Is the U.S. Credit Union Industry Overcapitalized? An Empirical Examination
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978-1-932795-25-7 An Empirical Examination Is the U.S. Credit Union Industry Overcapitalized? Is the U.S. Credit Union Industry Overcapitalized? An Empirical Examination William E. Jackson III, PhD ideas grow here Professor of Finance, Professor of Management, and the Smith Foundation Chair of Business Integrity PO Box 2998 Madison, WI 53701-2998 Culverhouse College of Commerce Phone (608) 231-8550 University of Alabama PUBLICATION #144 (11/07) www.filene.org ISBN 978-1-932795-25-7
Is the U.S. Credit Union Industry Overcapitalized? An Empirical Examination William E. Jackson III, PhD Professor of Finance, Professor of Management, and the Smith Foundation Chair of Business Integrity Culverhouse College of Commerce University of Alabama
Copyright © 2007 by Filene Research Institute. All rights reserved. ISBN 978-1-932795-25-7 Printed in U.S.A. ii
Filene Research Institute Deeply embedded in the credit union tradition is an ongoing search for better ways to understand and serve credit union members. Open inquiry, the free ﬂow of ideas, and debate are essential parts of the true democratic process. The Filene Research Institute is a 501(c)(3) not-for-proﬁt research organization dedicated to scientiﬁc and thoughtful analysis about issues aﬀecting the future of consumer ﬁnance. Through independent research and innovation programs the Institute examines issues vital to the future of credit unions. Ideas grow through thoughtful and scientiﬁc analysis of top- priority consumer, public policy, and credit union competitive issues. Researchers are given considerable latitude in their exploration and studies of these high-priority issues. The Institute is governed by an Administrative Board made up of the credit union industry’s top leaders. Research topics and priorities are set by the Research Council, a select group of credit union CEOs, and the Filene Research Fellows, a blue ribbon panel of academic experts. Innovation programs are Progress is the constant developed in part by Filene i3, an assembly of credit union replacing of the best there is executives screened for entrepreneurial competencies. with something still better! — Edward A. Filene The name of the Institute honors Edward A. Filene, the “father of the U.S. credit union movement.” Filene was an innovative leader who relied on insightful research and analysis when encouraging credit union development. Since its founding in 1989, the Institute has worked with over one hundred academic institutions and published hundreds of research studies. The entire research library is available online at www.ﬁlene.org. iii
Acknowledgments I oﬀer my deepest appreciation to George Hofheimer of the Filene Research Institute and Michael Schenk of CUNA for providing very valuable comments and suggestions. Their input greatly improved the overall quality of this report. Any errors or omissions are my own. v
Table of Contents Executive Summary and Commentary ix About the Author xi Chapter 1 Introduction 1 Chapter 2 Was the Credit Union Industry Adequately Capitalized in 1990? 5 Chapter 3 Did the Risk Proﬁle of the Credit Union Industry Increase Signiﬁcantly from 1990 to 2006? 9 Chapter 4 Review of Legislated Capital Requirements and Prompt Corrective Action for Credit Unions 21 Chapter 5 A Comparison of Credit Union and Commercial Bank Capital Requirements 25 Chapter 6 Review of the NCUA’s PCA Proposal for Reform of March 2005 31 Chapter 7 Conclusion 35 References 39 vii
Executive Summary and Commentary By George A. Hofheimer, In the movie Caddyshack, Chevy Chase and Ted Knight engage in Chief Research Oﬃcer one of the wittiest dialogues I can recall in the world of cinema. It goes something like this: Judge Smails (played by Ted Knight): Ty, what did you shoot today? Ty Webb (played by Chevy Chase): Oh, Judge, I don’t keep score. Judge Smails: Then how do you measure yourself with other golfers? Ty Webb: By height. Credit unions gauge themselves in a similarly peculiar manner. At your next credit union conference you may notice board members and employees alike sizing up their credit union using two measure- ments: asset size and capital ratio. For the former, bigger is always better; for the latter, there is a range of thought on what constitutes a good capital level. Most credit unions tend to believe their capital level is appropriate, with a general preference for more capital in case of the proverbial rainy day. The Filene Research Institute was curi- ous to know whether the “more capital is better” preference has led to U.S. credit unions holding too much capital. William Jackson, professor of ﬁnance, management, and ethics at the University of Alabama, meticulously answers the question, Are U.S. credit unions overcapitalized? What Did the Researcher Discover? Jackson reports that the capital level of the U.S. credit union indus- try stood at 11.6% at the end of 2006, more than four percentage points higher than the legislatively mandated level of Well Capi- talized and exactly four percentage points higher than U.S. credit unions’ capital ratio in 1990. Looking at these ﬁgures, most analysts would conclude that credit unions are overcapitalized today. But before any concrete conclusions can be made, this nuanced subject must be studied and analyzed. Jackson’s research approach, therefore, asks two critical questions: • Was the capitalization rate in 1990 reasonable given the risk proﬁle of the credit union industry? Jackson concludes the rate was reasonable and perhaps a bit too high. • Has the risk proﬁle of the credit union industry increased to such an extent to warrant an increase in capitalization from 7.6% to 11.6%? Jackson concludes the credit union industry in 2006 was less risky than it was in 1990. The answers to these questions, coupled with a thorough analysis of credit unions’ regulatory capital regime and a comparison of credit ix
union and bank capital requirements, lead Jackson to conclude that U.S. credit unions are “overcapitalized by an amount in the 30%– 40% range.” If you translate this assertion into real dollars, Jackson contends that U.S. credit unions are overcapitalized between $8.8 billion (B) and $11.7B. Practical Implications The dramatic conclusions from this research on overcapitalization may cause a great deal of debate across the credit union industry. This report calls attention to important issues. Credit unions are in the business of helping people. What beneﬁt accrues to members when their credit union holds on to excessive levels of capital? Credit unions need to balance their eﬀorts to achieve safety and soundness with eﬀorts to put their capital to its best use. While credit unions have done a superb job in the distant and recent past serving the ﬁnancial needs of consumers, the future success of the industry holds a host of challenges. To meet these challenges, credit unions need capital to invest in new delivery channels, technology, innovative products, talent development, collaborative strategies, marketing, and many other capital-intensive activities. According to Jackson’s assessment, almost all credit unions are overcapitalized to some degree. Therefore, the most practical thing you can do after read- ing this report and sharing it with your management/board team is to have an honest discussion about the most appropriate balance of safety and soundness vs. reinvestment in the credit union vis-à-vis your institution’s capital. Credit union capital is emblematic of the historical legacy of member involvement and usage. The accrual of such a storehouse of capital over the years represents a raging economic success story; however, as credit unions move forward, an honest debate must ensue about the most appropriate use of this accumulated goodwill. x
About the Author William E. Jackson III, PhD William E. Jackson III holds the appointments of professor of ﬁnance, professor of management, and the Smith Foundation Endowed Chair of Business Integrity in the Culverhouse College of Commerce at the University of Alabama. Before joining the faculty at the University of Alabama, Dr. Jackson was a ﬁnancial economist and associate policy advisor in the research department at the Federal Reserve Bank of Atlanta. At the Atlanta Fed, Dr. Jackson conducted original research on ﬁnancial markets and ﬁnancial institutions. He was also an advisor to the bank on the making of monetary policy in the United States. Previous to his position at the Atlanta Fed, Dr. Jackson was an associate professor of ﬁnance at the Kenan-Flagler Business School of the Univer- sity of North Carolina at Chapel Hill. His academic areas of expertise are ﬁnancial intermediation and industrial economics. Dr. Jackson’s research focuses on the role ﬁnancial markets and ﬁnancial institutions play in making the modern economy more eﬃcient and productive. Speciﬁc areas of research include corporate governance, business ethics, entrepreneurial ﬁnance, monetary policy and macroeconomics, indus- trial economics, ﬁnancial markets and institutions, corporate ﬁnance, ﬁnancial literacy, and public policy. Dr. Jackson earned his BA in economics and applied mathematics at Centre College, his MBA in ﬁnance at Stanford University, and his PhD in economics at the University of Chicago. Dr. Jackson’s research has been published in some of the leading academic journals in the areas of empirical economics, management, and ﬁnancial institutions and markets. His articles have appeared in the Review of Economics and Statistics, the Journal of Money, Credit and Banking, the Review of Industrial Organization, the Journal of Banking and Finance, Management Science, the Journal of Small Busi- ness Management, and Small Business Economics Journal. Dr. Jackson is currently an associate editor of one of the premier small-ﬁrm research journals, the Journal of Small Business Manage- ment. His monograph The Future of Credit Unions: Public Policy Issues was published by the Filene Research Institute in 2004. In July 2004, Dr. Jackson provided expert testimony before the U.S. House of Representatives on the deregulation of credit unions. In 2005 and 2006 he served as founding special issue editor for the Journal of Small Business Management. The special issue was entitled “Small Firm Finance, Governance, and Imperfect Capital Markets.” Dr. Jackson is also an inaugural member of the prestigious Filene Fellows Program. xi
CHAPTER 1 Introduction This study seeks to answer the important question of whether the credit union industry is overcapitalized by addressing two fundamental questions: Was the capitalization rate in 1990 reasonable given the risk proﬁle of the credit union industry? Assuming that the answer to this question is yes, has the risk proﬁle of the credit union industry increased to such an extent to warrant an increase in capitalization from 7.6% to 11.6%?
At the end of 1990 the percentage of net capital to assets for the credit union industry stood at 7.6%. By the end of 2000 this percentage had risen to 11.1%. It remained around this relatively high level, and at the end of 2006 it was 11.6% (see Figure 1). So why did the credit union industry need an 11.6% net capital percentage in 2006 if it had needed only a 7.6% net capital percentage in 1990? Or, stated diﬀerently, was the credit union industry severely undercapitalized in 1990, or is it severely overcapitalized today? Of course, there is at least one other possibility. Perhaps 7.6% was the correct capitalization rate in 1990 given the risk proﬁle of the industry, and perhaps the risk proﬁle of the industry has shifted (or increased) to the degree that 11.6% is the cor- rect capitalization percentage today—perhaps, but not very likely. This study seeks to answer the important question of whether the credit union industry is overcapitalized by addressing two fundamen- tal questions: Was the capitalization rate in 1990 reasonable given the risk proﬁle of the credit union industry? Assuming that the answer to this question is yes, has the risk of the credit union industry increased to such an extent to warrant an increase in capitalization from 7.6% to 11.6%? If the risk proﬁle has not increased, then the 7.6% capi- talization rate may still be appropriate (or it may be too high). This would suggest that the credit union industry is at least four percentage points (11.6 – 7.6 = 4.0) above the appropriate capitalization rate. The total assets of the credit union industry were $732.5B at the end of 2006. A four percentage point overcapitalization rate translates to an overcapitalization dollar amount of $29.3B ($732.5B × 4%) for the credit union industry. This suggests that the industry was holding $29.3B in capital that could have been used for other purposes by and for credit union members. This also means that the typical credit union held $34 of unnecessary capital for every $1001 of capital on its 1 4.0/11.6 equals 34%, or 34/100ths. 2
Figure 1: Credit Union Industry Net Worth Ratios, 1990–2006 12.0 11.0 10.0 Percent 9.0 8.0 7.0 6.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: CUNA (2007). books! However, before this conclusion can be reached, we must ﬁrst answer the two questions asked at the beginning of this chapter. The remainder of this report is organized as follows: • Question number one, Was the capitalization rate in 1990 reason- able given the risk proﬁle of the credit union industry? is addressed in Chapter 2. • Question number two, Has the risk proﬁle of the credit union industry signiﬁcantly increased? is addressed in Chapter 3. • A brief review of the legislatively mandated capital requirements and prompt corrective action procedures for credit unions is oﬀered in Chapter 4. • A discussion comparing credit union and commercial bank capital requirements is presented in Chapter 5. This chapter also includes a summary of a recent study investigating whether the capital needs of credit unions and commercial banks in the United States are identical. Chapter 1 3
• An overview of the National Credit Union Administration (NCUA) proposal on reform of prompt corrective action and capital requirements for credit unions is presented in Chapter 6. The NCUA proposal presents a system of requirements that is very closely aligned with BASEL II. It also suggests that the credit union industry is currently overcapitalized. This may be the ﬁrst time in U.S. history that a regulator of federally insured deposi- tory institutions has recognized a need to lower mandated capital requirements in an eﬀort to balance safety and soundness objec- tives with an eﬃcient use of capital in the economy. • I present my conclusions in Chapter 7. This chapter summarizes the evidence and provides a direct answer to the question of whether the credit union industry is currently overcapitalized. The answer is yes. 4
CHAPTER 2 Was the Credit Union Industry Adequately Capitalized in 1990? Unlike the commercial bank and savings and loan insurance funds, the credit union insurance fund was able to withstand the most turbulent and stressful ﬁnancial institution crisis in U.S. history since the Great Depression.
Adequate capital levels allow individual ﬁnancial institutions to absorb losses, often caused by unforeseen events (or bad luck), and survive. Capital is often considered the capstone on which a deposi- tory institution builds its operations. It is not unusual for capital to be called the lifeblood of commercial banks, thrifts, and credit unions. Capital serves many roles. At federally insured depository institu- tions, capital ensures the safety and soundness of the industry. From a public policy perspective, capital also acts to protect the appropri- ate deposit insurance agency (or fund) from bankruptcy and the necessity of taxpayer bailouts. The years 1980–1993 were very turbulent and volatile for ﬁnancial institutions. During this period, U.S. depository institutions experi- enced failure rates not seen since the Great Depression. The period was often categorized as a banking crisis. It was also called The years 1980–1993 were very turbulent and volatile for the “S&L debacle” by several ﬁnancial institutions. During this period, U.S. depository inﬂuential ﬁnance scholars. institutions experienced failure rates not seen since the Great At the end of the 1980s, the Depression. deposit insurance funds for commercial banks (the Federal Deposit Insurance Corporation [FDIC]) and the insurance funds for the S&Ls (the Federal Savings and Loan Insurance Corporation [FSLIC]) needed taxpayer bailouts to credibly support the continua- tion of these deposit insurance programs. However, the credit union industry insurance fund, the National Credit Union Share Insurance Fund (NCUSIF), did not experience a similar fate. The NCUSIF was recapitalized by the credit union industry without any assistance from taxpayers. Thus, unlike the commercial bank and S&L insurance funds, the credit union insur- ance fund was able to withstand the most turbulent and stressful 6
ﬁnancial institution crisis in U.S. history since the Great Depres- sion. Many ﬁnancial researchers consider the banking crisis of this time period to be analogous to a hundred-year ﬂood. As such, it served as a natural experiment that tested the ﬁnancial integrity of U.S. depository institutions. In particular, the question of whether the commercial banking industry, the S&L industry, and the credit union industry were adequately capitalized during the 1980s may be evaluated by considering the ability of their deposit insurance funds to survive this high-risk period. During the 1980s there was not enough capital held by S&Ls or commercial banks to prevent large numbers of these institutions from failing. About one-third of S&Ls and almost 1 out of 11 banks failed during this period. This was also a diﬃcult time for During the 1980s there was not enough capital held by credit unions, as the industry S&Ls or commercial banks to prevent large numbers of experienced average failure these institutions from failing. About one-third of S&Ls and rates similar to those of com- almost 1 out of 11 banks failed during this period. mercial banks. However, larger credit unions fared much better than larger banks over this period. The result was that on an asset- weighted basis, the credit union industry experienced a much lower failure rate compared to commercial banks over this time period (see Wilcox 2007, 10, Figure 1). It is apparent that credit unions entered the 1980s with a stronger capital position and a lower risk proﬁle than commercial banks. This allowed the credit union industry to survive one of the most failure- prone periods of modern U.S. ﬁnancial institution history without bankrupting its deposit insurer and seeking a taxpayer bailout. This suggests that the capital levels of the 1980s were adequate for the credit union industry’s risk proﬁle. Net capital averaged 6.6% for credit unions over the 1980–1989 period. If this 6.6% was adequate during the 1980s, it is reasonable to assume that a capitalization rate of 7.6% in 1990 was adequate for the risk proﬁle of the credit union industry at that time. (Note: It is just as reasonable to argue that a capitalization rate of 6.6% would be adequate for the credit union industry in 2006, because that was the average rate over the period 1980–1989.) Chapter 2 7
CHAPTER 3 Did the Risk Profile of the Credit Union Industry Increase Significantly from 1990 to 2006? Diﬀerent types of risks are used to develop the overall risk proﬁle for the credit union industry. Credit risk, interest-rate risk, liquidity risk, operational risk, and industry composition are considered when calculating the overall risk proﬁle.
In this chapter I evaluate the risk proﬁles of the credit union industry in 1990 and 2006 using the two prescribed risk metrics from BASEL II, plus two additional universally accepted risk factors associated with depository institutions. From BASEL II, I use credit risk and operational risk. The two additional risk factors are interest-rate risk and liquidity risk. I also consider changes in aggregate risk for the credit union industry that may be related to the changing composi- tion of the industry itself—for example, the asset size distribution of the industry, since relatively large credit unions are likely to be more eﬃcient and less risky than smaller credit unions. Overall, my analysis in this chapter leads me to the same conclusion reached by Sollenberger (2005): The credit union industry not only had much more capital in 2006 than it did in 1990, but it also had a lower risk proﬁle. In the next ﬁve sections I discuss measures for the diﬀerent types of risks used to develop the overall risk proﬁle for the credit union industry in 1990 and 2006. These risks are credit risk, interest-rate risk, liquidity risk, operational risk, and industry composition. Credit Risk Credit risk is typically given a place of prominence when evaluating the overall riskiness of depository institutions. Following the logic of BASEL II, I evaluate credit risk by reviewing the composition of credit union industry assets in 1990 relative to 2006. I start with a simple ratio of loans to total assets, as loans are typically more risky than the other assets held by depository institutions. As shown in Figure 2, two trends stand out concerning the loans-to-total-assets ratios. First, the ratios are volatile over time. They ﬂuctuate from a low of about 55% in 1993 to a high of almost 70% in 2006. Second, the ratio in 1990 of about 64% is not signiﬁcantly diﬀerent from the ratio in 2006 of about 70%. However, this is just the ﬁrst step in evaluating credit risk. A much more telling piece of evidence is the composition of loans, which is examined next. 10
Figure 2: Credit Union Industry Loans-to-Total-Assets Ratios, 1990–2006 75.0 70.0 65.0 60.0 Percent 55.0 50.0 45.0 40.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: CUNA (2007). Figure 3 presents evidence of a signiﬁcant change in the composition of credit union industry loans. The major change is associated with a shift from unsecured and other loans toward real estate loans. For example, total real estate loans represent about 34% of total credit union indus- try loans in 1990. However, by the end of 2006 this percentage has increased to almost 50%. Over the same time frame, unsecured and other loans drop from about 32% to about 15% of total credit union industry loans. From a BASEL II perspective, this trend suggests that the overall credit risk of the loan portfolio held by the credit union industry decreased from 1990 to 2006. I explain why below. BASEL II applies diﬀerent risk weights to diﬀerent categories of loans. Those loans secured by residential property are assigned a risk weight of 35%. This is the risk weight that applies to the “total real estate” category in Figure 3. BASEL II would apply a risk weight of 100% to the unsecured and other loan categories in Figure 3. Given that the percentage of loans with the much lower risk weight (total real estate) increases signiﬁcantly, from a BASEL II risk measurement calculation, the overall risk of the credit union loan portfolio decreases signiﬁcantly. Chapter 3 11
Figure 3: Composition of Loans at Credit Unions (Percentage of Total Loans) Automobile First mortgage First mortgage Other real Total real Year (new and used) (fixed-rate) (variable-rate) estate* estate Unsecured Other 1990 33.2 11.1 8.2 14.9 34.2 20.4 12.0 1995 40.0 12.7 7.8 11.7 32.2 20.0 7.8 2000 40.0 18.1 7.3 13.4 38.8 14.6 6.6 2006 35.4 21.0 11.4 17.0 49.4 9.9 5.2 60.0 50.0 Automobile (new and used) First mortgage (fixed-rate) 40.0 First mortgage (variable-rate) Other real estate* Percent 30.0 Total real estate Unsecured 20.0 Other 10.0 0.0 1990 1995 2000 2006 Year Source: CUNA (2007). * Home equity plus second mortgages. To further investigate the changing credit risk proﬁle of credit union industry loans, I also examine trends in loan delinquency ratios over the 1990–2006 time period. Figure 4 presents these ratios in bar chart form. At the end of 1990, the credit union industry loan delinquency ratio (loans 60 days past due) stands at about 1.7%. By 2006 the delinquency ratio has dropped by more than half, to just 0.7%. This strongly suggests that the quality of the credit union industry loan portfolio in 2006 was signiﬁcantly higher, and credit risk signiﬁcantly lower, than it was in 1990. And, as the BASEL II risk-based capital requirements system makes explicit, if credit risk is reduced, the amount of capital nec- essary to maintain a well-capitalized position is also reduced. 12
Figure 4: Credit Union Industry Loan Delinquency Ratios, 1990–2006 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 Percent 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: CUNA (2007). Interest-Rate Risk If unexpected changes in market interest rates have a material eﬀect on the net interest income or market value of a depository institution, then that depository institution is exposed to interest-rate risk. The funda- mental cause of interest-rate risk is an imbalance in the cash ﬂow matu- rity structure of interest-bearing assets and liabilities. It is com- Credit unions tend to be subject to less interest-rate risk mon for most ﬁnancial institu- than depositories such as thrifts because credit unions carry tions (especially depositories) to a much more diversiﬁed portfolio of loans. assume some amount of interest- rate risk. In the normal course of business, depository institutions often borrow short term (deposits) and lend longer term (loans). However, the institution must be diligent in monitoring and managing the amount of interest-rate risk undertaken through proscribed asset-liability management processes. Credit unions tend to be subject to less interest-rate risk than depositories such as thrifts because credit unions carry a much more diversiﬁed port- folio of loans. Nonetheless, Figure 3 provides evidence that suggests credit unions were exposed to more interest-rate risk in 2006 than in 1990. Chapter 3 13
This evidence is provided in the column “First mortgage (ﬁxed-rate).” From this column we observe that the percentage of total credit union industry loans in ﬁxed-rate mortgages increases from 11.1% in 1990 to 21.0% in 2006. Fixed-rate mortgages tend to carry a substantial amount of potential interest-rate risk. However, it is unlikely that an industry portfolio composed of 21.0% ﬁxed-rate mortgages is a signiﬁcant risk to the overall health of the credit union industry. To some extent, the increase in interest-rate risk associated with adding relatively more long- term assets (ﬁxed-rate mortgages) to the current credit union loan portfo- lio has likely been oﬀset by changes in the industry deposit portfolio. For example, in Figure 5 we observe that the percentage of credit union deposits in CDs increases from 21.7% in 1990 to 31.5% in 2006. This very likely resulted in an increase in the cash ﬂow maturity of liabilities (deposits) to help oﬀset the increase in the cash ﬂow maturity of assets Figure 5: Composition of Shares/Deposits at Credit Unions (Percentage of Total Deposits/Shares) Money market Regular shares Year Share drafts accounts CDs IRAs and other 1990 9.4 8.5 21.7 14.5 45.8 1995 11.2 9.2 21.3 12.0 46.3 2000 13.3 13.3 27.7 9.5 36.2 2006 11.7 16.7 31.5 8.6 31.5 50.0 40.0 Share drafts 30.0 Money market Percent accounts CDs 20.0 IRAs Regular shares and other 10.0 0.0 1990 1995 2000 2006 Year Source: CUNA (2007). 14
(ﬁxed-rate mortgages). However, also notice in Figure 5 that IRAs decrease from 14.5% in 1990 to 8.6% in 2006, while money market accounts increase from 8.5% to 16.7% of total deposits. Both of these trends may have resulted in decreasing the cash ﬂow maturity of liabili- ties. Interest-rate risk, especially at the industry level, is imprecise and costly to calculate based on a balance sheet assessment. This is why both the BASEL II and the current FDIC system deal with interest-rate risk under the second pillar of their capital requirements system—that is, a detailed and robust supervisory review process. Overall, I would evaluate the changes in observed cash ﬂow maturity of assets and liabilities to suggest a very moderate increase in interest- rate risk in the credit union industry from 1990 to 2006. Liquidity Risk Credit unions have a reputation for using conservative management practices. In the case of liquidity risk, this reputation is well deserved. In 1990 the credit union industry kept about 33.6% of its assets in surplus funds. These surplus funds are essentially investments. Credit union investments tend to be very high quality and very liquid. By the end of 2006, the credit union industry had reduced the ratio of surplus funds to about 26.3% of total assets. This is more than a seven percentage point decrease in the ratio of surplus funds to total assets. For other deposi- tory institutions, this large of a decrease in surplus funds relative to total assets would be a concern, but for the credit union industry it’s a sign of management moving in the right direction.2 Overall, the reduction in the surplus funds percentage from 33.6 to 26.3 for the credit union industry over the 1990–2006 time period does not result in a signiﬁcant increase in liquidity risk. If anything, this reduction moves the credit union industry toward a more eﬃ- cient use of members’ funds. Operational Risk Under BASEL II, operational risk is quantiﬁed using a basic indica- tor approach based on 15% of average gross income of the individual ﬁnancial institution over the previous three-year period. This variable is then converted to a risk asset by multiplying by the inverse of 8% (or 12.5). This approach would be very diﬃcult to rationalize as providing an adequate proxy for aggregate credit union industry operational risk. Operational risk is often considered to be very broad and complex. It usually encompasses important factors such as managerial qual- 2 Actually, it may simply be the result of the changing composition of the credit union industry. The size of the average credit union increased by over 400% from 1990 to 2006 (not adjusted for inflation). As large, well-diversified credit unions hold relatively lower proportions of surplus funds, this trend of credit unions getting much larger on average may explain this phenomenon. Chapter 3 15
ity, governance integrity, technological capabilities, and competitive strategies. Because it is so broad, I chose to examine three very broad and general trends in assessing whether there is a signiﬁcant change in operational risk for the credit union industry from 1990 to 2006. The three trends are proﬁtability (return on assets), overall annual growth in assets, and average asset size of credit unions. The ﬁrst two of these three trends are presented in Figures 6 and 7, respectively. The ratios of credit union industry annual net income to total assets (ROA) from 1990 to 2006 are presented in Figure 6. In 6 of these 17 years, ROA is 0.9% or less—but never below 0.8%. In 1990 and 1991, and again in 2004 and 2005, ROA is about 0.9%. In 2006, ROA for the credit union industry is a little above 0.8%. Overall, the proﬁtability of the credit union industry does not change signiﬁcantly between 1990 and 2006. A similar picture can be drawn from Figure 7 for credit union industry annual asset growth rates. Annual asset growth rates are at or above 10% for 5 of the 17 years shown in Figure 7. From 1990 to 2006, annual asset growth rates are never below 4%, and they are below 6% Figure 6: Credit Union Industry ROAs, 1990–2006 1.5 1.4 1.3 1.2 1.1 1.0 0.9 Percent 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: CUNA (2007). 16
Figure 7: Credit Union Industry Annual Asset Growth Rates, 1990–2006 16.0 14.0 12.0 10.0 Percent 8.0 6.0 4.0 2.0 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: CUNA (2007). in only 5 of the 17 years. The annual growth rate in 1990 is over 7%, while the annual growth rate in 2006 is not quite 5%. Overall, asset growth seems to moderate somewhat by 2005 and into 2006. Moderating asset growth, coupled with continued strong proﬁtability and increases in size- related eﬃciencies, suggests that operational risk for the credit union industry very likely remains relatively stable, or decreases, over the 1990–2006 time period. Credit unions tend to be relatively small ﬁnancial institutions. For example, in 1990 the average size in assets for U.S. credit unions was only $15.2 million (M). Small asset size may limit a ﬁnancial institution’s ability to exploit economies of scale and scope, especially with regard to advances in technology. However, by the end of 2006, the average asset size of credit unions in the United States had risen to $84.6M. This represents more than a ﬁvefold increase in average asset size. Even after adjusting for inﬂation, this represents more than a 3.6 times increase in average asset size. This large increase in aver- age asset size suggests an increase in the ability of the average credit Chapter 3 17
union to take advantage of economies of scale and other size-related eﬃciencies. This increase in eﬃciency potential is likely correlated with a decrease in aggregate operational risk in the industry. Moderating asset growth, coupled with continued strong proﬁtability and increases in size-related eﬃciencies, suggests that operational risk for the credit union industry very likely remains relatively stable, or decreases, over the 1990–2006 time period. Industry Composition Data from Wilcox (2007), which are reproduced in Figure 8 below, demonstrate that about 0.56% of small credit unions failed each year during the period 1981–2005. Wilcox deﬁnes small credit unions as those with less than $25M in assets. Wilcox (2007) also reports that over the same time frame not a single large credit union failed. Wilcox deﬁnes a large credit union as one with more than $250M in assets. Given that expected failure rates for large credit unions are much smaller than those for small credit unions, changes in the relative proportions of large and small credit unions will change the overall aggregate risk proﬁle of the industry. Figure 8: Failures of Federally Insured Credit Unions Time period All Small Medium Large Panel A. Failure rates (%) 1981–1993 0.77 0.85 0.20 0.0 1994–2005 0.18 0.23 0.04 0.0 1981–2005 0.49 0.56 0.12 0.0 Panel B. Number of failures 1981–1993 1,478 1,430 48 0 1994–2005 231 220 11 0 1981–2005 1,709 1,650 59 0 Panel C. Number of institutions (year-end) 1980 17,324 16,274 1,010 40 1993 12,317 9,709 2,356 252 2004 9,014 5,915 2,576 523 Source: Wilcox (2007, 10, Figure 1). Small is less than $25M in total assets, medium is $25M to $250M in total assets, and large is more than $250M in total assets. 18
Using Figure 8, I calculated that in 1993 small credit unions repre- sented 78.8% of the number of federally insured credit unions in the United States. In that same year, large credit unions represented only about 2.1% of the number of federally insured credit unions in the United States. However, by the end of 2004, large credit union representation had increased to 5.8%, and small credit union rep- resentation had fallen to 65.6% of the number of federally insured credit unions in the United States. This change in industry composi- tion toward relatively more large credit unions in 2004 compared to 1993 suggests that, over the 1990–2006 time frame, average credit union failure risk decreases. Of course, the beneﬁts of this decrease in average credit union failure risk may have been mitigated somewhat by an increase in the average expected cost of each individual credit union failure. Nonetheless, the overall result from this change in industry composition is likely a decrease in credit union industry risk borne by the deposit insurer. Overall Industry Risk After examining credit risk, interest-rate risk, liquidity risk, opera- tional risk, and industry composition for the credit union industry in 1990 and 2006, I arrived at the same conclusion as Sollenberger (2005). That is, the credit union industry in 2006 was less risky than it was in 1990. Figure 9 summarizes my conclusions about the changes from 1990 to 2006 for each component of the risk proﬁle of credit unions examined in this study. Figure 9: Summary of Changes in the Components of Credit Union Industry Risk Proﬁle from 1990 to 2006 2006 risk level compared to Risk category 1990 risk level Credit Much lower Interest rate Moderately higher Liquidity Similar Operational Lower Industry composition Lower Overall Lower Chapter 3 19
CHAPTER 4 Review of Legislated Capital Requirements and Prompt Corrective Action for Credit Unions Capital adequacy requirements use a ﬁve-tier system based on a ratio of net worth to total assets. For most credit unions, this ratio is about the same as the traditional total-equity-to-total-assets ratio. More than 99% of U.S. credit unions are in the Well Capitalized or Adequately Capitalized categories.
The Credit Union Membership Act of 1998 (CUMAA) required the NCUA to establish and implement a net worth classiﬁcation system that paralleled the current system used by banking regulators. The speciﬁc regulations implementing the legislation were deﬁned at year-end 1999 and became eﬀective in early 2001. The regula- tions were derived almost directly from the legislation because the legislation contained unusually speciﬁc directions for deﬁning capital adequacy within a prompt corrective action (PCA) framework. The PCA rules created a new system for evaluating capital adequacy (Sollenberger and Taggart 2006). The new system applies a single scale to all credit unions regardless of size and (except for complex credit unions) asset composition. The new system uses a ﬁve-tiered classiﬁcation scheme based on a net-worth-to-total-assets ratio. Net worth is basically a measure of equity that includes all equity accounts reported on credit union call reports. For most credit unions, this ratio is about the same as the traditional total-equity-to- total-assets ratio. The ﬁve-tiered classiﬁcation scheme is based on the following catego- ries and ratios: • 7% and above = Well Capitalized. • 6% to 6.99% = Adequately Capitalized. • 4% to 5.99% = Undercapitalized. • 2% to 3.99% = Signiﬁcantly Undercapitalized. • Under 2% = Critically Undercapitalized. By the time these regulations became eﬀective in 2001, more than 99% of U.S. credit unions were in the Well Capitalized or Adequately Capi- talized categories. This continues to be the case today. It is interesting that net worth requirements and PCA were not the original purpose of CUMAA. The stimulus for the 1998 CUMAA 22
was a decision by the Supreme Court that prohibited the NCUA from approving credit union “ﬁelds of membership” comprising more than one group. It has been suggested that the PCA require- ments of CUMAA were introduced into the act more for political reasons than for sound economics. There may be some support for this view when a comparison of PCA for banks and credit unions is examined. For example, CUMAA directed the NCUA to implement regula- tions that established a system of PCA for credit unions that was consistent with the PCA regime for banks and thrifts under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. However, there are several diﬀerences between the PCA for credit unions that Congress codiﬁed into CUMAA and By the time these regulations became eﬀective in 2001, more the PCA that covers banks and than 99% of U.S. credit unions were in the Well Capitalized thrifts through the FDICIA. I or Adequately Capitalized categories. This continues to be believe there are two key dif- the case today. ferences. First, the net worth levels for determining a credit union’s net worth classiﬁca- tion are not allowed to be ﬁne-tuned by the regulator (the NCUA), because they are speciﬁed in CUMAA. This is not true for the bank and thrift regulators. Second, the net worth ratios required in order for a credit union to be classiﬁed in the Well Capitalized or Adequately Capitalized categories are much higher—two percentage points—than those in place for banks and thrifts. This is especially egregious given that the overall risk of failure imposed on the credit union deposit insurance fund by credit unions is very likely to be lower than the respective failure risk imposed on the bank deposit insurance fund by banks. Because of the relatively high PCA capital requirements imposed on credit unions by CUMAA, many credit unions today hold more capital than they need to in order to operate in a safe and sound manner (Sollenberger 2005). As a result of the eﬀect of potential asset growth on a credit union’s net worth ratio, a very eﬃciently run credit union is essentially safe and sound from a regulatory perspective, yet it would be signiﬁcantly constrained by operating with a net worth ratio of 6% or 7% given the current PCA system. This is because credit unions do not have access to external capital markets in order to build net worth on a timely basis. Instead, credit unions must build net worth using only retained earnings (a few specialized exceptions apply). Given this situation, any signiﬁcant unexpected growth—perhaps as the result of members increasing their life cycle savings patterns—may quickly Chapter 4 23
lower a credit union’s net worth ratio below the planned 6% or 7%. This could occur even in the face of healthy additions to capital funded by generous ROAs. The concern on the part of credit union management and boards goes far beyond those credit unions that are close to the 6% or 7% line of demarcation for being considered Adequately Capitalized or Well Capitalized. Overall, credit unions have very conserva- tive management that appears to be part of their cooperative and volunteer-run culture. As a result, most credit unions seek to be Well Capitalized as opposed to Adequately Capitalized. This means that if they do not want to fall below a 7% net worth ratio and they are uncertain about future growth prospects, they must maintain a cushion above 7% to eﬀectively manage their capital ratio. Some suggest that a typical target (or cushion) is to hold enough capital to stay about 200 basis points above the 7% standard (Sollenberger 2005). This suggests that the current PCA regulations for credit unions provide powerful incentives that have induced credit unions, on average, to hold more than 50% more capital than is necessary for safety and soundness purposes. Indeed, the regulation states that a 6% net worth ratio is Adequate. Unfortunately, the PCA regulation in its current form induces most credit unions to operate at highly overcapitalized levels, which results in an ineﬃcient use of members’ resources. On the positive side, the NCUA, the credit union regula- tor, recognizes that the current system must be amended to correct this problem. I discuss the NCUA proposal to remedy this situa- tion in Chapter 6. In the next chapter, I discuss diﬀerences in the necessary capital requirements for credit unions and banks based on respective risk proﬁles and organizational structures. 24
CHAPTER 5 A Comparison of Credit Union and Commercial Bank Capital Requirements Theoretical and empirical evidence support the notion that the credit union industry needs less capital, or a lower capital requirement, than the banking industry.
One of the most interesting aspects of CUMAA is that Congress included a preamble that describes the major diﬀerences between credit unions and other depository institutions. The preamble states that “Credit Unions, unlike other participants in the ﬁnancial services market, are exempt from Federal and most State taxes because they are: (1) member-owned, (2) democratically operated, (3) not-for-proﬁt organizations, (4) generally managed by volunteer boards of directors, and (5) have the speciﬁc mission of meeting the credit and savings needs of consumers, especially persons of modest means.” Of interest is that CUMAA then goes on to establish PCA capital requirements for credit unions that are higher than those for banks or thrifts. However, the characteristics of credit unions described in the preamble suggest that the capital requirements for credit unions should be lower—not higher—than those for banks or thrifts. In this chapter, I discuss the theoretical and empirical evidence that supports this proposition. Theory The idea that not-for-proﬁt credit unions are likely to be less risky than for-proﬁt commercial banks is not new. For example, Smith (1984) provides the seminal report on the theory of credit union decision making. His report explains why the cooperative organi- zation of credit unions provides their management with less of an incentive to hold a portfolio of risky assets, relative to for-proﬁt com- mercial banks. A more recent article by Kane and Hendershott (1996) adds to this literature by providing a comprehensive analysis of how diﬀerences in incentive structure serve to mitigate the desirability of risk-taking activities by credit union managers and regulators. Kane and Hendershott (1996, 1309) state that the diﬀerences between credit unions and commercial banks “make it less feasible 26
for managers [of credit unions] to pursue and to beneﬁt from either corrupt lending or go-for-broke strategies of risk-taking. Manage- rial willingness to bet a credit union’s future viability on large risky projects is curbed by three constraints: its ﬁeld-of-membership limitations; its cooperative form; and private and federal monitor- ing.” For example, the authors state that the cooperative form of credit unions lessens any personal gains that can be captured by managers who successfully shift risk to the credit union deposit insurer, the NCUSIF. Speciﬁcally, incentives to shift the downside of a high-risk project to the NCUSIF is mitigated by the diﬃculties that credit union managers would face in attempting to divert to themselves a relatively large proportion of the gains if this high-risk project was successful. Of course, if credit union managers know that conversion to a stock- holder organization is easily available, then these eﬀects are limited. This suggests that obstacles to credit union conversions established by the NCUA may help to make the industry less risky. This is because these obstacles—by reducing the attractiveness of conver- sion—help align the interests of credit union managers (in avoiding high-risk projects) with those of the NCUSIF. Kane and Hendershott state that the diﬀerences between credit unions and commercial banks “make it less feasible for managers [of credit unions] to pursue and to beneﬁt from either cor- rupt lending or go-for-broke strategies of risk-taking.” Another factor that serves to mitigate risk taking by credit union managers is the extent and quality of private monitoring to which they are subjected (Kane and Hendershott 1996). For example, according to Kane and Hendershott (1996, 1311), the activities of credit union managers and boards of directors are typically bonded more extensively by outside private insurers than the activities of managers or boards of commercial banks. This more intense bond- ing coverage at credit unions transforms the private bonding agencies into coinsurers with the NCUSIF that have a much stronger ﬁnancial incentive to monitor internal controls and managerial policies to restrict behavior that threatens credit union failure and the NCUSIF. Agency theory dictates that the quality of monitoring done by a private insurer, whose managers recognize that the proﬁtability and survival of their company depend on their activities, can be expected to be superior to that done by insulated federal employees. But even if private monitoring were only of equal quality, the very existence of the independent private bonding agencies that cover some of the loss in failure-type events reduces the federal insurer’s (the NCUSIF) expected loss exposure (Kane and Hendershott 1996). Chapter 5 27
Another factor that serves to restrain credit union risk taking is the structure of the industry’s deposit insurance fund, the NCUSIF. Credit unions insured by the NCUSIF actually insure one another. That is, all institutions insured by the NCUSIF are “jointly and severally” responsible without limit for covering any shortage that the fund experiences. As Kane and Hendershott (1996) recognize, this responsibility eﬀectively transforms total industry net worth into a supplementary oﬀ–balance sheet fund of insurance reserves avail- able to the NCUSIF to use as needed. Not only does this expand the eﬀective size of the NCUSIF fund by several orders of magnitude, but it also enhances incentives for credit unions to cross-monitor one another. The NCUSIF since 1985 has been organized as what Kane and Hendershott (1996) call a deposit insurance premium “prepayment” system. This idea refers to the fact that insured credit unions are required to hold 1% of their shares on deposit with the NCUSIF, which is called the “capitalization deposit.” Income on interest received by the NCUSIF on this deposit is used to close insol- vent credit unions and cover operating expenses. Establishing the NCUSIF as a fund based on prepaid premiums aligns the incentives of all major stakeholders (e.g., the NCUA, politicians, credit union management, other credit union members, and taxpayers) better than the pay-as-you-go system of commercial banks (Kane and Hendershott 1996). Thus, the theoretical evidence suggests that the credit union indus- try is less likely to engage in levels of risk taking as high as those in the banking industry. This leads to the conclusion that the theory supports the notion that the credit union industry needs less capital, or a lower capital requirement, than the banking industry. There is empirical evidence that supports this, and I present a summary of that evidence in the next section. Empirical Evidence In a report by Smith and Woodbury (2001), the authors investigate whether the capital needs of U.S. credit unions and commercial banks are the same, given their respective aggregate risk proﬁles. To operationalize their investigation, the authors use a simple regression model that estimates the eﬀects of macroeconomic shocks on credit union and commercial bank risk measures over the business cycle. State-level unemployment rates are used as the measure of macro- economic shock. The dependent variables are aggregate loan delin- quencies and charge-oﬀs for credit unions and commercial banks at the state level. The authors use panel data covering all 50 states and the District of Columbia (51 panels) over 29 semiannual periods 28
from 1986 to 2000. The authors estimate models that include both contemporaneous and lagged independent variables as well as just contemporaneous variables. Using the coeﬃcients on the independent variable unemployment as the measure of sensitivity, the authors report the following ﬁnd- ings. First, commercial bank loan delinquencies are more than twice as sensitive to the business cycle as credit union loan delinquencies. They estimate that an increase of one percentage point in the unem- ployment rate is associated with a 23.7% increase in bank delinquen- cies but only a 10.0% increase in credit union delinquencies. Second, they report that credit union loan losses are less than two- thirds as sensitive to the business cycle as commercial bank loan losses. Their regression estimates suggest that a one-percentage- point increase in the unemployment rate is associated with a 30.8% increase in commercial bank charge-oﬀs over a one-year period. However, the corresponding increase in credit union charge-oﬀs is only 19.0%. The authors suggest that their ﬁndings have important implications for capital requirement regulations for credit unions and commercial banks. As their analysis indicates, credit unions are only about two- thirds as sensitive as commer- cial banks to macroeconomic As their analysis indicates, credit unions are only about two- shocks, and they suggest that thirds as sensitive as commercial banks to macroeconomic this diﬀerence be reﬂected in shocks, and they suggest that this diﬀerence be reﬂected in credit union capital require- credit union capital requirements. ments. Stated diﬀerently, any capital requirements designed to cover macroeconomic shocks for credit unions should be approximately three-quarters of the requirement for commercial banks. Given credit unions’ lower sensitivity to macroeconomic shocks, this level would produce a rea- sonably equivalent coverage for commercial banks and credit unions from the risks of loan losses. These ﬁndings by Smith and Woodbury (2001) are important because macroeconomic risks are extremely relevant in evaluating the overall ﬁnancial health of the credit union industry. Chapter 5 29
CHAPTER 6 Review of the NCUA’s PCA Proposal for Reform of March 2005 The NCUA proposal recognizes that there are inherent limitations in any given risk-based capital system, that the changes are designed to be comparable to the capital standards for the FDIC, that achieving comparability for the leverage standard requires the consideration of the NCUSIF, and that the risk-based requirement addresses only credit risk and operational risk.
In the preface to the NCUA’s Prompt Corrective Action Proposal for Reform, Chairman JoAnn M. Johnson highlights several key elements of the recommended statutory changes to the current PCA system for credit unions. These four key elements are as follows. First, the proposal recognizes that there are inherent limitations in any given risk-based capital system. Therefore, the NCUA advo- cates a system that includes both leverage and risk-based standards working in a complementary fashion. Second, the changes recom- mended in the proposal are designed to be comparable to the capi- tal standards for FDIC-insured ﬁnancial institutions because there should not be unwarranted diﬀerences in the capital standards for diﬀerent types of depository institutions. Third, achieving compa- rability for the leverage standard requires the consideration of the NCUSIF deposit-based funding mechanism. And fourth, consis- tent with BASEL II and the FDIC’s PCA system, the risk-based requirement addresses only credit risk and operational risk. Given that there are other forms of risk, for example, interest-rate risk, this proposal includes recommendations to address these other risks through a robust supervisory review process. On page 4 of the proposal, the current PCA system for credit unions is discussed. It is interesting to note the NCUA’s assess- ment of the current capital requirement regulations. For instance, the NCUA states that PCA for credit unions does not adequately distinguish between low-risk and higher risk activities. The current PCA system’s high leverage requirement (ratio of net worth to total assets) coupled with the natural tendency for credit unions to manage to capital levels well above the PCA requirements essentially creates a “one- size ﬁts all” system. This penalizes institutions with conservative risk proﬁles. While providing adequate protection for the insur- ance fund, a well designed risk-based system with a lower leverage 32
requirement would more closely relate required capital levels with the risk proﬁle of the institution and allow for better utilization of capital. The current high leverage ratio imposes an excessive capital requirement on low-risk credit unions. With a lower leverage require- ment working in tandem with a well-designed risk-based requirement, credit unions would have greater ability to serve members and manage their compliance with PCA. By managing the composi- tion of the balance sheet, credit unions would shift as needed to lower risk assets resulting in the need to hold less capital. Recognizing that the current PCA system for credit unions imposes an unreasonably high leverage requirement, the NCUA proposes changes to the current system that include lowering the leverage requirements for the Well Capitalized category from a 7% net worth ratio to a 5% ratio. The Adequately Capitalized category would likewise be reduced from 6% to 4%. These net worth ratios would be comparable to those used by the FDIC for thrifts and commercial banks. Additionally, the risk-based net worth ratios would also be set at levels comparable to the FDIC’s total risk-based capital require- ments and BASEL II. That requirement would be an 8% risk- based net worth ratio to be considered a Well Capitalized credit union. The NCUA’s proposal incorporates the risk weights for speciﬁc port- folio items based on BASEL II. Without any substantial or notewor- thy diﬀerences, the NCUA proposal applies the BASEL II risk-based system to credit unions. I believe the NCUA proposal to be a very good alternative to the current PCA system for credit unions. The NCUA may reconsider its proposed leverage ratio schedule, however. The NCUA states that its objective is to create a PCA system for credit unions that is comparable to the existing PCA system for FDIC-insured deposi- tories. To do so, the NCUA proposes the same net worth The NCUA should consider that equal leverage ratios in its ratios (leverages) for credit PCA systems is not the same as comparable capital require- unions as for FDIC-insured ments to risk levels for credit unions and other depositories. banks and thrifts. This has the eﬀect of lowering the leverage ratio of credit unions by 200 basis points for the Well Capitalized and Adequately Capitalized categories. This is a good start, but it may not achieve true comparability. The NCUA should consider that equal leverage ratios in its PCA systems is not the same as Chapter 6 33
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