Why Credit Unions Are Wrong On Risk-Based Capital

As faithful readers of this blog will know, I occasionally feel the need to remind people that the opinions expressed are mine, and mine alone, although you, of course, are welcome to agree with me. 

Both NCUA and credit unions are making serious mistakes in the march toward a more sophisticated risk-based capital scheme for credit unions with at least $50 million in assets.  Another time I will talk about NCUA’s mistakes, but today I think it is time to take the industry to task.  Most importantly, the industry can’t have it both ways when it comes to risk-based capital.  For at least a decade, it has been pushing NCUA to adopt a risk-based capital formula arguing that a capital framework more in line with that of banks will free up capital at well run credit unions and ultimately help more members.  This sounds great, but it is flawed for two reasons. 

First, NCUA has always said that with any risk-based capital proposal there are not only going to be winners, but losers.  If the industry wants capital reform but continues to insist that NCUA’s proposal is fatally flawed, then it has an obligation to come up with a workable alternative.  However, my guess is that anything resembling industry consensus on what an alternative proposal would look like is impossible to obtain.  For instance, if you think the proposal places too much emphasis on concentration risk, does that mean you’re in favor of increasing risk ratings across the board?  And if you don’t think concentration risk should be dealt with by imposing higher risk ratings on mortgages and MBLs, then how else should NCUA account for concerns that too much concentration of any given asset poses a greater systemic risk to the industry?  There is no win-win here; there are winners and there are losers.

Which leads us to the second, more fundamental problem with the industry’s position on risk-based capital.  The simple truth is that despite the glorification of the BASEL framework, there is absolutely no indication that risk-based capital regimes actually work.  remember that some of the largest banks that failed over the past five years were subject to BASEL requirements.  In fact, as summarized in a recently released analysis from George Mason University “since 1991 the Federal Reserve has employed a risk-based measure of bank capital as its primary tool for regulating risk.  However, RBC regulations are easily exploited and susceptible to regulatory arbitrage.  Evidence indicates that such regulations have increased individual bank risk as well as systemic risk in the banking system.”  Also, read the excellent quotes in the CU Times provided by Chip Filson, who is doing a great job leading the charge against a risk-based capital regime. 

The myth of risk-based capital is underscored by NCUA’s proposal.  Risk rating is complicated but at its core it is nothing more than a policy judgement on the part of regulators about which assets pose the greatest relative risk to safety and soundness.  The problem is that such policy judgements are inevitably based on preventing the last financial crisis from occurring again.  In reality, whether the next financial crisis occurs in five or fifty years, no one knows which assets truly pose the greatest risk to the safety and soundness of this industry. 

Against this backdrop of uncertainty, it makes more sense to maintain general capital requirements than it does to provide regulators, financial institutions and the general public with false assurances that institutions are well capitalized.  In short, if it was up to me, we would scrap NCUA’s proposal all together not because the proposal is so flawed, but because risk-based capital doesn’t work as advertised.