Recent changes to capital adequacy standards may encourage credit union mergers
The National Credit Union Administration (NCUA) Call Report announced significant reporting changes as of March 31 in addition to the application of the revised capital adequacy standards as part of its modernization initiative.
A key factor in the revised capital adequacy standards was the creation of the “complex” credit union and the “complex credit union leverage ratio” (CCULR). For credit unions with assets of $500 million or less, there were no changes to the capital calculation; however, credit unions with assets greater than $500 million need to determine whether they qualify for the simplified CCULR or need to complete the Schedule I for the risk-based capital ratio.
CCULR qualifications
If qualified, an election must be made to opt into the CCULR framework or opt out and calculate the risk-based capital ratio. To qualify for the CCULR, the credit union must meet the following criteria:
- Total assets greater than $500 million
- Net worth ratio greater than 9% (or within grace period criteria)
- Off balance sheet exposures must be 25% or less of total assets
- Trading assets or liabilities must be 5% or less of total assets
- Goodwill or other intangible assets must be 2% or less of total assets
Since the CCULR and the net worth ratio are the same, opting into the CCULR is significantly simpler and less labor intensive. If the credit union must complete the risk-based capital calculation, these three factors could negatively impact that ratio:
1. Deductions from equity that will reduce the risk-based capital ratio
Goodwill and other intangible assets: Core deposits and goodwill are created through mergers. Substantial amounts of goodwill may be created in merger transactions.
Large mortgage servicing assets: The credit union is allowed to include up to 25% of the total risk-based capital numerator before mortgage servicing assets deduction (RB0010). The amount over the 25% threshold is deducted from equity.
2. Assets with risk weights higher than 100% that will increase the total risk-based assets and decrease the risk-based ratio
Some common items include:
- Junior mortgage, consumer or commercial loans that are past due 90 days or more (150%)
- Current junior lien loans more than 20% of assets and current commercial loans more than 50% of assets (150%)
- Perpetual contributed capital in corporate credit unions and equity investments in CUSOs (150%)
- Amount of mortgage servicing rights included in equity (250%)
- Publicly traded equity investments (300%)
- Investment funds or separate account insurance with the option of the look-through approach (300%)
- Other non-traded equity, other than investment in CUSOs (400%)
3. The risk of certain off-balance sheet items must be included in the risk-based assets.
Credit conversion factors are applied in many cases prior to risk-weighting to reduce the overall impact, but the following can increase the risk-based capital and decrease the risk-based ratio:
- MPF Loans sold to FHLB and serviced by the credit union
- Loans serviced on behalf of others with limited recourse
- Unfunded commitments and letters of credit
- Nonderivative forward agreements
- Off balance sheet securitization exposures
- Derivative contracts
More merger opportunities
Maintaining the required 7% risk-based capital ratio to be considered well-capitalized can strain credit unions with a marginal capital and a riskier profile. Unlike banks, credit unions are not able to raise capital by bonds or selling shares of stock and must retain their own earnings to raise capital.
Growth is key for the long-term success of credit unions. Larger credit unions are able to retain more profit through efficiencies created by economies of scale. The capital generated can be invested in technology that will attract and retain members or used for growth through mergers.
Some believe this could incentivize smaller, less profitable credit unions to seek merger partners. Due to the unique merger processes for credit unions rooted in the deep understanding of the alignment of culture and member value, your organization can be better prepared for merger opportunities by understanding the following:
- The credit union’s desire to merge or remain independent and the preference for a particular strategy
- The credit union’s unique strengths, weaknesses and other factors as they relate to similar institutions
- The credit union’s tolerance toward risk
- Leadership’s and/or the board’s plan, options and preferred process toward a merger
How Wipfli can help
Getting ready and working through the complex decision process could allow a credit union to be in the ideal position to capitalize on opportunities that lead to growth, maintain a strong capital position and provide the best possible member experience. Contact Wipfli to learn more about what the new regulations means for your financial institution. Our specialized knowledge will keep you on top of evolving compliance requirements.
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