New Risk Based Capital Rules

Recently, many comments have been made regarding some of the proposed rules by the NCUA for changes in reserves due to proposed risk based capital requirements.  Why any regulatory body would propose such drastic changes would be because they believe that additional reserves need to be set aside in case of another downturn as we saw in 2008 with the last collapse.  The question is will these new rules be effective and what possible impact will they have on the rest of the core mission of the credit unions, which is to serve their membership.

It is also important to note that at the same time these proposed rules are on display, additional reserve requirements are also on the table for our banking brethren.  In a blog I had several weeks ago, I identified that this current recovery is already marked by a record low loan-to-deposit ratio as financial institutions continue to hoard capital.  In fact, the amount of excess reserves over what is a normal level at this time in the economic cycle adds up to over $2 trillion dollars.  This is also at a time when labor force participation is at an all time low, a record number of Americans have decided to live on government disability, we have a government that borrows nearly 40 cents of every dollar it spends, and more companies are actually closing for business than new companies are opening up. 

It is also interesting the same government, who arguably pressed rules and regulations that caused the mortgage meltdown in the first place is now the one attempting to prevent any collapse from reoccurring in the future.

It would seem that we are also suffering under the burden of over-regulation.  A recent Forbes article outlines the amount of money that is spent on compliance to various regulations in the US each year is greater than the entire GDP of Canada.  We also are living in a time when a record number of rules, regulations, and executive orders are levied against business as if it is the evil one here.  The last time that I checked, no government program created wealth, it only transfers it from one person to another.

Back to the new proposed risk based capital requirements.  Is it good to adjust reserves for additional risk that may be inherent within the asset?  That would seem wise.  What about adjusting for duration risk when either assets or liabilities are locked into rates and duration risk is evident?  Again, not a bad idea. 

One of the problems here is that risk needs to be identified and managed with a targeted approach and not a broad nuclear approach.  There is a tendency among the regulatory crowd to paint in broad strokes certain assets or liabilities as always bad.  A fine example here as I have pointed out in the past is the construction and development rules for credit unions.  All C&D is painted equally in the same risk classification.  In reality, there is a wide divergence of risk in C&D from spec to a project that has an established end business user, from horizontal development to vertical development, from construction with no permanent take out to those projects that have a perm funding source.

The new risk based capital rules are yet another example of a nuclear option when a sniper is needed. 

The new rules paint all business loans as equally bad compared to consumer lending.  It is done solely on the premise that a large business loan if it fails, could take down an institution.  True, there have been some mismanaged institutions that have seen such loans destroy a credit union.  But equally as true is the credit union that is slowly eaten away by multiple consumer loans going bad when a large employer which formed the base of membership, is forced to shut down.  Now instead of chasing one large business loan, there may be hundreds of smaller loans which require more time and resources to manage and oftentimes are not as well collateralized as a well structure business loan.  Yet these consumer loans are deemed less risky just on the mere fact that they are consumer in nature.  Perhaps studies on both consumer and business delinquency and default rates are in order, and not in a general sense, but divided up by credit score or industry type, to gain a true propensity for future problems.

The new proposed risk based capital rules will lower earnings as CUs will be forced to leave well structured and priced business loans in exchange for traditionally lower earning assets.  Reduced earnings will have a negative impact on the long-term viability of the firm as it is earnings that continue keep the institution going in the future.  We have seen the ROA of instutions that leave the majority of their resources in held-to-maturity securities and it is not a long term model for business growth. 

Another issue in the proposal that I take offense to is the negative impact on CUSOs.  It would appear that we are viewed as all the source of risk for any institution that does business with us.  Yet the fact of the matter is, a well run business CUSO can be an excellent source of knowledge and resources for the credit union to identify and manage credit risk.  At MWBS, we turn down far more deals than we do.  Now why would we do that when we should be trying to help the member?  Because a loan loss hurts the institution’s ability to help good credit risk members in the future.  Do we turn down everything?  Heck no, we understand that good assets need to be on your balance sheet for your future viability.

Another problem with the propose regulations is that it will slow down the economy. Part of economic growth requires the free flow of capital and credit.  As businesses are ready to grow, they require debt or equity to fund their expansion.  These rules will make it harder for companies to borrow, thus forcing them to stop growing and employing more people.  With more unemployment, more individuals will be facing a tougher time to meet their obligations, resulting in more losses for the credit union.  The RBC rules tend to favor the large companies that are stockpiling cash instead of the small companies that need well structured borrowing in order to go to the next level.  On that fact alone, it would seem that the government is taking the side of the big company as opposed to the small one.