# Risk-Based Capital

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3A2015-00947

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** January 27, 2015
- **Citation:** 80 FR 4340

## Text

NATIONAL CREDIT UNION ADMINISTRATION
12 CFR Parts 700, 701, 702, 703, 713, 723, and 747
RIN 3133-AD77
Risk-Based Capital

AGENCY:

National Credit Union Administration (NCUA).

ACTION:

Proposed rule.

SUMMARY:

The NCUA Board (Board) is seeking comment on a second proposed rule that would amend NCUA's current regulations regarding prompt corrective action (PCA) to require that credit unions taking certain risks hold capital commensurate with those risks. The proposal would restructure NCUA's PCA regulations and make various revisions, including amending the agency's current risk-based net worth requirement by replacing the current risk-based net worth ratio with a new risk-based capital ratio for federally insured natural person credit unions (credit unions). The proposal would also, in response to public comments received, make a number of changes to the original proposed rule that the Board published in the
Federal Register
on February 27, 2014. These changes include, among other things, exempting credit unions with up to $100 million in total assets from the new rule, lowering the risk-based capital ratio level required for an affected credit union to be classified as well capitalized from 10.5 percent to 10 percent, lowering the risk weights for various classes of assets, removing interest rate risk components from the risk weights, and extending the implementation timeframe to January 1, 2019. These changes would substantially reduce the number of credit unions subject to the rule, reduce the impact on affected credit unions, and afford affected credit unions sufficient time to prepare for the rule's implementation.

The proposed risk-based capital requirement set forth in this proposal would be more consistent with NCUA's risk-based capital measure for corporate credit unions and more comparable to the regulatory risk-based capital measures used by the Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve, and Office of the Comptroller of Currency (Other Banking Agencies).

In addition, the proposed revisions would amend the risk weights for many of NCUA's current asset classifications; require higher minimum levels of capital for credit unions with concentrations of assets in real estate loans or commercial loans or higher levels of non-current loans; and set forth how NCUA can address a credit union that does not hold capital that is commensurate with its risk.

The proposed revisions would also eliminate several provisions in NCUA's current PCA regulations, including provisions relating to the regular reserve account, risk-mitigation credits, and alternative risk weights. (For clarity, the “current” PCA regulations would remain in force until the effective date of a final risk-based capital rule.)

DATES:

Comments must be received by April 27, 2015.

ADDRESSES:

You may submit written comments, identified by RIN 3133-AD77, by any of the following methods (Please send comments by one method only):

• Federal eRulemaking Portal:
http://www.regulations.gov.
Follow the instructions for submitting comments.

• NCUA Web site:
http://www.ncua.gov/Legal/Regs/Pages/PropRegs.aspx.
Follow the instructions for submitting comments.

• Email: Address to
regcomments@ncua.gov.
Include “[Your name]—

Comments on Proposed Rule: Risk-Based Capital” in the email subject line.

• Fax: (703) 518-6319. Use the subject line described above for email.

• Mail: Address to Gerard Poliquin, Secretary of the Board, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428.

• Hand Delivery/Courier: Same as mail address.

You can view all public comments on NCUA's Web site at
http://www.ncua.gov/Legal/Regs/Pages/PropRegs.aspx
as submitted, except for those we cannot post for technical reasons. NCUA will not edit or remove any identifying or contact information from the public comments submitted. You may inspect paper copies of comments in NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by appointment weekdays between 9:00 a.m. and 3:00 p.m. To make an appointment, call (703) 518-6546 or send an email to
OGCMail@ncua.gov.

FOR FURTHER INFORMATION CONTACT:

Larry Fazio, Director, Office of Examination and Insurance, at (703) 518-6360; JeanMarie Komyathy, Director, Division of Risk Management, Office of Examination and Insurance, at (703) 518-6360; Steven Farrar, Loss/Risk Analyst, Division of Risk Management, Office of Examination and Insurance, at (703) 518-6393; John Shook, Loss/Risk Analyst, Division of Risk Management, Office of Examination and Insurance, at (703) 518-3799; Tom Fay, Senior Capital Markets Specialist, Division of Capital and Credit Markets, Office of Examination and Insurance, at (703) 518-1179; Rick Mayfield, Senior Capital Markets Specialist, Division of Capital and Credit Markets, Office of Examination and Insurance, at (703) 518-6501; or by mail at National Credit Union Administration, 1775 Duke Street, Alexandria, VA 22314.

SUPPLEMENTARY INFORMATION:

I. Introduction

II. Legal Authority

III. Summary of the Original Proposal and This Proposal

IV. Section-by-Section Analysis

V. Effective Date

VI. Impact of this Proposed Rule

VII. Regulatory Procedures

I. Introduction

NCUA's primary mission is to ensure the safety and soundness of federally insured credit unions. NCUA performs this function by examining and supervising all federal credit unions, participating in the examination and supervision of federally insured, state-chartered credit unions in coordination with state regulators, and insuring members' accounts at federally insured credit unions.
1

In its role as administrator of the National Credit Union Share Insurance fund (NCUSIF), NCUA insures and regulates approximately 6,400 federally insured credit unions, holding total assets exceeding $1.1 trillion and representing approximately 99 million members.

1
Within the nine states that allow privately insured credit unions, approximately 133 state-chartered credit unions are privately insured and are not subject to NCUA regulation or oversight.

At its January 2014 meeting, the Board issued a proposed rule (the Original Proposal)
2

to amend NCUA's PCA regulations, part 702. The Original Proposal sought to enhance risk sensitivity and address weaknesses in the existing regulatory capital framework for credit unions. The revisions in the Original Proposal included a new method for computing NCUA's risk-based requirement that would be more consistent with the risk-based capital ratio measure used for corporate credit unions
3

and more comparable to the risk-based capital ratio measures used by the Other Banking Agencies.
4

In general, this new method for computing NCUA's risk-based requirement would have adjusted the risk weights for many asset

classifications to lower the minimum risk-based capital ratio requirement for credit unions with lower-risk operations. Conversely, this new method would have required higher minimum levels of risk-based capital for credit unions with concentrations of assets in residential real estate loans or commercial loans, or high levels of non-current loans.

2
79 FR 11183 (Feb. 27, 2014).

3

See
12 CFR part 704.

4

See
78 FR 55339 (Sept. 10, 2013).

In addition, due to the inherent limitations of any widely applied risk-based capital measurement system, the Original Proposal also included procedures for the Board to require an individual credit union to hold a higher level of risk-based capital where NCUA staff raised specific supervisory concerns regarding the credit union's condition. Finally, the Original Proposal eliminated the provisions of current § 702.401(b) relating to transfers to the regular reserve account, current § 702.106 regarding the standard calculation of the RBNW ratio requirement, current § 702.107 regarding alternative components for the standard calculation, and current § 702.108 regarding the risk-mitigation credit.

In response to the Original Proposal, the Board received over 2,000 comments with many suggestions on how to improve the Original Proposal. The Board has reviewed the comments and determined that it was appropriate to issue a second proposed rule. The Board notes that, because this is a new proposed rule, it is not required to respond to any comments received on the Original Proposal. However, the Board believes it is important to address those comments, and has, therefore, included comment summaries and responses throughout the preamble to this proposal.

The Board is now requesting comment on this second proposed rule regarding risk-based capital. Based largely on comments it received on the Original Proposal, the Board is proposing many improvements to the Original Proposal, including: (1) Amending the definition of “complex” credit union by increasing the asset threshold from $50 million to $100 million; (2) reducing the number of asset concentration thresholds for residential real estate loans and commercial loans (formerly classified as MBLS); (3) assigning one-to-four family non-owner-occupied residential real estate loans the same risk weights as other residential real estate loans; (4) eliminating IRR from this proposed rule; (5) extending the implementation timeframe to January 1, 2019; and (6) eliminating the Individual Minimum Capital Requirement (IMCR) provision. Among other things, these changes would substantially reduce the number of credit unions subject to the rule, and would afford affected credit unions sufficient time to prepare for the rule's full implementation. A full discussion of the impact of these and other changes in this proposed rule is contained in Impact of the Proposed Regulation part of the preamble below.

As discussed in more detail below, the revisions in the Original Proposal and this proposal are intended to implement the statutory requirements of the Federal Credit Union Act (FCUA) and follow recommendations made by the Government Accountability Office (GAO).

II. Legal Authority

In 1998, Congress enacted the Credit Union Membership Access Act (CUMAA).
5

Section 301 of CUMAA added new section 216 to the FCUA,
6

which requires the Board to adopt by regulation a system of PCA to restore the net worth of credit unions that become inadequately capitalized.
7

Section 216(b)(1)(A) requires the Board to adopt by regulation a system of PCA for federally insured credit unions that is “consistent with” section 216 of the FCUA and “comparable to” section 38 of the Federal Deposit Insurance Act (FDI Act).
8

Section 216(b)(1)(B) requires that the Board, in designing the PCA system, also take into account the “cooperative character of credit unions” (
i.e.,
that credit unions are not-for-profit cooperatives that do not issue capital stock, must rely on retained earnings to build net worth, and have boards of directors that consist primarily of volunteers).
9

In 2000, the Board implemented the required system of PCA, primarily in part 702 of NCUA's regulations.
10

5
Public Law 105-219, 112 Stat. 913 (1998).

6
12 U.S.C. 1790d.

7
The risk-based net worth requirement for credit unions meeting the definition of “complex” was first applied on the basis of data in the Call Report reflecting activity in the first quarter of 2001. 65 FR 44950 (July 20, 2000). NCUA's risk-based net worth requirement has been largely unchanged since its implementation, with the following limited exceptions: Revisions were made to the rule in 2003 to amend the risk-based net worth requirement for MBLs, 68 FR 56537 (Oct. 1, 2003); revisions were made to the rule in 2008 to incorporate a change in the statutory definition of “net worth,” 73 FR 72688 (Dec. 1, 2008); revisions were made to the rule in 2011 to expand the definition of “low-risk assets” to include debt instruments on which the payment of principal and interest is unconditionally guaranteed by NCUA, 76 FR 16234 (Mar. 23, 2011); and revisions were made in 2013 to exclude credit unions with total assets of $50 million or less from the definition of “complex” credit union, 78 FR 4033 (Jan. 18, 2013).

8
12 U.S.C. 1790d(b)(1)(A);
see also
12 U.S.C. 1831o (Section 38 of the FDI Act setting forth the PCA requirements for banks).

9
12 U.S.C. 1790d(b)(1)(B).

10
12 CFR part 702;
see also
65 FR 8584 (Feb. 18, 2000)
and
65 FR 44950 (July 20, 2000).

The purpose of section 216 of the FCUA is to “resolve the problems of [federally] insured credit unions at the least possible long-term loss to the [NCUSIF].”
11

To carry out that purpose, Congress set forth a basic structure for PCA in section 216 that consists of three principal components: (1) A framework combining mandatory actions prescribed by statute with discretionary actions developed by NCUA; (2) an alternative system of PCA to be developed by NCUA for credit unions defined as “new”; and (3) a risk-based net worth requirement to apply to credit unions that NCUA defines as “complex.” This proposed rule focuses primarily on principal components (1) and (3), although amendments to part 702 of NCUA's regulations relating to principal component (2) are also included as part of this proposal.

11
12 U.S.C. 1790d(a)(1).

Among other things, section 216(c) of the FCUA requires NCUA to use a credit union's net worth ratio to determine its classification among five “net worth categories” set forth in the FCUA.
12

Section 216(o) generally defines a credit union's “net worth” as its retained earnings balance,
13

and a credit union's “net worth ratio”
14

as the ratio of its net worth to its total assets.
15

As a credit union's net worth ratio declines, so does its classification among the five net worth categories, thus subjecting it to an expanding range of mandatory and discretionary supervisory actions.
16

12
Section 1790d(c).

13
Section 1790d(o)(2).

14
Throughout this document the terms “net worth ratio” and “leverage ratio” are used interchangeably.

15
Section 1790d(o)(3).

16
Section 1790d(c) through (g); 12 CFR 702.204(a) and (b).

Section 216(d)(1) of the FCUA requires that NCUA's system of PCA include, in addition to the statutorily defined net worth ratio requirement applicable to federally insured natural-person credit unions, “a risk-based net worth
17

requirement for insured credit

unions that are complex, as defined by the Board . . . .”
18

Unlike the terms “net worth” and “net worth ratio,” the term “risk-based net worth” is not defined in the FCUA.
19

Accordingly, when read together, sections 216(b)(1) and 216(d)(1) grant the Board broad authority to design PCA regulations, including a risk-based net worth requirement, so long as the regulations are comparable to the Other Banking Agencies' PCA requirements and consistent with the requirements of section 216 of the FCUA and the cooperative character of credit unions.

17
For purposes of this rulemaking, the term “risk-based net worth requirement” is used in reference to the statutory requirement for the Board to design a capital standard that accounts for variations in the risk profile of complex credit union. The terms “risk-based capital ratio” and “risk-based capital ratio” are used to refer to the specific standards this rulemaking proposes to function as criteria for the statutory risk-based net worth requirement. For example, this rulemaking's proposed risk-based capital ratio would replace the risk-based net worth ratio in the current rule. The term “risk-based capital ratio” is also used by the Other Banking Agencies and the international banking community

when referring to the types of risk-based requirements that are addressed in this proposal. This change in terminology throughout the proposal would have no substantive effect on the requirements of the FCUA, and is intended only to reduce confusion for the reader.

18
12 U.S.C. 1790d(d)(1).

19

See
12 U.S.C. 1790d(o) (Congress specifically defined the terms “net worth” and “net worth ratio” in the FCUA, but did not define the statutory term “risk-based net worth.”).

The FCUA directs NCUA to base its definition of “complex” credit unions “on the portfolios of assets and liabilities of credit unions.”
20

It also requires NCUA to design a risk-based net worth requirement to apply to such “complex” credit unions.
21

The risk-based net worth requirement must “take account of any material risks against which the net worth ratio required for [a federally] insured credit union to be adequately capitalized [(six percent net worth ratio)] may not provide adequate protection.”
22

In the Senate Report on CUMAA, Congress expressed its intent with regard to the design of the risk-based requirement and the meaning of section 216(d)(2) by providing:

20
12 U.S.C. 1790d(d).

21

Id.

22
12 U.S.C. 1790d(d)(2).

The NCUA must design the risk-based net worth requirement to take into account any material risks against which the 6 percent net worth ratio required for a credit union to be adequately capitalized may not provide adequate protection. Thus the NCUA should, for example, consider whether the 6 percent requirement provides adequate protection against interest-rate risk and other market risks, credit risk, and the risks posed by contingent liabilities, as well as other relevant risks. The design of the risk-based net worth requirement should reflect a reasoned judgment about the actual risks involved.
23

23
S. Rep. No. 193, 105th Cong., 2d Sess. 13 (1998).

Section 216(c) of the FCUA requires that, if a credit union meets the definition of “complex” and its net worth ratio initially indicates that it meets or exceeds the net worth ratio requirement to be either “adequately capitalized” or “well capitalized,” the credit union must still satisfy the separate risk-based net worth requirement.
24

Under the separate risk-based net worth requirement, the complex credit union must, in addition to meeting the statutory net worth ratio requirement, also meet or exceed the minimum risk-based net worth requirement that corresponds to either the adequately capitalized or well capitalized capital category in order to receive a capital classification of adequately capitalized or well capitalized, as the case may be.
25

For example, if a complex credit union meets or exceeds the net worth ratio requirement to be classified as well capitalized, then it must also meet or exceed the corresponding risk-based net worth requirement to be well capitalized.

24
12 U.S.C. 1790d(c).

25
The risk-based net worth requirement also indirectly impacts credit unions in the “undercapitalized” and lower net worth categories, which are required to operate under an approved net worth restoration plan. The plan must provide the means and a timetable to reach the “adequately capitalized” category.
See
12 U.S.C. 1790d(f)(5)
and
12 CFR 702.206(c). However, for “complex” credit unions in the “undercapitalized” or lower net worth categories, the minimum net worth ratio “gate” to that category will be six percent or the credit union's risk-based net worth requirement, if higher than 6 percent. In that event, a complex credit union's net worth restoration plan will have to prescribe the steps a credit union will take to reach a higher net worth ratio “gate” to that category.
See
12 CFR 702.206(c)(1)(i)(A)
and
12 U.S.C. 1790d(c)(1)(A)(ii) and (c)(1)(B)(ii).

If any complex credit union meets or exceeds the net worth ratio requirement to be classified as well capitalized or adequately capitalized, but fails to meet the corresponding risk-based net worth requirement to be well capitalized or adequately capitalized, then the credit union's capital classification is determined based on the risk-based net worth requirement. For example, if a complex credit union is classified as well capitalized based on its net worth ratio, but only meets the risk-based net worth requirement that corresponds with the adequately capitalized capital category, then that credit union's capital classification would be adequately capitalized. Similarly, if a complex credit union meets the risk-based net worth requirement to be well capitalized, but only meets the net worth ratio requirement to be undercapitalized, then that credit union's overall capital classification is undercapitalized. In either case, the credit union would be subject to any mandatory and discretionary supervisory actions applicable to its lowest capital classification category.
26

26
12 U.S.C. 1790d(c)(1)(c)(ii).

In response to the Original Proposal, some commenters questioned NCUA's legal authority to impose a risk-based net worth requirement on both well capitalized and adequately capitalized credit unions. NCUA's position is that the Board is authorized to do so under the FCUA. Section 216(c)(1)(A) specifically provides that, to be classified as well capitalized, a complex credit union must meet the statutory net worth ratio requirement
and
any applicable risk-based net worth requirement. Section 216(c)(1) provides, in relation to “net worth categories,” that: (1) An insured credit union is “well capitalized” if it has a net worth ratio of not less than 7 percent;
and
it meets
any applicable risk-based net worth requirement
under subsection (d) of this section; (2) an insured credit union is “adequately capitalized” if it has a net worth ratio of not less than 6 percent;
and
it meets
any applicable risk-based net worth requirement
under subsection (d) of this section; and (3) an insured credit union is “undercapitalized” if it has a net worth ratio of less than 6 percent;
or
it fails to meet
any applicable risk-based net worth requirement
under subsection (d) of this section.
27

The language in components (1) and (2), when read in conjunction with the language in section 216(d), authorizes NCUA to impose risk-based net worth requirements on both well capitalized and adequately capitalized credit unions.

27
12 U.S.C. 1790d(c)(1)(A)-(C) (emphasis added).

In addition, section 216(d)(2) of the FCUA sets forth specific requirements for the design of the risk-based net worth requirement mandated under section 216(d)(1).
28

Specifically, section 216(d)(2) requires that the Board “design the risk-based net worth requirement to take account of
any material risks
against which the
net worth ratio
required for an insured credit union to be adequately capitalized may not provide adequate protection.”
29

Under section 216(c)(1)(B) of the FCUA, the
net worth ratio
required for an insured credit union to be adequately capitalized is six percent.
30

The plain language of section 216(d)(2) supports NCUA's interpretation that Congress intended for the Board to design a risk-based net worth requirement to take into account any material risks beyond those already addressed through the statutory 6 percent
net worth ratio
required for a

credit union to be adequately capitalized.
31

28

Id.
at section 1790d(d).

29

Id.
at section 1790d(d)(2).

30

Id.
at section 1790d(c)(1)(B).

31

See
S. Rep. No. 193, 105th Cong., 2d Sess. (1998) (providing in relevant part: “The NCUA must design the risk-based net worth requirement to take into account any material risks against which the 6 percent net worth ratio required for an insured credit union to be adequately capitalized may not provide adequate protection.”).

In other words, the language in section 216(d)(2) of the FCUA simply identifies the types of risks that NCUA's risk-based net worth requirement must address (
i.e.,
those risks not already addressed by the statutory six percent net worth ratio requirement). It is a misinterpretation of section 216(d)(2) to argue, as some commenters have in response to the Original Proposal, that Congress' use of the term “adequately capitalized” in section 216(d)(2) somehow limits the Board's authority to impose a higher risk-based capital ratio level for well capitalized credit unions. Rather than prohibiting the Board from imposing a higher risk-based capital ratio level for well capitalized credit unions, section 216(d)(2) simply requires that the Board design the risk-based net worth requirement to take into account those risks not adequately addressed by the statute's six percent
net worth ratio
requirement. Thus, the plain language of section 216(d) does not support these commenters' interpretation.

NCUA's interpretation of its legal authority to impose a risk-based net worth requirement on both well capitalized and adequately capitalized credit unions is further supported by the Other Banking Agencies' PCA statute and regulations.
32

Section 38(c)(1)(A) of the FDI Act, upon which section 216 of the FCUA was modeled,
33

requires that the Other Banking Agencies' “relevant capital measures” “include (i) a leverage limit; and (ii)
a risk-based capital requirement.”

34

Despite Congress' use of the singular noun “requirement” in section 38 of the FDI Act, the Other Banking Agencies' PCA regulations, which went into effect before Congress passed CUMAA, have long required that their regulated institutions meet different risk-based capital ratio levels to be classified as well capitalized, adequately capitalized, undercapitalized, or significantly undercapitalized. Therefore, by setting different risk-based capital ratio levels for credit unions to be adequately and well capitalized, NCUA's risk-based capital requirement would be consistent with the requirements of section 216 of the FCUA and would be “comparable” to the Other Banking Agencies' PCA regulations.

32

See
12 U.S.C. 1831o,
and, e.g.,
12 CFR 324.403(b).

33

See
S. Rep. No. 193, 105th Cong., 2d Sess., 12 (1998) (Providing in relevant part: “New section 216 [of the FCUA] is modeled on section 38 of the Federal Deposit Insurance Act, which has applied to FDIC-insured depository institutions since 1992.”).

34
12 U.S.C. 1831o(c)(1)(A) (emphasis added).

III. Summary of the Original Proposal and this Second Proposal

A. The Important Role and Benefit of Capital

Capital is the buffer that depository institutions, including credit unions, use to prevent institutional failure or dramatic deleveraging during times of strees. As evidenced by the recent recession, during a financial crisis a buffer can mean the difference between the survival or failure of a financial insitution. Financial crises are very costly, both to the economy in general and to individual depository institutions.
35

While the onset of a financial crisis is inherently unpredictable, a review of the historical record over a range of countries and recent time periods has suggested that a significant crisis involving depository institutions occurs about once every 20 to 25 years, and has a typical cumulative discounted cost in terms of lost aggregate output relative to the precrisis trend of about 60 percent of precrisis annual output.
36

In other words, the typical crisis results in losses over time, relative to the precrisis trend economic growth, that amount to more than half of the economy's output before the onset of the crisis.

35
Credit unions play a sizable role in the U.S. depository system. Assets in the credit union system amount to more than $1.1 trillion, roughly 8 percent of U.S. chartered depository institution assets (source: NCUA Calculation using the financial accounts of the United States, Federal Reserve Statistical Release Z.1, Table L.110, September 18, 2014). Data from the Federal Reserve indicate that credit unions account for about 12 percent of private consumer installment lending. (Source: NCUA calculations using data from the Federal Reserve Statistical Release G.19, Consumer Credit, September 2014. Total consumer credit outstanding (not mortgages) was $3,246.8 billion of which $826.2 billion was held by the federal government and $293.1 billion was held by credit unions. The 12 percent figure is the $293.1 billion divided by the total outstanding less the federal government total). Just over a third of households have some financial affiliation with a credit union. (Source: NCUA calculations using data from the Federal Reserve 2013 survey of Consumer Finance.) All Federal Reserve Statistical Releases are available at
http:\\www.federalreserve.gov\econresdata\statisticsdata.htm.

36
Basel Committee on Banking Supervision,
An assessment of the long-term economic impact of stronger capital and liquidity requirements
3-4 (August 2010), available at
http://www.bis.org/publ/bcbs173.pdf.
These losses do not explicitly account for government interventions that ameliorated the observed economic impact. This is the median loss estimate.

The 2007-2009 financial crisis and the associated economic dislocations during the Great Recession were particularly costly to the United States in terms of lost output and jobs. Real GDP declined more than four percent, almost nine million jobs were lost, and the unemployment rate rose to 10 percent.
37

The cited figures are just the direct losses. Compared to where the economy would have been had it followed the precrisis trend, the losses in terms of GDP and jobs would be higher. For example, using the results described in the previous paragraph as a guide, the cumulative loss of output from the recent financial crisis is roughly $10 trillion (2014 dollars).
38

Other estimates of the total loss, derived using approaches different than described in the previous paragraph, are similar. For example, researchers at the Federal Reserve Bank of Dallas, using a different approach that achieved results within the same range, estimated a range of loss of $6 trillion to $14 trillion due to the crisis.
39

37
The National Bureau of Economic Research Business Cycle Dating Committee defines the beginning date of the recession as December 2007 (2007Q4) and the ending date of the recession as June 2009 (2009Q2). See the National Bureau of Economic Research Web site:
http://www.nber.org/cycles/cyclesmain.html.
The real GDP decline was calculated by NCUA using data for 2007Q4 and 2009Q2 from the National Income and Product Accounts, Bureau of Economic Analysis, U.S. Department of Commerce; see Table 1.1.3. Data are available at
http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1.
Data accessed November 11, 2014. The jobs lost figure was calculated by NCUA using data from the Bureau of Labor Statistics (BLS), U.S. Department of Labor, Current Employment Statistics, CES Peak-Trough Tables. The statistic cited is the decline in total nonfarm employees from December 2007 through February 2010, which BLS defines as the trough of the employment series. Data available at:
http://www.bls.gov/ces/cespeaktrough.htm
and accessed on November 11, 2014. The unemployment rate was taken from the Bureau of Labor Statistics, U.S. Department of Labor, Current Population Survey, series LNS14000000. Accessed November 11, 2014 at
http://data.bls.gov/pdq/SurveyOutputServlet.
The unemployment rate peaked at 10 percent in October 2009.

38
NCUA calculations based on from the National Income and Product Accounts, Bureau of Economic Analysis, U.S. Department of Commerce. Data from Table 1.1.6 show real GDP at $14.992 trillion in 2007Q4 in chained 2009 dollars. Adjusting to 2014 dollars using the GDP price index and using the 60 percent loss figure cited yields an estimated loss of approximately $10 trillion in 2014 dollars. Data are available at
http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1.

39
Tyler Atkinson, David Luttrell & Harvey Rosenblum, Fed. Reserve Bank of Dall,
How Bad Was It? The Costs and Consequences of the 2007-2009 Financial Crisis
(July 2013), available at
https://dallasfed.org/assets/documents/research/staff/staff1301.pdf.

Research using bank data across several countries and time periods indicates that higher levels of capital insulate financial institutions from the

effects of unexpected adverse developments in their asset portfolio or their deposit liabilities.
40

For the financial system as a whole, research on the banking sector has shown that higher levels of capital can reduce the probability of a systemic crisis.
41

By reducing the probability of a systemic financial crisis and insulating individual institutions from failure, higher capital requirements confer very large benefits to the overall economy.
42

With the median long-term output loss associated with a crisis in the range of 60 percent of precrisis GDP, a one percentage point reduction in the probability of a crisis would add roughly 0.6 percent to GDP each year (permanently).
43

40

See
An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, Basel Committee on Banking Supervision, August 2010. Pages 14-17. The study indicates that the seven percent TCE/RWA ratio is equivalent to a five percent ratio of equity to total assets. The average ratio of equity to total assets for the 14 largest OECD countries from 1980 to 2007 was 5.3 percent.

41

Id.

42

Id.

43

Id.

While higher levels of capital can insulate depository institutions from adverse shocks, holding higher levels of capital does have costs, both to individual institutions and to the economy as a whole. For the most part, the largest cost associated with holding higher levels of capital, in the long term, is foregone opportunities; that is, from the loss of potential earnings from making loans, from the cost to bank customers and credit union members of higher loan rates and lower deposit rates, and the downstream costs from the customers' and members' reduced spending.
44

Estimating the size of these effects is difficult. However, despite limitations on the ability to quantify these effects, the annual costs appear to be significantly smaller than the losses avoided by reducing the probability of a systemic crisis. For example, research using data on banking systems across developed countries indicates that a one percentage point increase in the capital ratio increases lending spreads (the spread between lending rates and deposit rates) by 13 basis points.
45

The research also shows that the long-run reduction in output (real GDP) consistent with a one percentage point increase in the Tier 1 common equity
46

to risks assets ratio would be on the order of 0.1 percent.
47

Thus, it is clear that the relatively large potential long-term benefits of holding higher levels of capital outweigh the relatively small long-term costs.

44

See
An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, Basel Committee on Banking Supervision, August 2010. Pages 21-27.

45
There are a number of simplifying assumptions involved in the calculation, including the assumption that banks fully pass through the increase in the cost of capital to their borrowers.
See
Basel Committee on Banking Supervision,
An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements
21-27 (Aug. 2010).

46
Tier 1 common equity is made up of common stock, retained earnings, accumulated other comprehensive income, and some miscellaneous minority interests and common stock as part of an employee stock ownership plan.

47
To be clear, the 0.1 percent figure represents the one-time, long-term loss, which should be compared with the 60 percent loss potentially avoided by reducing the probability of a financial crisis by a little more than one percentage point. See
An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements,
Basel Committee on Banking Supervision, August 2010. Pages 21-27.

The recent financial crisis revealed a number of inadequacies in the current approach to capital requirements. Banks, in particular, experienced an elevated number of failures and the need for federal intervention in the form of capital infusions.
48

As discussed in more detail below, credit unions also experienced elevated losses and the need for government intervention. The clear implication is that capital levels in these cases were inadequate, especially relative to the riskiness of the assets that some institutions were holding on their books.

48
For a readable overview of the 2007-2008 financial crisis and the government response see,
The Final Report of the Congressional Oversight Panel,
Congressional Oversight Panel, March 16, 2011. See also Ben S. Bernanke, “Some Reflections on the Crisis and the Policy Response,” Speech at the Russell Sage Foundation and The Century Foundation Conference on “Rethinking Finance,” New York, New York, April 13, 2012. Available at:
http://www.federalreserve.gov/newsevents/speech/2012speech.htm.

In a risk-based capital system, institutions that are holding assets that have historically shown higher levels of risk are generally required to hold more capital against those assets. At the same time, an institution's leverage ratio, which does not account for the riskiness of assets, can provide a baseline level of capital adequacy in the event that the approach to assigning risk weights does not capture all risks. A system including well-designed and well-calibrated risk-based capital standards is generally more efficient from the point of view of the overall economy, as well as for individual institutions. In general, risk-based capital standards increase capital requirements at those institutions whose asset portfolios have, on average, higher risk. Conversely, risk-based capital standards generally decrease the cost of holding capital for institutions whose strategies focus on lower risk activities. In that way, risk-based capital standards generate the benefits of helping to insulate the economy from financial crises, while also preventing some of the potential costs that would occur from holding unnecessarily high levels of capital at low-risk institutions.

B. Why did the Board issue the Original Proposal?

The Original Proposal would have amended NCUA's risk-based net worth requirements to be more comparable to the Other Banking Agencies' regulations, as required by the FCUA.
49

In 2013, the Other Banking Agencies issued final rules materially updating the risk-based capital requirements for insured banks.
50

These changes to the Other Banking Agencies' risk-based capital requirements, the weaknesses in NCUA's current risk-based net worth ratio requirement exposed by the recession of 2007-2009, and the fact that NCUA's risk-based net worth requirement had not been meaningfully updated since 2002, prompted the Board to reconsider NCUA's current risk-based net worth ratio requirement and other aspects of NCUA's current PCA regulations. In so doing, the Board was also guided by specific recommendations to update NCUA's PCA regulations made by GAO in its January 2012 review of NCUA's system of PCA.
51

49

See
12 U.S.C. 1790d(b)(1)(A)(ii) (Requiring that the NCUA's system of PCA be “comparable” to the PCA requirements in section 1831o of the Federal Deposit Insurance Act).

50
78 FR 55339 (Sept. 10, 2013) (The FDIC published an interim final rule regarding regulatory capital for their regulated institutions separately from the Other Banking Agencies.)
and
78 FR 62017 (Oct. 11, 2013) (The Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System later published a regulatory capital final rule for their regulated institutions, which is consistent with the requirements in the FDIC's IFR.).

51

See
U.S. Govt. Accountability Office, GAO-12-247,
Earlier Actions Are Needed to Better Address Troubled Credit Unions,
(Jan. 2012)
available at http://www.gao.gov/products/GAO-12-247.

The Board issued the Original Proposal to enhance risk sensitivity and address weaknesses in the existing regulatory capital framework for credit unions. Under the current rule, only two credit unions are required to hold more capital as a result of the required risk-based net worth ratio measure. The Board emphasized that capital and risk operate synchronously, and that credit union senior management, boards, and regulators are all accountable for ensuring that appropriate capital levels are in place based on the credit union's risk exposure. The Original Proposal reflected the Board's initial effort to establish a system for assigning risk

weights that was more indicative of the potential risks existing within credit unions. Accordingly, the Original Proposal was intended to help credit unions better absorb losses and establish a safer, more resilient, and more stable credit union system that could weather periods of financial stress, thereby reducing risks to the NCUSIF.

The recent economic crisis highlighted the need for a sound system of capital requirements to address risk. From 2008 through 2012, 27 credit unions with assets greater than $50 million (the current threshold for applicability of the risk-based net worth requirement) failed at a cost of $728 million to the NCUSIF,
52

due in large part to holding inadequate levels of capital relative to the levels of risk associated with their assets and operations. In many cases, the capital deficiencies relative to elevated risk levels were identified by examiners and communicated through the examination process to officials at these credit unions.
53

Although the credit union officials were provided with notice of the capital deficiencies, they ignored the supervisory concerns or did not act in a timely manner to address the concerns raised. Furthermore, NCUA's ability to take enforcement actions to address supervisory concerns in a timely manner was cited by GAO as limited under NCUA's current regulations. As a result, over a dozen very large consumer credit unions, and numerous smaller ones, were in danger of failing and required extensive NCUA intervention, financial assistance, or both, along with increased reserve levels for the NCUSIF.
54

The Original Proposal sought to incorporate the lessons learned from those failures, and near failures, and better account for risks not addressed by NCUA's current PCA rule.

52
These figures are based on data collected by NCUA throughout the crisis, and do not include the costs associated with failures of corporate credit unions.

53

See, e.g.,
OIG-13-10, Material Loss Review of Chetco Federal Credit Union (October 1, 2013), OIG-13-05, Material Loss Review of Telesis Community Credit Union (March 15, 2013), OIG-10-15, Material Loss Review of Ensign Federal Credit Union, (Sept. 23, 2010), OIG-10-03, Material Loss Reviews of Cal State 9 Credit union (April 14, 2010).

54
As most of these credit unions are still active institutions, or have merged into other active institutions, NCUA cannot provide additional details publicly.

The Board notes that, in general, most credit unions with over $100 million in assets (the proposed new threshold for applicability of the risk-based capital ratio measure) hold capital well above the statutory net worth ratio for credit unions to be classified as well capitalized, as shown in the following table.
55

55
This statement and the majority of the related analysis in this section is specific to credit unions with $100 million in assets or greater, unless otherwise noted, as this proposed rule would only apply to credit unions at or above this level.

Number of Credit Unions with Assets of at Least $100 Million, by Net Worth Ratio

2006
2007
2008
2009
2010
2011
2012
2013

Net Worth Ratio:

Less than 6 percent
3
5
10
42
35
16
11
7

6 percent to 7 percent
8
7
32
63
44
35
17
9

7 percent to 8 percent
39
42
109
188
162
152
138
103

8 percent to 9 percent
123
109
185
248
243
256
269
234

9 percent to 10 percent
193
197
213
244
289
299
293
305

10 percent to 11 percent
205
217
212
192
192
213
231
257

Greater than 11 percent
628
642
522
388
404
430
478
540

Total
1,199
1,219
1,283
1,365
1,369
1,401
1,437
1,455

Many credit unions hold additional capital as a cushion against an unexpected adverse shock that might drive their net worth ratios below the well capitalized level. Because credit unions primarily generate capital only through retained earnings, there is an added incentive to hold higher levels of capital. Most banks, however, also hold capital in excess of their required well capitalized thresholds and on par with total capital levels held by credit unions, despite having the ability to raise capital outside of retained earnings.
56

This suggests that strong capital levels serve an important purpose for financial institutions despite any associated cost of the capital.

56
The aggregate core capital (leverage) ratio for all FDIC-insured institutions as of December 2013 was 9.41 percent. FDIC Quarterly, 2014, Volume 8, No. 1.

As shown in the table below, at year end 2013, 119 credit unions, or 7.3 percent of all credit unions with assets greater than $100 million in assets, exhibited a net worth ratio below eight percent. Of that 7.3 percent of credit unions, all were either already below the seven percent well capitalized threshold or were only slightly above, so they were vulnerable to falling below the well capitalized level with only a modest shock to their net income. Call report data as of December 31, 2013, indicates that these 119 credit unions hold assets of $68.7 billion, which is more than seven percent of all credit union assets (see table below).

Percentage Distribution of Total Assets of Credit Unions with Assets of at Least $100 Million, by Net Worth Ratio
57

2006
2007
2008
2009
2010
2011
2012
2013

Percent

Net Worth Ratio:

Less than 6 percent
0.1
0.2
1.4
2.6
2.6
0.5
0.4
0.3

6 percent to 7 percent
0.8
1.0
5.9
7.5
1.6
2.5
0.5
0.2

7 percent to 8 percent
4.9
5.8
10.9
13.6
15.3
12.6
9.1
6.8

8 percent to 9 percent
12.5
12.4
15.7
19.2
18.5
16.7
19.1
12.5

9 percent to 10 percent
18.2
21.6
23.2
24.8
28.1
24.5
21.1
22.9

10 percent to 11 percent
16.3
18.2
15.3
12.3
12.3
20.4
23.9
19.0

Greater than 11 percent
47.1
40.8
27.6
20.0
21.6
22.8
25.8
38.3

Total Assets, billions $
582.4
628.1
686.3
760.1
790.2
839.4
901.7
945.4

The table

below shows that credit unions falling below the seven percent well capitalized net worth ratio requirement tend to contract their asset base. By contrast, over the same period, credit unions that did not fall below the seven percent well capitalized net worth ratio requirement experienced annualized asset growth of almost seven percent.

57
Data based on year end Call Report data.

Growth in Assets at Credit Unions With More Than $100 Million in Assets
58

Growth over the four quarters after a
decline in the net
worth ratio below 7%

Growth over the four quarters where the net worth ratio did not fall below 7%

−4.3%
+6.8%

Unlike banks

that can issue other forms of capital like common stock, credit unions that need to raise additional capital when faced with a capital shortfall generally have no choice except to reduce member dividends or other interest payments, raise lending rates, or cut non-interest expenses in an attempt to direct more income to retained earnings.
59

Thus, the first round impact of falling or low capital levels at credit unions is likely a direct reduction in credit union members' access to credit or interest bearing accounts. Hence, an important policy objective of capital standards is to ensure that financial institutions build sufficient capital to continue functioning as financial intermediaries during times of stress without government intervention or assistance.

58
Based on Call Report data, using annualized growth 2007 Q4-2013 Q4.

59
Low-income designated credit unions can issue secondary capital accounts that count as net worth for PCA purposes. As of June 30, 2014, there are 2,107 low-income designated credit unions. Given the nature (
e.g.,
size) of these credit unions and the types of instruments they can offer, however, there is often a very limited market for these accounts.

NCUA's analysis of credit union Call Report data from 2006 forward, as detailed below, also makes it clear that higher capital levels keep credit unions from becoming undercapitalized during periods of economic stress. The table below summarizes the changes in the net worth ratio that occurred during the recent economic crisis. Of credit unions with a net worth ratio of less than eight percent in the fourth quarter of 2006, 80 percent fell below seven percent at some time during the financial crisis and its immediate aftermath. Of credit unions with 8 percent to 10 percent net worth ratios in the fourth quarter of 2006, just under 33 percent fell below seven percent during the crisis period. However, of credit unions that entered the crisis with at least 10 percent net worth ratios, less than five percent fell below the seven percent well capitalized standard during the crisis or its immediate aftermath.

Distribution of Net Worth Ratios of Credit Unions With at Least $100 Million in Assets by Lowest Net Worth Ratio During the Financial Crisis

Lowest Net Worth Ratio between 2007Q1 and 2010Q4
<6%
6-7%
7-8%
8-10%
≥10%

Total

Number of credit unions

Net Worth Ratio in 2006Q4

<8 percent
44.0
36.0
20.0
0.0
0.0
100.0
50

8-10 percent
13.0
19.6
38.0
29.4
0.0
100.0
316

≥10 percent
1.9
2.8
9.4
38.8
47.1
100.0
830

Similarly, the table below shows how credit unions with at least $100 million in assets in the fourth quarter of 2006 fared during the five years after the fourth quarter of 2007, which was the period that encompassed the Great Recession. The table shows that the credit unions that survived the crisis and recession had higher net worth ratios going into the Great Recession. In particular, credit unions with more than $100 million in assets before the crisis began, but failed during the crisis, had a median precrisis net worth ratio of less than nine percent, while similarly sized institutions that survived the crisis had, on average, precrisis net worth ratios in excess of 11 percent.

Characteristics of FICUs With Assets > $100 Million at the End of 2006 by Five Year Survival Beginning 2007 Q4

Number of
institutions

Median

Assets
($M)

Net Worth Ratio
(percent)

Loan to Asset Ratio
(percent)

Real Estate Loan Share
(percent)

Member
Business
Loan Share
(percent)

Failures
27
162.7
8.97
84.0
58.0
8.3

Survivors
1138
237.9
11.20
71.0
49.0
0.7

Survivorship is determined based on whether a FICU stopped filing a Call Report over the five years starting in the fourth quarter of 2007. Failures exclude credit unions that merged or voluntarily liquidated. Note: All failures had precrisis net worth ratios in excess of seven percent.

Aside from demonstrating the differences in the capital positions of credit unions that failed from those that did not fail, the table above highlights two additional considerations. First, the table shows that other performance indicators were different between the two groups of credit unions. In particular, the survivors had a lower median loan-to-asset ratio, a lower median share of total loans in real estate loans, and a lower share of member business loans in their overall loan portfolio.

A key limitation of the leverage ratio is that it is a lagging indicator because it is based largely on accounting standards. Accounting figures are point-in-time values largely based on historical performance to date. Further, the leverage ratio does not discriminate between low-risk and high-risk assets or changes in the composition of the balance sheet. A risk-based capital ratio measure is more prospective in that, as a credit union makes asset allocation choices, it drives capital requirements before losses occur and capital levels decline. The differences in indicators between the failure group and the survivors in the table above demonstrate that factors in addition to capital levels play an important role in preventing failure. For example, all of the failures listed in the table above had net worth ratios in excess of the well capitalized level at the end of 2006. The severe weakness of NCUA's current risk-based net worth requirement is further demonstrated by the fact that, of the 27 credit unions that failed during the Great Recession, only two of those credit unions were considered less than well capitalized due to the existing RBNW requirement.
60

A well designed risk-based capital ratio standard would have been more successful in helping credit unions avoid failure precisely because such standards are targeted at activities that result in elevated risk.

60
See table above (referencing the 27 failures of credit unions over $100 million in assets).

The need for a risk-based capital standard beyond a leverage ratio is further supported when considering a more comprehensive review of credit union failures. The figures below present data from NCUA's review of the 192 credit union failures that occurred over the past 10 years and indicates that 160 failed credit unions had net worth ratios greater than seven percent two years prior to their failure. Further, the failed credit unions exhibited a 12 percent average net worth ratio two years prior to their failure.

EP27JA15.004

EP27JA15.005

The table above shows that credit unions with high net worth ratios can and have failed, demonstrating that a leverage ratio alone has not always proven to be an adequate predictor of a credit union's future viability. However,

a more robust risk-based capital standard would reflect the presence of elevated balance sheet risk sooner, and in relevant cases would improve a credit union's odds of survival.

A recession or other source of financial stress poses more difficulties for credit unions with limited capital options and with capital levels lower than what their risks warrant. A capital shortfall reduces a credit union's ability to effectively serve its members. At the same time, the shortfall can cascade to the rest of the credit union system through the NCUSIF, potentially affecting an even broader number of credit union members. Credit unions are an important source of consumer credit and a capital shortfall that affects the credit union system could reduce general consumer access to credit for millions of credit union members.
61

Accordingly, a risk-based capital rule that is effective in requiring credit unions with low capital ratios and a large share of high-risk assets to hold more capital relative to their risk profile, while limiting the burden on already well capitalized credit unions, should provide positive net benefits to the credit union system and the United States economy. Improved resilience enhances credit unions' ability to function during periods of financial stress and reduce risks to the NCUSIF.

61
Credit unions play a sizable role in the U.S. depository system. Assets in the credit union system amount to more than $1.1 trillion, roughly eight percent of U.S. chartered depository institution assets (source: NCUA calculation using the financial accounts of the United States, Federal Reserve Statistical Release Z.1, Table L.110, September 18, 2014). Data from the Federal Reserve indicate that credit unions account for about 12 percent of private consumer installment lending. (Source: NCUA calculations using data from the Federal Reserve Statistical Release G.19, Consumer Credit, September 2014. Total consumer credit outstanding (not mortgages) was $3,246.8 billion of which $826.2 billion was held by the federal government and $293.1 billion was held by credit unions. The 12 percent figure is the $293.1 billion divided by the total outstanding less the federal government total). Just over a third of households have some financial affiliation with a credit union. (Source: NCUA calculations using data from the Federal Reserve 2013 survey of Consumer Finance.) All Federal Reserve Statistical Releases are available at
http:\\www.federalreserve.gov\econresdata\statisticsdata.htm.

The Original Proposal reflected the Board's objective of modifying the existing system for assigning risk weights to make it more indicative of the risks in credit unions. The Board intended it to help credit unions better absorb losses and establish a safer, more resilient, and more stable credit union system. However, as noted below, the Board believes the Original Proposal can be improved and is, therefore, issuing this second proposal.

C. What significant changes would the Original Proposal have made?

The Original Proposal would have changed the current risk-based net worth requirement applicable to complex credit unions (which was then defined as credit unions with more than $50 million in assets). In particular, the Original Proposal would have replaced the current risk-based net worth ratio measure with a new risk-based capital ratio measure that would have been more comparable to the risk-based capital requirement in the Other Banking Agencies' regulations. NCUA's capital requirements and PCA supervisory actions for “new” credit unions and credit unions with $50 million or less in assets would have remained largely unchanged, with a few exceptions.

The Board intended the change in the risk-based capital methodology in the Original Proposal to improve the comparability of risk-based capital ratios across financial institutions. Compared to the current risk-based net worth ratio measure, the methodology under the Original Proposal would have provided a more common measure both of credit union capital available to absorb losses and of asset risk. Moreover, the use of a consistent framework for assigning risk weights would have resulted in better comparability and improved understanding between all types of federally insured financial institutions, and would have increased the correlation between required capital levels and risk.

The Original Proposal would have replaced the current method used by credit unions to apply risk weights to their assets with a new risk-based capital ratio measure that is more commonly applied to depository institutions worldwide. The proposed risk-based capital ratio measure was the percentage of a credit union's capital available to cover losses, divided by the credit union's defined risk weighted asset base.

Under the current rule, the numerator of the RBNW ratio is “net worth” as defined in section 216(o)(2).
62

However, as discussed in the Legal Authority section of this preamble, the FCUA gives the Board broad discretion in designing the risk-based capital requirement.
63

Thus, the Original Proposal would have broadened the definition of the risk-based capital ratio numerator.

62

See
the definition of “net worth” at 12 U.S.C. 1790d(o)(2)(A) through (C).

63

See
section 1790d(d)(2) (Recognizing the limitations of the net worth ratio, Congress directed the Board to develop a risk-based net worth requirement that “take[s] account of any material risks against which the net worth ratio . . . may not provide adequate protection.”).

The Board chose to take this approach to provide a more comparable measure of capital across all financial institutions and to better account for those related elements of the financial statement that are available to cover losses and protect the NCUSIF. Under the Original Proposal, the risk-based capital ratio numerator essentially started with the generally accepted accounting principles (GAAP) definition of equity (which is broader than the statutory definition of “net worth”), adding the allowance for loan and lease losses (ALLL) account subject to some limitations, and deducting goodwill, intangible assets, and the NCUSIF deposit. In addition, to more accurately reflect capital available to absorb losses, this broader definition of the risk-based capital ratio numerator would have contributed over 50 basis points, on average, to credit unions' risk-based capital ratio.

With regard to the denominator for the risk-based capital ratio, Congress recognized that operating a credit union involves taking and managing a variety of risks. As stated previously, the FCUA mandates that NCUA's risk-based net worth requirement “take account of any material risks against which the net worth ratio required for [a federally] insured credit union to be adequately capitalized may not provide adequate protection.”
64

In the Senate Report on CUMAA, Congress expressed its intent with regard to the design of the risk-based net worth requirement by directing NCUA to “consider whether the 6 percent [net worth ratio] requirement provides adequate protection against interest-rate risk and other market risks, credit risk, and the risks posed by contingent liabilities, as well as other relevant risks.”
65

64

Id.

65
S. Rep. No. 193, 105th Cong., 2d Sess. 13 (1998).

The risk-based net worth ratio measure in NCUA's current PCA regulation, which has not been substantially updated since 2002, was designed to primarily address credit risk, concentration risk, interest rate risk (IRR), and liquidity risk. The current rule does this through the assignment of risk weights to different types of assets based on the predominant form of risk that is associated with the asset type. Loans and investments make up the vast majority (88 percent based on December 2013 Call Report data) of credit union assets and, therefore, are the primary variables for the denominator of a credit

union's current risk-based net worth ratio.

Under the current rule, most types of loans have risk weights based on credit risk. Concentration risk and IRR are incorporated for real estate loans and member business loans (MBLs) using a tiered risk weight framework. As a credit union's concentration in these loans increases, incrementally higher levels of capital are required. This requirement was intended to provide capital to protect against the concentration risk and IRR inherent in a long duration and/or complex whole loan portfolio with limited liquidity.
66

66
Concentration risk is mainly accounted for in commercial and real estate loans because, historically, this is where credit unions have experienced concentration and IRR problems. These types of assets are longer and/or provide fewer options and greater challenges in managing, restructuring, or selling such portfolios. Cash flows for shorter-term loans, like auto loans, are typically much less susceptible to changing rates; and portfolios customarily cash flow fast enough to mitigate concentration and IRR concerns.

The Original Proposal would have maintained a very similar risk weight structure for loans, with a few exceptions. The Original Proposal would have effectively reduced the capital required for a credit union to hold first-lien residential real estate loans, and raised the capital required to hold junior-lien residential real estate loans, consumer loans, and MBLs.

The current rule, as opposed to this second proposal, assigns risk weights to most types of investments based on their IRR and liquidity risk. The rationale for doing so was that most credit unions maintain liquidity in their investment portfolio. For credit unions with high loan volume involving long-term fixed rate products, the investment portfolio can exacerbate the interest rate and liquidity risks involved in meeting member lending and deposit preferences. NCUA's current rule, unlike this second proposal, assigns risk weights to most investments based on their weighted average life, with the weights generally calibrated to the projected loss in value of a U.S. Treasury security if interest rates increased by 300 basis points. The Original Proposal would have retained this approach to assigning investment risk weights. However, the Original Proposal would have effectively reduced the capital required for investments with weighted average lives of less than five years, and increased the capital required for investments with weighted average lives of greater than five years.

The Original Proposal was intentionally designed to parallel the current approach to applying risk weights to assets using existing information contained in the Call Report, thereby minimizing transition costs and associated reporting burdens. In comparison to the current risk-based net worth ratio method however, the originally proposed risk-based capital ratio method would have included a greater number of exposure categories for purposes of calculating a credit union's risk-weighted assets. Thus, the Original Proposal would have required that some additional data be collected on the Call Report. However, this additional data would not have represented a material increase to the burden of completing the Call Report. Further, under the Original Proposal, the rule would have provided an 18-month implementation period for credit unions to adjust their systems to account for the additional data items that would have been collected in the Call Report.

The way in which the risk-based net worth ratio functions in relation to the net worth categories under the current rule could result in a credit union's capital classification declining directly from well capitalized to undercapitalized if it fails to meet the required risk-based net worth ratio level.
67

The Original Proposal would have modified this approach by requiring credit unions to meet different risk-based capital ratio levels for the well capitalized (10.5 percent) and adequately capitalized (eight percent) categories. This formulation would have been comparable with the Other Banking Agencies' capital rules,
68

and would have encouraged (but did not require) credit unions to build capital sufficient to absorb losses and prevent precipitous declines in their overall capital classification. In addition to providing greater comparability with the Other Banking Agencies' rules, the different threshold levels also would have resulted in a risk-based net worth requirement that could have effectively addressed any “outlier” credit unions and encouraged them to accumulate additional capital.

67
Per the FCUA, “undercapitalized” is the lowest PCA category in which a failure to meet the risk-based net worth requirement can result.

68

See, e.g.,
12 CFR 324.10, 324.11 and 324.403.

The Original Proposal would have generally retained the definition of “complex” in the current rule so the proposed changes to the risk-based net worth requirement would have applied to all credit unions with over $50 million in total assets.
69

69
78 FR 4032 (Jan. 18, 2013).

D. Public Comments on the Original Proposal

The Board received 2,056 public comments on the Original Proposal from credit unions, trade associations, state credit union leagues, state supervisory authorities, public officials (including current and former members of the U.S. Congress), Federal Home Loan Banks, credit union members, and other interested parties. Because this is a new proposed rule, the Board notes it is not required to respond to any comments received on the Original Proposal. However, the Board believes it is important to address all relevant comments. Therefore, the Board has included comment summaries and responses throughout the preamble to this proposal.

Overall, while some commenters supported the concept of adopting risk-based capital standards for complex credit unions that were more comparable to those applicable to banks, most commenters opposed the Original Proposal, particularly those requirements that the commenters believed exceeded the requirements imposed on banks.

Most commenters also expressed concerns about the potential costs and burdens of various aspects of the Original Proposal. A significant number of commenters argued that new risk-based capital standards were not necessary at this time, particularly given the success of consumer credit unions during the recent financial crisis. A number of commenters also requested that the Board withdraw the Original Proposal and reissue a proposal for another round of public comments with significant revisions to the risk weights. Many commenters also asked for additional time to implement the new requirements and adjust their balance sheets.

The Board responds to the significant comments received on the Original Proposal throughout this preamble. More detailed discussions on the comments received on particular aspects of the Original Proposal, and NCUA's responses to those comments, are primarily provided in the section-by-section analysis part of the preamble.

General Comments on Application of Risk-Based Capital Standards to Credit Unions

The Board received over 2,000 comments regarding the application of risk-based capital standards to credit unions under the Original Proposal. A majority of the commenters stated that NCUA's current risk-based net worth ratio standard is working well,

particularly given that the credit union industry survived the recent financial crisis, and that maintaining the current system is far preferable to adopting the Original Proposal. Some commenters stated they were opposed to imposing a more sophisticated risk-based capital framework on credit unions. Other commenters stated they appreciated NCUA's efforts to keep the new requirements relatively simple and to minimize the implementation burden on affected institutions. A substantial number of other commenters agreed that updates to NCUA's risk-based net worth regulations were necessary to keep up with what other financial institutions are doing, but did not agree with certain aspects of the Original Proposal. Other commenters stated that some form of risk-based capital calculation was prudent to reward those institutions that do not stretch too hard for earnings or put their members' deposits at extraordinary risk. A significant number of commenters specifically suggested that the rule be amended to match the risk-based capital requirement for banks, the Basel III risk-based capital standards, or both. Other commenters suggested that the structure and performance of credit unions suggests that the risk weights should be less stringent than the risk weights applied to banks. Still other commenters suggested that instead of focusing on the past failures of credit unions, the Board should be focused on the successes of credit unions and issue regulations that help credit unions achieve success.

The Board received a significant number of comments questioning whether the proposal would actually serve to protect the NCUSIF and make the industry safer and sounder. A number of commenters stated that the proposal essentially represented a de facto assumption of important balance sheet management decisions by NCUA for purposes of protecting the NCUSIF at the expense of the current prerogatives and interests of individual credit unions and their members. Commenters contended that since the implicit incentives in the proposal are the same for every credit union, over the long run, the Original Proposal would cause credit unions to become less financially diverse, which would increase the vulnerability of the industry and NCUSIF to some future widespread economic adversity. Commenters stated that credit unions are in the risk business by nature and that the proposal was too focused on a number-generated, one-size-fits-all solution. Other commenters requested that the Board be mindful that the risk weights that are adopted in the rule could ultimately drive which types of products and services are offered by credit unions.

Some commenters suggested NCUA include a risk-capital model calculation as part of the examination process, similar to NCUA requirements for other types of modeling such as the model required for IRR testing. Those commenters suggested that the results of the risk-based capital model could be used to identify “potential risk” by examiners and credit union boards, calling for additional scrutiny in the exam, instead of prescribing a rule that is assumed to quantify “actual” risk.

A small number of commenters suggested that the Other Banking Agencies are all leaning toward simply using a simplified leverage ratio to account for risks.

Justification and Supporting Analysis

A number of commenters commented on the Board's justification and analysis supporting the need for a proposed rule. Commenters suggested the proposal was arbitrary and developed without feedback from the credit union industry. Other commenters suggested that the Board should have provided stakeholders with a more thorough discussion of how the proposal would fit into NCUA's regulatory framework, including recently issued final rules regarding liquidity risk, IRR, and stress testing and capital planning. Commenters stated there was no credible analysis available in the Original Proposal to suggest credit unions overall are unlikely to perform well under the current PCA system, which already includes a risk-based net worth requirement. Others commented that the proposal provided no evidence that this rule would help members.

Commenters suggested the Board did not sufficiently take into account the unique nature of credit unions and the financial performance and distinctive structure of credit unions in developing the proposal. They argued this was problematic because the Board is required to take into account the unique nature of credit unions in designing a system of PCA, and that by failing to sufficiently account for credit union differences and the lower level of risk that credit unions demonstrate as a result led to a proposal that would require well-managed credit unions to hold too much capital. Others suggested that the proposal failed to consider how the use of bank style capital levels could adversely impact credit unions. There were those who felt that the Board should propose a rule only if NCUA has prepared a reasoned determination that the rule's benefits justify its costs. They suggested that any benefits in terms of reduced NCUSIF losses would be minor at best and the very real costs of unnecessarily high capital requirements would be substantial. Commenters also suggested that the proposal was not tailored to impose the least burden.

The Board received a number of comments on the basis provided for the proposed rule. Commenters suggested the proposal should have been based on historical perspectives, and stated that based on their own analysis the proposal would have avoided few if any past credit union failures. One commenter stated that only 1.1 percent of credit unions with more than $50 million in assets have failed in the six-and-a-half years since the beginning of the worst financial crisis and recession in 80 years. The commenter did, however, acknowledge that the proposed system would have been more effective than the current system in identifying credit unions that subsequently failed.

One commenter suggested that the Board's justification that the proposal seeks to incorporate lessons learned from past failures of credit unions to hold sufficient levels of capital despite warnings from NCUA examiners was unsupportable because NCUA and state officials have various supervisory enforcement measures at their disposal (
e.g.,
preliminary warning letters, letters of understanding and agreement, and cease and desist orders) to force a credit union to improve the alignment between its risk exposures and its available capital.

A significant number of commenters questioned the Board's supporting analysis for various aspects of the proposal. Commenters suggested that the empirical foundation provided for the proposed risk weights was not sufficient. Other commenters stated that the Board should provide additional justification and more clarity as to why the proposed risk weights differ from those for other community financial institutions. Many commenters stated they would like an opportunity to review and comment on empirical data, but that they were not provided sufficient information to understand how the metrics behind the proposal were determined and how historic losses contributed to each calculation. One commenter suggested that NCUA should expand its research horizons to include data-sourcing outside the natural-person credit union space, claiming the Original Proposal contained several examples where “uncertain” conclusions were drawn from insufficient data or those where

research was halted due to the burdensome process of data collection. The commenter suggested that often these data sources are limited to natural-person credit unions, many of which have little exposure to the asset classes in question.

Another commenter suggested that the stated purpose of the proposal was to mitigate losses to the NCUSIF that could result from inadequate capital, but that GAO and NCUA's Office of Inspector General (OIG) reports demonstrate that deficiencies in the examination process contributed substantially to losses during the financial crisis, and that such deficiencies continue to be a significant factor in more recent credit unions failures. That commenter suggested that instead of focusing on a risk-based capital requirement for credit unions to contain NCUSIF losses, the Board should be improving examiner training so that agency field staff can more readily identify material risks without increasing the agency's budget, which is funded by credit unions.

A significant number of commenters expressed concerns regarding the justification and explanation of how credit risks as well as interest rate, concentration, liquidity, operational, market risks, and other types of risk were addressed in the proposed rule. Commenters questioned the Board's justification for including IRR and concentration risk in the proposed risk weights for investments, real estate loans, and member business loans. A small number of commenters suggested that there was no explanation of which portion of the proposed risk weight is intended to address each of these risk elements, and that, as a result, the risk weights did not reflect a reasoned judgment about the actual risks involved.

Competitive Concerns and Concerns Related to the Unique Nature of Credit Unions

The Board received a significant number of comments expressing concerns that the proposed rule would have put credit unions at a competitive disadvantage to banks. A majority of the commenters suggested that the differences between NCUA's proposed risk weights and the Other Banking Agencies' capital rules would have constrained the healthy growth of the credit union industry. Commenters suggested that the statutory seven percent net worth requirement to be classified as well capitalized was set artificially high by Congress to slow the growth of credit unions and that the proposed rule would build on that artificially high net worth requirement and further slow the growth of credit unions, putting credit unions at a further disadvantage to banks. A significant number of commenters stated that the competitive disadvantages in the proposed rule could incentivize many credit unions to switch to bank charters. Other commenters suggested that NCUA's proposed risk-based capital ratios were much more volatile than the risk weights under the Other Banking Agencies' rule, and that the proposed risk weights for some investments were excessively punitive and should be changed to match the risk weights used in Basel
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and the Other Banking Agencies' calculations. Still others suggested that it would be appropriate for NCUA to establish new risk-based capital ratio levels only when the leverage ratio requirements for credit unions to be adequately and well capitalized were lowered.

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Basel 1 (First Capital Accord) established minimum capital standards (1998). Basel II established the three pillar framework (first issued in 2004). Basel III is the most recent and builds upon Basel II pillars and enhances the core principles (first issued in 2010).

A small number of commenters stated that they appreciated that the Board kept the proposed risk-based capital calculation less complicated than the banking risk-based capital calculation.

A substantial number of commenters suggested that it was not appropriate for the Board to adopt the framework of the Basel system in the proposal and also take parts from NCUA's current PCA regulation that bear no relationship to Basel. A substantial number of commenters stated that neither Basel III nor the Other Banking Agencies rules attempt to capture IRR, liquidity risk, market risk, or operational risk in their risk weights, and that Basel III and the Other Banking Agencies' capital rules are only designed to take into account credit risk. Many commenters stated that adopting either the Basel III format or the Other Banking Agencies' risk weights accurately would give both NCUA and the credit union industry credibility to all outside parties. Other commenters suggested that, because of these and other differences, the proposal was not “comparable” with the Other Banking Agencies' rules, which is a requirement of the FCUA.

A substantial number of commenters stated that the structure and performance of credit unions suggests that the risk weights should be less stringent than the risk weights applied to banks. Other commenters suggested that the proposed risk-based capital standards for credit unions are comparable to FDIC standards, but that they fail to take into account the unique characteristics of the credit union system as required by the FCUA. Commenters noted that unlike banks, credit unions do not have capital stock and cannot go to outside investors to seek equity capital to fuel growth or shore up capital ratios in times of stress. They stated that the rule and associated risk weights should recognize that sources of capital within the credit union industry are not as easily acquired as capital sources for banks. A number of commenters stated that if Congress had intended credit unions to be subject to the same requirements as banks it would have said so, and suggested that the Board should stop treating credit unions like banks and judging them by return on investment, and instead judge them on how effectively they deliver on their mission and make a distinctive impact relative to their resources.

One commenter suggested that the rule should be based on three principles: (1) Risk weights should generally be similar to those applied to community banks in the United States; (2) for those assets where credit union loss experience is historically lower than bank loss rates, credit union risk weights should be at or below bank risk weights; and (3) concentration risk and IRR should not be incorporated into the risk-based capital system, but instead, should be addressed in the regulatory, examination and supervision process.

Another commenter claimed that the risk weights established by FDIC do not exceed 100 percent so NCUA's rule should not establish levels over 100 percent as it would impede growth and preclude credit unions from generating net income.

Commenters suggested that the differences between proposed risk weights and banks' rules would encourage credit unions to make consumer loans by discouraging credit unions from making other types of loans, such as mortgage loans, MBLs, or agricultural loans. Others suggested that the proposed rule would have forced all credit unions into a bank model that would have required them to pay less, charge more, and increase fees. Other commenters suggested that the proposed risk weights could drive many credit unions to a “cookie cutter” balance sheet where each credit union has the same percentage of total assets allocated to specific loan types, which could force a high percentage of credit unions into less profitable asset growth and make it challenging to differentiate themselves from competitors.

Commenters suggested that credit unions generally operate as portfolio lenders, making and holding high-quality consumer and residential real estate loans that serve their members and improve their communities, and that credit unions often carry significantly less exposure to volatile product lines such as acquisition development and construction loans, commercial real estate, and complex derivatives products.

Commenters added that credit unions also face stringent regulatory restrictions on their investment powers, and as a result, natural-person credit unions fared substantially better during the recent financial crisis than many other entities, including banks. Those commenters concluded that an appropriate risk-based capital requirement would reflect these important differences with a streamlined program that recognizes credit unions as strong counter-cyclical lenders while bolstering safety and soundness through meaningful benchmarks and access to supplemental capital.

Impacts

The Board received a substantial number of comments concerning the impact that the Original Proposal would have had on credit unions. In general, most of these commenters expressed concern that the Original Proposal would have had a material adverse impact on individual credit unions and the entire credit union industry. This section outlines these concerns.

A majority of commenters stated that the proposed risk-based capital requirement would weaken credit unions' ability to build the capital cushions they need to protect themselves against risk and would hamper credit unions' ability to grow and provide services to their members. Other commenters stated that the Original Proposal would constrain future investments by credit unions and, thus, would limit credit unions' ability to provide certain services, better loan rates, and dividends to their members. Others expressed concern that the proposal would impede growth and deter lending among credit unions, even those with demonstrated long-term ability to manage risk and net worth.

Many commenters stated that the Original Proposal seemed to be a reaction to the Great Recession and that the Board should further consider the Original Proposal's impact on the future of the credit union industry. Commenters suggested that the proposed requirement to hold a higher capital-to-asset ratio would cause credit union asset growth to stagnate and decline over the long term, for any given rate of return on assets, and that the Board should try to quantify these costs and weigh them against the uncertain benefits of minor reductions in the relative cost of credit union failures. Using the rule that the sustainable asset growth rate is equal to the return on equity, or Asset Growth Rate = ROA/Capital Ratio, some commenters estimated that asset growth for credit unions would slow to eight percent under the Original Proposal, or 1.1 percent lower than the asset growth rate would be without the Original Proposal.

Commenters stated that because credit unions can only build capital through retained earnings, the Original Proposal could severely limit credit unions' ability to grow, to increase the products and services they provide to their members, and to help their local communities prosper. They also suggested that the Original Proposal may actually reduce credit unions' ability to absorb losses, given their limited access to capital markets.

A number of commenters stated that the low risk weights applied to consumer loans and the high risk weights applied to first-lien mortgage loans, mortgage servicing rights, and subordinate-lien mortgage loans would push credit unions to make more consumer loans and fewer mortgage loans, despite a significant demand for real estate lending services at some credit unions. Other commenters stated that the Original Proposal would induce credit unions to focus on risk-based capital instead of growth in real capital. Still other commenters suggested the proposed risk weights would penalize non-consumer lending, which could force small credit unions to only make consumer loans on very low margins, a strategy that would not survive in the future.

One commenter suggested that the Original Proposal did not properly account for the effect of economic downturns on credit unions, and that it would be difficult or impossible for downgraded credit unions to rebuild following an economic downturn.

A substantial number of commenters suggested that NCUA underestimated the adverse effect of the Original Proposal. They maintained that the Board understated the number of credit unions whose net worth would have decreased to just barely over well capitalized or adequately capitalized levels. One commenter suggested that, under the Original Proposal, approximately 1,000 credit unions would be required to raise $4 billion in additional capital. Other commenters proffered that the Original Proposal would require the credit union industry to hold an additional $6.5 billion to $7 billion dollars in additional capital to retain the same buffers that exist today and still be considered well capitalized. Commenters suggested that the Board considered only the narrowest interpretation of the Original Proposal's impact, ignoring the immediate and long-term effects that it would have on individual credit unions and the entire credit union system. They stated that credit unions cannot easily manage their capital to the exact dollar level that equates to NCUA's proposed standards, and that credit unions typically strive to maintain sufficient space or buffers between their actual net worth ratios and the minimum required levels to be well capitalized because of the significant consequences of not meeting the net worth standards. According to the commenters, credit unions choosing to regain their buffer would only have three choices: (1) Rebalance their assets, recognizing an opportunity cost when they forego higher earnings, which would diminish their ability to grow; (2) ration services, stifling asset and membership growth; or (3) require members to pay more, resulting in fewer member benefits and increased competition from banks.

Commenters added that the Original Proposal would require many credit unions to adjust their capital levels to maintain current margins above the well capitalized threshold, at the same time as earnings at credit unions continue to be squeezed by low interest rates, downward pressure on other revenue streams, and moderate loan growth. They argued that these adjustments would pressure credit unions, already suffering from low to moderate loan-to-share ratios, to decrease their assets by curbing lending in an attempt to comply with the new requirements.

A significant number of commenters stated that the Original Proposal would cause the reallocation of credit union capital toward less productive uses. One commenter suggested that, for some credit unions, the Original Proposal would increase the amount of capital required to be well capitalized above the current level of seven percent of total assets, positing that 10.5 percent of risk assets amounts to more than seven percent of total assets for most credit unions, depending on the ratio of risk assets to total assets. The commenter assumed that, across all potentially affected credit unions, the total amount of capital necessary to be well capitalized would increase by $7.6 billion, or, in other words, that the Original Proposal would increase the

well capitalized net worth ratio requirement an average of 0.76 percent, from seven percent to 7.76 percent.

A number of commenters also noted their concern that the Original Proposal would force many credit unions out of business.

A significant number of commenters expressed concern that the Original Proposal would curtail MBL activities. They stated that the Original Proposal unfairly penalized credit unions that are exempt from the MBL limits in § 107A of the FCUA.
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Other commenters suggested that the Original Proposal would stifle the strategic business plans of credit unions that specialize in MBLs to grow their assets with additional commercial and real estate loans. They also stated that the Original Proposal would drive down MBL activity in rural areas because credit unions specializing in MBLs, particularly in agricultural loans and/or loans secured by farm land, cannot diversify their portfolio by providing other types of loans not needed by their members. Others stated that the proposed risk weights for MBLs would discriminate against credit unions that serve underserved and credit-challenged Americans—taxi drivers, farmers, and those in faith-based credit unions. Commenters suggested that, in order to increase their risk-based capital ratios required under the Original Proposal, credit unions may feel forced to reduce mortgage and business lending or increase loan rates and fees. They stated that the Original Proposal would have a negative effect on agricultural lending, farming communities, and credit union members, particularly those in rural and low-income areas. A number of commenters urged the Board to further consider the economic impact and consequences of reduced liquidity and financing for families and small businesses. Others argued that the Original Proposal would eliminate credit unions' business models centering on mortgage lending.

71
12 U.S.C. 1757a.

Commenters suggested that the proposed risk weights would discourage well capitalized credit unions from engaging in mergers of undercapitalized credit unions because the Original Proposal would force credit unions into less profitable asset growth. Other commenters maintained that the reduction of credit unions' capital margin or cushion would negatively impact credit unions' ability to merge, and would permit only the largest credit unions to merge with smaller credit unions. Still others suggested that the Original Proposal would encourage mergers of credit unions not meeting the risk-based requirements.

A substantial number of commenters stated that the Original Proposal would have a direct negative impact on credit union service organizations (CUSOs) by discouraging investment in CUSOs, thereby forcing many credit unions to limit services to their members.

Commenters feared that the Original Proposal would result in stricter scrutiny by examiners, which would increase NCUA's examination and supervision costs and, therefore, the costs borne by credit union members. Other commenters suggested that NCUA already has a large examination and oversight budget to eliminate risk to the NCUSIF; they contended the Original Proposal did not sufficiently address the aggregate costs of these initiatives to credit union members. According to these commenters, the impact of the Original Proposal on credit union members, in the form of excessive supervision and lost earnings due to overcapitalization, could itself pose a risk to the NCUSIF.

Some commenters shared their belief that the Original Proposal would reduce lending in dramatic ways and stifle the economy. Other commenters asserted that the Original Proposal would decrease member benefits, such as patronage dividends and reduced expenses. A number of commenters stated that the Original Proposal failed to consider impacts on businesses and the economy, particularly on small businesses that rely on credit unions for credit. Several commenters suggested that the Original Proposal would force some credit unions away from their missions to serve member in predominantly rural and low-income fields of membership.

A small number of commenters encouraged the Board to follow the cost-benefit analysis blueprint established by Executive Orders 13563 and 13579. Doing so, they argued, would allow meaningful, cumulative analysis that would result in a more coherent rule with fewer harmful, unintended consequences for the American economy.

A number of commenters expressed significant concerns about the Original Proposal's negative impact on the growth and viability of small credit unions. They suggested that the Original Proposal would inhibit the growth of credit unions that are developing from small credit unions (less than $50 million) to medium-size credit unions ($50 million-$99 million). Other commenters suggested it would reduce the monetary and other support that larger credit unions historically have provided to their smaller counterparts. They noted that some small credit unions depend on grants, scholarships, and training opportunities funded by larger credit unions. If these larger credit unions were compelled to change their loan and investment portfolios, or are required to adjust their capital, those commenters concluded their income levels would decline, thereby rendering it more difficult for them to fund as many opportunities for small credit unions. One credit union with less than $10 million in assets asserted that it would be adversely affected by the proposed change in the capital reserves requirement.

Other commenters suggested that the Original Proposal imposed unnecessary regulatory burdens that would impede small credit unions' ability to serve their members. A substantial number of commenters stated that small credit unions not classified as “complex” and not subject to the risk-based capital requirement would still be negatively affected because the Original Proposal estimated the paperwork burdens include over 160 hours of work for credit unions, which is significant for small credit unions with limited resources. Other commenters suggested that small credit unions would suffer significantly due to the complexity of this regulation and its implementation costs. Many commenters stated that small credit unions cannot survive under the current regulatory burdens. Others foresaw potentially disastrous consequences if this regulation were pushed down to small credit unions. An official at one small credit union asserted that the Original Proposal would affect its strategic planning as it approached $50 million in assets. Another commenter stated that, as a credit union with under $50 million in assets, it was concerned about the uncertainty of how the Original Proposal would affect privately insured credit unions.

Other Concerns

Several commenters expressed concerns that the proposal did not provide for input from state regulators who may have a different view or approach from that of NCUA. Other commenters suggested that the proposal was developed with no involvement or dialogue with state regulators. Commenters suggested that the Board should ensure that NCUA properly implements directives in the FCU Act and coordinates with state officials in implementing risk-based requirements and PCA.

E. What are the primary changes the Board has included in this proposal?

Similar to the Original Proposal, this proposal would replace the method currently used by credit unions to apply risk weights to their assets with a new risk-based capital ratio measure that is more comparable to that applied to depository institutions worldwide. The proposed risk-based capital ratio measure would be the percentage of a credit union's capital available to cover losses, divided by the credit union's defined risk-weighted asset base.

As noted in the introduction, this proposed rule would make substantial modifications to the Original Proposal to address specific concerns that were raised by commenters regarding the proposal's cost, complexity, and burden. These changes would include: (1) Amending the definition of “complex” credit union by increasing the asset threshold from $50 million to $100 million; (2) reducing the number of asset concentration thresholds for residential real estate loans and commercial loans (formerly classified as MBLS); (3) assigning one-to-four family non-owner-occupied residential real estate loans the same risk weights as other residential real estate loans; (4) eliminating IRR from this proposed rule; (5) extending the implementation timeframe to January 1, 2019; and (6) eliminating the Individual Minimum Capital Requirement (IMCR) provision. Among other things, these changes would substantially reduce the number of credit unions subject to the rule, and would afford affected credit unions sufficient time to prepare for the rule's full implementation. A full discussion of the impact of these and other changes in this proposed rule is contained in Impact of the Proposed Regulation part of the preamble below.

As discussed previously, the FCUA gives NCUA broad discretion in designing the risk-based net worth requirement. Thus, this proposal would incorporate a broadened definition of capital to be used as the numerator in calculating the proposed new risk-based capital ratio measure. The Board is proposing this change to provide a more comparable measure of capital across all financial institutions and to better account for related elements of the financial statement that are available to cover losses and protect the NCUSIF. This broader definition of capital would more accurately reflect the amount of capital that is available at a credit union to absorb losses. On average, it would increase a credit union's risk-based capital ratio by over 50 basis points as discussed in more detail below.

The Board agrees with the various comments received on the Original Proposal that suggested the allowance for loan and lease losses (ALLL) account should be included in its entirety in the risk-based capital ratio numerator (that is, not subject to a 1.25 percent cap), and that goodwill and other intangible assets specifically related to a supervisory merger that occurs before the Board finalizes its risk-based capital ratio rule should be included in the risk-based capital ratio numerator for some period of time before being excluded (approximately 10 years after any final rule is published in the
Federal Register
). For a more detailed discussion on these and the other proposed changes, and responses to the comments received on the Original Proposal, refer to the section-by-section analysis part of this preamble below.

In terms of the denominator for the risk-based capital ratio measure, section 216(d)(2) of the FCUA requires that the Board, in designing a risk-based net worth requirement, “take account of
any material risks
against which the net worth ratio required for [a federally] insured credit union to be adequately capitalized may not provide adequate protection.”
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Congress specifically listed IRR with respect to this provision in the Senate Report accompanying CUMAA, which added the aforementioned requirement to the FCUA.
73

Section 216(d)(2) of the FCUA differs from the corresponding provision in section 38 of the FDI Act,
74

which requires the Other Banking Agencies to implement risk-based capital requirements, because section 216(d)(2) specifically requires that NCUA's risk-based requirement address “
any material risks.
” Accordingly, despite the absence of an IRR component in the Other Banking Agencies' risk-based capital requirements,
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the Board is still required to account for any material risks in the risk-based requirement unless the risk is deemed
immaterial
because of the existence of some other mechanism that the Board believes adequately accounts for the risk.

72
12 U.S.C. 1790d(d)(2) (emphasis added).

73
S. Rep. No. 193, 105th Cong., 2d Sess. 13 (1998).

74
12 U.S.C. 1831o.

75
78 FR 55349, 55362 (Sept. 10, 2013) (“The risk-based capital ratios under these rules do not explicitly take account of the quality of individual asset portfolios or the range of other types of risk to which FDIC-supervised institutions may be exposed, such as interest rate, liquidity, market, or operational risks.”).

NCUA's risk-based net worth requirement has included some aspect of IRR since its inception in 2000. Further, the Board continues to believe that IRR, if not adequately addressed through some regulatory, statutory or supervisory mechanism, can represent a material risk for purposes of NCUA's risk-based requirement.
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The Board noted its concerns about IRR in the preamble of the final IRR rule issued in January 2012 when it highlighted the need for federally insured credit unions to have an effective IRR management program.
77

NCUA's requirement to have an effective IRR management program was necessitated in part by the Board's concern over the steady lengthening in maturity of average credit union assets, an increase that in turn was fueled by a steady and extended expansion into mortgage loans and investments. At the same time credit unions were experiencing an increase in the weighted average maturity of their assets, much of their current portfolio was established in a period of record-low interest rates and at contractually fixed coupon amounts. These asset factors, coupled with a large influx of non-maturity shares also priced at historically low rates, has created a unique mismatch between assets and liabilities and a potentially volatile sensitivity in earnings and capital. Accordingly, the Board continues to view IRR as a major risk facing credit unions.

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IRR has been NCUA's top supervisory priority for the last few years, and has appeared as an issue of significant concern in the Financial Stability Oversight Council's 2012 and 2013 Annual Reports.

77
77 FR 5155 (February 2, 2012).

Based on long-term balance sheet trends at credit unions and NCUA's experiences dealing with problem institutions, the Board has concluded that NCUA's current regulations and supervisory process alone cannot adequately address IRR. However, the Board agrees with commenters on the Original Proposal who suggested that measures of IRR based comprehensively on assets and liabilities (including hedges) should be favored over measures that are based upon an asset-only approach, which is the approach taken in the current rule and was also the approach taken in the Original Proposal. Accordingly, the Board is now proposing to exclude consideration of IRR from the risk-based capital ratio measure, but in the future intends to consider alternative approaches for taking into account the IRR at credit unions.

The proposed methodology for assigning risk weights in this proposed rule, therefore, would account only for credit risk and concentration risk. The Board believes that a capital-at-risk methodology is more appropriate for

measuring the risks arising from the changes in interest rates. The use of capital-at-risk methodologies to identify, measure and control IRR is a long standing practice in larger credit unions and a standard expectation among depository institution supervisors, including NCUA. Net economic value (NEV) is the most prevalent tool credit unions use to measure capital-at-risk. NEV measures the effect of changes in interest rates on a credit union's economic value. NCUA has had a supervisory expectation for the use of asset liability management modeling by large credit unions for decades. In 2013, NCUA codified the requirement for IRR policies and management programs under section 741.3(b)(5).
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Paragraph (b)(5) currently requires federally insured credit unions with over $50 million in assets to develop and adopt a written policy on IRR management, and a program to effectively implement that policy, as part of their asset liability management responsibilities.

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See also
78 FR 4032, 4037 (Jan. 18, 2013).

Because IRR will no longer be included in this proposal, NCUA will consider what alternative approaches can be taken to account for IRR at credit unions. Alternative approaches that could be taken include adding a separate IRR standard as a subcomponent of the risk-based net worth requirement to complement the proposed risk-based capital ratio measure. Conceptually, a separate IRR standard should be based on a comprehensive balance sheet measure, like NEV, that takes into account offsetting risk effects between assets and liabilities (including benefits from derivative transactions). The intent of such a measure would be to measure IRR consistently and transparently across all asset and liability categories, to address both rising and falling rate scenarios, and to supplement the supervisory process with a measure calibrated to address severe outliers. This approach would also incorporate a forward-looking, proactive measure into NCUA's capital standards, as recommended by GAO.
79

79

See
U.S. Govt. Accountability Office, GAO-12-247,
Earlier Actions Are Needed to Better Address Troubled Credit Unions,
(Jan. 2012)
available at http://www.gao.gov/products/GAO-12-247.

In light of the proposed elimination of IRR measures from the current rule, and GAO's recommendation for NCUA to incorporate a forward-looking measure into credit union's capital standards, the Board specifically requests comments on alternative approaches that could be taken in the future to reasonably account for IRR.

Because the Board has decided to exclude IRR from the computation of the risk weights for assets in this proposal, it was necessary to propose significant changes to how investments are currently risk-weighted. This proposal adopts a risk weight framework for investments based largely on the credit risk of the issuer or underlying collateral. This proposed approach would be substantially similar to the Other Banking Agencies' framework for investments.
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Because the same types of investments generally perform identically on a credit risk basis for credit unions and banks, the variations in this proposal from the Other Banking Agencies' investment risk weights primarily involve credit union-specific type investments. For example, the proposed risk weights assigned to investments in capital instruments issued by corporate credit unions and credit union service organizations would differ from the corresponding risk-weights assigned to bank investments. While this approach to assigning risk weight to investments would require credit unions to report additional data on the Call Report, the Board believes such an approach would result in net benefits to credit unions in terms of the improved precision of the capital requirements. Further, the more granular data will improve NCUA's offsite supervision capabilities. The section-by-section analysis part of the preamble contains more detailed discussions on the specific changes being proposed to the investment risk weights.

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See, e.g.,
12 CFR 324.32.

Concentration risk can also be a material risk. As the Basel Committee on Banking Supervision explained in Basel II:

Risk concentrations are arguably the single most important cause of major problems in banks. Risk concentrations can arise in a bank's assets, liabilities, or off-balance sheet items, through the execution or processing of transactions (either product or service), or through a combination of exposures across these broad categories. Because lending is the primary activity of most banks, credit risk concentrations are often the most material risk concentrations within a bank. Credit risk concentrations, by their nature, are based on common or correlated risk factors, which, in times of stress, have an adverse effect on the creditworthiness of each of the individual counterparties making up the concentration.
81

81
Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Comprehensive Version” 214 (June 2006)
available at http://www.bis.org/publ/bcbs128.pdf
(
Basel II
).

The concept of higher risk weights for concentrations of real estate loans and MBLs exists in the current risk-based requirement. Eliminating the concentration dimension for risk weights would be a step backward and is inconsistent with the concerns raised regarding concentration risk by GAO and in Material Loss Reviews (MLRs) conducted by NCUA's OIG. The 2012 GAO report notes credit concentration risk contributed to 27 of 85 credit union failures that occurred between January 1, 2008, and June 30, 2011. Credit unions with high MBL concentrations are particularly susceptible to changes in business conditions that can affect borrower cash flow, collateral value, or other factors increasing the probability of default. GAO found in its 2012 report that credit unions who failed had more MBLs as a percentage of total assets than peers and the industry average. GAO advised NCUA to revise PCA taking into account credit unions with a high percentage of MBLs to total assets. The report documented NCUA's agreement to revise PCA regulations so that capital standards adequately address concentration risk.
82

82

See
U.S. Govt. Accountability Office, GAO-12-247, Earlier Actions are Needed to Better Address Troubled Credit Unions (2012),
available at http://www.gao.gov/products/GAO-12-247.

GAO also recommended NCUA address the real estate concentration risk concerns raised by NCUA's OIG, who completed several MLRs where failed credit unions had large real estate loan concentrations. The NCUSIF incurred losses of at least $25 million in each of these cases. The credit unions reviewed held substantial residential real estate loan concentrations in either first-lien mortgage loans, home equity lines of credit (HELOCS), or both.
83

83

See
Office of Inspector General, National Credit Union Administration, OIG-10-03, Material Loss Review of Cal State 9 Credit Union (April 14, 2010), available at
http://www.ncua.gov/about/Leadership/CO/OIG/Documents/OIG201003MLRCalState9.pdf;
Office of Inspector General, National Credit Union Administration, OIG-11-07, Material Loss Review of Beehive Credit Union (July 7, 2011), available at
http://www.ncua.gov/about/Leadership/CO/OIG/Documents/OIG201107MLRBeehiveCU.pdf;
Office of Inspector General, National Credit Union Administration, OIG-10-15, Material Loss Review of Ensign Federal Credit Union, (September 23, 2010), available at
http://www.ncua.gov/about/Leadership/CO/OIG/Documents/OIG201015MLREnsign.pdf.

Accordingly, the Board is now proposing to include a tiered risk weight framework for high concentrations of residential real estate loans and commercial loans
84

in NCUA's risk-based capital ratio measure.
85

As a

credit union's concentration in these asset classes increases, incrementally higher levels of capital would be required. This approach would address concentration risk as it relates to minimum required capital levels through a transparent, standardized, regulatory requirement. Considering concentration risk solely in the examination process would be less consistent and transparent, and would lack a strong enforcement framework.

84
The definition of commercial loans and the differences between commercial loans and MBLs are discussed in more detail in the section-by-section analysis.

85
The tiered framework would provide for an incrementally higher capital requirement resulting

in a blended rate for the corresponding portfolio. That is, the portion of the portfolio below the threshold would receive a lower risk weight, and the portion above the threshold would receive a higher risk weight. The higher risk weight would be consistent across asset categories as a 50 percent increase from the base rate. Some comments on the Original Proposal suggested NCUA should have combined similar exposures across asset classes, such as investments and loans. For example, residential mortgage-backed security concentrations could have been included with the real estate loan thresholds due to the similarity of the underlying assets. However, given the more liquid nature and price transparency of a security, the Board believes including this with the risk thresholds for real estate lending is not necessary.

The Board agrees with various commenters on the Original Proposal that the tiered risk weight system should be adjusted so as to focus on material outliers, thereby creating more consistency of capital treatment with banks. Accordingly, the Board proposes to use a single, higher concentration threshold to simplify the risk weight framework and calibrate it to be applicable only to credit unions that deviate significantly from the mean.
86

This single, higher concentration threshold would provide sufficient flexibility for the vast majority of credit unions to operate at a level where the risk weights are substantially similar to the risk weights applied to similar bank assets under the Other Banking Agencies' capital regulations.
87

86
The concentration threshold for real estate loans is approximately two standard deviations from the mean. The concentration threshold for commercial loans is over five standard deviations from the mean.

87
Based on NCUA's analysis of call report data, approximately 90 percent of complex credit unions operate at levels below the concentration thresholds proposed for residential real estate loans. Over 99 percent of complex credit unions operate at levels below the concentration thresholds proposed for commercial loans.
See also, e.g.,
12 CFR 324.32(f) and (g) (corresponding FDIC risk weights).

The concentration thresholds would not limit a credit union's lending activity; rather, the thresholds would merely require the credit union to hold capital for the elevated risk. The Board does not believe credit unions would be at a competitive disadvantage because most loans (except for loans at extremely high concentrations) would be assigned risk weights similar to those applicable to banks.

Consistent with section 216(b)(1)(A)(ii) of the FCUA, which requires NCUA's PCA requirement be comparable to the Other Banking Agencies' PCA requirements, the Board largely relied on the risk weights assigned to various asset classes under the Basel Accords and the Other Banking Agencies' risk-based capital rules, as well as the underlying principles, for this proposal.
88

NCUA has, however, tailored the risk weights in this proposal for certain assets that are unique to credit unions; where a demonstrable and compelling case exists, based on contemporary and sustained performance differences, to differentiate for certain asset classes between banks and credit unions; or where a provision of the FCUA required doing so. Thus, this proposal provides for even greater comparability to Other Banking Agencies' risk weights than the Original Proposal by adjusting asset classes and recalibrating risk weight, including for all loans changing the definition of “current” from less than 60 to less than 90 days past due.

88
NCUA has attempted to simplify certain aspects of this proposed rule to take into account the cooperative character of credit unions while still imposing risk-based capital standards that are substantially similar and equivalent in rigor to the standards imposed on banks.
See
12 U.S.C. 1790d(b)(1)(B).

The following is a table showing a summary of the risk weights included in this proposal. See the section-by-section analysis part of the preamble below for more detail on the proposed changes to the asset classes and risk weights.

Summary of Proposed Risk Weights

0%
20%
50%
75%
100%
150%
250%
300%
400%
1250%

Cash/Currency/Coin
X

Investments:

Unconditional Claims—U.S. Govt. (Treas./GNMA)
X

Balances Due from Federal Reserve Banks
X

Federally Insured Deposits in Financial Institutions
X

Debt Instruments issued by NCUA and FDIC
X

CLF Stock
X

Uninsured deposits at U.S. Federally Insured Inst.

X

Agency Obligations

X

FNMA and FHLMC pass through MBS

X

Gen. Oblig. Bonds Issued by State or Political Sub.

X

FHLB Stock and Balances

X

Senior Agency Residential MBS or Asset Backed Securities (ABS) Structured

X

Revenue Bonds Issued by State or Political Sub.

X

Senior Non-Agency Residential MBS Structured

X

Corporate Membership Capital

X

Senior Non-Agency ABS Structured Securities

X

Industrial Development Bonds

X

Agency Stripped MBS (Int. Only and Prin. Only)

X

Mutual Funds Part 703 Compliant

X *

Value of General Account Insurance (BOLI/CUOLI)

X *

Corporate Perpetual Capital

X

Mortgage Servicing Assets

X

Separate Account Life Insurance

X *

Publicly Traded Equity Investment (non CUSO)

X

Mutual Funds Part 703 Non-Compliant

X *

Non-Publicly Traded Equity Inv. (non CUSO)

X

Subordinated Tranche of Any Investment

X **

Consumer Loans:

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2015-00947. Public record. Not legal advice.