NCUA Proposed Rule Breakdown: Prompt Corrective Action Risk-Based Capital

Transcription

1 NCUA Proposed Rule Breakdown: Prompt Corrective Action Risk-Based Capital Prepared by the NASCUS Legislative & Regulatory Affairs Department March 26, 2014 The National Credit Union Administration (NCUA) has issued a notice of proposed rulemaking that would redefine federally insured natural person credit unions with assets of more than $50 million as complex, and apply a new risk-based capital ratio calculation as part of a revised Prompt Corrective Action (PCA) framework. The proposed rule restructures 12 CFR Part 702 and renames the section Capital Adequacy. FISCUs are required to comply with Part 702 pursuant to section 216 of the Federal Credit Union Act and Part of NCUA's Rules and Regulations. NASCUS will file a comment letter on this proposed rule on behalf of the state credit union system. The below section-by-section summary of the proposed rule is intended to aid digestion and analysis of each provision s potential impact on the state system. NASCUS strength derives from the unique perspective of its regulator and credit union members; we encourage you to contact Sabrina Cotter or Brian Knight with your thoughts on this proposed rulemaking. A few of the initial issues that NASCUS is examining include: Whether NCUA should have authority to impose individual minimum capital requirements (IMCR) on credit unions, and the process of working with state regulators in making the determination that an IMCR is necessary; The procedure and consequences of determining that a credit union is unable to demonstrate, as required under (d), a comprehensive understanding of the features of the asset-backed investment resulting in a 1,250% risk-weight; The procedure around designating something an Identified Loss, including potential for disagreement between NCUA and state regulators; Whether a 250% risk-weight is appropriate for investments in CUSOs; and The misrepresentation of exposure on loans transferred with limited recourse. Comments are due to NCUA by May 28, Part 702; Capital Adequacy Part ; Authority, Purpose, Scope & Definitions

2 Summary: PCA is designed to restore and improve the capital adequacy of federally insured credit unions and minimize long-term loss to the National Credit Union Share Insurance Fund (NCUSIF). This section defines the key terminology involved in calculating the risk-based capital ratio and determining a credit union s PCA classification. The proposed rule would maintain most of the old definitions in this section and add several new definitions to help credit unions determine the allocation and risk-weight of their various assets. Many of the new definitions correspond to and are consistent with a related Call Report field, and should therefore be relatively easy to apply. Below are a few examples of definitions where we believe clarification or revision is necessary. First Mortgage Real Estate Loan: defined as loans and lines of credit fully secured by first liens on real estate (excluding MBLs) where original amortization does not exceed 30 years, the underwriting took into account all the borrower s obligations, and the loan underwriting concluded the borrower is able to repay. The proposed rule would benefit from a more robust discussion of the incorporation of the ability to repay standard into the regulatory capital calculation. What kind of liability does this create for a credit union, and what are the potential consequences of losing an ATR lawsuit by a consumer? Identified Losses: defined as those items that have been determined by an evaluation made by a state or federal examiner, as measured on the date of examination, to be chargeable against income, capital and/or valuation allowances such as the allowance for loan and lease losses. Clarification is needed regarding the process of determining the appropriate number during examination. If state and federal examiners disagree regarding identified losses in a FISCU, which number controls? Does this number remain constant between exam dates, or may a credit union petition to update it between exams? Loans Transferred with Limited Recourse: defined as the total principal balance outstanding of loans transferred, including participations, for which the transfer qualified for true sale accounting treatment under GAAP, and for which the transferor credit union retained some limited recourse. This definition is pulled from the related Call Report field and related definition, and is problematic in that it assigns exposure to the credit union equal to the total principal balance of loans transferred, instead of merely recognizing the small percentage for which the credit union has recourse liability. This definitional flaw results in a misrepresentation of a credit union s risk profile, and discourages credit union from participating in partial recourse programs that can be beneficial in managing interest rate risk and liquidity. Subpart A Prompt Corrective Action Part ; Capital Measures, Effective Date of Classification, and Notice to NCUA Summary: This section has been renamed from Measures and effective date of net worth classification to more accurately reflect the content of the section. The proposed rule would not materially alter this section, but replaces net worth with capital to reflect the updated terminology used throughout the new rule. The basic obligation of a credit union to determine its net worth category classification and provide notice to NCUA by timely filing of Call Reports remains unchanged.

3 Part ; Capital Category Classification Summary: This section continues to list the five statutory capital categories that are provided in section 216(c) of the Federal Credit Union Act. The rule retains the original statutorily mandated net worth ratio requirements for each classification, and adds an additional risk-based capital requirement for the well capitalized, adequately capitalized, and undercapitalized classifications. A credit union must satisfy both the net worth ratio and risk-based capital ratio requirements to qualify for a particular classification. The new proposed capital categories are outlined below 1 : A credit union s net worth classification is Net worth ratio Risk-based capital ratio* And subject to following condition(s) Well Capitalized 7% or above 10.5% or above Must pass both net worth ratio and riskbased capital ratio Adequately Capitalized 6% to 6.99% 8% to 10.49% Must pass both net worth ratio and riskbased capital ratio Undercapitalized 4% to 5.99% Less than 8% Must pass both net worth ratio and riskbased capital ratio Significantly Undercapitalized 2% to 3.99% N/A Or if undercapitalized at <5% net worth and fails to timely submit or materially implement an approved net worth restoration plan Critically Undercapitalized Less than 2% N/A None *applies only to credit unions with quarter-end total assets exceeding $50 million The rule also replaces the statutory term risk-based net worth with the term risk-based capital, but NCUA notes that the terms are functionally equivalent and the change in terminology does not reflect a deviation from the requirements of the statute. The language in the remaining subparts of this section is unaltered from the previous version: NCUA may, after notice and hearing, reclassify a credit union into a lower capital category for reasons other than net worth; NCUA may not delegate its authority to reclassify a credit union s capital category; and NCUA shall consult and work cooperatively with state regulators before reclassifying a state-chartered credit union. Part ; Applicability of Risk-Based Capital Ratio 1

4 Summary: The proposed rule would eliminate the requirement that a credit union s risk-based capital ratio exceed 6% in order to qualify as complex. Under the proposed rule, a credit union is complex if its quarter-end total assets exceed $50 million, as reflected in the most recent Call Report. The $50 million asset threshold corresponds to NCUA s definition of small entity. Part ; Risk-Based Capital Ratio Measures Summary: This section describes how a complex credit union must calculate its risk-based capital ratio. The risk-based capital ratio is a percentage, rounded to two decimal places, of the risk-based capital numerator to the total risk-weighted assets of a credit union. Risk-Based Capital Numerator: The risk-based capital numerator is comprised only of those elements of a credit union s equity that would be available to cover losses in a time of stress. The numerator is calculated by subtracting the Deductions listed below from the sum of the Additions listed below: Additions Undivided earnings (includes any regular reserve) Appropriations for non-conforming investments Other reserves Equity acquired in merger Net income ALLL (limited to 1.25% of risk assets) Secondary capital accounts included in net worth Section 208 assistance included in net worth (as defined in 702.2) Deductions NCUSIF deposit Goodwill Other intangible assets Identified losses not reflected as adjustments to components of the risk-based numerator Accumulated unrealized gains/losses and other comprehensive income would be excluded from the numerator to reduce volatility in the risk-based capital measure. The proposed rule also deducts intangible assets from both the numerator and denominator of the risk-based capital ratio because their value is inherently uncertain. Risk-Based Capital Denominator: The denominator of the risk-based capital ratio is comprised of the total risk-weighted assets of a credit union minus goodwill and other intangibles, identified losses, and the NCUSIF deposit. The proposed rule requires a credit union to consider: Risk-weighted on-balance sheet assets; Risk-weighted off-balance sheet assets; and Risk-weighted derivatives. (a) On-balance sheet assets On-balance sheet assets would be assigned to one of ten broad risk-weight categories according to asset type, collateral, and level of concentration. The capital charge, or amount of capital that

5 must be held against a tranche of assets, equals the nominal asset value multiplied by the applicable risk-weight, multiplied by 8% (the minimum capital requirement). For example, a credit union would have to hold $8 in capital for a $100 asset with a 100% risk-weight. In general, the proposed rule would increase risk-weights for MBLs across the board, and create a tiered system of risk-weights to reflect concentration risk in certain asset categories: 1) Zero Percent Cash on hand, NCUSIF capitalization deposit, debt instruments unconditionally guaranteed by NCUA or FDIC, U.S. Government obligations unconditionally guaranteed, and non-delinquent student loans unconditionally guaranteed by the U.S. Government. 2) 20 Percent Cash on deposit, cash equivalents, investments with weighted-average life of one year or less, residential mortgages guaranteed through the FHA or the VA, and loans guaranteed for 75% or more by the SBA or a U.S. Government Agency. 3) 50 Percent Investments with weighted average life between 1-3 years, current and nondelinquent first mortgage real estate loans equaling 25% or less of total assets. 4) 75 Percent Investments with weighted average life between 3-5 years, current and nondelinquent unsecured loans, vehicle loans, leases receivable, and all other loans (excluding MBLs), current and non-delinquent first mortgage real estate loans between 25-35% of total assets. 5) 100 Percent Corporate credit union non-perpetual capital, loans to CUSOs, current and non-delinquent first mortgage real estate loans greater than 35% of total assets, delinquent first mortgage real estate loans, other real estate secured loans less than or equal to 10% of assets, MBLs less than or equal to 15% of assets, loans held for sale, foreclosures and repossessed assets, land and building and any other fixed assets less depreciation, current non-federally insured student loans, and all other assets not specifically assigned a risk-weight but included in the balance sheet. 6) 125 Percent All other real estate secured loans between 10-20% of assets. 7) 150 Percent Investments with a weighted-average life between 5-10 years, delinquent unsecured loans, vehicle loans, leases receivable, and all other loans (excluding MBLs), other real estate secured loans greater than 20% of assets, any MBLs between 15-25% of assets. 8) 200 Percent Corporate credit union perpetual capital, investments with a weightedaverage life of greater than 10 years, and the total amount of MBLs greater than 25% of total assets. 9) 250 Percent Total value of investment in CUSOs and total value of mortgage servicing assets. 10) 1,250 Percent An asset-backed investment for which the credit union is unable to demonstrate, as required under (d), a comprehensive understanding of the features of the asset-backed investment that would materially affect its performance. A 1,250% risk-weight is equivalent to a dollar-for-dollar capital requirement ($100 asset x 1,250% x 8% = $100). (b) Off-balance sheet activities Under the proposed rule, risk-weights for off-balance sheet activities would be determined by multiplying the face value of the item by the appropriate credit conversion factor (CCF), and then by the assigned risk-weight. For example, the following assets would be multiplied by a 75% conversion factor with a 100% risk-weight:

6 Unfunded commitments for MBLs MBLs transferred with limited recourse Other real estate loans transferred with limited recourse Non-federally guaranteed student loans transferred with limited recourse Consequently, $1 million of off-balance sheet unfunded MBL commitments would result in $1,000,000 x.75 x 1 x.08 = $60,000 of required capital. The proposed rule also provides for 75% CCF and 50% risk-weight for first mortgage real estate loans transferred with limited recourse, and 75% CCF and 75% risk-weight for all other loans transferred with limited recourse. Total unfunded commitments on non-business loans would receive a CCF of 10% and a 75% risk-weight. (c) Derivatives Derivatives exposure is also included in the risk-based capital denominator or total riskweighted assets. The proposed rule provides a separate calculation to determine the appropriate exposure on a derivatives contract, and that exposure is then multiplied by the appropriate riskweight and added to the total risk-weighted assets. The proposed rule differentiates between exposure on single derivatives contracts and multiple derivatives subject to a netting agreement. A credit union may recognize the credit risk mitigation benefits of holding financial collateral for either type of arrangement. 1) Single Derivatives Contract A credit union s exposure on a derivatives contract that is not subject to a master netting agreement is equal to the sum of the current credit exposure (CCE) and any potential future credit exposure (PFE). a. Exposure on Single Derivatives Contract = CCE + PFE b. CCE = mark-to-fair value or zero, whichever is greater c. PFE = notional principal amount of derivative x Credit Conversion Factor (provided in table below) Remaining maturity Interest rate derivative Other One year or less Greater than one year and less than or equal to five years Greater than five years ) Netting Agreements Exposure on derivatives subject to a master netting agreement is equal to the sum of the net CCE and the adjusted sum of the PFE amounts for all derivatives subject to the netting agreement. a. Exposure on Netting Agreements = Net CCE + Adjusted Sum of PFEs b. Net CCE = net sum of all mark-to-fair values or zero, whichever is greater c. Adj. Sum of PFE = (0.4 x Gross PFE) + (0.6 x Net-to-Gross CCE Ratio x Gross PFE) d. Gross PFE = Sum of PFE amounts for each individual derivatives contract subject to the netting agreement

7 e. Net-to-Gross CCE Ratio = Net CCE/ Sum of positive CCEs of all derivatives in the netting agreement A credit union may account for the credit risk mitigation benefits of holding financial collateral by utilizing the simple approach or the alternative approach. 1) Simple Approach In order to qualify for the simple approach methodology, the financial collateral must meet the following requirements: a. The collateral must be subject to a collateral agreement for at least the life of the exposure; b. The collateral must be revalued at least every six months; and c. The collateral and the exposure must be denominated in the same currency. Under the Simple Approach a credit union may apply the risk-weight assigned to the specific type of collateral under (c) to the secured derivatives exposure. For example, if the collateral is comprised of investments with a weighted-average life between 1-3 years, the collateralized derivative exposure would be assigned a risk-weight of 50%. The uncollateralized portion of the derivative exposure would receive the applicable risk-weight based on the underlying exposure of the contract itself. 2) Alternative Approach As an alternative to the Simple Approach, a credit union may recognize the benefits of financial collateral on a derivatives contract by applying a riskweight to the exposure as if it were uncollateralized and adjusting the exposure amount calculated under the CCE+PFE formula using the collateral equation in section (c)(4)(v). In order to utilize the alternative approach the financial collateral must be marked-to-fair value on a daily basis and subject to a daily margin maintenance requirement. If a derivatives contract is marked-to-market on a daily basis and subject to a daily margin maintenance requirement, reduced risk-weight requirements apply. A credit union may assign a zero percent risk-weight to derivatives exposure that is collateralized by cash on deposit, or collateralized by an asset that qualifies for zero percent risk-weight under (c)(2)(ii), and the credit union has discounted the fair value of the collateral by 20%. If the credit union does not discount the value of the collateral, it must assign a 10% risk-weight to the exposure. (d) Due diligence for asset-backed investments This section outlines the minimum due diligence required for a credit union to demonstrate its comprehensive understanding of an asset-backed investment. If a credit union fails to demonstrate a comprehensive understanding, it must assign a 1,250% risk-weight to that exposure, meaning it must hold dollar-for-dollar capital on the investment exposure. Although this section describes the type of analysis NCUA will be looking for, the proposed rule also notes that analysis must be commensurate with the complexity of the asset-backed investment and the materiality of the position in relation to regulatory capital, and provides examiners with wide discretion in determining the adequacy of due diligence with respect to any asset-backed investment.

8 Due diligence must include an analysis of the risk of the investment conducted prior to acquiring it, and documented within 3 business days after acquiring it. The analysis must evaluate: Structural features of the investment that would materially impact the performance of the exposure; Relevant information regarding performance of the underlying credit exposure(s); Relevant market data of the asset-backed investment; and For reinvestment exposures, performance information on the underlying investment exposures. Credit unions must evaluate, review, and update this analysis for each investment exposure at least quarterly. Part ; Individual Minimum Capital Requirements Summary: This section of the proposed rule allows NCUA to require an individual credit union to maintain a higher risk-based capital ratio than otherwise required under the rule. This provision provides NCUA discretion to demand higher capital levels in any case where the circumstances indicate that the credit union s capital is or may become inadequate. Of particular concern to NASCUS is the lack of any mention of consultation or coordination with state supervisory authorities when making a determination that a FISCU should be subject to an Individual Minimum Capital Requirement (IMCR). Section notes that NCUA will forward a copy of the notifying letter to the appropriate SSA when the credit union is notified, but there is no discussion of the regulators working together in making the determination that an IMCR is necessary. The proposed rule includes 10 examples of circumstances where higher capital standards may be appropriate, including when a credit union: Is receiving special supervisory attention; Has poor liquidity or cash flow; Has a high degree of exposure to a specific type of risk, including IRR, prepayment risk, credit risk, or concentration risk; or Has inadequate underwriting policies, standards or procedures The proposed rule asserts that a decision regarding appropriate minimum capital levels is necessarily based, in part, on subjective judgment grounded in agency expertise, and will vary on a case-by-case basis. The identified standards for determining an appropriate individual minimum capital requirement include: 1) The conditions or circumstances leading to the determination that a higher minimum capital requirement is appropriate or necessary for the credit union; 2) The urgency of those circumstances or potential problems; 3) The overall condition, management strength, and future prospects of the credit union and, if applicable, its subsidiaries, affiliates, and business partners; 4) The credit union s liquidity, capital, and other indicators of financial stability, particularly as compared with those of similarly situated credit unions; and 5) The policies and practices of the credit union s directors, officers, and senior management as well as the internal control and internal audit systems for implementation of such adopted policies and practices.

9 Part ; PCA for Adequately Capitalized Credit Unions Summary: This section outlines the mandatory and discretionary supervisory actions that apply when a credit union s regulatory capital declines to Adequately Capitalized levels. This section renumbers current as , with minor conforming amendments, and eliminates the requirement that adequately capitalized credit unions transfer the earnings retention amount from undivided earnings to their regular reserve account. Part ; PCA for Undercapitalized Credit Unions Summary: The proposed rule would renumber current as , and would make only minor conforming adjustments to the text of the section. The requirement to transfer earnings retention from undivided earnings to the regular reserve account would also be eliminated. Part ; PCA for Significantly Undercapitalized Credit Unions Summary: The proposed rule would renumber current as , and would make only minor conforming adjustments to the text of the section. The requirement to transfer earnings retention from undivided earnings to the regular reserve account would be eliminated. Part ; PCA for Critically Capitalized Credit Unions Summary: The proposed rule would renumber current as , and would make only minor conforming adjustments to the text of the section. The requirement to transfer earnings retention from undivided earnings to the regular reserve account would be eliminated. Part ; Consultation with State Officials on Proposed PCA Summary: The proposed rule would renumber current as , and would make only minor conforming adjustments to the text of the section. NCUA would still be required to consult with the appropriate state regulator before placing a federally insured state-chartered credit union into conservatorship or liquidation, and to work cooperatively with state officials before taking any discretionary action under PCA. Part ; Net Worth Restoration Plans Summary: The proposed rule would renumber current as , make minor conforming amendments to the text, and add two new subparts within this section. Under subpart (c) the proposed rule would add a requirement that the Net Worth Restoration Plan (NWRP) include in its quarterly timetable of steps, a plan to raise its risk-based capital ratios, as well as its net worth ratio, if applicable. This subpart is also amended to remove the reference to transfer of earnings to the regular reserve account.

10 Under subpart(g) a new section (4) is added to address the submission of multiple unapproved NWRPs. The proposed rule provides that submission of more than 2 NWRPs that are not approved would be considered an unsafe and unsound condition and may subject the credit union to enforcement actions. A new subpart(j) is also added, which address the termination of a NWRP. A NWRP would terminate when the credit union attains the classification of Adequately Capitalized, and maintains it for 4 consecutive quarters. For example, a credit union that becomes Adequately Capitalized on December 31, 2015 would have its NWRP terminated on September 30, 2016, if it maintained the Adequately Capitalized classification throughout that timeframe. Part ; Reserves Summary: The proposed rule would renumber current as and eliminate all but section (a) of that provision: Each credit union shall establish and maintain such reserves as may be required by the FCUA, by state law, by regulation, or in special cases by the NCUA Board or appropriate state official. The proposed rule thereby eliminates the requirement to transfer earnings to the regular reserve account, and the process of requesting permission for charges to the regular reserve. Under the proposed rule, federal credit unions would simply close out their regular reserve balances into undivided earnings. State-chartered credit unions may still be required to maintain a regular reserve account by its state supervisory authority. Part ; Full and Fair Disclosure of Financial Condition Summary: The proposed rule would renumber current as and would delete the reference to transferring earnings to the regular reserve account. The meaning of this section is otherwise unaltered. Part ; Payment of Dividends Summary: The proposed rule would renumber current as and would make several amendments to the provision. The restriction on payment of dividends is revised to state that dividends will be paid from net worth, as opposed to the current rule, which states they will be paid from undivided earnings. This amendment would permit credit unions with substantial net worth, but no undivided earnings, to pay dividends without regulatory approval, but would prevent credit unions from paying out of the regulatory reserve account when undivided earnings are depleted. Previous (b) is also amended to replace undivided earnings with retained earnings, when determining if a credit union may authorize a dividend payment despite depletion of that account. The proposed rule also adds a requirement that the request for written approval to issue a dividend include a plan to eliminate any negative retained earnings balance, when issuing the dividend would cause the credit union s net worth classification to fall below adequately capitalized.

11 The proposed rule would also add a new subsection which, if it would drop the credit union s net worth ratio below 6% in the current quarter, would prohibit a credit union s board of directors from: 1) Declaring a dividend at a rate that is higher than the prevailing rates paid on comparable accounts and maturities in the relevant market area; 2) Declaring a non-repetitive dividend; or 3) Authorizing a refund of interest. This provision is meant to prohibit a credit union, even if well-capitalized, from unreasonably dissipating its capital through excessive dividend payments or a refund of interest in a manner that would undermine the safety and soundness of the credit union. Subpart B Alternative Prompt Corrective Action for New Credit Unions A new credit union is one that has been in operation for 10 years or less, or has $10 million or less in total assets. The capital adequacy rules that pertain to new credit unions are renumbered and contained in Subpart B of the proposed rule, but only a few changes are made to the overall operation of this section: 1) The definition of a new credit union is revised to eliminate the ability of a credit union to regain the designation of new after reporting total assets over $10 million; 2) All references and cross references to the requirement to transfer the earnings retention amount from undivided earnings to the regular reserve account are eliminated; 3) A new section (f)(3) is added to clarify that the submission of more than two revised business plans would be considered an unsafe and unsound condition; and 4) Several amendments are made to the requirements regarding payment of dividends: a. The restriction on dividends payments section is amended to allow only new credit unions with substantial net worth, but no undivided earnings, to pay dividends without regulatory approval; b. Adds the requirement that the request for written approval to issue a dividend when retained earnings are depleted must include the plan for eliminating any negative retained earnings balance; c. Adds new subsection (c) which prohibits a new credit union s board of directors from issuing a refund of interest, a non-repetitive dividend, or a dividend above market rates, if payment would cause the credit union s net worth ratio to fall below 6% in the current quarter. Part 713; Fidelity Bond and Insurance Coverage for Federal Credit Unions The maximum amount of allowable deductible is amended for credit union with over $1 million in assets to allow a maximum deductible of $1 million for credit unions that have received a composite CAMEL rating of 1 or 2 for the last two full examinations and maintained a capital classification of well-capitalized under Part 702 for the six immediately preceding quarters. This was amended to replace a reference to credit unions that qualify for NCUA s Regulatory Flexibility Program.

12 Part 747; Administrative Actions, Adjudicative Hearings, Rules of Practice and Procedure, and Investigations Part 747 is amended to add section regarding the review of an order imposing individual minimal capital requirements (IMCR) under proposed section This section requires NCUA to provide reasonable prior notice and an independent process for appealing NCUA staff decisions to the NCUA Board, pursuant to 216(k) of the Federal Credit Union Act. The proposed rule also requires NCUA to forward a copy of the notifying letter to the appropriate state supervisory authority if a state-chartered credit union would be subject to an IMCR. This section outlines the required content of NCUA s notice of intent to impose the IMCR and the credit union s response to that notice. The credit union must respond with 30 calendar days from the date of service of the notice, failure to respond within the required time period may constitute a waiver of any objections to the proposed IMCR. After expiration of the response period, NCUA will address all comments received within the response period and issue a final agency action. A credit union may make a written request that the NCUA reconsider the terms of the IMCR due to changed circumstances. The IMCR will remain in effect while the request is pending, but the request will be deemed granted if the NCUA Board fails to act within 60 days of receipt of such a request. A credit union may also request the recommendation of NCUA s ombudsman on the issuance or modification of an IMCR, but the request must be made within the 30 day response period or it will be deemed waived. The ombudsman shall promptly notify the credit union and the NCUA Board of his or her recommendation.