The Credit Union System: Developments in Lending and Prudential Risk Management
Released: 2020-05-15T00:00:00

Introduction

Credit unions are nonprofit depository financial institutions that are owned and operated entirely by their members. In other words, na tural person credit unions, also known as retail credit unions, are financial cooperatives that return profits to their memberships. For this reason, member deposits are referred to as shares , which may be used to provide loans to members, other credit unions, and credit union organizations; and the interest earned by members is referred to as share d ividends , which are comparable to shareholder profit distributions. Credit unions (and banks) engage in financial intermediation , or facilitating transfers of funds back and forth between savers (via accepting deposits) and borrowers (via loans).

The National Credit Union Administration (NCUA), an independent federal agency, is the primary federal regulator and share deposit insurer for credit unions. There are three federal bank prudential regulators: the Office of the Comptroller of the Currency (OCC) charters and supervises national depository (commercial) banks; the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance by collecting insurance premiums from member banks and places the proceeds in its Deposit Insurance Fund (DIF), which are subsequently used to reimburse depositors when acting as the receiver of a failed bank; and the Federal Reserve provides lender-of-last-resort liquidity to solvent banks via its discount window. The NCUA, by comparison, serves all three functions for federally regulated credit unions. The NCUA also manages the National Credit Union Share Insurance Fund (NCUSIF), which is the federal deposit insurance fund for credit unions.

Although scholars are unable to pinpoint the precise origin of the credit union movement, the organization of membership-owned cooperatives to raise funds for members lacking sufficient collateral or wealth necessary to qualify for bank loans dates back to colonial times. During their infancy stages, credit cooperatives basically emerged as a form of microlending in financially underserved localities to provide unsecured small-dollar loans. Small group cooperatives initially relied on pooled funds, donations, and subsidies to make loans (allocated via lotteries or auctions) until evolving into self-sufficient systems more reliant on deposits. The advantage of small memberships for group credit cooperatives allow members to know each other, which facilitates peer monitoring of the lending decisions and borrowers' repayment behavior. The original concept of a credit union stemmed from cooperatives formed to promote thrift among its members and to provide them with a low-cost source of credit.

Following numerous bank failures and runs during the Great Depression that resulted in an extensive contraction of credit, Congress sought to enhance cooperative organizations' ability to meet their members' credit needs. Congress passed the Federal Credit Union Act of 1934 (FCU Act; 48 Stat. 1216) to create a class of federally chartered financial institutions for "promoting thrift among its members and creating a source of credit for provident or productive purposes." Over time, Congress expanded credit unions' permissible activities because the original concept of a credit union arguably needed to evolve with the marketplace. According to the NCUA,

When Congress amended the FCU Act in 1977 to add an extensive array of savings, lending and investment powers, it intended to "allow credit unions to continue to attract and retain the savings of their members by providing essential and contemporary services," and acknowledged that credit unions are entitled to "updated and more flexible authority granting them the opportunity to better serve their members in a highly-competitive and ever-changing financial environment." H.R. Rep. 95â23 at 7 (1977), reprinted in 1977 U.S.C.C.A.N. 105, 110. Congress acknowledged the difficulty in "regulating contemporary financial institutions within the framework of an Act that has on a continuing basis required major updating by means of regulation."

Although small memberships may be more advantageous for informal microlending systems, advanced intermediation systemsâsuch as banking and the modern credit union industryâbenefit from economies of scale . In other words, more assets (loans), greater access to deposits, and increased transactions volumes provide greater risk diversification and lower average cost per transaction, thus reducing vulnerability to financial disruptions that would be confined to a particular small group.

On April 19, 1977, P.L. 95-22 (the Mini Bill of 1977) substantially amended the FCU Act. It authorized the credit union industry to provide many financial products (e.g., loans, checking and savings deposit services) similar to those offered by the commercial banking system. Today, modern credit unions primarily engage in consumer and residential lending, and some originate commercial business loans for members. The lending and investment powers of the credit union industry, however, are still more restrictive than those of commercial banks.

Credit unions can make loans only to their members, other credit unions, and credit union organizations, thus limiting who they can serve. A statutory interest rate cap for credit union loans exists (with exceptions that allow for sufficient earnings necessary to maintain credit availability). Loans made by federally insured credit unions are generally limited to 15 years (except for residential mortgages). Federal credit unions' investment authority is limited by statute to loans, government securities, deposits in other financial institutions, and certain other limited investments given their origins to promote thrift rather than be long-term investors. Business lending restrictions include an aggregate limit on an individual credit union's member business loan balances and on the amount that can be loaned to one member.

If some or all of these restrictions are relaxed to allow the credit union system's lending powers to expand and become more comparable to the banking system, the prudential regulatory regimes arguably may require greater harmonization to protect against comparable financial risk exposures.

This report focuses on policy developments pertaining to the credit union system. It begins with an overview of recent efforts to further expand system lending capacities. Next, it describes how the system's exposure to mortgage credit (default) risk grew after credit unions were given greater intermediation authorities in the mortgage lending space. It then discusses the system's financial distress and recovery resulting from the 2008 financial crisis, and updates the progress made to improve the system's resiliency to credit and insolvency risks. This discussion will use the balance sheet terminology defined in the box below.

Expanding Permissible Lending Activities

Congress has passed legislation, and the NCUA has implemented and proposed rules, supporting the expansion of lending activities that would increase financial transactions volumes (economies of scale). The expansion of lending activities, as discussed in this section, is likely to generate greater cash flows and revenues for the credit union system.

Field of Membership and Common Bonds

A credit union's "field of membership" is the legal definition of who is eligible to join. Federal or state governments grant credit union charters on the basis of a "common bond." There are three types of charters: a (1) single common bond (occupation or association based); (2) multiple common bond (more than one group each having a common bond of occupation or association); and (3) community-based (geographically defined) common bond. Individual credit unions are owned by their memberships. Credit union members elect a board of directors from their institution's membership (one member, one vote). Credit unions can make loans only to their members, other credit unions, and credit union organizations.

Field of membership restrictions may limit an intermediary's ability to collect deposits, which are used to fund loans. Common bond requirements on credit unions can be considered analogous to U.S. restrictions on interstate and branch banking, which are no longer in place. By limiting access to supplementary sources of funds, a credit union (or bank) becomes more vulnerable to cash flow disruptions (e.g., increases in loan defaults, substantial deposit withdrawals) following adverse eventsâparticularly those that would directly affect its field of membership. Despite field of membership restrictions, some of the larger credit unions may still be able to achieve a sufficiently large and diversified depositor base, allowing them to enjoy greater economies of scale. Nevertheless, all intermediaries of all sizes are still vulnerable to a sudden need for liquid funds following some unexpected or adverse interest rate movements or a national recession, discussed in the section entitled "Increased Exposure to Mortgage Credit Risk and Recent NCUSIF Management Initiatives." For this reason, access to more sources of depositors arguably enhances liquidity management for credit unions and banks, which typically have assets (portfolio loans) that are less liquid than their liabilities (deposits).

On December 7, 2016, the NCUA published a final rule comprehensively amending its chartering and field of membership rules to maximize access to federal credit union services to the extent permitted by law. Although NCUA cannot change the three initial statutory field of membership categories, it revised certain terms such as local community , rural district , underserved area , and multiple common-bond credit union , among other things to broaden access to federal credit unions. Competitors of credit unions, however, legally challenged the revisions, arguing that an associational charter may limit the ability of a credit union to add underserved areas (e.g., local urban or rural underserved areas as determined by the NCUA) to its field of membership unless it also has a multiple common-bond charter.

On August 20, 2019, the D.C. Circuit Court of Appeals upheld the rule but remanded two provisions of the NCUA's revised field of membership rule. One provision, to satisfy a community-based common bond charter, would have allowed a combined statistical area with fewer than 2.5 million people to qualify as a local community; arguably, this provision could have had a discriminatory impact on poor and minority urban residents. The second remanded provision would have raised the population limit for rural districts from the greater of 250,000 or 3% of the relevant state's population to 1 million people; some geographical areas arguably could have been defined to extend beyond the state borders of a credit union's headquarters. The NCUA proposed to clarify its authority to reject fields of membership applications that would want to exclude low- or moderate-income individuals. On November, 7, 2019, the NCUA proposed to re-adopt the provision pertaining to the combined statistical area to clarify existing requirements and add an explicit provision to the rule to address potential discriminatory concerns.

Member Business and Commercial Lending

Lending caps on member business (commercial) loans offered by credit unions did not exist until 1998. Congress included provisions in the Credit Union Membership Access Act of 1998 (CUMAA; P.L. 105-219 ) that established a commercial lending cap that limits most credit unions to lending no more than 12.25% of their assets to small businesses, among other provisions. The following passages from the Senate's CUMAA report explain the rationale for establishing the member business loan (MBL) cap.

"The purpose of H.R. 1151, the CUMAA, as reported from the Committee, is to amend existing law with regard to the field of membership of federal credit unions, to preserve the integrity and purpose of federal credit unions and to enhance supervisory oversight of federally insured credit unions.... The bill significantly strengthens the prudential safeguards applicable to federally insured credit unions and makes the credit union system safer, sounder and more resilient." " Section 203. Limitation on member business loans . In new section 107A(a), the Committee has imposed substantial new restrictions on commercial business lending by insured credit unions. Those restrictions are intended to ensure that credit unions continue to fulfill their specified mission of meeting the credit and savings needs of consumers, especially persons of modest means, through an emphasis on consumer rather than business loans. The Committee action will prevent significant amounts of credit union resources from being allocated in the future to large commercial loans that may present additional safety and soundness concerns for credit unions, and that could potentially increase the risk of taxpayer losses through the National Credit Union Share Insurance Fund ('Fund')."

The CUMAA contained the following provisions:

The MBL definition was codified and defined as "any loan, line of credit, or letter of credit, the proceeds of which will be used for a commercial, corporate or other business investment property or venture, or agricultural purpose," but it does not include an extension of credit that is fully secured by a lien on a one-to-four-family dwelling that is a member's primary residence. The aggregate amount of MBLs that can be made by an individual credit union was limited to the lesser of 1.75 times the credit union's actual net worth or 1.75 times the minimum net worth amount required to be well-capitalized under the prompt corrective action supervisory framework, typically calculated to be 12.25%. Three exceptions to the aggregate MBL limit were authorized for credit unions (1) that have low-income designations or participate in the Community Development Financial Institutions program; (2) chartered for the purpose of making business loans (as determined by the NCUA); and (3) with a history of primarily making such loans (as determined by the NCUA).

In addition to the statute, a NCUA regulation limits the aggregate amount of a business loan that can be made to one member or group of associated members at 15% of the credit union's net worth or $100,000, whichever is greater.

MBL Definition and Requirement Updates

On March 14, 2016, the NCUA implemented final MBL rules to replace the prescriptive requirements (and limitations) with a broad principles-based regulatory approach, which became effective on January 1, 2017. The prescriptive approach, for example, required credit unions to request MBL origination waivers for NCUA approval, among other requirements. According to the NCUA, the prescriptive approach took significant time and resources from both credit unions and NCUA, resulting in delays in processing MBL applications. The principles approach, by contrast, streamlines the MBL underwriting process by granting credit unions more flexibility and individual autonomy to best fit their members' needs. Credit unions are still expected to comply with prudential underwriting practices and commensurate net worth requirements.

To facilitate the streamlined underwriting approach, the NCUA updated various MBL exemptions, resulting in several new definitions. For example, a commercial loan is a business loan (1) that is fully guaranteed by a federal or state agency or provides an advance commitment to purchase in full or (2) made to a nonmember or part of a joint lending arrangement with an entity that is not a member of the credit union system. Commercial loans do not count toward the MBL cap.

On May 24, 2018, Section 105 of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA; P.L. 115-174 ) amended the statutory MBL definition (i.e., it removed the words ''that is the primary residence of a member'') to address a disparity in the treatment of certain residential real estate loans made by credit unions and banks. The NCUA has since revised the MBL definition to exclude all extensions of credit that are fully secured by a lien on a one-to-four-family dwelling regardless of the borrower's occupancy status. For this reason, non-owner occupied real estate (e.g., rental property) loans are no longer considered MBLs and do not count toward the aggregate MBL cap.

In addition to amending the MBL definition, EGRRCPA Section 103 amended the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA; P.L. 101-73 ) to exempt from appraisal requirements certain federally related, rural real estate transactions valued at or below $400,000 if no state-certified or state-licensed appraiser is available. The NCUA implemented this provision in a July 2019 final rule. Depository institution lending typically requires appraised collateral as backing for the loans. The rise in home prices (since the $250,000 appraisal threshold was set in 1994) along with the innovation of less expensive automated appraisal valuations arguably has reduced the need for manual appraisals on less expensive homes, thereby lowering borrowers' closing costs. The NCUA also increased the appraisal threshold to $1 million for commercial real estate and qualified MBLs. The $1 million commercial appraisal threshold is higher than the current $500,000 for banks. The NCUA board, however, did not unanimously agree on the $1 million commercial appraisal threshold because, despite the system's low exposure to commercial real estate risks, the banking system still has more expertise evaluating and managing commercial lending risks than does the credit union system.

Policy Options Related to an MBL Cap Increase

The credit union industry has generally supported efforts to increase or eliminate the MBL cap. At the end of 2018, the NCUA reported that the credit union system originated 4.7% in MBLs relative to its assets. If MBL capacity were increased, some larger credit unions could become more competitive with small community banks as well as with some midsize and regional banks. Credit unions that currently enjoy a presence in the commercial lending market, have a sufficiently large asset base, or already operating close to the existing statutory limit would be more likely to increase their presence in the commercial market if the cap were raised.

In addition, the credit union system as a whole can support increased member business lending by increasing its use of participation loans . Financial institutions use loan participations to provide credit jointly. The loan originator, that often structures the loan participation arrangement, typically retains the largest share of the loan and sells smaller portions to other institutions. This practice allows the originator to maintain control of the customer relationship (including the loan servicing) and overcome funding limitations. In addition, all of the institutions involved in the participation loan use their individual portions of the loan to diversify their asset (loan) portfolios, which can be a cost-effective financial risk management tool. The credit union system could, therefore, become a more prominent competitor in the commercial lending market with the banking system, which also uses participation lending arrangements to diversify risks. Nevertheless, because all lending entails exposure to financial risks, having multiple credit unions involved in participations would still pose risk to the NCUSIF.

From an economics perspective, a lending cap imposes an arbitrary limit that may be too high for some credit unions and too low for others, thus resulting in MBL shortages in the latter situations. For those credit unions that provide very few or no MBLs, a cap is irrelevant. Credit unions facing an active MBL market must abruptly cease this type of lending when activity volume reaches the cap, which some may argue is set "too low," given that they can no longer satisfy their memberships' financial needs. Hence, a lending cap is arguably a blunt instrument to the extent that it imposes the same requirement on all institutions without taking into account differences in asset size and market purview.

Alternatively, a policy tool with a greater focus on the costs to originate MBLsâspecifically subjecting the net income derived from MBL activities to a type of taxâwould impose financial costs on credit unions without directly capping their lending ability. For example, the unrelated business income tax (UBIT) for tax-exempt organizations could be applied to MBLs. At the entity level, credit unions are exempt from federal income tax because they are not-for-profit financial cooperatives. If, for example, a credit union were to provide financial services (e.g., check-cashing) to nonmembers, any revenue generated from those activities would be subject to UBIT. Likewise, implementing the UBIT for MBLs would allow costs to grow in proportion to the amount of MBL activity while minimizing an abrupt discontinuation of the activity for those credit unions nearing an established policy cap.

Another policy option, also with similarities to a tax, would be to adopt capitalization requirements comparable to those implemented for the banking system. The CUMAA established the MBL cap and a capital-based supervisory framework as tools to enhance prudential safety and soundness, ultimately providing more protection for the share deposit insurance fund. Enhanced capitalization (net worth) requirements arguably could substitute for an MBL cap. In short, policy tools operating via cost disincentives rather than quantity restrictions may still allow the credit union system to restrain MBL activity but with more flexibility for certain circumstances.

Greater Flexibility in Lending Terms

As previously discussed, the credit union system has evolved to a formal intermediation system that provides a range of financial services; however, it still has not acquired all of the lending powers comparable to those of banks. In addition, some of the system's current lending authorities are temporary and must be regularly renewed. This section reviews some of the temporary or limited lending authorities that the credit union industry and some policymakers argue could be enhanced.

Interest Rate Ceilings and Temporary Exemptions

The FCU Act sets an annual 12% interest rate ceiling (or cap) for loans made by federally chartered credit unions and federally insured state-chartered credit unions. The statutory loan interest rate ceiling was raised to 15% per annum after the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA; P.L. 96-221 ) was passed. The DIDMCA also authorized the NCUA to set a ceiling above the 15% cap for up to an 18-month period after consulting with Congress, the U.S. Department of the Treasury, and other federal financial agencies.

The credit union interest rate ceiling is currently set at 18%. According to NCUA notices, its interest rate ceiling is an annual percentage rate (APR) rather than a pure interest rate. The APR represents the total annual borrowing costs of a loan expressed as a percentage, meaning that it is calculated using both interest rates and origination fees. The text-box below explains more about how to calculate and interpret the APR.

In December 1980, the NCUA board raised the ceiling to 21%. In May 1987, the board reduced the rate ceiling and has since maintained it at 18%. When setting the interest rate above 15%, the NCUA must (1) review money market interest rate trends and (2) assess how prevailing interest rate movements (volatility) might threaten credit unions' safety and soundness in terms of the ability to sustain their lending activities, the effect on their net-interest income (earnings), and the effect on their liquidity. In July 2018, for example, the board expressed concern that a ceiling below 18% could result in lower net interest income, considered to be the key driver of credit union earnings, thus reducing credit union profitability and limiting borrowers' access to credit. On January 23, 2020, the board retained the current 18% rate ceiling for federally insured credit union loans, from March 11, 2020, through September 10, 2021, after (1) observing rising money market rates over the preceding six-month period; (2) observing adverse liquidity, capital, earnings, and growth trends; and (3) consulting with the relevant federal agencies.

The Military Lending Act of 2006 (MLA; P.L. 109-364 ) was passed to protect active duty military personnel and their eligible family members from predatory lending. The MLA limits the Military Annual Percentage Rate (MAPR) to 36% for small-dollar loans and credit products, such as credit cards, deposit advances, overdraft lines of credits, and certain types of installment loans. Â The MLA, however, does not apply to mortgages, automobile loans, and secured loans. A credit union borrower typically receives an APR below the MAPR ceiling for covered transactions. Hence, the credit union interest rate ceiling is currently below the federal MLA cap on consumer loans offered to military personnel.

The NCUA, however, permits the credit union system to make payday alternative loans (PALs) to its membership with certain restrictions. Under the existing permissible framework, PAL amounts may range from $200 to $1,000; they must have fully amortizing payments; the term length must range from 46 days to 180 days; and the application fee must be $20 or less. If the borrower cannot repay the initial PAL, a credit union may allow for a rollover into a new PAL of the same initial maturity as long as no additional fees are charged or no additional credit is extended. No more than three PALs can be made to a single borrower in a rolling six-month period. This specific loan product, referred to as a PALs I, requires a one-month membership before it can be offered.

The PALs program has a 28% ceiling, meaning that it is exempt from the 18% interest rate ceiling that covers other loan originations made by federally insured credit unions and from the 36% MAPR ceiling. The MAPR ceiling includes the origination fees, but the NCUA PALs ceiling excludes the $20 origination fee. The PAL loan APR when including the $20 origination fee, in many cases, exceeds the 36% MAPR ceiling. To avoid lending reductions by credit unions to military service customers, the NCUA requested and was granted a PAL exemption from the MAPR so that the PAL application fee is not included in the APR computation. The higher PAL ceiling also does not include an initial origination fee of up to $20 in the APR calculation.

On October 1, 2019, the NCUA broadened the PALs framework to allow credit unions to offer additional short-term, small-dollar products. A new PALs II product may have an amount up to $2000 and have fully amortizing payments over a 1-to-12-month term. Furthermore, there is no minimum membership length requirement to be eligible for a PALs II, which may allow borrowers to quickly consolidate multiple non-credit union payday loans into one PALs loan. Credit unions may not charge any overdraft or insufficient funds fees for any PALs II drawn against a member's account, which may reduce the likelihood of creating a negative balance in the account while still allowing credit unions to make sufficient (as opposed to maximum) profit in this line of business.

Loan Maturity Length and Exemption Caps

When the FCU Act was initially passed, credit unions were allowed to make loans not to exceed two years. Congress has since increased system-originated loan maturity lengths.

On September 22, 1959, Section 8 of P.L. 86-354 amended the FCU Act to increase credit union loan maturities for up to 5 years. On July 5, 1968, Section 1 of P.L. 90-375 amended the FCU Act to allow credit unions to make unsecured loans with maturities not to exceed 5 years and secured loans with maturities not to exceed 10 years. The Mini Bill of 1977 allowed loan maturities not to exceed 12 years. It also allowed credit unions to make residential real estate loans with maturities up to 30 years; home improvement loans and mobile home loans (for principal residence) were allowed for up to 15 years. The Garn-St. Germain Depository Institutions Act of 1982 (Garn-St. Germain Act; P.L. 97-320 , 96 Stat. 1469) permitted mortgage loan refinancing, and extended the maturity limit to 15 years for all second mortgages. The Competitive Equality Banking Act of 1987 (CEBA; P.L. 100-86 ) amended the FCU Act to authorize the NCUA to allow second-mortgage, home-improvement, and mobile home loans beyond 15 years. On October 1989, the NCUA finalized the rule to extend the maturity limit to 20 years. On October 13, 2006, Section 502 of P.L. 109-351 amended the FCU Act to set a 15-year maximum maturity on credit union loans, with some exceptions. For example, residential one-to-four family mortgages may exceed the 15-year maturity term as long as the property is the borrower's primary residence.

In the 116 th Congress, H.R. 1661 was introduced on March 8, 2019, and referred to the House Committee on Financial Services. H.R. 1661 , if enacted, would amend Section 107(5) of the FCU Act to allow NCUA the flexibility to extend maturities for all loans, including MBLs and student loans.

Developments in the Credit Union System's Prudential Risk Management

Congress created the NCUSIF in 1970 to be the insurance fund for all federally regulated credit unions. The NCUA manages the NCUSIF, which is completely funded by insured credit unions. The NCUSIF's primary income source is the premiums collected from credit unions, which pay the fund's operating expenses, cover losses, and build reserves. Premiums were originally set at one-twelfth of 1% of the total amount of member share accounts, but P.L. 98-369 required each federally insured credit union to maintain a fund deposit equal to 1% of its insured share accounts. Examination fees and any penalties NCUA collects from insured institutions are also deposited into the NCUSIF. Fund portions not applied to current operations can be invested in government securities, and the earnings also generate fund income. The NCUSIF's reserves consist of the 1% deposit, plus the fund's accumulated insurance premiums, fees, and interest earnings.

Prudential safety and soundness regulation, which includes holding sufficient capital reserves, may reduce the financial institutions' insolvency (failure) risk and promote public confidence in the financial system. Although higher capital requirements may not prevent adverse financial risk events from occurring, more capital enhances the financial firms' ability to absorb greater losses associated with potential loan defaults. The enhanced absorption capacity may strengthen public confidence in the soundness of these financial institutions and increase their ability to function during periods of financial stress. For this reason, the NCUA has proposed enhanced net worth (capitalization) requirements for credit unions, which is intended to increase the credit union system's resilience to insolvency risk and to minimize possible losses to the NCUSIF and ultimately to taxpayers. These prudential issues are discussed in this section.

Increased Exposure to Mortgage Credit Risk and Recent NCUSIF Management Initiatives

Credit unions were granted the authority to increase their participation in the mortgage market during the late 1970s and 1980s. In light of the savings and loan (S&L) crisis, discussed in the text box below, the credit union system was also granted more powers to mitigate interest rate risk stemming from exposure to mortgage market risk. The following list highlights some of these authorities:

After the Mini Bill of 1977 was passed, the NCUA adopted regulations on August 7, 1978, permitting credit unions to sell mortgage loans in the secondary marketâspecifically to Fannie Mae, Freddie Mac, and Ginnie Mae (government-sponsored enterprises, or GSEs) as well as to federal, state, and local housing authorities. On August 16, 1978, federal credit unions were also granted the authority to sell their members' federally guaranteed student loans. The Garn-St. Germain Act, as mentioned, eliminated limits on the size and maturity of first lien mortgages, permitted refinancing of mortgage loans, and extended the maturity limit to 15 years for all second mortgages. The CEBA amended the FCU Act to authorize the NCUA to allow second-mortgage, home-improvement, and mobile home loans beyond 15 years. The Garn-St. Germain Act also amended the FCU Act to allow credit unions to issue and sell securities, which are guaranteed pursuant to Section 306(g) of the National Housing Act. In other words, federal credit unions were given the authority to participate in activities that would allow them to securitize assets. In 1988, the NCUA allowed credit unions to invest in mortgage-backed securities (MBS). Rather than hold, for example, 30-year mortgages, the ability to hold MBS of shorter (e.g., 10 year) maturities reduces asset duration risk (discussed in the text box below). In 1989, credit unions were allowed to use financial derivatives to purchase insurance against declines in GSE-issued MBS values that would occur after a rise in interest rates, thus protecting the overall value of their asset (loan) portfolios. (NCUA noted that the credit union system had experienced a 48% increase in real estate lending in 1987.)

Consequently, as credit unions and other financial intermediaries increased their participation in the mortgage market, they also grew more susceptible to the financial risks linked to this market. Rising interest rates was a major risk factor in the S&L crisis during the 1980s, whereas rising mortgage defaults or credit risk was a major factor in the financial crisis that occurred in 2008. Because of the greater exposure to mortgage credit risk, the credit union system along with numerous financial entities in 2008 experienced distress after a sharp rise in the percentage of seriously delinquent mortgage loans in the United States.

According to the NCUA chairman, corporate credit unions faced increasing liquidity pressures during 2008 after a significant portion of their MBSsâfollowing a deterioration of the underlying real estate collateralâlost value and were subsequently downgraded below investment grade. Corporate credit unions operate as wholesale credit unions, meaning that they provide financing, investment, and clearing services for the retail credit unions that interface directly with customers. The corporates accept deposits from, as well as provide liquidity and correspondent lending services to, retail credit unions. This reduces the costs that smaller institutions would bear individually to perform various financial transactions for members. Given that retail credit unions are cooperative owners of corporate credit unions, they are also federally insured by the NCUSIF. The NCUA placed two corporate credit unions into conservatorship in March 2009 and three additional corporates in September 2010. The five corporates under conservatorship at the time had represented approximately 70% of the entire corporate system's assets and 98.6% of the investment losses within the system.

The share equity ratioâthe ratio of total funds in the NCUSIF relative to the estimated amount of share deposits held by credit unionsâis an indicator that represents the adequacy of reserves available to protect share depositors and maintain public confidence. The NCUA annually determines the normal operating level for the share equity ratio, which statutorily must fall between 1.2% and 1.5%. The 2006 equity ratio was 1.30% and fell below the statutory minimum to 1.18% by August 2010. The NCUA board may assess a premium when the ratio falls between 1.2% and the declared operating level; however, it is required to assess a premium if the equity ratio falls below 1.2%. Similarly, the NCUA board may declare a dividend if, at the end of the calendar year, the equity level exceeds the normal operating level; it is required to do so if the equity ratio exceeds 1.5%.

Rather than deplete the NCUSIF, Congress in May 2009 established a Temporary Corporate Credit Union Stabilization Fund (TCCUSF) to accrue and recover losses from the corporates. The TCCUSF borrowed from Treasury to help cover conservatorship costs, and the NCUA also raised assessments on all federally insured credit unions, including those that did not avail themselves of corporate credit union services. The premium assessment reflected a plan to restore the NCUSIF equity ratio to 1.3%, which happened by December 2011.

After achieving a positive net position of $1.9 billion as of May 2017, the NCUA, in July 2017, proposed closing the TCCUSF and providing credit unions with a Share Insurance Fund distribution in 2018, estimated to be between $600 million and $800 million. The TCCUSF officially closed on October 1, 2017; its assets and obligations were transferred to the NCUSIF. The NCUA reduced the share equity ratio from 1.39, which had previously been set in September 2017, to 1.38, administering an equity distribution (rebate) of $160.1 million to member institutions.

The Risk-Based Capital Rule

On January 23, 2014, the NCUA announced increases in capital requirements for a subset of natural person credit unions designated as complex . NCUA initially defined a complex credit union to have at least $50 million in assets. On January 27, 2015, the NCUA revised the initial proposed rule, amending the definition as having at least $100 million in assets. On October 29, 2015, the NCUA finalized the risk-based capital rule. Some of the rule's specific requirements included the following:

A new asset risk-weighting system was introduced that would apply to complex credit unions, which would be more consistent with the methodology used for U.S. federally insured banking institutions. A new risk-based capital ratio (defined using the narrower risk-based capital measure in the numerator and total risk-weighted assets, which are computed using the new risk-weighting system, in the denominator) of 10% would be required for complex credit unions to be well-capitalized under the prompt corrective action supervisory framework. The risk-based capital ratio was designed to be more consistent with the capital adequacy requirements commonly applied to depository (banking) institutions worldwide. Compliance of complex credit unions with the risk-based capital ratio requirements as well as the existing statutory 7% net-worth asset ratio would have been effective by January 1, 2019, to avoid NCUA supervisory enforcement actions. Non-complex credit unions with assets below $100 million would not have been required to comply with the new risk-weighting system, and they would no longer be required to risk-weight their assets. Instead, non-complex credit unions must comply with the existing statutory 7% net-worth asset ratio. Credit unions with a concentration in commercial lending in excess of 50% of their total assets would be required to hold higher amounts of net worth to abate the higher levels of concentration risk.

On December 17, 2019, the NCUA issued a final rule to move the effective date to January 1, 2022. The NCUA also amended the complex credit union's definition by increasing the asset threshold level from $100 million to $500 million. The NCUA also wanted more time to consider the feasibility of adopting a capital framework for the credit union system that would be similar to the community bank leverage ratio framework. Under this framework, banks with less than $10 billion in average total consolidated assets may elect to maintain a leverage ratio of greater than 9% to satisfy both the risk-based and leverage capital requirements to be well-capitalized. Nevertheless, the delays have prompted some Members of Congress to monitor the implementation progress of the risk-based capital rule for credit unions.

Supplemental Capital

Because credit unions do not issue common stock equity, they do not have access to capital sources beyond retained earnings. If alternative sources of capital, referred to as supplemental capital, were to be used in addition to net worth, then credit unions would be able to increase their lending while remaining in compliance with their safety and soundness net worth requirements. The proposal discussed below to adopt supplemental capital requirements would enhance the credit union system's lending capacity and introduce a new prudential risk management tool.

An NCUA working group has developed three general sources of supplemental capital, all of which would be repaid after reimbursement of the NCUSIF following liquidation of an insolvent credit union. Credit unions could raise

voluntary patronage capital (VPC) if (noninstitutional) members were to purchase "equity shares" in the organization. VPC equity shares would pay dividends; however, a VPC investor would not obtain any additional voting rights, and no investment would be allowed to exceed 5% of a credit union's net worth.

mandatory membership capital (MMC) if a member pays what may be conceptually analogous to a membership fee. MMC capital would still be considered equity for the credit union but, unlike VPC, it would not accrue any dividends.

subordinate debt (SD) from external and institutional investors. SD investors would have no voting rights or involvement in a credit union's managerial affairs. SD would function as a hybrid debt-equity instrument, meaning the investor would simply be a creditor with no equity share in the credit union while it is solvent and would not be repaid principal or interest should the credit union become insolvent. SD investors must make a minimum five-year investment with no option for early redemption.

A credit union 's net worth is defined in statute; therefore, congressional legislative action would be required to permit other forms of supplemental capital to count toward their net worth prudential requirements.

Conclusion

Credit union industry advocates argue that lifting lending restrictions to make the system more comparable with the banking system would increase borrowers' available pools of credit. Community banks, which often compete with credit unions, argue that policies such as raising the business lending cap, for example, would allow credit unions to expand beyond their congressionally mandated mission and could pose a threat to financial stability. By amending the FCU Act several times to expand permissible lending activities, Congress arguably had recognized that the credit union system has evolved into a more sophisticated financial intermediation system. Congress has also emphasized prudential safety and soundness concerns. Following the 2008 financial crisis, the federal bank prudential regulators implemented prudential requirements to enhance the U.S. banking system's resiliency to systemic risk events. The NCUA initially proposed in 2014 to increase capital requirements particularly for large credit unions (those with $500 million or more in assets); however, the proposal has been revised, delayed, and is currently scheduled to become effective in January 2022. In the meantime, the NCUA has implemented and proposed rules to support expanding lending activities that would increase financial transactions volumes (economies of scale), thus possibly generating greater cash flows and profitability for the credit union system. The adoption of enhanced prudential net worth requirements for the credit union system, however, arguably may facilitate mitigating the financial risks that typically accompany increases in lending.