Could Credit Unions Face Higher Net Worth Requirements?

Credit unions should pay careful attention to proposed changes in capital requirements coming out of Basel; because credit unions may face higher minimum net worth requirements in the future.

The Basel Committee on Banking Supervision has agreed that banks should hold more capital in the future to avoid the type of turmoil seen in recent years. At present, banks must have a risk-based capital ratio of at least 8 percent and a leverage ratio of at least 4 percent. Under the Basel Committee agreement, the risk-based capital floor will rise to 10.5 percent and the capital-to-asset ratio will either be replaced or augmented with a new capital-to-risk-weighted-asset minimum of 7 percent. These are the new standards for being adequately capitalized. Banking regulators will apply higher cut-offs to be well capitalized.

These new requirements will be phased in over time. However, U.S. banking regulators may move quicker than the proposed Basel Committee timeline to meet Dodd-Frank Act deadlines.

U.S. regulators have until Jan. 1, 2013, to implement the agreement. In the past, U.S. bank regulators have applied these requirements to all banks and I suspect this will be the case with these proposed capital standards.

But why am I saying that this may mean higher future net worth requirements for credit unions.

Section 1790d(c)(2)(A) of the Federal Credit Union Act, which deals with Prompt Corrective Action, states that “[i]f … the Federal banking agencies increase or decrease the required minimum level for the leverage limit, the [NCUA] Board may correspondingly increase or decrease 1 or more of the net worth ratios … in an amount that is equal to not more than the difference between the required minimum level most recently established by the Federal banking agencies and 4 percent of total assets.”

In order for this adjustment to occur, two conditions must be met. First, the NCUA must determine, in consultation with the Federal banking agencies, that the reason why the agencies changed the required minimum level for the leverage limit also justifies the proposed adjustment in net worth ratio for credit unions. Second, NCUA must determine that the resulting net worth ratios for credit unions is sufficient to carry out the purpose of this section of the Federal Credit Union Act.

While NCUA has some discretion associated with adjusting the net worth ratio for credit unions, deciding not to adjust the minimum net worth requirement when the Federal bank regulators have raised the minimum capital requirements for banks may come at enormous political cost to the agency.

Therefore, I believe credit unions should begin to prepare for higher future minimum net worth requirements.

Alternative Capital – Not A Panacea

Alternative capital may not be a panacea for the capital woes of credit unions.

In a December 7, 2009 letter to Chairman Barney Frank, NCUA Chairman Deborah Matz noted a trend where some well-capitalized credit unions were discouraging consumer deposits because rapid deposit growth could negatively impact their net worth ratio subjecting the credit unions to prompt corrective action. With the exception of low income credit unions, the only vehicle for credit unions to build capital or net worth is retained earnings. Chairman Matz proposed allowing qualified credit unions to issue some form of alternative capital to supplement retained earnings.

What is alternative capital?

Alternative capital may include – uninsured certificate of deposits, subordinated debt, membership capital shares (MCS), and members’ paid-in capital.

However, under Basel capital rules, uninsured certificates of deposit and subordinated debt would not count as core capital, but rather as tier 2 capital. This would not provide the capital relief that credit unions are seeking.

The capital instruments that would most likely be viewed as core capital are membership capital shares and members’ paid-in capital.

Membership capital shares have some of the prerequisites to be counted as core capital: MCS can only be withdrawn, when membership is terminated. Moreover, credit unions have a legal right to refuse to pay out these minimum amounts if net worth levels are inadequate. However, MCS are currently covered by federal insurance from the NCUSIF, which disqualifies MCS as core capital. To be counted as capital, membership capital shares would have to become uninsured.

Therefore, member paid-in capital appears to offer the best prospect as a source of core alternative capital. Member paid-in capital is permanent, perpetual, and uninsured. Also, dividends would be treated as non-cumulative. Since, these funds are at risk, credit unions would have to pay a significantly higher dividend rate to compensate these investors for their risk.

However, several aspects may make members’ paid-in capital unattractive to credit unions.

First, in general, depositors are risk-averse. Therefore, credit union members are unlikely to put their money at risk.

Second, members’ paid-in capital is illiquid, because this investment cannot be sold.

Third, members’ paid-in capital may attract professional depositors who would want to force the credit union to go public.