services    5. Reverse Purchase Program    6. Securities Safekeeping  H. Other (Specify.)  2. ATM/Pay Card Services    3. CDs    4. Consulting Services    8. Fraud Protection Products  15. Payment and Technology Products   17. Share Draft Electronic Image Exchange  18. Transit Return Processing  Responses displayed are as reported by corporates.
I = 23 (74.19%)
I = 23 (74.19%)
I = 17 (54.84%)
I = 23 (74.19%)
I = 14 (45.16%)
I = 12 (38.71%)
I = 10 (32.26%)
S = 4 (12.90%)
S = 5 (16.13%)
S = 7 (22.58%)
S = 5 (16.13%)
S = 3 (9.68%)
S = 5 (16.13%)
S = 2 (6.45%)
D = 0 (0%)
D = 1 (3.23%)
D = 5 (16.13%)
D = 0 (0%)
D = 0 (0%)
D = 1 (3.23%)
D = 0 (0%)
NA = 4 (12.90%)
NA = 2 (6.45%)
NA = 2 (6.45%)
NA = 2 (6.45%)
NA = 13 (41.94%)
NA = 13 (41.94%)
NA = 8 (25.81%)
I = 25 (80.65%)
I = 24 (77.42%)
I = 24 (77.42%)
I = 20 (64.52%)
I = 25 (80.65%)
I = 18 (58.06%)
I = 18 (58.06%)
S = 2 (6.45%)
S = 4 (12.90%)
S = 4 (12.90%)
S = 5 (16.13%)
S = 3 (9.68%)
S = 0 (0%)
S = 0 (0%)
D = 1 (3.23%)
D = 3 (9.68%)
D = 3 (9.68%)
D = 6 (19.35%)
D = 2 (6.45%)
D = 1 (3.23%)
D = 1 (3.23%)
NA = 3 (9.68%)
NA = 0 (0%)
NA = 0 (0%)
NA = 0 (0%)
NA = 1 (3.23%)
NA = 12 (38.71%)
NA = 12 (38.71%)
I = 24 (77.42%)
I = 23 (74.19%)
I = 19 (61.29%)
I = 23 (74.19%)
I = 16 (51.61%)
I = 17 (54.84%)
I = 11 (35.48%)
S = 3 (9.68%)
S = 5 (16..13%)
S = 6 (19.35%)
S = 5 (16.13%)
S = 1 (3.23%)
S = 2 (6.45%)
S = 3 (9.68%)
D = 1 (3.23%)
D = 3 (9.68%)
D = 6 (19.35%)
D = 2 (6.45%)
D = 1 (3.23%)
D = 1 (3.23%)
D = 0 (0%)
NA = 3 (9.68%)
NA = 0 (0%)
NA = 0 (0%)
NA = 1 (3.23%)
NA = 11 (35.48%)
NA = 11 (35.48%)
NA = 6 (19.35%)
I = 17 (54.84%)
I = 19 (61.29%)
I = 15 (48.39%)
I = 19 (61.29%)
I = 11 (35.48%)
I = 8 (25.81%)
I = 5 (16.13%)
S = 4 (12.90%)
S = 4 (12.90%)
S = 5 (16.13%)
S = 3 (9.68%)
S = 4 (12.90%)
S = 7 (22.58%)
S = 5 (16.13%)
D = 0 (0%)
D = 1 (3.23%)
D = 4 (12.90%)
D = 1 (3.23%)
D = 0 (0%)
D = 0 (0%)
D = 0 (0%)
NA = 10 (32.26%)
NA = 7 (22.58%)
NA = 7 (22.58%)
NA = 8 (25.81%)
NA = 15 (48.39%)
NA = 16 (51.61%)
NA = 10 (32.26%)
I = increased, S = stayed the same, or D = decrease since calendar year 1992.  N/A = not applicable.
CU eArchive Solutions (CUeas)
CU National Item Capture (CUNIC)
Item processing for share drafts/check  (CUFSLP)
Carolina CU Services, Inc.
Credit Union Direct Lending (CUDL)
CSC II, Inc.
CU Business Partners (CUBP)
CU Investment Solutions, Inc.
CU West Mortgage (CUWM)
Merchant services and entry into loans,  deposits, payroll, commercial credit analysis   Member Trade Advisory Services, LLC  ALM educational, analytical, and advisory  Member Trade Financial Services, LLC  Mid-States Investment Solutions, Inc.
Open Financial Solutions, Inc.
Wisconsin CD Shared Service Center  This column indicates the total of corporate credit unions that indicated having ownership stakes in the Credit  Union Service Organizations.
Competition will remain about the same  6.45% Question 11:  Current Investment Authorities Held By Corporate Credit Unions  These two corporates offered loan participations through a waiver from NCUA. In addition, one of these  two respondents has “derivatives vendor status,” as approved by NCUA.
Corporate Credit Unions’ Plans to Seek Additional Expanded Authorities in the Next Two  Question 13:  Percentage Of Corporate Credit Unions’ Investments Made Through U.S. Central  Percent calculations did not include U.S. Central, therefore the base is 30 versus 31 corporate credit  unions.
Continue present level of investment with U.S. Central  Less investment with U.S. Central  Increase investments with U.S. Central Do not currently invest with U.S. Central and do not plan to do so in next  percent exceeds 100 percent because one corporate credit union responded to two response categories and was  included in both categories.
Positive response to risk-based approach   (for example, targeted exams)
No discernable impact from risk-based  Expressed concerns about targeted exam  approachTotal of this column is greater than 100 percent because two respondents expressed concerns in addition  to their comments (see table footnote b below).
Two respondents expressed concerns in addition to their comments on their reaction to the risk-based  approach.  Specifically, one respondent had a positive reaction and the other experienced no discernable  impact.
Currently have national field of  Do not currently have national field of  One of these corporates, Kentucky Corporate Federal Credit Union, has a regional field of membership; and the  other, LICU Corporate Federal Credit Union, facilitates payment and payroll processing for a league of IBM credit  unions.
Question 21a:  Contributing Factors to Consider Mergers Benefits to corporate and members  Increases in membership   Asset quality and increasesOthernext two years.
section_title: Financial Condition of Corporates, 1992-2003
paragraphs: The corporate credit union network has consolidated since 1992, with asset  concentration rising moderately. As corporates’ investments have grown,  their composition has changed, with relatively more emphasis on privately  issued mortgage-related and asset-backed securities and a shift toward  more variable-rate investments. Concurrent with net income ratios,  interest-related income and expense ratios have declined recently. In  recent years, natural person credit unions have invested less in corporates.
subsections: section_title: Corporate Credit Union Network Has Consolidated and Asset Concentration Has Risen Moderately
paragraphs: Since 1992, the corporate system has consolidated, a change primarily  driven by mergers. This consolidation trend has resulted in a moderate  increase in asset concentration. For more detailed, year-by-year  information, see the table and figures below.
section_title: Investments of Corporates Have Grown since 1992, and Composition Has Changed
paragraphs: As noted earlier, investments, which are the vast majority of corporates’  assets, have grown since 1992, but recently the percentage of corporates’  investments in U.S. Central has declined somewhat and corporates have  moved relatively more of their investments into privately issued mortgage- related and asset-backed securities. We made this determination using call  reports and other data (for more information on our methodology see app.  I). Since there were significant changes to NCUA’s call reports in 1997, in  the transition from Form 5300 to Form 5310, some account codes were not  available previously and thus could not be disaggregated.
In general, corporates’ investments in mortgage-backed securities  (including mortgage pass-throughs, collateralized mortgage obligations,  and real estate mortgage investment conduits) as a percentage of total  investments declined from the mid-1990s through 1998 in the wake of the  Cap Corp failure, which was largely driven by ineffective interest-rate risk  management for collateralized mortgage obligations. However, since 1998,  corporates steadily have been increasing their investments in mortgage- backed securities. In addition, corporates have been shifting more of their  investments in mortgage-related and asset-backed securities to variable- rate securities, a move that tends to lessen interest-rate risk. In particular,  while 41.7 percent of corporates’ asset-backed securities were classified as  fixed-rate at the end of 1997, by the end of 2003 this proportion stood at  18.0 percent. The trend in collateralized mortgage obligations and real  estate mortgage investment conduits (REMIC) has been similar, with a  relatively greater proportion now classified as variable rate. Table 3 offers  additional details of corporates’ investments in U.S. Central, privately  issued mortgage-related securities, and asset-backed securities, from 1997  through 2003.
section_title: Concurrent with Net Income Ratios, Interest- Related Income and Expense Ratios Have Declined Recently
paragraphs: Concurrent with the recent low-interest rate environment, corporates’  interest-related income and expenses, relative to average assets, have  declined, as illustrated in figure 10. Net interest income, total noninterest  income, and operating expense ratios cycled from 1993 through 2003,  generally expanding from 1995 through 2000 and then contracting through  2003. Recently, net interest income and operating expense ratios were  lower and total noninterest income ratios were higher, suggesting that fee  income has become more important for corporates.
Net interest income as a percentage of average assets is often referred to as  net interest margin. A corporate can maximize its net interest margin by  effectively allocating resources among earning and nonearning assets,  maintaining low levels of nonperforming assets, providing adequate  funding through the lowest cost mix of funds, and maintaining a strong  capital position. In a volatile interest-rate environment, large changes in a  corporate’s net interest margin are associated with high-interest-rate risk  exposures and weak risk management.
Net interest income, which is interest income minus interest expense, is  normally the primary source of income for a corporate and a key indicator  of earnings performance and stability. Interest income consists of interest  earned on loans and investments. The major contributor to interest income  within a corporate is normally the investment portfolio. Interest expense  consists of the corporate’s cost of funding operations, or simply its “cost of  funds.” Interest expense in a corporate is realized through dividends on  shares, share certificates, member capital accounts, and interest on  borrowings (for example, loans and commercial paper). As illustrated in  figure 11, interest income and expense have narrowed significantly since  2000.
section_title: In Recent Years, Natural Person Credit Unions Have Invested Less in Corporates
paragraphs: Natural person credit unions’ investments in corporates, which include  membership capital, paid-in capital, and other investments, actually were  lower at the end of 2003 than at the end of 1998—both in amount ($37.8  billion versus $29.1 billion) and as a percentage of investments (30.4  percent versus 18.1 percent). The smallest natural person credit unions  (those with assets of less than $100 million) consistently invested more in  corporates, as a percentage of their total investments, from 1998 through  2003. It is important to note that this measure does not include cash on  deposit in corporates, since these data were not disaggregated from  deposits in other financial institutions in the Form 5310 report until 2003.
At the end of 2003, natural person credit unions reported $26.2 billion in  cash on deposit at corporates, which represented over three-quarters of  natural person credit unions’ total cash on deposit. Corporates held $55.3  billion, or 26.9 percent, of the total amount of natural person credit unions’  cash on hand, cash on deposit, and investments at the end of 2003, with the  smallest natural person credit unions (those with assets of less than $100  million) holding around 34 percent and the largest (those with assets in  excess of $1 billion) holding around 23 percent of their total in corporates.  While it cannot be confirmed given the available data, the growth in natural  person credit unions’ loans, coupled with the possibility that natural person  credit unions have become more willing to invest their funds directly rather  than through corporates, may have resulted in relatively less funds flowing  from natural person credit unions into corporates.
section_title: Financial Condition of U.S. Central Generally Mirrors Other Corporates
paragraphs: U.S. Central Credit Union (U.S. Central) is a nonprofit cooperative that is  owned by corporates, and it serves these member-owners much like  corporates serve their natural person credit union members. Trends in U.S.  Central’s balance sheet and income statement suggest that its financial  condition has been similar to other corporates, with greater profitability  and slightly higher capital ratios.
The balance sheet of U.S. Central grew overall from 1992 through 2003.  However, as with the corporates, the dynamics of its asset and share  growth have varied as the use of U.S. Central by its member-owners has  varied. Investments, the vast majority of U.S. Central’s assets, have  mirrored the general growth pattern of its assets, declining through the  early to mid-1990s and rising thereafter. Recently, U.S. Central has moved  relatively more of its investments into privately issued mortgage-related  securities.
Overall, total assets and shares of U.S. Central have grown since 1992; after  generally declining in the early to mid-1990s, by the end of 2003 they were  reported at $35 billion and $30.7 billion, respectively (see fig. 12).
U.S. Central’s balance sheet is primarily influenced by the balance sheet  dynamics of its underlying corporate member-owners, which have varied  since 1992. As noted earlier, corporates saw their assets and shares decline  in the early to mid-1990s but then rebound; corporates’ assets and shares  both grew by over 80 percent from 2000 through 2003. While displaying a  similar cyclical trend from 1992 through 2003, U.S. Central did not  experience the same degree of growth from 2000, as assets grew by around  54 percent and shares grew by around 57 percent. As with corporates, in  general investments represent over 90 percent of U.S. Central’s assets, as  illustrated in figure 13.
Investments in accounts at U.S. Central, including overnight accounts, term  certificates, structured products, and membership shares, are important to  many corporates, especially the smaller ones. As of the end of 2003, 17, or  57 percent of all corporates, had at least 70 percent of their total  investments in accounts at U.S. Central and 4 had over 60 percent. With the  recent investment environment characterized by historic low interest rates,  U.S. Central’s members may have increased their utilization of U.S.  Central’s economies of scale to help increase the spreads between the rates  they offered their customers and the rates they earned on their  investments. In general, it seems sensible for corporates—especially the  smaller ones—to be able to rely on the services of U.S. Central given its  economies of scale. This reliance, however, adds more weight to the need  for U.S. Central to be a safe and sound investment.
As U.S. Central’s total investments have grown, the composition of these  investments has changed, particularly with increases in investments in  mortgage-related securities since 1997 (see table 4). U.S. Central’s  investments in privately issued mortgage-related securities increased from  3.4 percent of its total investments in 1997 to 24.7 percent of its total  investments in 2003. Overall, U.S. Central’s mortgage-related investments,  including government and agency mortgage-related issues, rose from 10.5  percent of its total investments to 32.7 percent of its total investments over  this period. As with corporates, asset-backed securities have consistently  been an important investment type for U.S. Central.
Holding variable-rate investments and securities with shorter weighted  average lives tends to result in relatively lower interest-rate risk. U.S.  Central, like the corporates, tends to have significant holdings of mortgage- related issues and asset-backed securities—80 percent of its portfolio was  in such investments at the end of 2003—but holds most of these in the form  of variable-rate and shorter weighted average life issues. Holdings of  variable-rate asset-backed and privately issued mortgage-related securities  accounted for 67 percent of all investments at the end of 2003. According to  its 2003 annual report, at the end of the year, mortgage-related and asset- backed securities in U.S. Central’s portfolio had weighted average lives of  approximately 2.8 years and 3 years, respectively, and approximately 83  percent of interest-earning assets were set to reprice or mature within 1  year. Table 5 details selected investments of U.S. Central from 1997 through  2003.
subsections: section_title: U.S. Central’s Capital Levels Generally Increased Since 1998 and, Despite Recent Asset Growth, Capital Ratios Were Higher in 2003 Than in 1998
paragraphs: Since 1998, U.S. Central’s capital has generally been rising. Total capital, as  defined in Part 704, rose from $1.2 billion in 1998 to $2 billion at the end of  2003. Figure 14 illustrates the growth in U.S. Central’s total capital.  Retained earnings and membership capital have grown overall, but paid-in  capital has remained constant since 1999.
Since 1998, undivided earnings (a component of retained earnings) have  provided the fastest growth, increasing 61 percent, while membership  capital, the largest component, has grown 37 percent. At the end of 2003,  membership capital accounted for 58 percent, or $1.1 billion, of U.S.  Central’s total capital.
Despite recent asset growth, U.S. Central’s capital ratios have remained  relatively stable, as shown in figure 15. After peaking in 2000, capital ratios  declined in 2001 but have since leveled off. They remain above the current  regulatory requirements.
section_title: U.S. Central’s Net Income and Profitability Have Grown Since 1992
paragraphs: U.S. Central’s net income has grown since 1992 and was at its highest level  at the end of 2003. As depicted in figure 16, after declining to $10.7 million  at the end of 1994, U.S. Central’s net income rebounded, generally rising  through 1998. After peaking in 1998 at $38.4 million, net income declined to  $22.8 million at the end of 2000. However, by the end of 2003, net income  had tripled to $67.9 million. U.S. Central’s profitability—that is, net income  divided by average assets—followed the general pattern exhibited by net  income since 1992, and it was at its highest at the end of 2003.
As with the corporates, U.S. Central witnessed a narrowing of its yields on  investments recently. However, while profitability suffered at the  corporates since 2001, U.S. Central managed to increase its profitability, in  part through increased noninterest income.
section_title: Expanded Authorities Available to Corporates
paragraphs: In 1998 NCUA revised Part 704. Among other things, the new regulations  provided qualified corporates with expanded authorities that allowed  corporates having a strong financial position, management, and  infrastructure to exercise greater flexibility in managing their risks subject  to NCUA approval. For example, corporates with certain levels of  expanded authorities were allowed to invest in foreign securities or A-  rated securities, compared with the higher-rated AAA securities in which  other corporates were allowed to invest. In 2002, NCUA again revised Part  704 to allow for further flexibilities in expanded investment authorities.  For example, qualified corporates were allowed to invest in BBB rated  securities, subject to NCUA approval. Table 6 provides more detail on the  types of investments allowed under the various levels of expanded  authorities, and the number of corporates that currently have these  authorities.
section_title: Comments from the National Credit Union Administration
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to those named in the body of this report, the following  individuals made key contributions: William Chatlos, May Lee, John Lord,  Alexandra Martin-Arseneau, Kimberley Mcgatlin, José R. Peña, Julie  Phillips, Mitch Rachlis, Barbara Roesmann, Paul Thompson, and Richard  Vagnoni.
section_title: GAO’s Mission
paragraphs: The Government Accountability Office, the audit, evaluation and  investigative arm of Congress, exists to support Congress in meeting its  constitutional responsibilities and to help improve the performance and  accountability of the federal government for the American people. GAO  examines the use of public funds; evaluates federal programs and policies;  and provides analyses, recommendations, and other assistance to help  Congress make informed oversight, policy, and funding decisions. GAO’s  commitment to good government is reflected in its core values of  accountability, integrity, and reliability.
section_title: Obtaining Copies of GAO Reports and Testimony
paragraphs: The fastest and easiest way to obtain copies of GAO documents at no cost  is through GAO’s Web site (www.gao.gov). Each weekday, GAO posts  newly released reports, testimony, and correspondence on its Web site. To  have GAO e-mail you a list of newly posted products every afternoon, go to  www.gao.gov and select “Subscribe to Updates.”
subsections: section_title: Order by Mail or Phone
section_title: To Report Fraud, Waste, and Abuse in Federal Programs
section_title: Congressional Relations
section_title: Public Affairs