Risk-Based Capital

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:

Final rule.

SUMMARY:

The NCUA Board (Board) is amending NCUA's current regulations regarding prompt corrective action (PCA) to require that credit unions taking certain risks hold capital commensurate with those risks. The risk-based capital provisions of this final rule apply only to federally insured, natural-person credit unions with assets over $100 million.

The overarching intent is to reduce the likelihood of a relatively small number of high-risk outliers exhausting their capital and causing systemic losses—which, by law, all federally insured credit unions would have to pay through the National Credit Union Share Insurance Fund (NCUSIF).

This final rule restructures NCUA's PCA regulations and makes various revisions, including amending the agency's current risk-based net worth requirement by replacing it with a new risk-based capital ratio for federally insured, natural-person credit unions (credit unions).

The risk-based capital requirement set forth in this final rule is more consistent with NCUA's risk-based capital measure for corporate credit unions and, as the law requires, more comparable to the regulatory risk-based capital measures used by the Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve System, and Office of the Comptroller of Currency (Other Banking Agencies). The effective date is intended to coincide with the full phase-in of FDIC's risk-based capital measures in 2019.

The final rule also eliminates several provisions in NCUA's current PCA regulations, including provisions relating to the regular reserve account, risk-mitigation credits, and alternative risk weights.

DATES:

This final rule is effective on January 1, 2019.

FOR FURTHER INFORMATION CONTACT:

Policy and Accounting:

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; John Shook, Loss/Risk Analyst, Division of Risk Management, Office of Examination and Insurance, at (703) 518-3799; Steven Farrar, Supervisory Financial Analyst, Division of Capital and Credit Markets, Office of Examination and Insurance, at (703) 518-6393; 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; Aaron Langley, Risk Management Officer, Division of Analytics and Surveillance; Office of Examination and Insurance, at (703) 518-6360; or

Legal:

John H. Brolin or Justin Anderson, Senior Staff Attorneys, Office of General Counsel, at (703) 518-6540; or by mail at National Credit Union Administration, 1775 Duke Street, Alexandria, VA 22314.

SUPPLEMENTARY INFORMATION:

I. Background

II. Summary of the Final Rule

III. Legal Authority

IV. Section-by-Section Analysis

V. Effective Date

VI. Impact of This Final Rule

VII. Regulatory Procedures

I. Background

NCUA's primary mission is to ensure the safety and soundness of federally insured credit unions. NCUA performs this function by examining and supervising federally chartered 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 all federally insured credit unions.

1

In its role as the administrator of the NCUSIF, NCUA insures and regulates approximately 6,270 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 129 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 proposed amendments were intended to implement the statutory requirements of the Federal Credit Union Act (FCUA) and follow recommendations made by the Government Accountability Office (GAO) and NCUA's Inspector General. The proposal was also intended to amend NCUA's risk-based capital regulations to be more consistent with NCUA's risk-based capital measure for corporate credit unions and comparable to the new regulatory risk-based capital regulations finalized by the Other Banking Agencies in 2013.

3

In response to the Original Proposal, the Board received over 2,000 comments with many suggestions on how to improve the proposed regulation. The comments received addressed a wide range of issues. In general, however, the commenters nearly all agreed that, because the proposal assigned higher risk weights to some credit union asset classes, it would have placed credit unions at a competitive disadvantage to banks. The change most frequently recommended by commenters to address this concern was to adopt the same risk weights as the Other Banking Agencies. The Board generally agreed and, after reviewing all of the comments received, determined that it was appropriate to issue a second proposed rule.

2

79 FR 11183 (Feb. 27, 2014).

3

The Office of the Comptroller of Currency, and the Board of Governors of the Federal Reserve System: 78 FR 62017 (Oct. 11, 2013);

and

the Federal Deposit Insurance Corporation: 78 FR 55339 (Sept. 10, 2013).

So, at its January 2015 meeting, the Board issued a second proposed rule (the Second Proposal)

4

to amend NCUA's PCA regulations, part 702. The Second Proposal, which was based largely on the comments NCUA received on the Original Proposal, addressed the competitive disadvantage concerns raised by commenters and made the proposal more comparable to the Other Banking Agencies' risk-based capital requirements. Particular changes from the Original Proposal included: (1) Amending the definition of “complex” credit union, resulting in an increase in 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 member business loans); (3) assigning the same risk weights to one-to-four family non-owner-occupied residential real estate loans and other types of residential real estate loans; (4) eliminating provisions intended to address interest rate risk (IRR); (5) eliminating the proposed individual minimum capital requirement; and (6) extending the effective date to January 1, 2019. These changes would have, among other things, substantially reduced the number of credit unions subject to the rule, and would have provided credit unions significantly

more time to prepare to implement the rule's requirements.

4

80 FR 4339 (Jan. 27, 2015).

Summary of Public Comments on the Second Proposal

In response to the Second Proposal, the Board received over 2,100 comments. While the total number of comment letters received was higher than the number received in response to the Original Proposal, the comment letters responding to the Second Proposal were significantly shorter and raised fewer distinct concerns regarding the rule's provisions. In addition, significantly fewer credit unions sent in comment letters in response to the Second Proposal. In response to the Original Proposal, NCUA received comment letters from more than 1,100 different credit unions, while only 514 different credit unions sent in comment letters in response to the Second Proposal. In addition, more than 900 of the comment letters received in response to the Second Proposal provided no substantive input on the rule. Nearly all of these non-substantive letters simply stated that the commenter believed Congress should “approve” the rule, or that the commenter wanted to “vote no” on the rule.

A majority of significant comment letters received stated that the commenter opposed the proposal in its entirety and suggested that the Second Proposal be withdrawn. Most of these commenters stated they opposed the rule for one or more of the following reasons: A substantial number of commenters suggested that the strong performance of credit unions and the NCUSIF during and after the 2007-2009 financial crisis demonstrated there was no need for the proposal, and that the Board provided no evidence that the proposal would have reduced material losses to the NCUSIF if it had been in place before the financial crisis. Other commenters maintained that the proposal was unnecessary given how extremely well capitalized the industry is today. Commenters contended further that, given NCUA's own estimates that fewer than 30 credit unions would be less than well capitalized under the proposed risk-based capital ratio if it went into effect immediately, NCUA's current risk-based capital regulations and other supervisory tools seem to be doing an adequate job. Several commenters claimed that most credit union failures, including the corporate credit unions (Corporates), and significant losses to the NCUSIF were the result of high concentration levels in risky loans and investments, or were otherwise related to a lack of internal controls that should have been identified through the examination process. Commenters suggested that, instead of updating NCUA's risk-based capital regulations, the Board should focus on enhanced training to improve examiner skills. A substantial number of commenters also claimed that the proposal would regulate credit unions in the same general manner as banks. They argued credit unions should be regulated differently than banks because they are structured and operate differently. Other commenters argued the proposed rule would place credit unions at a competitive disadvantage to banks, because in these commenters' opinion, the proposed rule would require credit unions to hold incrementally more capital than banks given similar levels of asset concentration. At least one commenter suggested that the proposal would drive the largest credit unions to convert to bank charters. Other commenters argued that risk-based capital requirements, to which banks have been subject for approximately 25 years, have not worked well. In addition, they argued that bank regulators are now moving away from risk-based capital structures after they failed to help banks during the 2007-2009 recession. In support of this argument, many commenters cited a statement in which one FDIC Board Member, the FDIC's Vice Chairman, stated publicly that he believed the risk-based capital approach to regulation was a bad idea. A substantial number of commenters expressed concern that the proposal would stifle growth, innovation, diversification, and member services within credit unions by restricting credit unions' use of capital, and would impose excessive costs on credit unions and their members. At least one commenter suggested that the proposal would likely cause more risk, not less risk, to the system as a whole because the lower risk weightings assigned in some asset classes compared to others would force credit unions to take on excessive concentrations of lower risk-weighted assets. This, the commenter argued, would increase concentration risk compared to a diverse balance sheet.

Other commenters expressed concern that the proposal would be detrimental to the interests of many credit union members because credit unions would have to charge their members higher interest rates and fees and pay lower interest on deposits to raise the additional capital required under the proposal. A significant number of commenters maintained that the benefits of the proposal did not outweigh its costs to the credit union industry.

A significant number of commenters opposing the rule also argued that the Board failed to adequately justify the proposed changes to NCUA's current risk-based net worth requirement. At least one commenter suggested that the Board should not base its justification for the risk-based capital regulation on global financial trends. Other commenters claimed that the historical loss data and other information provided by NCUA in the proposed rule did not support establishing a higher capital standard for credit unions than banks. Some commenters disagreed with the Board's statutory justification for NCUA to maintain comparability with the capital rules of FDIC, and argued that the Board overemphasized the need for the regulation to be comparable to the other banking agency regulations. Commenters acknowledged that comparability is commendable where there are truly comparable institutions. Commenters suggested, however, that the fundamental structure of credit unions as not-for profit financial cooperatives is not comparable with the for-profit banking system. Commenters suggested further that member-owned credit unions generally have a different risk model than the profit-oriented banks, so if anything credit unions should have lower risk-based capital requirements than banks. Those commenters argued that the narrative accompanying the Second Proposal did not indicate sufficient research and analysis into the differences between banks and credit unions had been done or, if it had, that it was not presented in a transparent manner that adequately justified the structure of the proposal.

A substantial number of commenters pointed out that, of the 1,400 credit unions with more than $100 million in assets, only 27 would have a risk-based capital ratio below the 10 percent level proposed for a credit union to be well capitalized. Commenters contended that, based on these numbers, the current rule and other supervisory tools already at NCUA's disposal were already doing an adequate job. Other commenters argued that only 112 credit unions failed during the 2007-2009 recession, costing the insurance fund less than $1 billion, which they suggested was remarkable considering the dollars and number of commercial banks that failed. Of the natural-person credit unions that did fail during the crisis, the commenters acknowledged that most were under the $100 million asset size threshold proposed. Commenters contended that, from 1998

to 2012, the NCUSIF fund losses were only $989 million; $513 million came from 7 credit unions in the $200 million to $500 million asset range, and $343 million came from credit unions under $100 million that would not have been covered under the Second Proposal. At least one commenter claimed that its analysis of the 26 credit unions with more than $80 million in assets just before the crisis (as of December 2007) that subsequently failed revealed that only seven would have had a lower capital classification under Second Proposal. The commenter suggested that six of the 21 well-capitalized credit unions under current rules would have been downgraded—four to adequately capitalized and two to undercapitalized—and that one adequately capitalized credit union under the current rules would have been classified as undercapitalized under the proposal. In other words, the commenter maintained, of the 26 failures, a total of three credit unions would have been demoted to undercapitalized if the Second Proposal had been in effect before the crisis. And the amount of capital they would have been required to obtain to become adequately capitalized was only $7 million, as compared to the insurance loss of over $700 million. The commenter claimed that the amount of capital that would have been necessary for all seven downgraded credit unions to regain their previous capital classifications (six to well-capitalized, one to adequately-capitalized) would have totaled $43 million.

While most commenters did oppose finalizing the proposal, a substantial number of the commenters who opposed the rule acknowledged that the Board, in response to comments received on the Original Proposal, had made significant improvements to Second Proposal. Specific improvements mentioned included: The removal of the IRR provisions; the new zero percent risk weight assigned to cash held at the Federal Reserve; the reduction of the concentration thresholds from three to two tiers for residential mortgages, junior liens, and commercial loans; the removal of the 1.25 percent cap on allowance for loan and lease losses (ALLL); the lower 10 percent risk-based capital ratio threshold level required for credit unions to be classified as well capitalized; the removal of the enumerated processes to require that individual credit unions hold higher levels of capital under certain circumstances; the increase in the asset size threshold for defining credit unions as “complex”; the extended implementation period; the lower risk-weights assigned to many categories of assets; and the designation of one-to-four family non-owner occupied mortgage loans as residential loans.

A small number of commenters stated that they supported the Second Proposal. These commenters generally agreed that the credit union system should have risk-based capital requirements that protect the Share Insurance Fund and other well run credit unions by requiring that credit unions with more complex balance sheets hold modestly more capital. Several commenters supported the proposal because they felt that the Board had listened to commenters following the Original Proposal and had made substantial improvements to the Second Proposal. Several commenters supported the proposal for various other reasons: One financial services consulting firm suggested that, overall, the proposal presented a fair alternative to the risk-based capital requirements applicable to banks. At least one state supervisory authority suggested that, on the whole, the proposal was sound and substantially better than NCUA's current risk-based capital rule. One credit union commenter stated that it supported the proposal because insured credit unions, which together hold assets of $1.1 trillion, are backed by the full faith and credit of the United States. And if insured credit unions engaging in high-risk lending fail in significant enough numbers, then the taxpayer is left holding the bill. One individual stated that he supported the proposal because, in his opinion, it would lower the number of loans credit unions could make by imposing higher risk weights on loans made to higher-risk persons. Another individual supported the proposal because he believed it would lower rates for consumers who utilize credit unions. Yet another individual suggested that he supported the proposal because credit unions should be given the same scrutiny as other major lenders and not be given a free pass because they have good intentions as non-profits. The commenter suggested further that credit unions should be subject to tough and robust regulations such as the proposed risk-based capital rule.

In addition to the comments on the Second Proposal discussed above, NCUA received the following general comments: At least one commenter agreed that NCUA's current risk-based net worth regulation is outdated and does not accurately reflect the level of risk in individual credit unions, but criticized that the statutory net worth ratio level is fixed at 7 percent. The commenter suggested that if the 7 percent net worth ratio level is inadequate, the Board should convince Congress to arrive at an appropriate net worth level rather than address risks through revisions to NCUA's risk-based capital regulations. Another commenter recommended that a risk-based capital requirement be developed to replace the statutory net worth ratio, instead of imposing a risk-based capital requirement in addition to the statutory net worth ratio requirement. The commenter argued that managing two different capital limits would place an unnecessary burden on credit unions and serve as an additional competitive disadvantage to the credit union charter. A significant number of commenters suggested that the proposed rule went too far in treating credit unions like banks, and that if credit unions are regulated and supervised as banks they will be forced to act more like banks, which would be to the detriment of their members. At least one state supervisory authority agreed with using a Basel III style capital model, but remained concerned that notable differences continued to exist between NCUA's proposed model and the one employed by FDIC and other federal bank regulators. In particular, the commenter suggested that the differences between the risk weightings for a number of the proposed asset categories represented a missed opportunity to reduce public confusion, and might actually increase confusion. The commenter explained that public users of government-provided Call Report data could assume that NCUA's risk-based capital ratio is the same as other institutions' measurements of capital using the same terminology, but, under the Second Proposal, the ratios could be materially different for banks and credit unions. A bank trade association recommended the Board adopt the same Basel III model adopted by the Other Banking Agencies because without comparable capital requirements, credit unions will be undercapitalized relative to community banks, and such undercapitalization, along with credit unions' limited access to alternative forms of capital when needed, could increase the bailout risk faced by the American taxpayer. The commenter suggested that because credit unions are not required to pay federal income taxes on earnings and can retain a larger percentage of their earnings than community banks, they should have little or no difficulty in maintaining very high levels of Tier 1 capital. The commenter also suggested

that the Board impose a capital surcharge of 5 percent on credit unions when they exceed total consolidated assets of $10 billion because large credit unions, with their limited ability to react to depleted capital levels in times of economic uncertainty, should be subjected to increased scrutiny and additional capital reserves. Other commenters suggested that, before issuing a proposed rule, NCUA test regulatory approaches of the type included in the Second Proposal through the examination process and share the results with the industry. Some commenters suggested that the rule does not take into account that the vast majority of credit unions already have written policies to deal with balance sheet risk. At least one commenter suggested that the rule would not protect credit unions or NCUA in the event of another crisis that requires natural-person credit unions to pay out huge assessments. A few commenters recommended that the proposed risk-based capital ratio measure should be used as a modeling tool rather than a rigid rule, similar to interest rate risk monitoring tools. The commenters suggested that this would allow credit union risk to be calculated as a model by examiners using risk weights appropriate for each credit union's environment, and discuss with boards and management their views of risk for various asset classes. A model, the commenters suggested, would be far more flexible than a rule, and would allow for the pragmatic management of risk rather than through rule-based estimates of risk, which may or may not be accurate. Finally, one credit union supported making the risk-based capital framework as complicated as it needs to be to more accurately reflect the unique needs and structure of the credit union industry. The commenter suggested that the Board, for example, took a step in that direction in the Second Proposal when it created a risk-weight category for “commercial loans” as distinct from traditional member business loans for purposes of the risk-based capital ratio measure.

Discussion

Commenters calling for a withdrawal of the proposed rule altogether are ignoring NCUA's general statutory requirement to maintain a risk-based system comparable to the Other Banking Agencies' requirements.

5

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

6

The changes to the Other Banking Agencies' risk-based capital regulations, the lessons learned from the 2007-2009 recession, and the fact that NCUA's current risk-based net worth requirement is ineffective and has not been materially updated since 2002, prompted the Board to propose revisions to NCUA's current risk-based net worth ratio requirement and other aspects of NCUA's current PCA regulations. The proposed changes were also prompted by specific recommendations to NCUA made by GAO in its January 2012 review of NCUA's system of PCA. In particular, GAO recommended that NCUA design a more forward-looking system to detect problems earlier.

7

5

See

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

6

78 FR 55339 (Sept. 10, 2013) (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 FDIC's IFR.).

7

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 Second Proposal addressed the important role and benefits of capital. The proposal discussed the impact of a financial crisis and the benefit a higher level of capital provided to insulate certain financial institutions from the effects of unexpected adverse developments in assets and liabilities. Higher levels of capital can reduce the probability of a systemic crisis, allow credit unions to continue to serve as credit providers during times of stress without government intervention, and produce benefits that outweigh the associated costs. The proposal also emphasized that credit unions' senior management and boards are accountable for ensuring that appropriate capital levels are in place based on the credit union's risk exposure.

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 2007-2009 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.

8

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.

9

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.

8

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.

9

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.

10

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 2007-2009 financial crisis is roughly $10 trillion (2014 dollars).

11

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.

12

10

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.

11

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

.

12

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.

13

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.

14

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.

15

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).

16

13

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.

14

Id.

15

Id.

16

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.

17

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.

18

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

19

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

20

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.

17

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.

18

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).

19

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.

20

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 2007-2009 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.

21

21

For a readable overview of the 2007-2009 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.

Credit unions also experienced elevated losses and the need for government intervention. From 2008 through 2012, five corporate credit unions failed. Had NCUA not intervened in 2009 and 2010 by providing over $20 billion in liquidity assistance, over $100 billion in guarantees, and borrowing over $5 billion from the U.S. Treasury, the resulting losses to consumer credit unions on their uninsured funds invested at these institutions would have exceeded $30 billion. NCUA estimates as many as 2,500 consumer credit unions would have failed at additional cost to the Share Insurance Fund.

In addition, during that same period, 27 consumer credit unions with assets greater than $50 million failed at a cost of $728 million to the NCUSIF.

22

NCUA performed back-testing of the 9 complex credit unions (those with over $100 million in assets) that failed during this period to determine whether this final rule would have resulted in earlier identification of emerging risks and reduced losses to the NCUSIF. The back-testing revealed that maintaining a risk-based capital ratio in excess of 10 percent would have required 8 of the 9 complex credit unions that failed to hold additional capital.

22

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.

The failure of the 27 consumer credit unions was 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.

23

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.

23

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).

From 2008 to 2012, over a dozen very large consumer credit unions, and numerous smaller ones, also were in danger of failing and required extensive NCUA intervention, financial assistance, or both, along with increased reserve levels for the NCUSIF.

24

NCUA estimates these actions saved the NCUSIF over $1 billion in losses.

24

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

The clear implication from the impact of the 2007-2009 recession on the credit unions noted above 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.

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.

25

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.

25

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 2007-2009 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

Net worth ratio in 2006Q4

Lowest net worth ratio between 2007Q1 and 2010Q4

<6%

6-7%

7-8%

8-10%

≥10%

Total

Number of credit unions

<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 2007-2009 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 2007Q4

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.

26

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.

26

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.

BILLING CODE 7535-01-P

ER29OC15.000

ER29OC15.001

BILLING CODE 7535-01-C

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.

27

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.

27

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.

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.

This final rule replaces the current method for calculating a credit union's risk-based net worth ratio with a new method for calculating a credit union's risk-based capital ratio. Under the current risk-based net worth ratio measure, a lower ratio is reflective of financial strength. So the current measure is not intuitive, and, more importantly, can't be compared against the risk-based capital measures of other financial institutions. The new risk-based capital ratio, however, is more commonly applied to depository institutions worldwide. Generally, the new risk-based capital ratio is the percentage of equity and accounts available to cover losses divided by risk-weighted assets. Under this approach, a higher risk-based capital ratio is an indicator of financial strength.

The new risk-based capital ratio adopted in this final rule is designed to complement the statutory net worth ratio, which is often referred to as the leverage ratio. The net worth ratio is a measure of statutorily defined capital divided by total assets. The net worth ratio does not assign relative risk weights among asset classes, making it more difficult to manipulate and provides a simple picture of a financial institution's ability to absorb losses, regardless of the source of the loss. The new risk-based capital ratio, on the other hand, is a measure of loss absorption ability to assets weighted based on the associated risk, and is intended to be more forward looking and reactive to changes in the risk profile of a credit union. In general, a risk-based capital requirement increases capital requirements at those institutions with asset portfolios that are, on average, higher risk. Conversely, risk-based capital standards generally decrease capital requirements at institutions with lower risk profiles. 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.

Many commenters suggested that the Board withdraw the Second Proposal and retain the existing risk-based capital requirement and the related risk-weights, which are based largely on interest rate risk and liquidity risk. Ironically, most of the commenters objected to the Original Proposal because it included IRR and liquidity risk in the proposed risk weights. As discussed in the Original Proposal, since its implementation, the current risk-based net worth requirement has required less than a handful of credit unions to hold higher levels of capital than required by the net worth ratio. Under the current risk-based net worth requirement, those credit unions that invest in longer-term, low-credit risk investments experience a higher risk-based net worth requirement and thus have a lower buffer above the net worth ratio than they will have under the final rule.

The current risk-based net worth requirement also fails to allow for comparison of capital adequacy on a risk-weighted level across financial institutions. A creditor or uninsured depositor is able to obtain and understand the capital measures available for all banks. Creditors generally know that, for banks, a higher capital ratio is an indication of better financial strength and a reduction in their risk of loss. Creditors and uninsured shareholders in credit unions, however, generally do not understand the application of the risk-based net worth requirement where a lower ratio is an indicator of financial strength; nor are they generally aware that the risk-based net worth requirement is only available by reviewing a specific page of the Call Report. The current lack of a comparable risk-based capital measure for credit unions deprives creditors and uninsured shareholders of a useful measure in determining the financial strength of credit unions.

The Board also disagrees with commenters who called for a withdrawal of the Second Proposal because a limited number of credit unions may experience a decline in their capital classification, or because commenters claimed that back-testing the proposal would have resulted in only minor savings to the NCUSIF had the proposal's capital requirement been in place during the 2007-2009 recession. The Original Proposal would have imposed higher risk-weights for concentrations of MBLs, junior-lien real estate loans, and equity investments, which would have resulted in approximately 199 credit unions experiencing a decline in their capital classification and could have reduced losses to the NCUSIF to a greater degree had those requirements been in place prior to the 2007-2009 recession. Due to legitimate concerns raised by commenters regarding the impacts of the Original Proposal, however, the Board reduced the risk-weights for concentrations of MBLs and real estate loan concentrations in the Second Proposal. Thus, the potential impacts of the Second Proposal were lower, but still require that credit unions taking higher levels of risk hold higher levels of capital. Based on the comments received on the Original Proposal and the Second Proposal, the risk weights in the Second Proposal are calibrated to appropriately balance the impact of the proposed changes on credit unions while also providing meaningful improvement to the risk-based capital standards to which credit unions will be held in the future.

The Board disagrees with commenters who suggested that the Board not finalize the proposal and instead focus on enhancing training to improve examiner skills to reduce the number of failures and losses to the NCUSIF. NCUA already continually seeks to enhance the training and skills of examiner staff within budget limitations. NCUA already performs analyses of all material losses to the NCUSIF, including material loss reviews prepared by NCUA's Inspector General on losses that exceed $25 million. The loss reviews include analyses of NCUA's and the State Supervisory Authorities' supervision of credit unions and include recommendations to addresses any weaknesses in related supervision policies and approaches. Additionally, not issuing a final rule would result in retention of the current risk-based net worth measure, which is not a comparable measure across financial institutions and contains risk-weights that are less closely associated with credit risk.

Moreover, the Board disagrees with commenters who suggested that credit unions should have less stringent regulatory capital standards than banks. The combined statutory requirement for a minimum net worth ratio and the risk-based capital requirement, supported by the supervision process, is the backbone of protection for both the credit union and bank insurance funds. In addition, prudent capital standards serve to protect taxpayers who ultimately must fund any reliance by the insurance funds on the full faith and credit of the United States.

Commenters claimed that the Second Proposal would place credit unions at a competitive disadvantage to banks by requiring credit unions to hold incrementally more capital than banks given similar asset-concentration levels. The net worth ratio, which is defined by statute, requires credit unions to hold more capital than banks are required to hold using the comparable Tier 1 leverage ratio for banks.

28

Congress

required NCUA to develop PCA regulations that are comparable to those of banks, including the risk-based net worth requirement for complex credit unions. The Board ensured compliance with the law while issuing the Second Proposal, which would not place credit unions at a competitive disadvantage to banks. The vast majority of risk weights for credit unions would be comparable to the risk weights for banks, and some risk weights for credit unions would actually be lower than the risk weights for banks. Because the Second Proposal generally used the same overall risk-based capital levels as banks, the differences in the individual elements of the calculation can be easily identified and understood. For example, the proposed risk weight for secured consumer loans, which represent about 20 percent of total assets for complex credit unions, is 25 basis points less than the corresponding risk weight for banks. The Second Proposal also would not cap credit unions' allowance for loan and lease losses at 1.25 percent of risk assets, while the Other Banking Agencies impose such a cap in the risk-based capital ratio calculation for banks. In the few instances where the risk weights are higher for credit unions, they apply to a very low percentage of total assets and are directly tied to sources of higher losses to the NCUSIF, primarily concentrations of real estate and business assets.

28

The net worth ratio and a bank's Tier 1 leverage ratio are both based on the total assets of the institution. Congress set the net worth ratio 200 basis points higher than the Tier 1 leverage ratio

level for banks due to the nature of the 1 percent NCUSIF deposit, the level of investment within the corporate credit union system, and credit unions' limited access to capital other than retained earnings. U.S. Department of Treasury,

Credit Unions

(1997).

The table below contains an estimate of how risk-weights generally compare between the risk-weights in this final rule to the risk-weights applied to FDIC insured institutions.

Sub-category as % of total assets

Category as % of total assets

Lower Risk Weight Than FDIC

Secured Consumer Loans

21.09%

More Conservative Risk Weight Than FDIC

First-Lien Real Estate Loans >35 percent of assets

1.19%

Junior-Lien Real Estate Loans >20 percent of assets

0.11%

Commercial Loans >50 percent of assets

0.13%

Non-Current Junior-Lien Real Estate Loans

0.02%

Unfunded Non-Commercial Loans

1.46%

2.91%

Not Directly Comparable to FDIC

CUSO Investments and Corporate Capital

0.34%

Comparable Risk Weight to FDIC

All Other Assets

75.66%

Commenters asserted that bank regulators are moving away from risk-based capital structures and referenced the FDIC Vice Chairman's related statements. The FDIC Vice Chairman, however, has favored higher generally accepted accounting principles (GAAP) equity ratios at banks of at least 10 percent of assets as an alternative to risk-based capital structures.

29

The NCUA Board lacks authority to impose higher GAAP equity-to-asset ratios because the FCUA specifically defines the net worth ratio for credit unions and sets forth the minimum ratio levels required. Moreover, the current statutory net worth ratio requirement, combined with a reasonable risk-based capital ratio requirement to address institutions taking higher levels of risk, provides a well targeted level of protection to the NCUSIF.

29

Thomas M. Hoening, American Banker,

The Safe Way to Give Traditional Banks Regulatory Relief,

(June 22, 2015),

available at https://www.fdic.gov/news/letters/reg-relief.html

.

The Board disagrees with commenters who suggested that the proposal would stifle growth, innovation, diversification, and member services. The commenters' suggested revisions to the proposal revealed there is clear disagreement among credit unions and other interested parties regarding how the proposal would have impacted factors such as growth, innovation, diversification, and member services at credit unions. This final rule better reflects each individual credit union's risk profile, provides for more active management of risk in relation to capital, further ensures individual credit unions can continue to serve as credit providers even during times of stress, and promotes the safety and soundness of the credit union system.

Commenters asserted that credit unions would need to charge higher interest rates, higher fees, and pay lower rates on deposits to raise capital because of the new risk-based capital measure. Credit unions, however, would have more than three years before the new risk-based capital requirement goes into effect. A credit union that determines it is in danger of having a risk-based capital ratio level below the required minimum level has the option of: Reducing the amount of risk-weighted assets it holds; raising additional capital, primarily through earnings; or both.

NCUA's analysis of credit union Call Report data indicates that the overwhelming majority of complex credit unions already have sufficient capital to comply with the proposed risk-based capital regulation. In particular, NCUA estimates that over 98 percent of complex credit unions would be in compliance with the regulatory capital minimums under the final rule if it were in effect today. The final rule is designed to ensure that these credit unions maintain their capacity to absorb losses in the future. A few credit unions, however, will likely want to take advantage of the three-year implementation period provided in this final rule to accumulate retained earnings, reduce their level of risk-assets, or both. As noted above, the overwhelming majority of credit unions have sufficient capital to comply with the revised capital rules, and the resulting improvements to the stability and resilience of the credit union

system outweigh any costs associated with its implementation.

In this final rule, the Board complied with the statutory requirement to take into account the cooperative character of credit unions in that they are not-for-profit, do not issue capital stock, must rely on retained earnings to build net worth, and have boards of directors that consist primarily of volunteers. To do this, the Board avoided undue complexity within the rule by, among other things, not implementing a complex conservation buffer requirement; establishing a simple and straightforward proxy for the definition of a complex credit union; reducing the number of asset concentration thresholds; and requiring only complex credit unions to have a written strategy for maintaining an appropriate level of capital.

Accordingly, and for the reasons discussed in more detail below, the Board is now adopting this final rule to revise NCUA's current regulations regarding PCA to require that complex credit unions taking certain risks hold capital commensurate with those risks.

II. Summary of the Final Rule

This final rule replaces the method currently used by complex credit unions to apply risk weights to their assets with a new risk-based capital ratio measure that is generally comparable to that applied to depository institutions worldwide. As discussed in more detail in the Legal Authority part of this preamble, the FCUA gives NCUA broad discretion in designing the risk-based net worth requirement applicable to complex credit unions. Accordingly, this final rule revises part 702 of NCUA's current regulations to establish a risk-based capital ratio measure that is the percentage of a credit union's capital available to cover losses, divided by the credit union's defined risk-weighted asset base.

This final rule adopts a broadened definition of capital to be used as the numerator in the new risk-based capital ratio measure. The Board is adopting 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 specifically available to cover losses and protect the NCUSIF. This broader definition of capital more accurately reflects the amount of capital that is actually available at a credit union to absorb losses.

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.”

30

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

31

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, the Board is required to account for any material risks in the risk-based requirement unless the risk is deemed

immaterial

because of the existence of another mechanism that the Board believes adequately accounts for the risk.

30

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

31

12 U.S.C. 1831o.

NCUA's risk-based net worth requirement has included some aspect of IRR since its inception in 2000. Further, 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. Based on long-term balance sheet trends at credit unions, the comments received on the Second Proposal, and NCUA's experiences dealing with problem institutions, however, the Board concluded that NCUA can adequately address IRR through its other regulations and supervisory processes. Accordingly, the final rule generally excludes IRR from NCUA's risk-based capital ratio calculation. But the Board may consider adopting additional regulatory or supervisory approaches for addressing IRR at credit unions if the need arises in the future.

With the removal of the IRR component from the current rule, this final rule narrows the list of risks accounted for in the denominator of the new risk-based capital ratio measure. The methodology for assigning risk weights in this final rule primarily accounts for credit risk and concentration risk.

This final rule incudes a tiered risk weight framework

32

for high concentrations of residential real estate loans and commercial loans

33

in NCUA's risk-based capital ratio measure. As a credit union's concentration in these asset classes increases, incrementally higher levels of capital are required. This approach addresses concentration risk as it relates to minimum required capital levels through a transparent, standardized, regulatory requirement. The concentration thresholds do not limit a credit union's lending activity; rather, the thresholds merely require the credit union to hold additional capital to account for the elevated concentration risk. The inclusion of concentration risk in the final rule does not put credit unions at a competitive disadvantage to banks because most real estate and member business loans (except for loans held in high concentrations) would still be assigned risk weights similar to those applicable to banks.

32

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.

33

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

Consistent with many commenters and 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 relied primarily on the risk weights assigned to various asset classes under the Basel Accords and the Other Banking Agencies' risk-based capital regulations for this final rule.

34

So this final rule provides for greater comparability to the Other Banking Agencies' risk weights than NCUA's current risk-based net worth regulation. The Board, however, has tailored the risk weights in this final rule for certain assets that are unique to credit unions or where a demonstrable and compelling case exists, based on contemporary and sustained performance differences, to differentiate for certain asset classes (such as consumer loans) between banks and credit unions, or where a provision of the FCUA requires doing so.

34

The Board has simplified certain aspects of this final 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

final rule. See the section-by-section analysis part of the preamble below for more details on the changes to the asset classes and risk weights.

35

The “look-through” approaches are discussed in more detail in the part of this preamble discussing § 702.104(c)(3)(iii)(B).

36

The “gross-up” approach is discussed in more detail in the part of this preamble discussing § 702.104(c)(3)(iii)(A).

37

Under § 702.104(c)(3)(i) of this final rule, a credit union has non-significant equity exposures if the aggregate amount of its equity exposures does not exceed 10 percent of the sum of the credit union's capital elements of the risk-based capital ratio numerator (as defined under paragraph § 702.104(b)(1)). To determine its aggregate amount of its equity exposures, the credit union must include the total amounts (as recorded on the statement of financial condition in accordance with GAAP) of the following (1) equity investments in CUSOs, (2) perpetual contributed capital at corporate credit unions, (3) nonperpetual capital at corporate credit unions, and (3) equity investments subject to a risk weight in excess of 100 percent.

Summary of the Risk Weights

0%

20%

50%

75%

100%

150%

250%

300%

400%

1250%

Cash/Currency/Coin

X

Investments:

Unconditional Claims—U.S. Government

X

Balances Due from Federal Reserve Banks

X

Federally Insured Deposits in Financial Institutions

X

Debt Instruments issued by NCUA and FDIC

X

Central Liquidity Facility Stock

X

Uninsured deposits at U.S. Federally Insured Institutions

X

Agency Obligations

X

FNMA and FHLMC pass through Mortgage Backed Securities (MBS)

X

General Obligation Bonds Issued by State or Political Subdivisions

X

Federal Home Loan Bank Stock and Balances

X

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

X

Revenue Bonds Issued by State or Political Subdivisions

X

Senior Non-Agency Residential MBS Structured

X

Corporate Membership Capital

X

c

Industrial Development Bonds

X

Agency Stripped MBS (Interest Only)

X

Part 703 Compliant Investment Funds

a

X

Value of General Account Insurance (bank owned life insurance, and credit union owned life insurance)

a

X

Corporate Perpetual Capital

X

c

X

c

Mortgage Servicing Assets

X

Separate Account Life Insurance

a

X

Publicly Traded Equity Investment (non-CUSO)

X

c

X

c

Mutual Funds Part 703 Non-Compliant

a

X

Non-Publicly Traded Equity Investments (non-CUSO)

X

c

X

c

Subordinated Tranche of Any Investment

b

X

Consumer Loans:

Share-Secured (shares held at the credit union)

X

Share-Secured (shares held at another depository institution)

X

Current Secured

X

Current Unsecured

X

Non-Current

X

Real Estate Loans:

Share-Secured (shares held at the credit union)

X

Share-Secured (shares held at another depository institution)

X

Current First Lien <35% of Assets

X

Current First Lien >35% of Assets

X

Not Current First Lien

X

Current Junior Lien <20% of Assets

X

Current Junior Lien >20% of Assets

X

Noncurrent Junior Lien

X

Commercial Loans:

Share-Secured (shares held at the credit union)

X

Share-Secured (shares held at another depository institution)

X

Portion of Commercial Loans with Compensating Balance

X

Commercial Loans <50% of Assets

X

Commercial Loans >50% of Assets

X

Non-current

X

Miscellaneous:

Loans to CUSOs

X

Equity Investment in CUSO

X

c

X

c

Other Balance Sheet Items not Assigned

X

a

With the option to use the look-through options.

35

b

With the option to use the gross-up approach.

36

c

If a credit union's total equity exposures are “non-significant”

37

under § 702.104(c)(3)(i), then the risk weight is 100 percent. This lowers the risk weight to 100 percent for CUSO equity exposures, corporate perpetual capital, and all other equity investments when they are part of a credit union's non-significant equity exposures.

The following table provides an estimate of the risk weighting for aggregate assets held by complex credit union assets as of December

31, 2014.

38

Includes off-balance sheet items after application of the credit conversion factor.

Risk weight

Complex credit union assets

(in millions)

38

Percent of complex credit union assets

Cumulative percent of complex credit union assets

0%

$18,713

1.82

1.82

20%

289,932

28.15

29.97

50%

224,618

21.81

51.78

75%

270,440

26.24

78.02

100%

217,159

21.08

99.01

150%

8,017

0.78

99.88

250% or greater

1,195

0.12

100.00

The following table compares on-balance sheet risk weights in this final rule to the applicable risk weights assigned by other federal banking agencies:

NCUA

Risk-weight

FDIC

Risk-weight

Cash/Currency/Coin

0%

0%

Investments:

Unconditional Claims—U.S. Government

0%

0%

Balances Due from Federal Reserve Banks

0%

0%

Federally Insured Deposits in Financial Institutions

0%

0%

Debt Instruments issued by NCUA and FDIC

0%

0%

Central Liquidity Facility Stock

0%

n/a

Uninsured deposits at U.S. Federally Insured Institutions

20%

20%

Agency Obligations

20%

20%

FNMA and FHLMC pass through Mortgage Backed Securities (MBS)

20%

20%

General Obligation Bonds Issued by State or Political Subdivisions

20%

20%

Federal Home Loan Bank Stock and Balances

20%

20%

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

20%

20%

Revenue Bonds Issued by State or Political Subdivisions

50%

50%

Senior Non-Agency Residential MBS Structured

50%

Gross-up or Simplified Supervisory Formula

Corporate Membership Capital

100%

n/a

Industrial Development Bonds

100%

100%

Agency Stripped MBS (Interest Only)

100%

100%

Part 703 Compliant Investment Funds

100%

a

n/a

Value of General Account Insurance (bank owned life insurance, and credit union owned life insurance)

a

100%

100%

Corporate Perpetual Capital

100%/150%

c

n/a

Mortgage Servicing Assets

250%

250%

Separate Account Life Insurance

300%

a

Look-through

Publicly Traded Equity Investment (non-CUSO)

100%/300%

c

300%

Mutual Funds Part 703 Non-Compliant

300%

a

n/a

Non-Publicly Traded Equity Investments (non-CUSO)

100%/400%

c

400%

Subordinated Tranche of Any Investment

1,250%

b

Gross-up or Simplified Supervisory Formula

Consumer Loans:

Share-Secured (shares held at the credit union)

0%

0%

Share-Secured (shares held at another depository institution)

20%

20%

Current Secured

75%

100%

Current Unsecured

100%

100%

Non-Current Consumer

150%

150%

Real Estate Loans:

Share-Secured (shares held at the credit union)

0%

0%

Share-Secured (shares held at another depository institution)

20%

20%

Current First Lien <35% of Assets

50%

50%

Current First Lien >35% of Assets

75%

50%

Not Current First Lien

100%

100%

Current Junior Lien <20% of Assets

100%

100%

Current Junior Lien >20% of Assets

150%

100%

Noncurrent Junior Lien

150%

100%

Commercial Loans:

Share-Secured (shares held at the credit union)

0%

0%

Share-Secured (shares held at another depository institution)

20%

20%

Portion of Commercial Loans with Compensating Balance

20%

n/a

Commercial Loans <50% of Assets

100%

100%/150%

d

Commercial Loans >50% of Assets

150%

100/150%

d

Non-current Commercial

150%

150%

Miscellaneous:

Loans to CUSOs

100%

100%

Equity Investment in CUSO

100%/150%

c

100%-600%

Other Balance Sheet Items not Assigned

100%

100%

a

With the option to use the look-through options.

b

With the option to use the gross-up approach.

c

If a credit union's total equity exposures are “non-significant” under § 702.104(c)(3)(i), then the risk weight is 100 percent. This lowers the risk weight to 100 percent for CUSO equity exposures, corporate perpetual capital, and all other equity investments when they are part of a credit union's non-significant equity exposures.

d

FDIC identifies certain commercial loans as High Volatility Commercial Real Estate (HVCRE) and assigns a 150% risk weight.

The Board notes that FDIC's capital standards are the “minimum capital requirements and overall capital adequacy standards for FDIC-supervised institutions . . . include[ing] methodologies for calculating minimum capital requirements . . . .”

39

In other words, FDIC may require an FDIC-supervised institution to hold an amount of regulatory capital greater than otherwise required under its capital rules if FDIC determines that the institution's capital requirements under its capital rules are not commensurate with the institution's credit, market, operational, or other risks.

40

39

See, e.g.,

12 CFR 324.1(a).

40

See, e.g.,

12 CFR 324.1(d).

As indicated above, FDIC's approach to risk weights is calibrated to be the minimum regulatory capital standard. Similarly, this final rule is calibrated to be the minimum regulatory capital standard. Accordingly, the final rule incorporates a broader regulatory provision reminding complex credit unions that, as a matter of safety and soundness, they are required to maintain capital commensurate with the level and nature of all risks to which they are exposed.

41

In addition, the final rule adds a new provision requiring complex credit unions to maintain a written strategy for assessing capital adequacy and maintaining an appropriate level of capital.

41

See, e.g.,

12 U.S.C. 1786.

Capital ratio thresholds are largely a function of risk weights; and this final rule more closely aligns NCUA's risk weights with those assigned by the Other Banking Agencies.

42

Accordingly, the final rule adopts a 10 percent risk-based capital ratio level for well capitalized credit unions, and an 8 percent risk-based capital ratio level for adequately capitalized credit unions. To take into account the cooperative character of credit unions, the Board set the risk-based capital ratio level for well capitalized credit unions at 10 percent, and omitted the capital conservation buffer imposed on banks.

43

The omission of the capital conservation buffer simplifies NCUA's risk-based capital requirement relative to the Other Banking Agencies' rules without appreciably lowering the protections provided by NCUA's risk-based capital regulations.

44

42

See, e.g.,

12 CFR 324.32;

and

12 CFR 324.403.

43

The “capital conservation buffer” is explained in more detail in the discussion on § 702.102(a) in the section-by-section analysis part of this preamble.

44

See, e.g.,

12 CFR 324.403.

The final rule defines a credit union as “complex” if it has assets of more than $100 million.

45

Credit unions meeting this threshold have a portfolio of assets and liabilities that is complex, based upon the products and services in which they are engaged. As discussed later in this document, the $100 million asset threshold is a proxy measure based on detailed analysis, and a clear demarcation line above which all credit unions engage in complex activities and where almost all such credit unions (99 percent) are involved in multiple complex activities.

45

There is no exemption for banks from the risk-based capital requirements of the other banking agencies. There are 1,872 FDIC-insured banks with assets less than $100 million as of December 2014.

An asset size threshold is clear, logical, and easy to administer when compared with the more complicated formula used to determine whether a credit union is complex under the current rule.

46

Using a more straightforward proxy for determining complexity also helps account for the cooperative character of credit unions, particularly, the fact that credit unions have boards of directors that consist primarily of volunteers. The $100 million asset size threshold exempts approximately 76 percent of credit unions

47

from many of the regulatory burdens associated with complying with this rule; yet it will cover almost 90 percent of the assets in the credit union system. The threshold is consistent with the fact that the majority of losses (as measured as a proportion of the total dollar cost) to the NCUSIF result from credit unions with assets greater than $100 million. For a more detailed discussion of the rationale the Board considered in defining complex, see the detailed discussion associated with section 702.103 in the Section-By-Section Analysis part of the preamble below.

46

12 CFR 702.106.

47

Based upon December 31, 2014 Call Report data.

In response to public comments received, the final rule also makes a number of changes to the Second Proposal. These changes include: Assigning a lower risk weight to non-significant equity exposures and certain share-secured loans; giving credit unions the option to assign a 100 percent risk weight to certain charitable donation accounts; permitting credit unions to use the gross-up approach for non-subordinated investment tranches; assigning principal-only mortgage-backed-security STRIPS a risk-weight based on the underlying collateral; extending the period during which credit unions can count supervisory goodwill and supervisory other intangible assets in the risk-based capital ratio numerator; and incorporating the text of the gross-up and look-through approaches into a new appendix A to the PCA regulation. As discussed in more detail below, for certain assets, these changes will lower the risk weights that would have been assigned under the Second Proposal, extend the period during which certain assets can be included in a credit union's risk-based capital ratio

numerator—effectively lowering certain credit unions' overall capital requirement for 10 years—and lower the impact of the rule for certain complex credit unions. The final rule also makes conforming and other minor changes to NCUA's regulations, which are also discussed in more detail below.

To provide credit unions and NCUA sufficient time to make the necessary adjustments, such as systems, processes, and procedures, and to reduce the burden on affected credit unions, the revisions adopted in this final rule will not become effective until January 1, 2019. This effective date is intended to coincide with the full phase-in of FDIC's risk-based capital measures in 2019.

III. Legal Authority

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

48

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

49

which requires the Board to maintain, by regulation, a system of PCA to restore the net worth of credit unions that become inadequately capitalized. Section 216(b)(1)(A) requires that NCUA's system of PCA for federally insured credit unions be “

consistent with

” section 216 of the FCUA, and “

comparable to

” section 38 of the Federal Deposit Insurance Act (FDI Act).

50

Section 216(b)(1)(B) requires that the Board, in designing the PCA system, take into account credit unions' cooperative character: 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.

51

In 2000, the Board first implemented the required system of PCA

52

and, prior to this rulemaking, had made only minor adjustments to the rule's original requirements.

53

48

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

49

12 U.S.C. 1790d.

50

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).

51

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

52

See

65 FR 8584 (Feb. 18, 2000);

and

65 FR 44950 (July 20, 2000) (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.)

53

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). 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).

The stated 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].”

54

To carry out that purpose, Congress set forth a basic structure for PCA in section 216 that consists of three principal components: (1) A statutory framework that requires certain mandatory classifications of credit unions and that NCUA take certain mandatory and discretionary actions against credit unions based on their classification; (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” that applies to credit unions that NCUA defines as “complex.” This final 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 final rule.

54

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

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

55

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

56

and a credit union's “net worth ratio”

57

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

58

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.

59

55

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

56

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

57

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

58

12 U.S.C. 1790d(o)(3).

59

12 U.S.C. 1790d(c)-(g);

and

12 CFR 702.204(a) & (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, “a risk-based net worth requirement

60

for insured credit unions that are complex, as defined by the Board . . . .”

61

Unlike the terms “net worth” and “net worth ratio,” which are specifically defined in section 216(o), the term “risk-based net worth” is not defined in the FCUA.

62

While Congress prescribed the net worth ratio requirement in detail in section 216, it elected not to define the term “risk-based net worth,” leaving the details of the risk-based net worth requirement to be filled in by the Board through the notice and comment rulemaking process. Section 216, when read as a whole, grants the Board broad authority to design reasonable PCA regulations, including a risk-based net worth requirement, so long as the regulations are comparable to the Other Banking Agencies' PCA requirements, are consistent with the requirements of section 216 of the FCUA, and take into account the cooperative character of credit unions.

60

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 unions. The term “risk-based capital ratio” is 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.

61

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

62

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.”).

Section 216(d)(1) of the FCUA directs NCUA, in determining which credit unions will be subject to the risk-based net worth requirement, to base its definition of complex “on the portfolios of assets and liabilities of credit unions.”

63

The statute does not require, as some commenters have argued, that the Board adopt a definition of “complex” that takes into account the portfolio of assets and liabilities of each credit union on an individualized basis. Rather, section 216(d)(1) authorizes the Board to develop a single definition of complex that takes into account the portfolios of assets and liabilities of all credit unions.

63

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

In addition, section 216(d)(2) specifies that 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)]

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 and the meaning of section 216(d)(2) by providing:

64

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

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.

65

65

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

As indicated by the language above, Congress intended the Board, in designing the risk-based net worth requirement, to address any risks that may not be adequately accounted for by the statutory 6 percent net worth ratio requirement. The legislative history is silent on why Congress chose to tie the provision in section 216(d)(2) to the statutory 6 percent net worth ratio requirement for adequately capitalized credit unions and not the 7 percent net worth ratio requirement for well capitalized credit unions.

Section 216(c) of the FCUA provides that, if a credit union meets the definition of “complex” and it meets or exceeds the net worth ratio requirement to be classified as either adequately capitalized or well capitalized, the credit union must also satisfy the corresponding risk-based net worth requirement to be classified as either adequately capitalized or well capitalized.

66

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

67

For example, a complex credit union must meet or exceed both the applicable net worth ratio requirement and the applicable risk-based net worth requirement to be classified as well capitalized. If the credit union fails to meet either requirement, it is classified in the lowest category for which it meets both the net worth ratio requirement and the risk-based net worth requirement.

66

See

12 U.S.C. 1790d(c)(1)(A) & (c)(1)(B).

67

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) & (c)(1)(B)(ii).

If a 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 minimum risk-based net worth requirement to be adequately capitalized, then the credit union's capital classification is “undercapitalized” based on the risk-based net worth requirement. Similarly, if a complex credit union's net worth ratio meets or exceeds the requirement that corresponds to the well capitalized category, but its risk-based net worth ratio meets only the requirement that corresponds with the adequately capitalized capital category, then that credit union's capital classification is adequately capitalized. In either case, the credit union is subject to the mandatory supervisory and discretionary supervisory actions applicable to its capital classification category.

68

68

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

In response to the Second Proposal, a significant number of commenters questioned the Board's legal authority to impose a risk-based net worth requirement on both well capitalized and adequately capitalized credit unions. As also discussed in the Section-by-Section part of the preamble below, the commenters' selective reading of section 216 of the FCUA is a misinterpretation. NCUA is legally authorized to impose a risk-based net worth requirement on both well capitalized and adequately capitalized credit unions 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)(A)(ii) provides that a credit union must meet

any

applicable risk-based net worth requirement under section 216(d) of this section to be classified as well capitalized. The plain language of sections 216(c)(1)(A)(ii) and (c)(1)(B)(ii),, read in conjunction with the language in section 216(d), indicates Congress' intent to authorize the Board to impose risk-based net worth requirements on both well capitalized and adequately capitalized credit unions.

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).

69

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.”

70

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.

71

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 that may not be addressed adequately through the statutory 6 percent

net worth ratio

required for a credit union to be adequately capitalized.

72

69

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

70

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

71

12 U.S.C. 1790d(c)(1)(B).

72

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 should 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, that Congress's use of the term “adequately capitalized” in section 216(d)(2) somehow limits the Board's authority to require that complex credit unions maintain a higher risk-based capital ratio level to be classified as well capitalized. Rather than prohibiting the Board from imposing a higher risk-based capital ratio level for credit unions to be classified as well capitalized, section 216(d)(2) simply requires that the Board design the risk-based net worth requirement to take into account those risks that may not adequately be addressed by the statute's six percent

net worth ratio

requirement. Thus, the plain language of section 216(d) does not support those commenters' interpretation.

The Board's 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.

73

Some commenters have argued that Congress's use of the singular noun “requirement” in Section 216(d) of the FCUA indicates its intent that there be only one risk-based net worth ration level tied to the adequately capitalized level. Section 38(c)(1)(A) of the FDI Act, upon which section 216 of the FCUA was modeled,

74

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

requirement.

”

75

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. Moreover, the United States Code addresses the singular—plural question in its rules of statutory construction: “In determining the meaning of any Act of Congress, unless the context indicates otherwise . . . words importing the singular include and apply to several persons, parties, or things; words importing the plural include the singular . . .”

76

Therefore, setting different risk-based capital ratio levels for credit unions to be adequately and well capitalized, is consistent with the requirements of section 216 of the FCUA and is “comparable” to the Other Banking Agencies' PCA regulations.

73

See

12 U.S.C. 1831o,

and, e.g.,

12 CFR 324.403(b).

74

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.”).

75

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

76

1 U.S.C. 1.

As explained in the Second Proposal, the FCUA requires NCUA to establish a risk-based capital system that is comparable to that in place for FDIC insured banks,

and

to take into account the cooperative character of credit unions. Some commenters criticized, however, that the Second Proposal took into account only the comparability requirement, and ignored the requirement to take into consideration the cooperative nature of credit unions. In support of their assertion, the commenters suggested that, because of their unique cooperative structure, strong member focus, and the absence of stock options for executives or pressure from stockholders, credit unions eschew excessive risk taking. The commenters suggested further, that in the face of the 2007-2009 financial crisis, credit unions—unlike their counterparts in the for-profit banking sector—served as both a counter-cyclical force and a safe haven, with much stronger loan and deposit growth than banking institutions. Accordingly, many commenters suggested that the Board, to take into account the cooperative character of credit unions, must impose risk-based capital requirements that are equal to or lower than the standards applicable to banks.

The Board disagrees with the claim that NCUA failed to take into account the cooperative character of credit unions in designing the risk-based capital requirement. In the Original Proposal, which varied to a greater degree from the Other Banking Agencies' capital regulations than the Second Proposal, the Board proposed a significant number of alternative provisions, many of which were specifically intended to take into account the cooperative character of credit unions. The overwhelming response from credit unions in relation to that proposed approach, however, was to recommend that the Board revise the proposal to be more like the capital requirements adopted by the Other Banking Agencies to avoid putting credit unions at a competitive disadvantage to banks. As discussed in more detail below, the Board generally agreed with commenters' recommendations in that regard, and designed the Second Proposal to be more like the Other Banking Agencies' capital regulations. In the preamble to the Second Proposal, however, the Board specifically discussed ways in which the proposal continued to deviate from the Other Banking Agencies' capital requirements to take into account the cooperative character of credit unions. Furthermore, while it may generally be true that “credit unions eschew excessive risk taking,” as suggested by some commenters, that fact alone does not support assigning lower risk weights to credit union assets, or requiring that credit unions meet lower risk-based capital ratio levels to be adequately or well capitalized. To the contrary, for reasons explained in more detail below, a credit union that eschews excessive risk taking should have no trouble maintaining a high risk-based capital ratio level under this final rule.

At least one commenter also suggested that credit unions' reliance primarily on retained earnings to build capital and operate make their operational structures both unique and challenging. Thus, the commenter concluded that, by requiring a higher risk-based capital ratio level for well capitalized credit unions, the Second Proposal failed to take these factors into consideration, as required by section 216(b)(1)(B) of the FCUA. The Board disagrees. Credit unions' limited access to supplemental forms of capital and reliance primarily on retained earnings for building capital suggests, if anything, that requiring credit unions to maintain higher levels of capital is appropriate. In a financial downturn, the retained earnings of a financial institution are likely to decrease. Under such circumstances, an institution with limited access to other alternative forms of capital needs a higher level of capital on hand to ensure its survival. In the case of NCUA's capital requirements, that higher level of capital is already required under the statutory net worth ratio requirement, which requires credit unions maintain higher leverage (net worth) ratios than banks. Accordingly, consistent with the Second Proposal, the risk-based capital ratio levels adopted in this final rule for adequately and well capitalized credit unions are designed to be generally equivalent to the corresponding risk-based capital ratio levels required for banks.

IV. Section-by-Section Analysis

Part 702—Capital Adequacy

Revised Structure of Part 702

Consistent with the Second Proposal, this final rule reorganizes part 702 by consolidating NCUA's PCA requirements, which are currently included under subsections A, B, C, and D, under new subparts A and B. New subpart A is titled “Prompt Corrective Action” and new subpart B is titled “Alternative Prompt Corrective Action for New Credit Unions.” The reorganization is designed so that a credit union need only reference the subpart that applies to its institution, rather than having to flip back-and-forth between multiple subparts in part 702 to identify the applicable minimum capital standards and PCA regulations. Consolidating these sections reduces confusion and will save credit union staff from having to frequently flip back and forth through the four subparts of the current PCA rule.

In general, this final rule restructures part 702 by consolidating most of the sections relating to capital and PCA that are applicable to only credit unions that are not “new” under new subpart A. The specific sections that would be included in new subpart A and the changes to those sections are discussed in more detail below.

Similarly, this final rule consolidates most of NCUA's rules relating to alternative capital and PCA requirements for “new” credit unions under new subpart B. The sections under new subpart B remain largely unchanged from the requirements of current part 702 relating to alternative capital and PCA, except for revisions to the sections relating to reserves and the payment of dividends. The specific sections included in new subpart B and the specific changes to the sections are discussed in more detail below.

Finally, this final rule retains subpart E of part 702, Stress Testing, but re-designates and re-numbers the current subpart as subpart C. Other than re-designating and re-numbering the subpart, the language and requirements of current subpart E are unchanged by this final rule.

Section 702.1 Authority, Purpose, Scope, and Other Supervisory Authority

Consistent with the Proposal, § 702.1 of the final rule remains substantially similar to current § 702.1, but is amended to update terminology and internal cross references within the section, consistent with the changes that are being made in other sections of part 702. No substantive changes to the section are intended.

Section 216(b)(1) of the FCUA requires the Board to adopt by regulation a system of PCA for insured credit unions that is “comparable to” the system of PCA prescribed in the FDI Act, that is also “consistent” with the requirements of section 216 of the FCUA, and that takes into account the cooperative character of credit unions.

77

Paragraph (d)(1) of the same section requires that NCUA's system of PCA include “a risk-based net worth requirement for insured credit unions that are complex . . .” When read together, these sections grant the Board broad authority to design reasonable risk-based capital regulations to carry out the stated purpose of section 216, which is to “resolve the problems of [federally] insured credit unions at the least possible long-term loss to the [National Credit Union Share Insurance] Fund.”

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As explained in more detail below, this final rule is comparable, although not identical in detail, to the PCA and risk-based capital requirements for banks. In addition, as explained throughout the preamble to this final rule, this rule deviates from the PCA and risk-based capital requirements applicable to banks as required by section 216 of the FCUA, and to take into account the cooperative character of credit unions. Accordingly, the revised risk-based net worth requirement and this final rule are consistent with section 216 of the FCUA.

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

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

Section 702.2—Definitions

The Second Proposal would have removed the paragraph numbers assigned to each of the definitions under current § 702.2 and would have reorganized the section so the new and existing definitions were listed in alphabetic order. Many of the definitions in current § 702.2 were retained, however, with no substantive changes. The reorganization of the section and the removal of the paragraph numbering made proposed § 702.2 more consistent with current §§ 700.2, 703.2 and 704.2 of NCUA's regulations.

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In addition, proposed § 702.2 included a number of new definitions, and would have amended some of the definitions in current § 702.2.

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12 CFR 700.2; 12 CFR 703.2;

and

12 CFR 704.2.

Consistent with section 202 of the FCUA,

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the Second Proposal also incorporated the phrase `in accordance with GAAP' into many of the definitions to clarify that generally accepted accounting principles must be used determine how an item is recorded on the statement of financial condition from which it would be incorporated into the risk-based capital calculation. This proposed change was intended to help clarify the meaning of terms used in the Second Proposal.

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12 U.S.C. 1782(a)(6)(C)(i).

The Board received no comments on the proposed technical changes to § 702.2. The Board did, however, receive one general comment on the definitions section: At least one commenter stated that the revisions to the definitions, particularly those that now rely on GAAP definitions, seemed fair and reasonable. At least one commenter also suggested that the proposed changes to the definitions were all for the better and made the rule much clearer. The Board agrees with the commenters and has decided to retain the changes described above in this final rule.

The following definitions, consistent with the Second Proposal, are also added to, amended in, or removed from § 702.2 by this final rule:

Allowances for loan and lease losses (ALLL).

The Second Proposal defined the term “allowances for loan and lease losses” as valuation allowances that have been established through a charge against earnings to cover estimated credit losses on loans, lease financing receivables or other extensions of credit as determined in accordance with GAAP.

The Board received no comments on the proposed definition and has decided to retain the definition in this final rule without change.

Amortized cost.

The Second Proposal defined the term “amortized cost” as the purchase price of a security adjusted for amortizations of premium or accretion of discount if the security was purchased at other than par or face value.

The Board received no comments on the proposed definition and has decided to retain the definition in this final rule without change.

Appropriate regional director.

The Second Proposal would have amended current § 702.2 to remove the definition of the term “appropriate regional director” from the current rule.

The Board received no comments on this proposed revision and has decided to retain the revision in this final rule without change.

Appropriate state official.

Under the Second Proposal, the Board proposed revising the definition of the term “appropriate state official” by adding the italicized words (“state” and “the”) to the current definition, and by removing the words “chartered by the state which chartered the affected credit union.” The revised definition would have provided that the term “appropriate state official” means the state commission, board or other supervisory authority having jurisdiction over the credit union.

Public Comments on the Second Proposal

One commenter suggested that, although the proposed revision to the definition was meant to provide clarity, it might obfuscate the role of state supervisors in the PCA process because several states could have “jurisdiction” over a given credit union on a particular issue. In contemplating the possible effects of the proposed revision, the commenter asked a number of questions: Will NCUA consult with all state regulators where an affected credit union has a branch or member when taking discretionary supervisory action?

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Will a credit union have to obtain approval from all states that it operates in before issuing dividends when less than adequately capitalized?

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The commenter suggested further that while timely sharing of information across all

affected regulators was a laudable goal, crucial and time sensitive decisions regarding the reclassification or conservatorship of a credit union should be made by only the primary chartering authority of the institution in consultation with the deposit insurer. Accordingly, the commenter recommended that the Board should amend this definition to read “the state commission, board or other supervisory authority which chartered the affected credit union.”

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12 CFR 702.110(c).

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12 CFR 702.114(b).

Discussion

The Board generally agrees with the commenter and is adopting the proposed revisions to the definition of “appropriate state official” by making the following changes: At the end of the proposed the definition, the final rule deletes the words “having jurisdiction over the” from the proposed definition, and adds in their place the words “that chartered the affected.” This change clarifies that NCUA must consult with only the state authority that chartered the credit union; not every state agency having some form of jurisdiction over the credit union.

Accordingly, the final rule defines “appropriate state official” as the state commission, board or other supervisory authority that chartered the affected credit union.

Call Report.

The Second Proposal defined the term “Call Report” as the Call Report required to be filed by all credit unions under § 741.6(a)(2).

The Board received no comments on the definition and has decided to retain the proposed definition in this final rule without change.

Carrying value.

The Second Proposal defined the term “carrying value,” with respect to an asset, as the value of the asset on the statement of financial condition of the credit union, determined in accordance with GAAP.

The Board received no comments on the proposed definition, but is clarifying in this final rule that “carrying value” applies to both assets and liabilities. Accordingly, this final rule defines “carrying value” as the value of the asset or liability on the statement of financial condition of the credit union, determined in accordance with GAAP.

Central counterparty (CCP).

The Second Proposal defined the term “central counterparty” as a counterparty (for example, a clearing house) that facilitates trades between counterparties in one or more financial markets by either guaranteeing trades or novating contracts.

The Board received no comments on the definition and has decided to retain the proposed definition in this final rule without change.

Charitable donation account.

The Second Proposal did not use or define the term “charitable donation account.” Under the proposal, such accounts, which federal credit unions are authorized to establish under § 721.3(b)(2) of NCUA's regulations, would have been assigned a risk weight based on the risk-weight of each individual asset type in the account.

Public Comments on the Second Proposal

NCUA received several comments regarding the risk weights assigned to charitable donation accounts under the Second Proposal. Commenters suggested that the proposed risk weights assigned to charitable donation accounts would contravene the appeal for credit unions to put money into these investments to fund charitable activities. The commenters pointed out that the risk-based capital regulation from the Office of the Comptroller of the Currency (OCC) recognizes the importance of community development investments and assigns a risk weight of 100 percent to such assets. Commenters suggested that the NCUA Board should adopt a similar approach to encourage charitable donation accounts to support charitable goals and purposes.

Discussion

The Board generally agrees with the commenters and, as also discussed in the part of the preamble associated with § 702.104(c), has decided to assign a 100 percent risk weight to certain charitable donation accounts under this final rule, at the credit union's option. Under the Second Proposal, the assets held in a charitable donation account were each assigned a risk weight based on each individual asset type in the account. After reviewing the comments received, however, the Board generally agrees with commenters who suggested that charitable donation account equity exposures, which are held at credit unions, have a role analogous to community development equity exposures, which are held at banks, and therefore warrant assigning such accounts an equivalent risk weight. Community development equity exposures are assigned a 100 percent risk weight under the Other Banking Agencies' regulations. Thus, this final rule gives credit unions the option for risk weighting charitable donation accounts in a manner that is generally equivalent to the Other Banking Agencies' 100 percent risk weight for community development investment equity exposures. Under this final rule, a credit union has the option of applying risk weights to the individual assets within a charitable donation account, or just applying a 100 percent risk weight to the whole charitable donation account. A credit union cannot, however, use a combination of the two methods described to assign a risk weight to the same charitable donation account.

In defining “charitable donation account,” the Board chose to limit the types of accounts that would qualify for the 100 percent risk weight. In particular, the Board chose allow such treatment for accounts only if they met certain restrictions in 12 CFR 721.3(b)(2)(i), (b)(2)(ii), and (b)(2)(v). Thus, to qualify for the optional 100 percent risk weight under § 702.104(c)(3)(ii) of this final rule, an account must meet the following criteria:

• The book value of the credit union's investments in all charitable donation accounts (CDAs), in the aggregate, as carried on its statement of financial condition prepared in accordance with generally accepted accounting principles, must be limited to 5 percent of the credit union's net worth at all times for the duration of the accounts, as measured every quarterly Call Report cycle. This means that regardless of how many CDAs the credit union invests in, the combined book value of all such investments must not exceed 5 percent of its net worth. The credit union must bring its aggregate accounts into compliance with the maximum aggregate funding limit within 30 days of any breach of this limit.

• The assets of a charitable donation account must be held in a segregated custodial account or special purpose entity and must be specifically identified as a charitable donation account.

• The credit union is required to distribute to one or more qualified charities, no less frequently than every 5 years, and upon termination of a charitable donation account regardless of the length of its term, a minimum of 51 percent of the account's total return on assets over the period of up to 5 years. Other than upon termination, the credit union may choose how frequently charitable donation account distributions to charity will be made during each period of up to 5 years. For example, the credit union may choose to make periodic distributions over a period of up to 5 years, or only a single distribution as required at the end of that period. The credit union may choose to donate in excess of the minimum distribution frequency and amount;

The three criteria above are included in the definition of charitable donation account to ensure that such accounts, if assigned a 100 percent risk weight, will be used primarily for charitable purposes and not present a material risk to a credit union regardless of the types of assets held in the accounts. The definition includes a 5 percent of net worth limit on charitable donation accounts to reflect an amount that allows a credit union to generate income for the charity while ensuring any risks associated with such accounts do not pose safety and soundness issues. In determining the 5 percent of net worth limit, the Board considered the investment types a credit union could purchase in a charitable donation account, which can include investments with significant credit risk. The Board determined that a 5 percent of net worth limit was reasonable given NCUA's charitable donation account regulations and necessary to ensure that the accounts were small enough to not pose a safety and soundness issue to the NCUSIF if assigned a 100 percent risk weight.

The definition also specifies that charitable donation accounts must be held in segregated custodial accounts or special purpose entities, and must be specifically identified as charitable donation accounts, to ensure holdings can be measured for exposure and monitored for performance and distribution. The Board determined the segregation of accounts is necessary to ensure a credit union and NCUA could measure compliance with the net worth and distribution criteria, consistent with safety and soundness and the account's purpose.

Finally, the definition specifies that distributions must be made in a particular manner to ensure such accounts are used primarily for charitable giving. By specifying the distribution manner, the definition of charitable donation account ensures that the account will primarily be used for charitable giving. This distinction is generally consistent with the Other Banking Agencies' regulations, which assign a 100 percent risk-weight to community development investment equity exposures.

Without each of the three criteria discussed above, a charitable donation account would primarily be an investment vehicle for a credit union and could present a material risk to the credit union and the NCUSIF. Accordingly, this final rule defines “charitable donation account” as an account that satisfies all of the conditions in 12 CFR 721.3(b)(2)(i), (b)(2)(ii), and (b)(2)(v).

Commercial loan.

The Second Proposal defined the new term “commercial loan” as any loan, line of credit, or letter of credit (including any unfunded commitments) to individuals, sole proprietorships, partnerships, corporations, or other business enterprises for commercial, industrial, and professional purposes, but not for investment or personal expenditure purposes. The definition would have also provided that the term commercial loan excludes loans to CUSOs, first- or junior-lien residential real estate loans, and consumer loans.

Public Comments on the Second Proposal

The Board received many comments regarding the proposed new term “commercial loan” and its definition. Several commenters agreed with creating a category of “commercial loans” as distinct from traditional member business loans for purposes of the risk-based capital ratio requirement. At least one commenter stated that, while differentiating between “commercial loans” for risk-based capital purposes and “member-business loans” as defined for lending purposes is appropriate, the subtle differences in these definitions may cause confusion. Similarly, another commenter suggested that even though it would require changes to the call report and how credit union classify these loans, the Board was right to use the broader definition of commercial loans in the proposal because there is no difference in the credit risk of member business loans and commercial loans.

Conversely, other commenters suggested that replacing the term “member business loan,” which credit unions and NCUA's regulations already use, with the new term “commercial loan” for purposes of the risk-based capital regulation would cause unnecessary confusion. Other commenters suggested that the proposed definition of “commercial loan” should be revised to be consistent with the definition of “member business loan” in part 723 of NCUA's regulations because they believed the differences between the two definitions were immaterial to a credit union's capital requirement, but would add unnecessary administrative burden to the Call Report.

In addition, a trade association commenter pointed out that the proposed definition of a “commercial loan” specifies that it is a loan “to individuals, sole proprietorships, partnerships, corporations, or other business enterprises,” and explicitly excludes loans to CUSOs, first- or junior-lien residential real estate loans, and consumer loans. The commenter pointed out, however, that the preamble to the Second Proposal seemed to indicate that whether or not a loan is “commercial” will be based exclusively on the purpose of the loan, use of the proceeds, and type of collateral. The Commenter suggested that if a loan can be considered commercial regardless of the type of borrower, the Board should consider removing the list of potential borrowers and simply retaining the exclusions of specific loan types. The commenter suggested further that the proposal specified that a commercial loan is a loan made for “commercial, industrial, and professional purposes, but not for investment or personal expenditure purposes.” But, under part 723 of NCUA's regulations, MBLs are made for commercial, corporate, other business investment property or venture, or agricultural purposes.

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The commenter recommending clarifying the alignment of these two definitions in the final rule, and that if the only intended differences in treatment arise from the definitions of loans to CUSOs, first- or junior-lien residential real estate loans, and consumer loans, then the Board should consider adopting the member business loan language and retaining those explicit exclusions. At least one commenter also pointed out that current § 723.1(d) and (e) of NCUA's member business lending regulations reference treatment of purchased member and non-member loans and loan participations for risk-weight purposes under part 702, and encouraged the Board to review those sections for consistency with the proposed definition of commercial loan. Another commenter requested that the Board clarify whether the definition of “commercial loans” includes loans to non-profits. One state supervisory authority commenter requested clarification on whether the definition, which lists a number of specific asset types, would include agricultural loans.

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12 CFR 723.1(a).

Discussion

As stated in the Second Proposal, the new term “commercial loan” and its proposed definition more accurately capture the risks these loans present than the term MBL, and better identifies loans that are made for a commercial purpose and have similar risk characteristics. While there could be some initial confusion associated with the use of this new term, the Board notes that such confusion can be addressed during the implementation period and in guidance before the final rule becomes effective in 2019.

Guidance contained in the Call Report for the proper reporting of commercial loans will also provide information to credit unions to ensure proper reporting of both “commercial” loans for the purpose of assigning risk weights and the reporting of MBLs for the purpose of monitoring compliance with the statutory limit.

The Board agrees, however, with commenters who suggested that the purpose of a loan determine its classification as a “commercial” loan. The risks associated with a commercial loan are related to its purpose. Moreover, the proposed list of entities that could have received the loans encompassed all possibilities, including non-profit organizations. Thus the removal of the list of parties who could receive the loans would be inconsequential. Accordingly, the Board is amending the definition of “commercial loan” to remove the words “to individuals, sole proprietorships, partnerships, corporations, or other business enterprises.”

The Board maintains, however, that the listing of commercial purposes in the proposed definition was adequate and plainly included agricultural loans if they are granted for a commercial or industrial purpose. Similarly, it is clear that a loan purchased by a credit union, which was made for a commercial purpose, was also included within the proposed definition of a commercial loan, whether it is a loan to member or non-member. Thus no additional changes to the definition are necessary.

Accordingly, this final rule defines “commercial loan” as any loan, line of credit, or letter of credit (including any unfunded commitments) for commercial, industrial, and professional purposes, but not for investment or personal expenditure purposes. The definition provides further that the term commercial loan excludes loans to CUSOs, first- or junior-lien residential real estate loans, and consumer loans.

Commitment.

The Second Proposal defined the term “commitment” as any legally binding arrangement that obligates the credit union to extend credit, to purchase or sell assets, or enter into a financial transaction.

The Board received no comments on the proposed definition, but has decided to clarify in this final rule that a “commitment” can also refer to funding transactions. Accordingly, this final rule would define “commitment” as any legally binding arrangement that obligates the credit union to extend credit, purchase or sell assets, enter into a borrowing agreement, or enter into a financial transaction.

Consumer loan.

The Second Proposal defined the term “consumer loan” as a loan to one or more individuals for household, family, or other personal expenditures, including any loans secured by vehicles generally manufactured for personal, family, or household use regardless of the purpose of the loan. The proposed definition would have provided further that the term consumer loan excludes commercial loans, loans to CUSOs, first- and junior-lien residential real estate loans, and loans for the purchase of fleet vehicles.

Public Comments on the Second Proposal

The proposed definition of “consumer loan” referenced loans “to one or more individuals . . . including any loans secured by vehicles generally manufactured for personal, family, or household use regardless of the purpose of the loan.” At least one commenter requested that the Board clarify whether the same loan would still be considered a consumer loan if made to an incorporated entity. If the definition is not dependent on the type of borrower, the commenter suggested that the words “one or more individuals” were not necessary. The commenter also requested that the Board clarify the definition of a loan “for the purchase of fleet vehicles,” and, to maximize ease of compliance, recommended the Board incorporate the definition of “fleet” contained in a 2012 NCUA legal opinion directly into the definition.

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84

NCUA,

Definition of Fleet,

Legal Opinion Letter 12-0764 (Sept. 13, 2012),

available at

http://www.ncua.gov/Legal/Pages/OL2012-12-0764.aspx

.

Discussion

The Board agrees with the commenter who suggested that a consumer loan should be defined by the purpose of the loan and not depend on the type of entity receiving the loan, be it an individual, corporation, or some other business. The material risks associated with holding a prudently underwritten consumer loan are related to its purpose, not on the type of borrower. Accordingly, this final rule amends the proposed definition of consumer loan to remove the words “to one or more individuals” from the definition.

The Board also generally agrees with the commenter who suggested the final rule should further clarify the reference to “fleet vehicles” in the proposed definition of consumer loans. As pointed out by the commenter, NCUA's General Counsel issued a legal opinion letter in 2012 that interprets the term “fleet” for purposes of § 723.7(e) of NCUA's regulations.

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The letter provides that a fleet means “five or more vehicles that are centrally controlled and used for a business purpose, including for the purpose of transporting persons or property for commission or hire.” The meaning of the term “fleet,” as used in the proposed definition of consumer loan, should be consistent with the use of the term in § 723.7(e). While the Second Proposal did not propose adopting the definition of “fleet” provided in the 2012 legal opinion letter, the term should have the same meaning. The term does not need to be defined in this final rule. Future changes in market realities surrounding the use of the term “fleet” make adopting a fixed definition of the term impractical. The Board agrees, however, that revising the proposed use of the term “fleet” in the definition of consumer loan to be more consistent with the use of the term fleet in § 723.7(e) will help avoid confusion regarding the term's meaning. Accordingly, the final rule revises the last clause in the second sentence of the definition of the term “consumer loan” to provide, “and loans for the purchase of one for more vehicles to be part of a fleet of vehicles.”

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NCUA,

Definition of Fleet,

Legal Opinion Letter 12-0764 (Sept. 13, 2012),

available at http://www.ncua.gov/Legal/Pages/OL2012-12-0764.aspx

.

NCUA will provide separate examiner guidance on the application of the definition of consumer loans to ensure consistent interpretation of the definition in the future. NCUA's Call Report instructions will also contain appropriate guidance for the proper reporting of consumer loans. For the reasons discussed above, this final rule defines the term “consumer loan” as a loan for household, family, or other personal expenditures, including any loans that, at origination, are wholly or substantially secured by vehicles generally manufactured for personal, family, or household use regardless of the purpose of the loan. The definition provides further that the term consumer loan excludes commercial loans, loans to CUSOs, first- and junior-lien residential real estate loans, and loans for the purchase of one or more vehicles to be part of a fleet of vehicles.

Contractual compensating balance.

The Second Proposal defined the term “contractual compensating balance” as the funds a commercial loan borrower must maintain on deposit at the lender credit union as security for the loan in accordance with the loan agreement, subject to a proper account hold and on deposit as of the measurement date.

The Board received no comments on the definition and has decided to retain the proposed definition in this final rule without change.

Credit conversion factor (CCF).

The Second Proposal defined the term “credit conversion factor” as the percentage used to assign a credit exposure equivalent amount for selected off-balance sheet accounts.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Credit union.

The Second Proposal defined the term “credit union” as a federally insured, natural-person credit union, whether federally or state-chartered. The proposal would have amended the current definition of the term “credit union” to remove the words “as defined by 12 U.S.C. 1752(6)” from the end of the definition because they were unnecessary, and could mistakenly be read to limit the definition of “credit unions” to state-chartered credit unions.

The Board received no comments on the proposed revisions to the definition of “credit union” and has decided to retain the proposed definition in this final rule without change.

Current.

The Second Proposal defined the term “current,” with respect to any loan, as less than 90 days past due, not placed on non-accrual status, and not restructured.

Public Comments on the Second Proposal

The Board received only a small number of comments on the proposed definition of the term “current.” Most commenters who mentioned it supported the proposed definition of “current.” One credit union commenter, however, suggested that the Board should define “current” as loans that are 60 days past due, which was the period provided in the Original Proposal, because expanding the delinquency loans to 90 days has more risk and greater exposer to potential loss. Another commenter recommended that the definition of “current” be revised so it does not automatically exclude all restructured loans. Another commenter argued that while it is understandable to require a higher risk-weighting for non-current loans, lumping restructured loans into this same category and treatment would be punitive. The commenter suggested that the definition of “restructured loans” be amended to specifically address loans that the commenter referred to as “troubled debt relief assets,” which are loans that have been modified because of financial hardship in the face of some type of credit impairment. According to the commenter, the Financial Accounting Standards Board already requires excess reserves be held for these assets based on the difference between the net present value of the loans under the original terms versus the modified terms. The commenter contended that credit unions currently hold reserves of over 10 percent against loans that are performing and have very low incidents of future default. Therefore, the commenter concluded, treating a “troubled debt relief asset” as a non-current loan would not reflect the fact that a modification has been made to a loan and it is performing. The commenter suggested that such restructurings aid the future performance of such loans.

Discussion

The Board believes that the proposed definition of “current” is consistent with § 741.3(b)(2), which specifies that a credit union's written lending policies must include “loan workout arrangements and nonaccrual standards that include the discontinuance of interest accrual on loans past due by 90 days or more,” and aligns well with the definition of “current loan” under the Other Banking Agencies' regulations.

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In general, loans that are more than 90 days past due, or restructured, tend to have higher incidences of default resulting in losses. The proposed definition is consistent with the definition used under the Other Banking Agencies' risk-based capital rules and is not dependent upon, nor contradictory to, related accounting pronouncements. Additional guidance will be provided to credit unions in the future regarding reporting troubled debt restructuring (TDR) loans through supervisory guidance and in the instructions on the Call Report. Accordingly, the Board has decided to retain the proposed definition in this final rule without change.

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See, e.g.,

12 CFR 324.32(k).

CUSO.

The Second Proposal defined the term “CUSO” as a credit union service organization as defined in parts 712 and 741.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Custodian.

The Second Proposal defined the term “custodian” as a financial institution that has legal custody of collateral as part of a qualifying master netting agreement, clearing agreement or other financial agreement.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Depository institution.

The Second Proposal defined the term “depository institution” as a financial institution that engages in the business of providing financial services; that is recognized as a bank or a credit union by the supervisory or monetary authorities of the country of its incorporation and the country of its principal banking operations; that receives deposits to a substantial extent in the regular course of business; and that has the power to accept demand deposits. The definition provided further that the term depository institution includes all federally insured offices of commercial banks, mutual and stock savings banks, savings or building and loan associations (stock and mutual), cooperative banks, credit unions and international banking facilities of domestic depository institutions, and all privately insured state-chartered credit unions.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Derivatives Clearing Organization (DCO).

The Second Proposal defined the term “Derivatives Clearing Organization (DCO)” as having the same definition as provided by the Commodity Futures Trading Commission in 17 CFR 1.3(d).

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Derivative contract.

The Second Proposal defined the term “derivative contract” as a financial contract whose value is derived from the values of one or more underlying assets, reference rates, or indices of asset values or reference rates. The definition provided further that the term derivative contract includes interest rate derivative contracts, exchange rate derivative contracts, equity derivative contracts, commodity derivative contracts, and credit derivative contracts. The definition also provided that the term derivative contract also includes unsettled securities, commodities, and foreign exchange transactions with a contractual settlement or delivery lag that is longer than the lesser of the market standard for the particular instrument or five business days.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Equity investment.

The Second Proposal defined the term “equity

investment” as investments in equity securities, and any other ownership interests, including, for example, investments in partnerships and limited liability companies.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Equity investment in CUSOs.

The Second Proposal defined the term “equity investment in CUSOs” as the unimpaired value of the credit union's equity investments in a CUSO as recorded on the statement of financial condition in accordance with GAAP.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Exchange.

The Second Proposal defined the term “exchange” as a central financial clearing market where end users can trade derivatives.

The Board received no comments on this definition, but has decided to clarify in this final rule that derivatives are engaged in through agreements and not traded like securities. Accordingly, this final rule would define “exchange” as a central financial clearing market where end users can enter into derivative transactions.

Excluded goodwill, and excluded other intangible assets.

The Second Proposal defined the term “excluded goodwill” as the outstanding balance, maintained in accordance with GAAP, of any goodwill originating from a supervisory merger or combination that was completed no more than 29 days after publication of this rule in final form in the

Federal Register

. The definition provided further that the term excluded goodwill and its accompanying definition would expire on January 1, 2025.

The Second Proposal would have also defined the term “excluded other intangible assets” as the outstanding balance, maintained in accordance with GAAP, of any other intangible assets such as core deposit intangibles, member relationship intangibles, or trade name intangible originating from a supervisory merger or combination that was completed no more than 29 days after publication of this rule in final form in the

Federal Register

. The definition provided further that the term excluded other intangible assets and its accompanying definition would expire on January 1, 2025.

Public Comments on the Second Proposal

The Board received many comments regarding the proposed treatment of goodwill and other intangible assets under NCUA's risk-based capital requirement. A significant number of commenters requested that the terms “excluded goodwill” and “excluded intangible assets” and their proposed treatment be retained permanently (or, if not retained permanently, commenters requested that the time period during which they are allowed be extended). The specific comments received and a more detailed description of the Board's response are provided below in the part of the preamble associated with § 702.104(b)(2).

Discussion

The Board generally agrees with commenters who suggested the time periods allowed for these proposed exclusions be extended. The Board added these two definitions to take into account the impact goodwill or other intangible assets recorded from transactions defined as supervisory mergers or combinations have on the calculation of the risk-based capital ratio upon implementation. The proposed exclusions would have applied to supervisory mergers or combinations that were completed prior to the date of publication of this final rule in the

Federal Register

. The proposed exclusion would have ended on January 1, 2025. For the reasons discussed below in the part of the preamble associated with § 702.104(b)(2), the Board has decided to revise the proposed definitions of “excluded goodwill” and “excluded other intangible assets” to extend the period during which credit unions can count these assets in the risk-based capital ratio numerator to January 1, 2029. In addition, the Board is extending the period, after the publication of this final rule in the

Federal Register

, during which credit unions can obtain “excluded goodwill” and “excluded other intangible assets” to 60 days to allow credit unions additional time to adjust to the changes made by this final rule.

Accordingly, this final rule defines “excluded goodwill” as the outstanding balance, maintained in accordance with GAAP, of any goodwill originating from a supervisory merger or combination that was completed on or before a date to be set upon publication, which will be 60 days after publication of this final rule in the

Federal Register

. The definition provides further that the term and definition expire on January 1, 2029.

Similarly, this final rule also defines “excluded other intangible assets” as the outstanding balance, maintained in accordance with GAAP, of any other intangible assets such as core deposit intangible, member relationship intangible, or trade name intangible originating from a supervisory merger or combination that was completed on or before a date to be set upon publication, which will be 60 days after publication of this final rule in the

Federal Register

. The definition provides further that the term and definition expire on January 1, 2029.

Exposure amount.

The Second Proposal defined the term “exposure amount” as:

• The amortized cost for investments classified as held-to-maturity and available-for-sale, and the fair value for trading securities.

• The outstanding balance for Federal Reserve Bank stock, Central Liquidity Facility stock, Federal Home Loan Bank stock, nonperpetual capital and perpetual contributed capital at corporate credit unions, and equity investments in CUSOs.

• The carrying value for non-CUSO equity investments, and investment funds.

• The carrying value for the credit union's holdings of general account permanent insurance, and separate account insurance.

• The amount calculated under § 702.105 of this part for derivative contracts.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Fair value.

The Second Proposal defined the term “fair value” as having the same meaning as provided in GAAP.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Financial collateral.

The Second Proposal defined the term “financial collateral” as collateral approved by both the credit union and the counterparty as part of the collateral agreement in recognition of credit risk mitigation for derivative contracts.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

First-lien residential real estate loan.

The Second Proposal defined the term “first-lien residential real estate loan” as a loan or line of credit primarily secured by a first-lien on a one-to-four family residential property where: (1) The credit union made a reasonable and good faith determination at or before consummation of the loan that the member will have a reasonable ability to repay the loan according to its terms; and (2) in transactions where the credit union holds the first-lien and junior-

lien(s), and no other party holds an intervening lien, for purposes of this part the combined balance will be treated as a single first-lien residential real estate loan.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

GAAP.

The Second Proposal defined the term “GAAP” as generally accepted accounting principles in the United States as set forth in the Financial Accounting Standards Board's (FASB) Accounting Standards Codification (ASC).

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

General account permanent insurance.

The Second Proposal defined the term “general account permanent insurance” as an account into which all premiums, except those designated for separate accounts are deposited, including premiums for life insurance and fixed annuities and the fixed portfolio of variable annuities, whereby the general assets of the insurance company support the policy. Under the proposed definition, general account permanent insurance would have included direct obligations to the insurance provider. This would have meant that the credit risk associated with general account permanent insurance was to the insurance company, which generally makes such insurance accounts have a lower credit risk than separate account insurance. A separate account insurance is a segregated accounting and reporting account held separately from the insurer's general assets.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

General obligation.

The Second Proposal defined the term “general obligation” as a bond or similar obligation that is backed by the full faith and credit of a public sector entity.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Goodwill.

The Second Proposal defined the term “goodwill” as an intangible asset, maintained in accordance with GAAP, representing the future economic benefits arising from other assets acquired in a business combination (

e.g.,

merger) that are not individually identified and separately recognized. The Proposed definition provided further that goodwill does not include excluded goodwill.

The Board received no comments on this definition and has decided to retain the proposed definition in this final rule without change.

Government guarantee.

The Second Proposal defined the term “government guarantee” as a guarantee provided by the U.S. Government, FDIC, NCUA or other U.S. Government agencies, or a public sector entity.

Public Comments on the Second Proposal

One state supervisory authority commenter requested clarification on the definition of “government guarantee,” and whether the definition includes any type of guarantee from a state government, state government agency, or municipality.

Discussion

The Board definition of “government guarantee” does include guarantees from a state government, state government agency, or municipality. The definition expressly includes a guarantee provided by a “public sector entity,” which the second proposal defines separately in § 702.2 as a state, local authority, or other governmental subdivision of the United States below the sovereign level. The proposed definition of “public sector entity” would include state governments, state government agencies, and municipalities. Accordingly, the Board has decided to retain the proposed definition of “government guarantee” in this final rule without change.

Government-sponsored enterprise (GSE).

The Second Proposal defined the term “government-sponsored enterprise” as an entity established or chartered by the U.S. Government to serv

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