Concerns about PCA Appear to Drive Industry Interest in Secondary Capital

The credit union industry’s recent interest in using alternative forms of  capital appears to be associated primarily with three concerns about PCA  for credit unions. Finally, several credit union officials are concerned that the PCA  tripwires for credit unions are too high, given the conservative risk profile  of most credit unions. In contrast, the proposed  abbreviated NWRP did not address the credit union’s net worth after the  end of the term of the plan. However, taking into account that (1) corporate credit unions and natural  person credit unions are not comparable given their member base, and (2)  there are far fewer corporate credit unions compared with the total number  of federally insured credit unions, those 18 corporate credit unions with  member paid-in capital and 30 with membership capital do not provide a  representative or sufficient sample that can be used as a model to  demonstrate how secondary capital could be used for all federally insured  credit unions. While Many View Risk- Based Capital as an Enhancement to PCA for Credit Unions, Key Structural Issues Remain Unresolved

The debate about the potential use of risk-based capital for all credit unions  revolves around key structural issues, including (1) the extent to which  risk-based ratios would be used to augment, versus replace, the current  PCA net worth (leverage) requirements and (2) how key risk components  and weights that are appropriate to the unique characteristics of credit  unions would be defined. Moreover, each proposal lacked details of  key components upon which to base any assessment of their merits. The market-risk capital ratio augments the definitions of  qualifying capital in the credit risk requirement by adding an additional  capital component (tier 3). Available indicators suggest that the credit union industry as a whole has  not been overly constrained as a result of the implementation of PCA. Allowing credit unions to use secondary capital instruments to meet their  regulatory net worth requirements would raise a number of issues and  concerns. While allowing credit  unions to sell secondary capital instruments to investors outside of the  credit union industry would provide market discipline, this would raise  concerns about the potential impact on the member-owned, cooperative  nature of credit unions. Some have proposed limiting potential investors to  credit union members, other credit unions, and corporate credit unions;  however, in-system investors could impose less discipline and raise  systemic risk concerns if it were to create a situation where weaker credit  unions brought down stronger credit unions due to secondary capital  investments. Other issues relate to the specific form of the capital  instruments, and how they would be incorporated into the regulatory net  worth requirement for credit unions. The credit union industry itself  appeared divided on the desirability or appropriate structure of secondary  capital instruments. Conceptually, the potential use of a risk-based capital system for all credit  unions appears less controversial. In recognition of the  limitations of risk-based capital systems, the bank and thrift regulators use  both risk-based and nonrisk weighted (leverage ratio) capital requirements  for PCA purposes. Moreover, our analysis of aggregated credit union data indicated that credit  unions have been able to maintain a rate of growth that has exceeded that  of banks and thrifts in the three full calendar years that PCA has been in  place for credit unions. We are aware that NCUA is constructing a more detailed risk-based  capital proposal that incorporates both risk-based and leverage  requirements; however, due to the lack of formalized details, we could not  perform a meaningful assessment of the proposal.
Why GAO Did This Study

Since the passage of the Credit Union Membership Access Act of 1998 (CUMAA), many in the credit union industry have sought legislative changes to the net worth ratio central to prompt corrective action (PCA). The current debate centers on the issue of allowing federally insured credit unions to include additional forms of capital within the definition of net worth. In light of the issues surrounding the debate, GAO reviewed (1) the underlying concerns that have prompted the credit union industry's interest in making changes to the current capital requirements, (2) the issues associated with the potential use of secondary capital in all federally insured credit unions, and (3) the issues associated with the potential use of risk-based capital in all federally insured credit unions.

What GAO Found

The credit union industry's interest in making changes to the current capital requirements for credit unions appears to be driven by three primary concerns: (1) that restricting the definition of net worth solely to retained earnings could trigger PCA actions due to conditions beyond credit unions' control; (2) that PCA in its present form acts as a restraint on credit union growth; and (3) that PCA tripwires, or triggers for corrective action, are too high given the conservative risk profile of most credit unions. Despite these concerns, available indicators suggest that the credit union industry has not been overly constrained as a result of the implementation of PCA. As a group, credit unions have maintained capital levels well above the level needed to be considered well-capitalized and have grown at rates exceeding those of other depository institutions during the three calendar years that PCA has been in place for credit unions. Allowing credit unions to use secondary capital instruments to meet their regulatory net worth requirements would raise a number of issues and concerns, with perhaps the most important issue centering on who would purchase the secondary capital instruments. While outside investors would provide market discipline, this would raise concerns about the potential impact on the member-owned, cooperative structure of credit unions. Inside investors, however, could impose less discipline and raise systemic risk concerns if it resulted in a situation where weaker credit unions could bring down stronger credit unions due to secondary capital investments. Other issues relate to the specific form of the capital instruments for credit unions. The credit union industry itself appeared divided on the desirability or appropriate structure of secondary capital instruments. Conceptually, the use of risk-based capital to address the concerns some in the credit union industry expressed about PCA is less controversial. Though two risk-based capital proposals were put forward, neither has garnered industry consensus and both lacked details of key components upon which to base any assessment of their merits. Risk-based capital is intended to reflect the unique risk profile of individual financial institutions; however, there are other factors that can affect an institution's financial condition that are not easily quantified. In recognition of the limitations of risk-based capital systems, bank and thrift regulators use leverage and risk-based capital requirements in tandem. GAO is aware that NCUA is constructing a more detailed risk-based capital proposal that incorporates both risk-based and leverage requirements; however due to the lack of formalized details, GAO could not perform a meaningful assessment of the proposal.