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FEBRUARY 6, 2015

Originally Appearing in the Credit Union Journal

Capital modernization is the generational issue of credit unions today.

If we get it right, the credit union charter will be viable and competitive for the next twenty-five years – impacting millions of folks from all walks of life with lower cost financial services from a safe, sound and growing industry.

If we fumble this opportunity, the result could be a less desirable credit union charter and fewer lives impacted in a positive way – probably leaving many credit unions to evaluate other charter and insurance options, not to the benefit of the industry or our members.

There are four crucial pillars of effective capital modernization.  Any of the pillars, without the others, will be insufficient and leave credit unions looking for a better way to serve their members and meet their strategic business needs.

The four pillars are (1) a balanced risk-based capital system; (2) a reasoned supplemental capital option; (3) a coordination and consistency of both risk-based capital and supplemental capital with the existing statutory PCA net worth system passed by Congress in 1998 and (4) a progressive approach to field of membership that will allow credit unions to grow sufficiently to build the necessary capital to make the credit union charter viable from both a member service and a financial strength perspective.

We will look at each of these four essential pillars below.

A Balanced Risk-Based Capital (RBC) System

NCUA is moving toward progress on this pillar.  While there are still some improvements that could be made in a final RBC, the agency has made significant steps in response to over 2100 commenters that almost unanimously felt that the original RBC proposal was not sufficiently balanced between the stated safety and soundness needs of the regulator and the strategic member service needs of the regulated.

The revised RBC proposal presently out for its second comment period could still incorporate more nuanced risk weights in certain areas (CUSO investments and mortgage servicing rights, for example) and a more reasonable trigger to be well-capitalized; however, the second iteration of RBC is considerably more balanced than the original.

With a few changes, it could become a good pillar to address this important component of effective capital modernization.

The fact remains, however, that no matter how better balanced RBC2 may be over RBC1 – risk-based capital, alone without the other three pillars, will not be solid enough to sustain the structure the credit union industry will require to be safe, sound and strategically growing over the decades to come.

Yes, risk-based capital is necessary for capital modernization.  But it is not within itself, nor will it ever be, capital modernization.

A Reasoned Supplemental Capital Option

Supplemental capital is so essential to effective capital modernization that RBC should have its effective date tied to subsequent enactment of a supplemental capital regulation that will offer complex credit unions the option of building capital to meet the RBC requirements through a reasonable subordinated debt methodology in addition to retained earnings.

Admittedly, most credit unions will not seek to issue supplemental capital instruments.  But all credit unions subject to RBC should have the option to do so.

Supplemental capital protects the share insurance fund with another level of buffer.  It opens the door for strategic investment of capital in strategic growth, technology, products, services and member outreach to more persons in communities across the nation.

To pursue RBC without addressing supplemental capital, particularly when over 2200 credit unions are now low-income designated (a number that could go up with some strategic and statutorily allowed low-income qualification amendments by NCUA regulation) and currently eligible by law to hold supplemental capital, is an incomplete and unbalanced approach to public policy.

Just as RBC is good public policy if done right and in conjunction with the three other pillars of capital modernization, RBC becomes virtually ineffective as a public policy if approved to stand alone.

Before RBC is made effective by regulation, supplemental capital must be addressed or capital modernization talk becomes simply all sizzle and no steak – or all downside for strategic credit unions investment and no upside.

Consistency with Existing Law and Regulation

This is the question that is at the crux of the legal argument as to whether Congress intended NCUA to come along almost two full decades after the passage of the Credit Union Membership Access Act (CUMAA) and lay a second level of capital requirements on credit unions at the expense of the 7% net worth requirement to be well-capitalized that was approved by Congress in 1998.

Whether NCUA wishes it were so or not, Congress clearly set a statutory standard of 7% net worth to be considered well-capitalized.  This congressionally mandated standard has been law for almost seventeen years.  RBC and supplemental capital must be considered for capital modernization, but not at the expense of current law.

Any RBC final rule, as well as supplemental capital to hopefully come before its effective date, must in some meaningful way incorporate the 7% net worth PCA standard approved by Congress.

There are a number of way to do this, but two come immediately to mind.  The easiest way would be to make the final RBC trigger to be well-capitalized or adequately capitalized consistent with the current PCA law at 7% and 6% respectively.  This would recognize congressional intent and incorporate it directly into the RBC rule, basically making more difficult the charge that RBC is an unauthorized regulatory revision to a statutory mandate.

A second method of bringing RBC into consistency with current law, although a bit more nuanced than making the triggers line up, would be for the final RBC rule to clarify that a credit union falling below the RBC trigger to be adequately capitalized will have any required corrective action determined in conjunction with the statutory 7% net worth standard to be well-capitalized.  If RBC brings a credit union below the trigger that it exceeds under statutory PCA, a mitigation of corrective action should be implemented in deference to the statutory standard being met.

RBC will always be subject to possible congressional hearings or even legal challenge if it does not recognize the 1998 statutory mandate of 7% net worth being the trigger for a well-capitalized credit union – a standard higher then, and still higher today because it is based upon retained earnings only, than the requirement for community banks.

To have RBC in as much consistency as possible with the current PCA law is crucial as a pillar of effective capital modernization because, well, frankly, the law is the law.  Any regulation ignores it at its own peril.  And there are ways to incorporate the PCA net worth standards into RBC, and these should be pursued in the final RBC regulation to make sure the legal pillar is solid and not still being debated a decade from now.

Field of Membership is Key to the Growth Necessary to Build Capital

Capital, at least traditional credit union capital, comes from earnings.  Earnings come from members.  Members come from potential members.  Potential members come from a viable field of membership.

Every statistic validates that the growing credit unions are performing better and building more capital than those not growing.  Therefore, NCUA must incorporate a more progressive approach to field of membership into any scenario in which RBC is a key pillar.

Why?  Because credit unions have to grow in order to build the capital required under RBC.  It does not happen by magic.

Field of membership is as key of a pillar to effective capital modernization as airlines are to an effective airport.  Something has to get the passengers off the ground and to their destination or they have no reason to go to the airport.  Within itself, an airport is an expensive dead building with security.

The federal charter is losing the FOM battle to the state charter today.  Our firm is working fourteen federal to state charter conversions right now, each and every one based upon the greater FOM flexibility allowed by their states.  (Nine of them are converting solely because of the NCUA’s extremely tight interpretation of what is really an associational SEG – some of which organizations have been in existence, and even part of a credit union’s FOM, for decades.)

Within existing law, NCUA absolutely can and certainly should restore the ability of credit unions to apply for community charters beyond a strict MSA definition, bring the 98% of associational SEGs that are legitimate organizations into their FOM, have a SEG “reasonable proximity” standard beyond an anachronistic 25-mile-from-a-branch limit, eliminate punitive matrices that disqualify many underserved areas, allow community chartered credit unions to also apply to serve underserved areas outside their community, establish more qualifiers such as loans or deposits to the LICU approval criteria and define “in danger of insolvency” more broadly to facilitate mergers between credit unions with different FOM types.

Despite NCUA’s tight FOM interpretations that most federal chartered credit union leaders frankly feel take a much too over-zealous conservative approach to reading of the statute that is, interestingly, not similarly reflected in their quite open-minded approach to what the statutes allow on RBC (not to mention the recently approved CUSO reg), there are no direct statutory prohibitions from pursuing any of the above listed FOM modernization initiatives.

If NCUA wants to see RBC become more than one singular pillar that within itself creates an unbalanced foundation upon which not much substantive for credit union growth can be built for the future, and perhaps not even all can be maintained long term that has been built over the decades, they should prioritize these other three necessary areas of focus in conjunction with RBC.

If so, they can bring about true capital modernization and position the credit union charter for its greatest period of member service, strategic outreach and financial stability in its history.

And they will deserve the commendation they receive for not stopping with three-quarters of the journey yet ahead of them.  Likewise, if they ignore the other three pillars with a single-minded focus on RBC only, they will deserve the criticism of those whose foundations are damaged in the process.

I join the credit union community, and the millions of Americans whose hope of financial self-sufficiency depend upon consumer choice of a lower-cost option through a viable credit union industry, in hoping that RBC is the beginning of comprehensive capital modernization with all four necessary pillars.  Each pillar is essential to a credit union industry that both the regulator and the regulated feel good about for generations to come.

Dennis Dollar is a Principal Partner in Dollar Associates LLC, a Birmingham-Alabama based full-service credit union consulting firm.  Mr. Dollar is a former two-term Mississippi legislator, credit union CEO and NCUA Chairman.  He can be reached at [email protected] or 205-991-1525.