Corporate credit unions occupy a unique niche among financial institutions. They are nonprofit financial cooperatives that are owned by natural person credit unions (that is, credit unions whose members are individuals), and provide lending, investment, and other financial services to these credit unions. For example, corporates offer loans to member credit unions, which in turn use these loans to meet the loan demands of their individual members. However, corporates are not the only financial institutions that provide products and services to credit unions. For example, some credit unions may also obtain loans from Federal Reserve Banks or Federal Home Loan Banks. Additionally, corporates offer credit unions investment products and investment advice, but credit unions can also obtain these services from broker-dealers or investment firms. Finally, corporates also offer automated settlement, securities safekeeping, data processing, accounting, and electronic payment services, which are similar to the correspondent services that large commercial banks have traditionally provided to smaller banks. With an emphasis on safety and liquidity, corporates seek to provide their members with higher returns on their deposits and lower costs on products and services than can be obtained individually elsewhere. However, corporates’ limited ability to generate profits—as nonprofit institutions, owned and controlled by their primary customers—constrains their ability to build a financial cushion against adverse financial conditions or unexpected losses. Since 2000, corporates have experienced deposit inflows from natural person credit unions that increased corporates’ assets and shares. Corporates act as a “liquidity sponge” for the underlying natural person credit union system, and the cyclical rise and fall of corporates’ assets and shares (deposits) are rooted in the deposit flows of the natural person credit unions. Thus, these inflows and outflows of deposits, which are beyond corporates’ control, affect their measures of financial strength—such as profitability and capital ratios. As we discuss later in the report, this has exacerbated the stress on their financial condition. Since 1992, the number of corporates in the corporate network has decreased, with assets more concentrated in larger institutions. (See fig. 1 for an illustration of the network’s geographic distribution.) Mainly as a result of mergers, corporates have decreased in number from 44, at the end of 1992, to 30 as of December 31, 2003, excluding U.S. Central. On average, corporates also have become larger, with the median asset size (excluding U.S. Central) increasing from $450.6 million in 1992 to $1.2 billion at the end of 2003. However, the corporate network still encompasses small and large institutions, ranging in size from $7.3 million in assets to $25 billion, as of December 31, 2003. In addition, asset concentration in the network has become more pronounced since 1992. Excluding U.S. Central, at the end of 1992 the three largest corporates accounted for approximately 42 percent of the corporates’ total assets. By the end of 2003, these corporates accounted for roughly half of corporates’ total assets and the largest corporate accounted for about one-third. As shown in figure 2, the credit union industry is organized into three closely connected groupings. At the “top” or retail level, as of December 31, 2003, there were the 9,488 credit unions that served roughly 82 million individual customers. In the middle are the 30 corporates, which serve credit unions by investing the cash they have not lent out and by providing loans and other financial services to the credit unions. Finally, on the “bottom” or wholesale level is U.S. Central, which provides corporates a range of products and services, similar to those that corporates provide to credit unions. Since their inception, corporates’ primary functions have been to accept deposits and make loans to their members. In addition, today, they also provide investments and other financial services to credit unions, and corporates over time have broadened the types of products and services they offer. Most corporates offer electronic services, such as the Automated Clearing House (ACH) and correspondent services, such as settlements with the Federal Reserve and other financial institutions; check services, including collection and settlement of money orders and traveler’s checks; credit card settlement; and education and training. However, corporates now offer or plan to introduce new products and services such as online training, electronic bill payment, Internet banking, asset/liability management (ALM), and brokerage services. For more detailed information on the products and services corporates offered or planned to offer, see appendix IV. While the first credit union in the United States started in 1909, the first corporate did not start operations until 1968. Many corporates grew out of the various state credit union leagues and initially served only single states or regions. Over time, corporates were granted national fields of membership that allowed them to expand the number of credit unions they served. While corporate credit union membership can be national, corporates can have either a state or federal charter. As of December 31, 2003, 18 of the 31 corporates, including U.S. Central, were state-chartered. In terms of oversight, NCUA has authority for supervision and examination of federally chartered corporates. Under the dual-chartering system, the supervisory authorities for those states that have state-chartered corporates are primarily responsible for supervision of these institutions. However, since all corporates provide deposit, liquidity, and correspondent services to federally insured credit unions, NCUA also has regulatory authority over state-chartered corporates and assesses the risks federally insured, state-chartered corporates and noninsured, state-chartered corporates present to the National Credit Union Share Insurance Fund (NCUSIF). This assessment, which is essentially an examination of the corporates’ operations, is performed jointly with state supervisory authorities during their examinations of state-chartered corporates. Part 704 of NCUA’s regulations, together with the relevant provisions of the Federal Credit Union Act of 1934, constitutes the primary federal regulatory framework for both state- and federally chartered corporates. NCUA first issued Part 704 in 1982. Since our previous report on corporates in 1991, NCUA made significant revisions to Part 704 in 1998 and 2002 relating to risks, capital, investments, and other areas covered by this report. Like other financial institutions, corporates face a challenging business environment that affects their financial condition and is characterized by increasing competition, changing product and service offerings, and rapid technological advances. Moreover, recent pressure from a low-interest-rate environment and rapid growth in assets has put additional stress on the corporate network’s profitability and capital ratios. While net income levels have grown since 2000, corporates’ profitability was lower in 2003 than in 1993. As rapid asset growth negatively impacts profitability, it affects corporates’ ability to generate sufficient retained earnings—the primary component of their capital. As overall capital levels have been rising, corporates have been relying more on less permanent (relatively weaker) forms of capital. Additionally, rapid asset growth and the relatively slower growth in retained earnings has put pressure on corporates’ capital ratios, which could be a cause for concern since capital ratios are an important indicator of financial strength. Growth and changes in corporate investments, such as recent shifts of more of the corporates’ investment portfolios into potentially higher yielding and more volatile securities, may increase interest-rate risk if the investments are not managed properly. In particular, the percentage of corporate investments in obligations of U.S. Central has declined while the percentages of corporates’ investments in privately issued mortgage-related and asset-backed securities have increased. Corporates appear to be managing risk by shifting toward more variable-rate and shorter-term securities, providing a potentially better match for the relatively short-term nature of their members’ deposits. However, a regulatory change effective in 2003 allowed certain corporates to purchase securities with lower credit quality (more credit risk), raising implications for NCUA oversight since this activity may lead to increased risk if it is not managed properly. Corporate credit unions are operating in a challenging business environment characterized by increased competition, pressure to increase returns on their investments in a low-interest-rate environment, and the need to invest in technology and personnel to meet the demands of their credit union members for new and more sophisticated products and services. To obtain the corporates’ views on their business environment, we distributed a questionnaire to the entire network and achieved a 100 percent response rate. The corporates reported that they faced competition from outside the corporate network from entities such as banks, broker-dealers, the Federal Reserve System, and Federal Home Loan Banks. About 87 percent of the corporates reported that they also faced competition from other corporates despite the cooperative nature of the network. In addition, in recent years (since 2000), corporates have received a large inflow of deposits from their natural person credit union members, which had increasing amounts of unloaned funds because of the “flight to safety” that occurred in the wake of the stock market downturn. These inflows increased corporates’ assets, pressuring them to ensure that they received sufficient returns when investing these funds to maintain adequate capital levels and fund operations. However, over the last several years, low interest rates have reduced the returns that corporates could obtain on their investments, which has put stress on their overall profitability. Finally, the corporates stated that they faced a rapidly changing marketplace, particularly related to the increased demands from credit unions for more sophisticated products and services such as electronic banking. The strategies corporates have employed to respond to their challenging business environment can have positive or negative impacts on their overall financial condition. For example, over time, corporates have increasingly invested in securities such as privately issued mortgage-related and asset-backed securities and less so in obligations of U.S.Central, suggesting that they are seeking to enhance the yields on their investments.