Credit Unions: Available Information Indicates No Compelling Need for Secondary Capital
Published: 2004-08-06T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since the passage of the Credit Union Membership Access Act of 1998 (CUMAA), many in the credit union industry have sought legislative changes to the net worth ratio central to prompt corrective action (PCA). The current debate centers on the issue of allowing federally insured credit unions to include additional forms of capital within the definition of net worth. In light of the issues surrounding the debate, GAO reviewed (1) the underlying concerns that have prompted the credit union industry's interest in making changes to the current capital requirements, (2) the issues associated with the potential use of secondary capital in all federally insured credit unions, and (3) the issues associated with the potential use of risk-based capital in all federally insured credit unions.
section_title: What GAO Found
paragraphs: The credit union industry's interest in making changes to the current capital requirements for credit unions appears to be driven by three primary concerns: (1) that restricting the definition of net worth solely to retained earnings could trigger PCA actions due to conditions beyond credit unions' control; (2) that PCA in its present form acts as a restraint on credit union growth; and (3) that PCA tripwires, or triggers for corrective action, are too high given the conservative risk profile of most credit unions. Despite these concerns, available indicators suggest that the credit union industry has not been overly constrained as a result of the implementation of PCA. As a group, credit unions have maintained capital levels well above the level needed to be considered well-capitalized and have grown at rates exceeding those of other depository institutions during the three calendar years that PCA has been in place for credit unions. Allowing credit unions to use secondary capital instruments to meet their regulatory net worth requirements would raise a number of issues and concerns, with perhaps the most important issue centering on who would purchase the secondary capital instruments. While outside investors would provide market discipline, this would raise concerns about the potential impact on the member-owned, cooperative structure of credit unions. Inside investors, however, could impose less discipline and raise systemic risk concerns if it resulted in a situation where weaker credit unions could bring down stronger credit unions due to secondary capital investments. Other issues relate to the specific form of the capital instruments for credit unions. The credit union industry itself appeared divided on the desirability or appropriate structure of secondary capital instruments. Conceptually, the use of risk-based capital to address the concerns some in the credit union industry expressed about PCA is less controversial. Though two risk-based capital proposals were put forward, neither has garnered industry consensus and both lacked details of key components upon which to base any assessment of their merits. Risk-based capital is intended to reflect the unique risk profile of individual financial institutions; however, there are other factors that can affect an institution's financial condition that are not easily quantified. In recognition of the limitations of risk-based capital systems, bank and thrift regulators use leverage and risk-based capital requirements in tandem. GAO is aware that NCUA is constructing a more detailed risk-based capital proposal that incorporates both risk-based and leverage requirements; however due to the lack of formalized details, GAO could not perform a meaningful assessment of the proposal.

section_title: Letter
paragraphs: Credit unions, which have approximately 82 million members across the  United States, historically have occupied a unique niche among depository  institutions. Credit unions are member-owned cooperatives that are  exempt from federal income taxes. They do not issue capital stock; rather,  they are not-for-profit entities that build capital by retaining earnings.  Recent debate about and support for changes to the existing capital  requirements for credit unions—which establishes the percentage of net  worth to total assets that they must maintain—has raised concerns about  potential safety and soundness implications. These implications derive  from the many important purposes a depository institution’s capital serves.  From a regulatory perspective, capital acts as a buffer against unexpected  operating losses or other adverse financial results. From a depository  institution’s perspective, capital serves as a basis to generate long-term  growth. Capital is also commonly viewed as a measure of financial  strength.
Prior to 1998, the National Credit Union Administration (NCUA), which  regulates federally chartered credit unions and certain aspects of federally  insured state-chartered credit unions, did not impose any net worth  requirement on federally insured credit unions. Instead, as noted by  NCUA, Section 116 of the Federal Credit Union Act (FCUA) required credit  unions to make a periodic reserve transfer until reserves reached 6 percent  of risk-assets (10 percent for credit unions with under $5 million in assets).  Then in 1998, the Credit Union Membership Access Act (CUMAA)  established a capital-based supervisory framework called prompt  corrective action (PCA) that requires NCUA to classify federally insured  credit unions into five categories—well-capitalized, adequately capitalized,  undercapitalized, significantly undercapitalized, and critically  undercapitalized—based on net-worth-to-total-assets ratios. Under PCA,  credit unions that are less than well-capitalized must take actions  prescribed by statute and discretionary actions developed by NCUA based  on the institutions’ capitalization category.
Since the implementation of PCA for credit unions, some sectors of the  credit union industry have been calling for changes to the capital  requirements for credit unions. The changes called for generally include (1)  amending the definition of net worth to include alternative forms of capital,  such as unsecured subordinated debt instruments—known as secondary  capital instruments; (2) moving to risk-based capital standards; and (3)  some combination of the changes discussed above.
As agreed, you asked us to describe (1) the underlying concerns that have  prompted the credit union industry’s interest in making changes to the  current capital requirements, (2) the issues associated with the potential  use of secondary capital in all federally insured credit unions, and (3) the  issues associated with the potential use of risk-based capital in all federally  insured credit unions.
To identify and describe concerns regarding the current capital  requirements for credit unions, we interviewed credit union industry  groups, several credit union chief executive officers, credit union  regulators and two banking regulators. Additionally, in these interviews we  gathered information on the issues and concerns associated with the  potential use of secondary capital and risk-based capital by credit unions.  We also conducted a literature search to identify studies on the potential  use of secondary capital by credit unions and spoke with academics and  other industry observers. Appendix I provides additional details on our  scope and methodology. We are aware that NCUA is constructing a more  detailed risk-based capital proposal that incorporates both risk-based and  leverage requirements; however due to the lack of formalized details, we  could not perform a meaningful assessment of the proposal. We conducted  our work in Washington, D.C., from November 2003 through July 2004 in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: The current U.S. bank risk-based capital regulations implement the 1988  Basel Accord on risk-based capital. The Basel Accord established the  widespread use of capital ratios that bank and thrift regulators could use as  a starting point for assessing the financial condition—that is, safety and  soundness—of internationally active banks and thrifts. In the United  States, U.S. bank regulators applied the Basel Accord to all banks, rather  than just internationally active ones. In 1991, GAO recommended a tripwire  approach—incorporating capital and safety and soundness standards, or  levels at which supervisory actions would be triggered—based on our  findings that regulatory discretion and a common philosophy of trying to  resolve the problems of troubled institutions informally and cooperatively  resulted in enforcement actions that were neither timely nor forceful  enough to prevent or minimize losses to the deposit insurance fund.  Moreover, acting in response to the large number of bank and thrift failures  in the late 1980s and early 1990s, Congress enacted the Federal Deposit  Insurance Corporation Improvement Act of 1991 (FDICIA), which included  a capital-based regulatory structure known as PCA. Specifically, FDICIA  categorizes depository institutions into five classifications on the basis of  their capital levels and imposes increasingly more severe restrictions and  supervisory actions as an institution’s capital level deteriorates.
CUMAA required NCUA to adopt a system of PCA comparable with that of  FDICIA for use on federally insured credit unions, which NCUA initially  implemented in 2000. CUMAA defined the net worth ratio for PCA  purposes as net worth to total assets. Under CUMAA, net worth is defined  as the retained earnings balance of the credit union at quarter end, as  determined under generally accepted accounting principles (GAAP).   NCUA regulations provide four alternative methods that credit unions can  use to calculate total assets for use in the net worth ratio: (1) average of  quarter-end balances of the current and three preceding calendar quarters,  (2) average of month-end balances over the three calendar months of the  calendar quarter, (3) average daily balance over the calendar quarter, or (4)  quarter-end balance of the calendar quarter as reported on the credit  union’s call report. NCUA regulations state that for each quarter, a credit  union must elect a measure of total assets from these four alternatives to  apply for all PCA purposes, except for the risk-based net worth  requirement.
CUMAA prescribes three principal components of the PCA system for  credit unions: (1) a comprehensive framework of actions, including actions  prescribed by statute and discretionary actions to be developed by NCUA,  for credit unions that are less than well-capitalized; (2) an alternative  system of PCA to be developed for credit unions that NCUA defines as  “new”; and (3) a risk-based net worth requirement to apply to credit unions  that NCUA defines as “complex.” Table 1 summarizes the PCA capital  requirements for regular and complex credit unions.
CUMAA imposes up to four mandatory supervisory actions—an earnings  transfer, submission of an acceptable net worth restoration plan, a  restriction on asset growth, and a restriction on member business  lending—depending on a credit union’s capital classification, as  determined by net worth ratios. Credit unions that are not well-capitalized  are required to take an earnings transfer. Credit unions that are  undercapitalized, significantly undercapitalized, or critically  undercapitalized are subject to all four actions. In addition, CUMAA  requires NCUA to appoint a conservator or liquidation agent within 90 days  of a credit union becoming critically undercapitalized unless the NCUA  Board of Directors determines that other action would better achieve PCA’s  purpose. Pursuant to CUMAA, NCUA also developed discretionary  supervisory actions, such as the dismissal of officers or directors of an  undercapitalized credit union, to complement the prescribed actions under  the PCA program.
While CUMAA required NCUA to implement a system of capital-based  tripwires, capital-based safeguards of insurance funds are inherently  limited because capital does not typically show a decline until an  institution has experienced substantial deterioration in other components  of its operations and finances. Deterioration in an institution’s internal  controls, asset quality, and earnings can occur years before capital is  adversely affected. Financial regulators recognize that, though essential, a  capital requirement is only one of a larger set of prudential tools used to  protect customers and ensure the stability of financial markets they  regulate. For depository institutions, the key or critical tool that financial  regulators use to ensure the adequacy of an institution’s capital levels and  its safety and soundness is the on-site examination process.
section_title: Concerns about PCA Appear to Drive Industry Interest in Secondary Capital
paragraphs: The credit union industry’s recent interest in using alternative forms of  capital appears to be associated primarily with three concerns about PCA  for credit unions. First, several credit union officials argued that secondary  capital or other alternatives were needed, given concerns that credit unions  might trigger PCA restrictions because of rapid inflows of deposits due to  investors’ “flight to safety”; however, we have not found widespread  evidence to support these concerns. To assist credit unions that fall  marginally below “adequately capitalized” primarily because asset growth  has outstripped income growth, NCUA proposed the use of an abbreviated  net worth restoration (NWRP) plan. According to an NCUA official, the  proposed rule was not pursued further because it was considered too  complicated, would only benefit a very small number of credit unions, and  did not appear to provide material relief. Second, other credit union  officials contended that PCA acts as a restraint on credit union growth. Our  analysis of credit union and bank data indicates that credit unions have  been growing faster than banks in the 3 years credit union PCA has been in  effect. Finally, several credit union officials are concerned that the PCA  tripwires for credit unions are too high, given the conservative risk profile  of most credit unions. It should be noted that, according to Treasury,  Congress established the capital level 2 percentage points higher because 1  percent of a credit union’s capital is deposited in NCUSIF and another 1  percent of the typical credit union’s capital is invested in a corporate credit  union.
subsections: section_title: “Flight to Safety” Raised Concerns about PCA, Although Net Worth Ratios Generally Remained above Well-Capitalized Levels
paragraphs: As investors sought high-quality (that is, safe) investments due to weak  performance by the stock and other investment markets in the early 2000s,  credit unions experienced significant growth in member share deposits.  Several credit union industry officials expressed concern that this inflow of  new shares into credit unions might dilute net worth ratios, thus triggering  net worth restoration plans and other supervisory actions under PCA.
To assist credit unions that fall marginally below “adequately capitalized”  primarily because asset growth outstrips income growth, NCUA introduced  the concept of an abbreviated NWRP in June 2002. While no specific  proposal was introduced, the NCUA board invited public comment on the  concept of what was then referred to as “safe harbor” approval of a  NWRP—that is, notice of certain criteria established by regulation that,  when met, will ensure approval.
In November 2002, NCUA put forth a proposed rule and request for public  comment on allowing the use of abbreviated NWRP—which NCUA  referred to as a first-tier NWRP—by qualifying federally insured credit  unions whose net worth ratio declined marginally below the adequately  capitalized threshold (6 percent) because growth in assets outpaced  growth in net worth. Under the proposal, a credit union would have been  eligible to file an abbreviated NWRP if it satisfied three criteria: historical  net worth, performance, and growth.
There were three principal differences between the content requirement of  a standard NWRP and the abbreviated NWRP proposed by NCUA. First, the  proposed abbreviated NWRP would require only 4 quarters of pro forma  projections of total assets, shares and deposits, and return on average  assets, while the standard NWRP required complete pro forma financial  statements covering a minimum of 2 years. Second, the abbreviated NWRP  would not require a credit union to specify what steps it would take to meet  its schedule of quarterly net worth targets, which is required for a standard  NWRP. Finally, a standard NWRP requires those steps to extend beyond the  term of the plan to ensure that the credit union remains at least adequately  capitalized for 4 consecutive quarters thereafter. In contrast, the proposed  abbreviated NWRP did not address the credit union’s net worth after the  end of the term of the plan. NCUA’s proposed rule also detailed the criteria  for approval of the abbreviated NWRP and the circumstances in which a  credit union that would otherwise be eligible to file an abbreviated NWRP  would have been required to file a standard NWRP instead.
According to an NCUA official, the proposed rule was not pursued further  because it was considered too complicated, would benefit only a very small  number of credit unions, and did not appear it would provide material relief  since some form of NWRP (albeit somewhat abbreviated) was still required  by statute. NCUA officials stated that the credit union industry supported  the proposal for an abbreviated NWRP but the credit union industry was  advocating a proposal that would be automatically approved if it met a  fixed set of objective criteria. However, NCUA officials explained that  CUMAA requires a case-by-case determination by NCUA that a plan “is  based on realistic assumptions and is likely to succeed in restoring the net  worth of the credit union.”
Although NCUA’s proposal to assist certain credit unions that fall  marginally below “adequately capitalized” was not pursued further, we  found that despite a recent inflow of member share deposits, the credit  union industry as a whole has been able to maintain net worth ratios well  above the PCA threshold for well-capitalized credit unions. Moreover,  current data suggest that the “flight to safety” may be over, as investors  appear to be returning to the investment markets. Figure 1 illustrates that  during the period that PCA has been in place for credit unions (2001–2003),  the net worth ratios for federally insured credit unions dropped somewhat  initially but stabilized at the close of 2003.
Groups such as the National Association of State Credit Union Supervisors  (NASCUS) and several credit union chief executive officers (CEO) told us  that that the combination of PCA requirements and members’ flight to  safety from the markets could force both fast-growing credit unions and  small to midsize credit unions to choose between (1) refusing deposits, (2)  reducing services to members in order to retard the growth of assets, (3)  converting to a savings and loan or community bank, or (4) merging with  another credit union. While some of the larger credit union CEOs with  whom we spoke stated that PCA is not causing capital constraints  currently, they told us the potential exists for share growth to outstrip their  ability to retain earnings, thus triggering net worth restoration plans and  other supervisory actions under PCA. On the other hand, according to  some CEOs of small and midsize credit unions, these constraints are  affecting them currently. While the constraints noted above may have  occurred to some extent in a limited number of credit unions, we did not  find evidence of widespread net worth problems for federally insured  credit unions during the period PCA has been in place. Moreover, as of  December 2003, less than 3 percent of federally insured credit unions have  reported a net worth ratio below the well-capitalized threshold.
section_title: PCA Cited as a Restraint on Growth, Although Credit Unions Have Had Stronger Growth Rates Than Banks and Thrifts
paragraphs: Some credit union industry officials have indicated that the current credit  union PCA system acts as a restraint on credit union growth, because any  additional new member shares (deposits) would increase their assets and  correspondingly reduce their net worth ratios. While most credit unions  have been well-capitalized during the period that PCA has been in place,  some industry officials have suggested that the capital constraints it  imposes will become increasingly difficult to manage, forcing credit unions  to turn away deposits so as not to dilute or decrease their net worth ratios.  It should be noted that PCA was intended to curb aggressive growth, since  uncontrolled growth was one of the common attributes of thrifts and banks  that failed during the banking crisis of the late 1980s and early 1990s.
Credit union industry officials, including NCUA, have stated that some  credit unions have had to reduce their services to members in an effort to  satisfy PCA requirements. NCUA officials told us credit unions that have  decreased services to their members have done so as part of net worth  restoration plans. However, NCUA officials told us they would have no way  of determining the number of credit unions considering decreasing services  in an effort to prevent being subject to regulatory actions by NCUA. We  have not found any evidence that federally insured credit unions are  limiting their services to accommodate a rapidly growing deposit base.  Moreover, active asset management is a major component of the  operations of any financial institution. Credit union managers are expected  to manage the growth of their institutions so that an influx of member  deposits would not cause the credit union to become subject to PCA.
Despite the concerns about PCA acting as a constraint against asset  growth, credit unions have grown at a higher rate than banks and thrifts  during the period that PCA has been in place for credit unions (see fig. 2).  This was particularly the case in 2001, the first full calendar year in which  PCA was in place for credit unions. In that year, credit unions achieved an  asset growth rate of more than 14 percent, compared with an approximate  growth rate of 6 percent for other depository institutions. The disparity in  growth rates narrowed in 2002 and 2003.
section_title: Industry Has Contended That PCA Triggers Are Too High
paragraphs: The credit union industry has consistently criticized PCA triggers (that is,  capital thresholds) as being too high. Some credit union officials have  noted that PCA encourages credit union managers to hold more capital  than is necessary, which does not allow them to maximize shareholder  value. In addition, they said that PCA tripwires for credit unions are higher  than those of banks and thrifts despite the more conservative risk profile of  credit unions.
Banks and thrifts are required to meet two capital requirements in order to  be adequately capitalized: (1) a minimum tier 1 leverage ratio—that is a  minimum ratio of total capital to total assets, which is generally 4 percent  of tier 1 capital; and (2) a risk-based capital ratio of 8 percent capital to  risk-weighted assets. Under CUMAA’s net worth requirements, federally  insured credit unions must maintain at least 6 percent net worth to total  assets to be considered adequately capitalized. This exceeds the 4 percent  tier 1 leverage ratio applicable for banks and thrifts (and is statutory, as  opposed to regulatory). In its 2001 report, Treasury stated that Congress  determined that a higher ratio was appropriate because credit unions  cannot quickly issue capital stock to raise their net worth as soon as a  financial need arises. Instead, credit unions must rely on retained earnings  to build net worth, which necessarily takes time. Moreover, Treasury stated  that Congress established the capital level 2 percentage points higher, a  level recommended by Treasury in its 1997 report on credit unions, because  1 percent of a credit union’s capital is deposited in NCUSIF and another 1  percent of the typical credit union’s capital is invested in a corporate credit  union. Effective July 3, 2003, a federally insured credit union is allowed to  invest up to 2 percent of its assets in any one corporate credit union and, in  the aggregate, up to 4 percent of its assets in multiple corporate credit  unions.
section_title: Potential Use of Secondary Capital in the Credit Union Industry Poses Many Unanswered Questions
paragraphs: Though some in the credit union industry seek use of alternative forms of  capital, little information exists that would allow us to assess the  implications of using these instruments. We found that the credit union  industry lacks consensus on the desirability of these instruments, with one  of the key issues in the current debate over secondary capital centered on  who would purchase these instruments and their resulting impact on the  unique nature of credit unions—member-owned, not-for-profit  cooperatives. Also, we could not identify a definitive proposal that  specifically addressed other critical issues relating to the use of secondary  capital instruments, such as pricing and market demand. While low income  credit unions are allowed to use secondary capital instruments and  corporate credit unions are allowed to use secondary capital instruments  and count it toward their net worth requirements, their experiences are too  narrow to offer insight into the value of such an instrument for all federally  insured credit unions. However, one industry group has developed a list of  principles, or minimum set of criteria, to consider for any proposal.
subsections: section_title: Industry and Other Experts Disagree on the Merits of Using Secondary Capital
paragraphs: The credit union industry is divided on the merits and potential effects of  using alternative capital. Credit union industry officials have expressed  concerns that credit unions may find their rate of share (deposit) growth  exceeding their ability to accumulate retained earnings, triggering net  worth restoration plans and other supervisory actions under PCA.  According to one trade association, the Credit Union National Association  (CUNA), building net worth through earnings retention is a time- consuming process, and being able to use alternative capital instruments  would allow a credit union to quickly build its capital levels. Additionally,  some credit union officials believe that the current credit union capital  system encourages managers to overcapitalize their credit unions (that is,  hold excessive capital), which is not always the best alternative for  financial institutions. Some officials have stated that secondary capital  would allow credit union managers the flexibility to be more proactive in  managing their capital.
One credit union CEO, whose institution is one of the largest federally  insured credit unions, stated that three of the five largest federally  chartered credit unions were against allowing credit unions to acquire  secondary capital. He countered arguments for changing PCA by citing his  credit union’s experience with a dramatic influx in shares 2 years ago. He  noted the influx did not trigger PCA because his institution’s capital was  aggressively managed. The CEO added that the dividends paid to the credit  union’s members, along with other services, were not limited or reduced as  a result of this aggressive management. He explained that the excess  capital (which was built over time through returns on investments at higher  interest rates) in concert with diligent capital management kept the credit  union from triggering PCA.
section_title: Industry Debate Centers around Key Issue of Outside Versus In-System Investors
paragraphs: Debate over secondary capital centers around who should be allowed to  purchase these instruments. Some in the credit union industry argue that  allowing outsiders to invest in the credit union industry would increase  market discipline, but there are concerns that outside investment would be  more costly and change the structure of the credit union industry.  Opponents of secondary capital suggest that allowing voting, or even  nonvoting, secondary capital from investors outside of the credit union  industry would dilute the ownership structure of credit unions—not-for- profit, member-owned cooperatives. For example, one credit union CEO  asserts that secondary capital would allow outside investors “a place at the  table,” whether the subordinated debt instruments carry voting or  nonvoting rights. He explained that the outside investors could demand  returns on investments through changes in interest rates or another form of  return, or a right of first refusal if the credit union should ever adopt a for- profit model. Other credit union managers, including those in favor of  secondary capital, told us that if done carelessly, secondary capital for  credit unions could be disastrous; however, they will continue to promote  the use of secondary capital provided it does not change the credit union’s  ownership rights.
To alleviate these concerns, others suggest allowing investors from within  the industry (in-system investors). This approach, however, raises  concerns about investor protection and other systemic risks. Moreover, in- system investors could impose less discipline than out-of-system investors.  According to one academic expert, the credit union industry is divided on  the topic of alternative capital; the academic stated that at least 55 percent  of credit unions want to avoid the capital markets, while the remainder  would be more open to entering the capital markets and become  increasingly banklike. He cautioned that alternative capital should not be  used to sustain credit unions that were not already solvent. He explained  that secondary capital from investors within the credit union system—that  is, credit union members and other credit unions—might introduce  systemic risk, wherein the risks of the issuing credit union were inherently  spread to the credit union holding the debt instrument. For example, if  Credit Union A purchased subordinated debt from Credit Union B and  Credit Union B failed and was forced to liquidate its assets, Credit Union A  would then be financially affected, possibly resulting in two failed credit  unions.
Additionally, some officials in the credit union industry suggested that with  appropriate disclosure, individual credit union members could invest in  secondary capital instruments offered by credit unions. However, even  with these disclosures (recognizing that alternative capital instruments are  uninsured, nonvoting, and subordinated to other shares), it is possible that  credit union members may not fully understand and appreciate the  subordinated nature of their investments.
section_title: Industry Has Not Produced Detailed Proposals; Other Literature on Secondary Capital Also Limited
paragraphs: We identified one proposal and one academic study that suggest how  secondary capital could be utilized by all federally insured credit unions;  however, these lacked sufficient detail and did not address critical issues.  Specifically, the proposal and academic study did not address the specific  form of the capital instruments, criteria governing its issuance (including  how it would be incorporated into the regulatory net worth requirement for  credit unions), market viability and demand (including in-system or out-of- system investors), and pricing analysis to effectively discuss its potential  benefits and implications. As a result of the lack of detail, we were unable  to fully assess the issues associated with the potential use of secondary  capital by all credit unions.
The secondary capital proposal—“Capital Notes”—was developed by the  CUNA Mutual Group, a company that offers health insurance and financial  services to credit unions. CUNA Mutual Group believes the Capital Notes  program, slated for two phases, could help credit unions meet their capital  needs. CUNA Mutual Group is piloting this secondary capital mechanism to  low income credit unions, which are already permitted under NCUA  regulations to count secondary capital toward their PCA requirements. The  Capital Notes program allows low income credit unions to issue unrated  subordinated debt in a private placement with flexible terms and rates.  CUNA Mutual Group purchases the notes issued by the low income credit  unions to hold in its investment portfolio.
According to CUNA Mutual Group, if the PCA definition of net worth is  changed to include secondary capital, the subsequent planned phase of the  Capital Notes program will allow all federally insured credit unions to issue  unrated, unsecured notes that would be purchased by a trust. The trust  would then go through a ratings process and issue its own notes that  institutional investors such as corporate credit unions, CUNA Mutual  Group, and other insurance companies could purchase. CUNA Mutual  Group representatives stated that corporate credit unions would then  purchase the highest-rated notes and CUNA Mutual Group, or other  insurance companies, would most likely hold the lower-rated or first-loss  notes. According to CUNA Mutual Group, the advantages of its Capital  Notes program are that it  allows fast-growing and low-capitalized credit unions to secure   provides additional protection to NCUSIF, the share insurance fund;   allows credit unions access to capital sources already available to other  depository institutions, such as banks;   maintains members’ governance rights; and  avoids potential abuses in sales of the notes by restricting purchasers to  qualified (institutional) investors.
Because the Capital Notes program began its pilot phase in December 2003,  insufficient time has passed to allow for an assessment of the effectiveness  of the program for low income credit unions. In addition, the motivation of  secondary capital investors in low income credit unions is likely  significantly different from that of investors in other federally insured  credit unions. Consequently, the pricing analysis, market viability, and  demand (in-system as well as out-of-system) of the first phase of Capital  Notes may not be applicable to the proposed second phase of the program.
We identified an academic study regarding the potential use of alternative  capital instruments by credit unions. This study, issued by the Filene  Research Institute and the Center for Credit Union Research, concluded  that allowing credit unions to sell subordinated debt to parties outside of  the credit union industry to meet their capital requirements could provide  the following advantages:  In terms of market discipline, the higher interest costs associated with  debt of riskier credit unions would reduce the temptation of excessive  risk taking by credit union managers and would send a forward-looking  signal to regulators if credit unions’ risk taking increased.
In terms of transparency and disclosure, marketing of subordinated  debt, directly or via a pool arrangement, would require increased  transparency and disclosure about the condition of credit unions.
In terms of maintaining a larger cushion for the share insurance fund,  the holders of subordinated debt would be compensated only after  NCUSIF was fully compensated out of sales of existing assets, thereby  reducing the risk to the insurance fund.
In terms of increasing the incentives for prompt action by supervisors,  holders of subordinated debt would encourage regulators to act  promptly if credit unions became excessively risky or troubled.
However, while presenting a framework for using secondary capital, the  authors of the study did not provide a specific proposal. In addition, they  did not address market demand for secondary capital, pricing or the  ultimate cost of these instruments to credit unions or assess the impact of  the external subordinated debt holders on the member-owned and member- operated structure of credit unions.
section_title: Few Credit Unions Have Experience with Secondary Capital Instruments
paragraphs: NCUA first authorized the issuance of secondary capital instruments by  low income credit unions in 1996. According to NCUA, it granted the  authority in recognition of the special needs of these credit unions to raise  capital from sources outside of their low income communities. Under  NCUA regulations, credit unions with a low income designation can (1)  receive nonnatural person, nonmember deposits that are not NCUSIF- insured; (2) offer uninsured secondary capital accounts and include these  accounts on the credit union’s balance sheet for accounting purposes; and  (3) include these secondary capital accounts in the credit union’s net worth  for PCA purposes. However, investment in low income credit unions does  not offer a template for the industry because the motivations of secondary  capital investors in low income credit unions may be different from  investors in other federally insured credit unions. For example, banks may  obtain credit under the Community Reinvestment Act (CRA) for their  investment in low income credit unions. In addition, many foundations  and philanthropic organizations also are involved in providing secondary  capital to low income credit unions in an effort to ensure that the credit  unions are able to provide needed financial services to areas traditionally  underserved by mainstream financial institutions.
Moreover, as of December 31, 2003, less than 6 percent of all low income  credit unions had secondary capital accounts. Additionally, low income  credit unions that had secondary capital accounts represented less than 1  percent of all federally insured credit unions. Thus, in addition to the  different incentives for investment, the limited experience of low income  credit unions with secondary capital instruments also provides little insight  into the potential market demand and pricing of secondary capital  instruments for all federally insured credit unions.
Corporate credit unions—whose members are credit unions, not  individuals—also can issue forms of secondary capital. According to  NCUA, corporate credit unions have been allowed to use secondary capital  instruments to meet their regulatory capital requirements since 1992 in  recognition that the ability of corporate credit unions to build capital is  limited by the combined effects of (1) conservative investment standards  imposed by NCUA and (2) the competitive markets in which corporate  credit unions vie for credit unions’ investment funds. Capital for corporate  credit unions is defined as the sum of a corporate credit union’s retained  earnings, paid-in capital (both member and nonmember), and membership  capital. NCUA refers to this paid-in capital and membership capital as  corporate credit union secondary capital; among other things, these two  types of capital are not insured by NCUSIF and are generally longer-term  investments. As of December 31, 2003, 18 out of all 31 corporate credit  unions had member paid-in capital accounts, 30 out of 31 had membership  capital accounts, and none had nonmember paid-in capital accounts.  However, taking into account that (1) corporate credit unions and natural  person credit unions are not comparable given their member base, and (2)  there are far fewer corporate credit unions compared with the total number  of federally insured credit unions, those 18 corporate credit unions with  member paid-in capital and 30 with membership capital do not provide a  representative or sufficient sample that can be used as a model to  demonstrate how secondary capital could be used for all federally insured  credit unions. Thus, the limited experience of corporate credit unions with  member paid-in capital, coupled with the lack of experience with  nonmember capital sources, provides little insight into the potential  demand and pricing of secondary capital instruments for all federally  insured credit unions.
section_title: Although the Credit Union Industry Lacks Consensus on Proposals, One Industry Group Has Developed a Set of Principles
paragraphs: The credit union industry as a whole has neither endorsed secondary  capital nor put forth a specific secondary capital proposal; however,  several officials with whom we spoke referred to the principles of the  National Association of Federal Credit Unions (NAFCU) board for the  development of a secondary capital instrument as a set of criteria to  consider. Listed in table 2 are the NAFCU board’s principles recommended  for any secondary capital instrument designed for use by all federally  insured credit unions.
While we believe that this list incorporates key factors that should be  considered for an alternative capital proposal, it should be noted that this is  not an exhaustive list of all the possible concerns that may develop as a  result of allowing all federally insured credit unions the use of alternative  capital instruments. NAFCU officials told us that they have not been able to  produce an alternative capital proposal that satisfies these seven principles  because of some of the inherent tensions among the principles. For  example, were alternative capital issued only within the credit union  system, the number of investors would be more limited than if it were  issued to the general public, suggesting that a viable alternative capital  instrument should be issued in the markets—that is, outside of the credit  union system. However, issuing alternative capital instruments outside of  the credit union system may create another “class” of owners, thereby  changing the nature of credit unions.
section_title: While Many View Risk- Based Capital as an Enhancement to PCA for Credit Unions, Key Structural Issues Remain Unresolved
paragraphs: The debate about the potential use of risk-based capital for all credit unions  revolves around key structural issues, including (1) the extent to which  risk-based ratios would be used to augment, versus replace, the current  PCA net worth (leverage) requirements and (2) how key risk components  and weights that are appropriate to the unique characteristics of credit  unions would be defined. While all banks and thrifts are required to meet  both a risk-based capital ratio and a leverage ratio to be classified as  adequately capitalized, most credit unions are required to meet only one—a  leverage ratio—to be classified as adequately capitalized. Bank and thrift  regulators recognized the limitations of a solely risk-based capital  requirement and continued the leverage requirements to address other  factors that can affect a bank’s financial condition, which a risk-based ratio  does not address. NCUA has adopted a risk-based component of PCA;  however, it affects only a small percentage of credit unions—those that  meet NCUA’s definition of “complex.” Though a credit union trade  association has put forward two risk-based capital proposals, neither has  garnered industry consensus. Moreover, each proposal lacked details of  key components upon which to base any assessment of their merits. NCUA  officials told us they are developing, but have not yet finalized, a risk-based  capital proposal to augment current PCA for all credit unions that they  believe acknowledges the unique nature of credit unions and incorporates  the relevant and material risks credit unions face.
subsections: section_title: Leverage Ratio Requirements Used to Augment Risk-Based Capital for All Banks and Thrifts
paragraphs: FDICIA requires all banks and thrifts to meet both a risk-based and a  leverage requirement. Leverage ratios have been part of bank regulatory  requirements since the 1980s. They were continued after the introduction  of risk-based capital requirements as a cushion against risks not explicitly  covered in the risk-based capital requirements. According to regulatory  guidelines on capital adequacy, the final supervisory judgment of a bank’s  capital adequacy may differ from the conclusions that might be drawn  solely from the risk-based capital ratio. Banking regulators recognized that  the risk-based capital ratio does not incorporate other factors that can  affect a bank’s financial condition, such as interest-rate exposure, liquidity  risks, the quality of loans and investments, and management’s overall  ability to monitor and control financial and operating risks. FDICIA also  requires bank regulators to monitor other risks, such as interest-rate and  concentration risks.
FDICIA requires the federal bank and thrift regulators to establish criteria  for classifying depository institutions into five capital categories: well- capitalized, adequately capitalized, undercapitalized, significantly  undercapitalized, and critically undercapitalized. Figure 3 illustrates four  capital categories and ratio requirements of FDICIA’s PCA provisions.
Although not shown in figure 3, a fourth ratio—tangible equity—is used to  categorize an institution as critically undercapitalized. Any institution that  has a 2 percent or less tangible equity ratio is considered critically  undercapitalized, regardless of its other capital ratios. The amount of  capital held by a bank is to be greater than or equal to the leverage ratio.  However, if the risk-based capital calculation yields a higher capital  requirement, the higher amount is the minimum level required.
Although U.S. bank risk-based capital guidelines address several types of  risk, only credit and market risk are explicitly quantified. The quantified  risk-based capital standard is defined in terms of a ratio of qualifying  capital divided by risk-weighted assets. All banks are required to calculate  their credit risk for assets, such as loans and securities; and off-balance  sheet items, such as derivatives or letters of credit. There are two  qualifying capital components in the risk-based credit risk computation— core capital (tier 1) and supplementary capital (tier 2). In addition to credit  risk, banks with significant market risk exposures are required to calculate  a risk-based capital ratio that takes into account market risk in positions  such as securities and derivatives in an institution’s trading account and all  foreign exchange and commodity positions, wherever they are located in  the bank. The market-risk capital ratio augments the definitions of  qualifying capital in the credit risk requirement by adding an additional  capital component (tier 3). Tier 3 capital is unsecured, subordinated debt  that is fully paid up, has an original maturity of at least 2 years, and is  redeemable before maturity only with approval by the regulator. To be  included in the definition of tier 3 capital, the subordinated debt must  include a lock-in clause precluding payment of either interest or principal  (even at maturity) if the payment would cause the issuing bank’s risk-based  capital ratio to fall or remain below the minimum requirement.
section_title: Current Risk-Based Component of PCA for Credit Unions Applies to Few Credit Unions
paragraphs: NCUA’s PCA risk-based capital rule currently applies to relatively few  credit unions—approximately 8 percent of all federally insured credit  unions that were designated as “complex” as of December 31, 2003. It  should be noted that none of the five largest credit unions, and only one of  the top 10 credit unions in terms of assets, met NCUA’s definition of  complex. CUMAA mandated a risk-based net worth requirement for  “complex” credit unions, for which NCUA was required to formulate a  definition according to the risk level of the credit union’s portfolios of  assets and liabilities. These credit unions are subject to an additional risk- based net worth requirement to compensate for material risks, against  which a 6 percent net worth ratio may not provide adequate protection.  Specifically, the risk-based net worth calculation measures the risk level of  on- and off-balance sheet items in the credit union’s “risk portfolios.”
NCUA uses two methods to determine whether a complex credit union  meets its risk-based net worth requirement: (1) a “standard calculation,”  which uses specific standard component amounts; and (2) a calculation  using alternative component amounts. A credit union’s risk-based net  worth requirement is the sum of eight standard components, which include  such items as unused member business loan commitments and allowance  for loan and lease losses. Appendix II provides an example of the standard  calculation of the risk-based net worth requirement, including the  definitions of the risk portfolios and weighted average life for investments.  Although not shown in appendix II, the alternative method of calculating  the risk-based requirement involves weighting four of the risk portfolio  components—long-term real estate loans, member business loans,  investments, and loans sold with recourse—according to their remaining  maturity, weighted average life, and weighted average recourse,  respectively. In addition, the risk-based net worth requirement allows  credit unions that succeed in demonstrating mitigation of interest-rate or  credit risk to apply to NCUA for a risk mitigation credit. The credit, if  approved, would reduce the risk-based net worth requirement a credit  union must satisfy to remain classified as adequately capitalized or above.  According to NCUA, between March 2002 and December 2003 there have  been 38 credit unions that failed the standard risk-based net worth  requirement, with two credit unions failing both the standard and  alternative calculation requirements. In addition, toward the end of 2003  two credit unions submitted applications for a risk mitigation credit.
section_title: Existing Industry Proposals Lack Specificity and Consensus
paragraphs: The credit union officials with whom we spoke disagreed whether the  current PCA system should be replaced or augmented by a risk-based PCA  system. One credit union official—a recognized proponent of secondary  capital—told us that risk-based capital should be used to augment, but not  replace, the current leverage-based net worth capital requirements.  Conversely, two industry groups told us that they see risk-based capital  requirements serving as a complement to secondary capital, if it were  allowed to be included as a component of net worth. Many credit union  officials told us that current PCA is “one size fits all” but would not  comment further on risk-based capital. In addition, NASCUS told us that it  has recently endorsed the risk-based language in a House of  Representatives bill, although it continues to support secondary capital for  all credit unions. However, it should be noted that for most credit unions,  risk-based assets are less than total assets; therefore, a given amount of  capital would have a higher net worth ratio if risk-based assets were used.  And capital requirements would likely be reduced if risk-based capital were  an alternative, rather than a complement, to leverage ratios.
CUNA put forward two risk-based capital proposals that they believe (1)  would preserve the requirement that regulators must take prompt and  forceful supervisory actions against credit unions that become seriously  undercapitalized and (2) would not encourage well-capitalized credit  unions to establish such large buffers over minimum net worth  requirements that they would become overcapitalized. However, both  proposals lacked details of key components that would be needed in order  to assess their merits. The first CUNA proposal does not provide a clear  definition of risk assets. The second CUNA proposal does not provide  specific risk weights and asset classifications appropriate for credit unions.
The first proposal would replace the current two-phased PCA system with  a single system using risk-based and net worth ratio requirements for all  credit unions. This system would incorporate NCUA’s pre-CUMAA  definition of risk assets—all loans not guaranteed by the federal  government, and all investments with maturities over 5 years—into the  PCA system by modifying the current definition of net worth ratio.   Specifically, the first proposal would lower the current net worth ratios for  each PCA category to parallel the leverage ratio requirement for banks and  thrifts and add a risk-based net worth ratio requirement using the existing  PCA threshold levels for credit unions. For example, an adequately  capitalized credit union would be defined as having a risk-based net worth  ratio of 6 percent or greater and a net worth ratio of 4 percent or greater.  Under this proposal, if a credit union’s net worth ratio falls into different  categories by risk and total assets, the lower classification would apply.  The proposal stated that risk assets could be defined as nonguaranteed  loans and long-term investments, or NCUA could be instructed to define  risk assets in a manner consistent with its pre-CUMAA requirements.
The second proposal would incorporate components of both the Basel  capital framework currently in use by banks and thrifts in the United States  and the risk-based portion of the current credit union PCA applicable to  complex credit unions. Specifically, this proposal states that net worth  requirements could be based on risk weights for assets as in place for  banks, but with the weights established on the basis of both credit and  interest-rate risk. Under this proposal, the risk weights could be set by  NCUA based on the Basel system. According to the second proposal, it is  likely that NCUA could choose to adopt some credit-risk weights that are  different from those currently in use by bank and thrift regulators under the  Basel system because some of the weights would be assigned on the basis  of interest-rate risk. The proposed risk-based ratio requirements for each  PCA category would parallel the current total risk-based requirement for  banks and thrifts. In addition, this proposal states that a credit union could  also be required to maintain a net worth ratio equivalent to the leverage  ratio required for banks and thrifts. Similar to the first proposal, if a credit  union’s net worth ratio falls into different categories by risk and total  assets, the lower classification would apply. For example, in order to be  adequately capitalized under the second proposal, a credit union would  have to have a risk-based ratio of 8 percent or greater and a net worth ratio  of 4 percent or greater.
section_title: NCUA Suggests Using Risk- Based Capital Requirements for All Credit Unions
paragraphs: According to NCUA officials, NCUA envisions a risk-based PCA system  similar in structure to that currently employed in the banking system.  However, they stated that NCUA would tailor the risk weights and the  categories into which assets fall, to take into consideration the unique  nature of credit unions and the loss histories of their asset portfolios. In  addition, the NCUA officials told us that a risk-based credit union PCA  system should be designed to address all relevant and material risks (for  example, interest-rate risk). According to these NCUA officials, the credit  union PCA system should be robust enough so as not to be “one-size-fits- all,” but simple enough to facilitate administration of the system and be  well understood by credit unions. NCUA officials told us that they are in  the process of developing a risk-based PCA proposal that would be used for  all credit unions, not just complex credit unions. See appendix III for items  being used in the development of NCUA’s risk-based PCA proposal.
NCUA officials emphasized that the CUMAA mandate to take prompt  corrective action to resolve problems at the least long-term cost to NCUSIF  is good public policy and consistent with NCUA’s fiduciary responsibility to  the share insurance fund. However, they stated that they believe additional  flexibility is needed to enable NCUA to work with problem institutions.  They explained that the additional flexibility could be structured to  constrain any tendency toward regulatory forbearance and preserve the  objective of PCA. NCUA officials told us that they believe a revised system  would alleviate most concerns that credit unions have with PCA. They  believe changing the system would provide credit union management with  the ability to manage compliance by making adjustments to their asset  portfolios, maintain ample protection for the system and individual credit  unions, and preserve NCUA’s ability to address net worth problems. NCUA  officials told us that such a system would likely obviate the need or desire  for secondary capital for the vast majority of credit unions.
section_title: Observations
paragraphs: Despite concerns raised by some in the credit union industry, available  information indicates no compelling need for using secondary capital  instruments to bolster the net worth of credit unions, or to make other  significant changes to PCA as it has been implemented for credit unions.  Available indicators suggest that the credit union industry as a whole has  not been overly constrained as a result of the implementation of PCA.  Notably, credit unions were able to maintain capital levels well in excess of  the PCA requirements during a period of rapid share or deposit growth.  One of the inherent weaknesses in PCA is its focus on capital, which  typically is a lagging indicator of a financial institution’s health. As such, it  will be important for NCUA to distinguish between capital deterioration  that occurs because of fundamental weaknesses in the institution’s  structure or management versus temporary capital shortfalls due to  constraints beyond a credit union’s control. While we do not find the  arguments for using secondary capital instruments to be compelling, to the  extent that well-managed and -operated credit unions do experience  temporary capital constraints, NCUA may want to revisit the concept of an  abbreviated net worth restoration plan for marginally undercapitalized  credit unions. Consideration of changes such as this seem to be more  consistent with the notion that the problems some credit unions may be  facing are temporary and, therefore, best tackled with temporary, not more  permanent, solutions, such as secondary capital instruments.
Allowing credit unions to use secondary capital instruments to meet their  regulatory net worth requirements would raise a number of issues and  concerns. One of the key issues is who would be allowed to invest in the  secondary capital instruments of credit unions. While allowing credit  unions to sell secondary capital instruments to investors outside of the  credit union industry would provide market discipline, this would raise  concerns about the potential impact on the member-owned, cooperative  nature of credit unions. Some have proposed limiting potential investors to  credit union members, other credit unions, and corporate credit unions;  however, in-system investors could impose less discipline and raise  systemic risk concerns if it were to create a situation where weaker credit  unions brought down stronger credit unions due to secondary capital  investments. Other issues relate to the specific form of the capital  instruments, and how they would be incorporated into the regulatory net  worth requirement for credit unions. The credit union industry itself  appeared divided on the desirability or appropriate structure of secondary  capital instruments.
Conceptually, the potential use of a risk-based capital system for all credit  unions appears less controversial. Risk-based capital is intended to require  institutions with riskier profiles to hold more capital than institutions with  less risky profiles. However, not all of the risks that credit unions face, such  as liquidity and operational risk, can be quantified. In recognition of the  limitations of risk-based capital systems, the bank and thrift regulators use  both risk-based and nonrisk weighted (leverage ratio) capital requirements  for PCA purposes. The requirements are used in tandem to better ensure  safety and soundness in banks and thrifts. Among the numerous issues that  would need to be addressed in a risk-based capital proposal, given the  unique nature of credit unions, would be the appropriate risk weights and  categories into which assets fall and the appropriate risk-based and  nonrisk-based capital ratios for each PCA category. We are aware that  NCUA is constructing a more detailed risk-based capital proposal that  includes both risk-based and leverage requirements for all credit unions  and believe that any proposal should be based on the premise that risk- based capital be used to augment, but not replace, the current net worth  requirement for credit unions.
We remain a strong supporter of PCA as a regulatory tool. The system of  PCA implemented for credit unions is comparable with the PCA system  that bank and thrift regulators have used for over a decade. The concerns  raised by the credit union industry appear to reflect the inherent tension  between credit union managers’ desire to maintain the optimal amount of  capital to efficiently fuel growth and returns to credit union members and  Congress’s desire to protect the federal share insurance funds from losses  that could have been prevented by early and forceful supervisory action. As  we stated in our October 2003 report, credit unions have been subject to  PCA for a short time, and the advantages and disadvantages of the current  program are not yet evident. Additional time and greater experience with  the use of PCA in the credit union industry would provide greater insight  into the need for any significant changes to PCA as well as the best options  for any changes.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Chairman of the National Credit  Union Administration and the Secretary of the Treasury for review and  comment. We received written comments from NCUA that are reprinted in  appendix IV. In addition, we received technical comments from NCUA and  Treasury that we incorporated into this report, as appropriate.
NCUA concurred with this report’s assessment that there is no compelling  need for secondary capital. For example, NCUA concurred that there are  key unresolved issues, such as whether secondary capital instruments  would be commercially viable, to whom these instruments could and  should be sold (e.g. inside versus outside investors), the effects on the  member-owned, cooperative structure of credit unions, and any safety and  soundness and systemic risk implications posed by this activity. NCUA also  concurred that there is a lack of consensus within the credit union system  on the need for and appropriate structure of secondary capital instruments.  Finally, NCUA stated that the vast majority of insured credit unions  maintain extremely strong capital positions, notwithstanding a recent  prolonged period of rapid share growth.
NCUA stated that it concurred with views expressed by many within the  credit union industry that the current PCA tripwires were too high. NCUA  disagreed with Treasury’s rationale for the higher limit—1 percent for the  deposit in NCUSIF and another 1 percent for the typical credit union’s  capital invested in corporate credit unions—than that imposed on banks  and thrifts. NCUA stated that under GAAP, which Congress mandated  credit unions follow, the NCUSIF deposit is considered an asset on the  financial statements of a credit union. Further, NCUA stated that the  NCUSIF deposit is not related to a credit union’s net worth from either an  accounting or financial risk standpoint. In addition, NCUA noted that not  all credit unions belong to corporate credit unions or hold this form of  investment; therefore, using a “one size fits all” approach to trigger PCA  supervisory actions based on this assumption is inherently unfair. Finally,  NCUA stated that PCA tripwires are too high, penalizes institutions with  conservative risk profiles, and allows higher risk earnings strategies  without commensurate net worth levels. While we did not perform an  evaluation of PCA, which would include a discussion of the thresholds, we  note that the NCUSIF deposit is not liquid and, therefore, not immediately  accessible for credit unions to use as a capital buffer. Though we agree that  not all credit unions are engaged in corporate credit union investments, we  believe that these investments are still relevant as a PCA consideration and  any risk-based capital standards should appropriately recognize these  investments.
NCUA stated that based on their experience gained to date with the PCA  system for federally insured credit unions, adjustments are needed to  better achieve PCA’s overall objectives. Specifically, NCUA stated that the  adjustments should move PCA to a more fully risk-based system, with a  lower leverage ratio required of a credit union to meet the well-capitalized  levels. NCUA believes that a well-capitalized leverage requirement in the  range of 5 percent would be more than sufficient to meet the safety and  soundness goals of PCA. However, NCUA did not provide evidence that the  current 7 percent net worth requirement has been a hardship to the credit  union industry. As noted in this report, credit unions cannot quickly raise  their capital through the issuance of capital stock when a financial need  arises, they must rely on retained earnings to build sufficient capital— which necessarily takes time. Further, we believe that the generally  favorable economic climate for credit unions coupled with the relatively  short amount of time that PCA has been in place for credit unions do not  provide a sufficient testing of the current system of PCA for credit unions  to determine if changes are warranted.
NCUA stated that it recognized that, as our draft report indicated, the  efficacy of a risk-based system is highly dependent on the details of the risk  categories and weights, as well as the complementary relationship between  the risk-based and leverage requirements. However, NCUA stated that the  draft report suggested that a risk-based system would result in risk assets  being lower than total assets for most credit unions, resulting in a given  amount of capital producing a higher net worth ratio. NCUA stated that  such a result was not a foregone conclusion. NCUA indicated that a  proposal under consideration included risk categories with weights at and  above 100 percent. The statement in the draft report was based on our  discussion with representatives of the credit union industry. As we noted in  our draft report, no detailed proposals regarding a risk-based system for all  credit unions was available for our analysis, including that being developed  by NCUA. In the absence of details, we cannot comment on the ultimate  effect of a proposal that is in the process of being developed on the  required capital levels for credit unions. However, we believe that, used in  tandem with leverage capital requirements, any risk-based capital  standards should appropriately recognize the risks credit unions face.
In response to the statement in our draft report that PCA was intended to  act as a restraint on growth, NCUA stated that it was important to  differentiate overly aggressive growth from robust growth, consistent with  sound business strategy, experienced by healthy credit unions. While we  agree that there are different types of growth, institutions still need to hold  sufficient capital regardless of the type of growth experienced. As noted in  this report, PCA was intended to curb aggressive growth, since  uncontrolled growth was one of the common attributes of banks and thrifts  that failed during the banking crisis of the late 1980s and early 1990s.  Moreover, our analysis of aggregated credit union data indicated that credit  unions have been able to maintain a rate of growth that has exceeded that  of banks and thrifts in the three full calendar years that PCA has been in  place for credit unions.
NCUA noted that our draft report suggested that NCUA revisit the concept  of an abbreviated NWRP for marginally undercapitalized credit unions for  situations involving temporary capital shortfalls. It noted that the statutory  language of CUMAA precluded NCUA from providing any significant  regulatory relief in this regard. NCUA stated that it supported a statutory  change to provide NCUA the regulatory authority to waive the requirement  to submit a NWRP for credit unions that have a temporary, marginal drop in  their net worth ratio below adequately capitalized, as determined on a case- by-case basis. While NCUA put forth a proposed rule on an abbreviated  NWRP, NCUA did not pursue it further. We believe it is important that  NCUA explore and use all of the available options and discretion provided  by CUMAA. While an abbreviated NWRP may not be viewed by NCUA or  the industry as granting significant regulatory relief, the experiences gained  with an abbreviated NWRP would provide NCUA and Congress with  additional information regarding the need for additional regulatory  authorities. Moreover, it is important to note that none of the federal bank  or thrift regulators have similar authority to that being sought by NCUA.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from its  issuance date. At that time, we will send copies of this report to the  Chairman and Ranking Minority Member of the Senate Committee on  Banking, Housing, and Urban Affairs. We also will send copies to the  National Credit Union Administration and the Department of the Treasury  and make copies available to others upon request. In addition, this report  will be available at no charge on the GAO Web site at http://www.gao.gov.
This report was prepared under the direction of Harry Medina, Assistant  Director. If you or your staffs have any further questions, please contact me  at (202) 512-8678 or hillmanr@gao.gov, or Harry Medina, Assistant Director,  at (415) 904-2220 or medinah@gao.gov. Key contributors are acknowledged  in appendix V.
section_title: Objectives, Scope, and Methodology
paragraphs: To identify and describe concerns regarding the current capital  requirements for credit unions, we interviewed credit union industry  groups, several credit union chief executive officers, credit union  regulators, and two banking regulators. Additionally, through these  interviews we gathered information on the issues and concerns associated  with the potential use of secondary capital and risk-based capital by credit  unions, including any documented proposals. We also conducted a  literature search to identify studies on the potential use of secondary  capital by credit unions and spoke with academics and other industry  observers.
To illustrate credit union prompt corrective action (PCA) capital levels  over time, we conducted research on PCA regulations and reviewed the  National Credit Union Administration’s (NCUA) Form 5300 (call report)  database for 1994-2003 for federally insured, natural person credit unions.  We reviewed NCUA-established procedures for verifying the accuracy of  the Form 5300 database and found that the data constituting this database  are verified on an annual basis, either during each credit union’s  examination, or through off-site supervision. We determined that the data  were sufficiently reliable for the purposes of this report. In addition, we  reviewed capital requirements of banks and thrifts for comparison with  credit union capital requirements.
Credit unions have been subject to PCA programs for a short time, and the  advantages and disadvantages of the current programs are not yet evident.  As a result, we did not perform an evaluation or assessment of credit union  PCA. We are aware that NCUA is constructing a more detailed risk-based  capital proposal that incorporates both risk-based and leverage  requirements; however, due to the lack of formalized details, we could not  perform a meaningful assessment of the proposal. Given that none of the  secondary capital or risk-based PCA proposals provided to us have  garnered credit union industry consensus or contain sufficient details on  which to base an assessment, we did not perform an evaluation of these  proposals or an analysis of their potential benefits and implications.
We conducted our work in Washington, D.C., from November 2003 through  July 2004 in accordance with generally accepted government auditing  standards.
section_title: Items in Use by NCUA in Developing Its Risk- Based Capital Proposal
paragraphs: While NCUA has not finalized its risk-based PCA proposal for all credit  unions, NCUA officials provided us items being used in the development of  their risk-based PCA proposal: NCUA supports a statutorily mandated PCA system, with a minimum  core leverage requirement (hard floor of 2 percent of total assets for  critically undercapitalized); a statutory definition of net worth (with  ability through regulation to reduce what qualifies as net worth, not  increase it); and statutory thresholds based on risk assets defined by  NCUA for the various net worth categories. NCUA also believes it  should be provided with the authority to set the remaining elements of  the risk-based PCA system by regulation.
With the exception of being able to set by regulation a minimum level of  net worth in relation to total assets (for example, 4 percent or 5 percent,  tied to the credit union’s CAMEL rating) to be considered adequately  capitalized, NCUA believes the current thresholds (but in relation to risk  assets) are acceptable and best left established by statute.  However,  NCUA wants to keep the parity provision in the current statute, which  provides the authority to change the thresholds by regulation,  commensurate with any changes to the banks’ PCA thresholds.
With regard to the net worth ratio numerator, NCUA also supports a  statutory definition for net worth, but the current definition should be  expanded beyond retained earnings under generally accepted  accounting principles (GAAP). NCUA believes a better definition of net  worth is equity of the credit union as determined under GAAP and as  authorized by the NCUA board. NCUA believes this would provide the  NCUA board with the authority through regulation to subtract from net  worth balance sheet items (such as goodwill that have no value in the  event of a payout) the NCUA board deems appropriate. Additionally,  NCUA believes that this definition preserves the requirement to comply  with GAAP and limits statutorily what can be included in net worth,  while providing NCUA with the flexibility to reduce assets that count  toward net worth for PCA purposes but that do not have value to the  insurance fund.
With regard to the net worth ratio denominator, NCUA advocates having  the regulatory flexibility to set the risk weights for assets and adjust  them, as it deems appropriate.
In cases where there is a marginal drop in net worth below adequately  capitalized, NCUA advocates having the regulatory flexibility to  temporarily waive a credit union’s requirement to submit a net worth  restoration plan if:  (a) the credit union is CAMEL-rated 1 or 2 with a net  worth ratio in the range of 5 percent to 7 percent, (b) the credit union’s  book of business does not present a safety and soundness issue, and (c)  the credit union’s assets are well managed. In addition, NCUA desires  the regulatory flexibility to revisit the credit union after a specified time  to determine if the temporary waiver is still appropriate and, if not,  require the credit union to submit a net worth restoration plan. NCUA  believes that this would reduce the burden placed on credit unions  experiencing a small, temporary decline in the net worth ratio due to  circumstances such as unsolicited, robust share growth that do not pose  a safety and soundness concern. Further, NCUA believes such a  provision would still provide NCUA with adequate authority to address  any concerns on a case-by-case basis.
section_title: Comments from the National Credit Union Administration
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to those named above, Heather T. Dignan, Landis L. Lindsey,  Kimberly A. Mcgatlin, Carl M. Ramirez, Barbara M. Roesmann, Paul G.  Thompson, John H. Treanor, and Richard J. Vagnoni made key  contributions to this report.
section_title: GAO’s Mission
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