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Committee on Financial Services

United States House of Representatives

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Text as Prepared for Delivery
March 11, 1998

 

CREDIT UNIONS

 

Testimony of the Honorable Richard S. Carnell
Assistant Secretary of the Treasury
for Financial Institutions

Before the Committee on Banking and Financial Services
U.S. House of Representatives

March 11, 1998

 

 

SUMMARY

The Treasury’s testimony deals with two main topics: (1) the safety and soundness reforms recommended in our recent Congressionally mandated report on credit unions; and (2) the common bond of credit union membership.

The Treasury’s Recommended Safety and Soundness Reforms

Our report recommended that Congress take several steps to make federally insured credit unions and the National Credit Union Share Insurance Fund even safer, sounder, and more resilient.

Capital Requirements and Prompt Corrective Action

Credit unions hold over $300 billion in federally insured deposits. But unlike all other federally insured depository institutions, they are not currently subject to capital requirements or to a system of prompt corrective action.

We recommend that Congress require federally insured credit unions to have 6 percent net worth to total assets in order to be in good standing. We also recommend requiring credit unions to set aside, as retained earnings, a small percentage of their gross income if they have less than 7 percent net worth. Credit unions’ balance sheets indicate that credit unions themselves recognize the wisdom of maintaining such capital levels. Of the federally insured credit unions operating at the end of 1996, 96 percent had more than 6 percent net worth, and those credit unions held 98 percent of total credit union assets.

We further recommend that Congress establish a system of prompt corrective action for credit unions. This system would be a streamlined version of that currently applicable to all FDIC-insured institutions, and would be specifically tailored to credit unions as not-for-profit, member-owned cooperatives.

Other Capital-Related Reforms

We recommend that Congress direct the NCUA to develop an appropriate risk-based capital requirement for complex credit unions. This risk-based requirement would take account of risks that the simple 6 percent net worth requirement does not adequately cover -- risks that may be appreciable only at a small subset of credit unions.

We also recommend that Congress direct the NCUA to require federally insured credit unions to deduct from their net worth for purposes of regulatory capital requirements and prompt corrective action, certain investments in equity securities issued by corporate credit unions. The goal is for each level of the credit union system to have sufficient capital for the risks undertaken at that level and, more specifically, to help ensure that a corporate credit union’s losses do not cascade to its member credit unions.

Reforms Involving the National Credit Union Share Insurance Fund

We propose the following reforms relating to the Share Insurance Fund:

  • Requiring more timely and accurate calculation of the Fund’s equity ratio -- i.e., the ratio of the Fund’s reserves to the total amount of the deposits that the Fund insures -- the standard measure of the Fund’s health. The NCUA’s method of measuring the equity ratio generally overstates the reserves actually available.
  • Not permitting distributions to dissipate the Fund’s reserves when the Fund’s ratio of high-quality, liquid net reserves to the total deposits that the Fund insures (the available-assets ratio) falls below 1 percent.
  • Requiring federally insured credit unions with more than $50 million in total assets to adjust their 1 percent deposit in the Fund semi-annually (instead of just annually).
  • Giving the NCUA some discretion to adjust the premium rate according to the Fund’s financial needs.
  • Imposing a premium if the Fund’s equity ratio falls below 1.2 percent, in keeping with the NCUA’s longstanding practice.
  • Giving the NCUA discretion to let interest on the Fund’s reserves increase the Fund’s equity ratio to 1.5 percent from the current ceiling of 1.3 percent. This change would permit the Fund to accumulate additional investment earnings in good times that would increase its resiliency during economic downturns. The NCUA would remain free to distribute as dividends any reserves above 1.3 percent, or to use part of the Fund’s earnings to increase the reserve ratio and distribute the rest as a dividend on credit unions’ 1 percent deposit.

Credit Unions’ Access to Emergency Liquidity

Congress created the Central Liquidity Facility (CLF) in 1978 to serve as a governmental lender of last resort for credit unions. We are concerned that the CLF could not handle the very sort of systemic crisis for which it was designed. The CLF has little capital of its own, and appropriations Acts have allowed it to lend credit unions no more than $600 million. Considering that credit unions hold over $300 billion in deposits, the CLF would need billions upon billions of dollars in lending authority to be assured of having the resources to carry out its original purpose. Even as the CLF faces these constraints, credit unions have access to a governmental lender of last resort with unlimited borrowing authority: the Federal Reserve System.

Accordingly, we recommend: that Congress discontinue the CLF; that larger credit unions take the modest steps needed to line up access to emergency liquidity through the discount window; and that Congress direct the NCUA to periodically assess federally insured credit unions’ potential needs for liquidity and their options for obtaining it.

The Importance of Enacting These Safety and Soundness Reforms Now

Now is an excellent time to enact these safety and soundness safeguards -- with the economy strong and credit unions flourishing. Our proposed changes involve little cost or burden to credit unions today, yet they could pay enormous dividends in more difficult times.

Moreover, as credit unions increase in size and complexity and compete directly with banks and thrifts, Congress needs to ensure that comparable safeguards apply to credit unions’ risk-taking. The safeguards applicable today fall short of being comparable. And if the ultimate outcome of the current debate over the common bond is to provide greater flexibility, allowing the continued emergence of larger, less closely knit credit unions, it will be all the more important to have adequate safeguards in place.

The Common Bond of Credit Union Membership

General Principles

Between the polar-opposite outcomes of having no common bond requirement and requiring all members of a credit union to share a single, tightly defined common bond, are an array of possible policies. We suggest that Congress consider possible policies in light of the following principles:

1. Reaffirm Credit Unions’ Role in Serving People of Modest Means

Credit unions have historically had a special role in serving people of modest means. The Federal Credit Union Act reflects this public purpose: it is an "Act . . . to make more available to people of small means credit for provident purposes." We believe that federal policy towards credit unions should continue to promote this objective.

2. Correct Perverse Incentives to Abandon Occupation- and Association-Based Federal Credit Union Charters

A stringent federal common bond requirement serves no public purpose if it merely prompts credit unions to switch to state charters with a looser common bond requirement (or none at all). Similarly, a stringent occupational or associational common bond requirement serves no public purpose if it simply prompts credit unions to switch to broad, geographically based charters. We believe that public policy should avoid creating perverse incentives to seek one type of credit union charter over another, particularly if the upshot is to encourage credit unions to select charters that weaken the affinity among their members.

3. Preserve a Meaningful Common Bond as a Characteristic of Credit Unions

We see the common bond requirement as a distinguishing characteristic of credit unions -- one that helps set them apart from banks and thrifts, and that reinforces their other defining characteristics: their cooperative structure, democratic governance, not-for-profit orientation, and public purpose of serving people of modest means. Weakening the common bond might well put strain on credit unions’ cooperative, not-for-profit orientation, including their willingness to pay special attention to members of lesser means.

4. Assure Safety and Soundness

With the rise of larger, more impersonal credit unions, formal safeguards and effective supervision become all the more important.

5. Take Account of Market Dynamics

Economies of scale in providing technology-based services, downsizing, the large number of workers at firms too small to support their own credit union, and the safety and soundness benefits of diversification lend weight to permitting credit unions to expand beyond a single membership group. Yet other market factors -- such as the credit risk-reducing influence of a sense of affinity, and the dubious incentives credit union managers may have to increase the size of their credit unions -- suggest limits on the economic case for attenuating the common bond requirement. Flexibility on the common bond requirement should be tempered by the other principles outlined here.

6. Protect Existing Credit Union Members and Membership Groups

In adding new membership groups pursuant to NCUA policy, credit unions acted in good faith. Disenfranchising existing credit union members or membership groups would not serve the public interest.

Next Steps

We look forward to working with the Committee to develop legislation dealing with the common bond requirement. We suggest that such legislation should: grandfather all existing credit union members and membership groups added before the Supreme Court ruling, and permit such membership groups to add new members; include the safety and soundness reforms outlined in the Treasury report; and preserve a meaningful common bond requirement while providing reasonable flexibility for credit unions to include additional groups within their membership.

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CREDIT UNIONS

Testimony of Richard S. Carnell
Assistant Secretary of the Treasury

Before the Committee on Banking and Financial Services
United States House of Representatives

March 11, 1998

 

Mr. Chairman, Congressman LaFalce, Members of the Committee.

I appreciate this opportunity to present the Treasury’s views on two topics involving credit unions. First, the safety and soundness reforms recommended in the Treasury’s recent Congressionally mandated report on credit unions. Second, the common bond of credit union membership, including the implications of the decision rendered by the Supreme Court two weeks ago.

As not-for-profit depository institutions, credit unions add something special to our financial system. They give their members an alternative, cooperative structure for depositing savings and obtaining credit and other financial services. The credit union ideal is one of mutual self-help.

I. THE TREASURY’S STUDY OF CREDIT UNIONS

By a statute enacted in September 1996, Congress required the Treasury to study and report on a series of issues involving credit unions (a list that did not, incidentally, include the common bond requirement). In preparing our report, we consulted widely with the National Credit Union Administration (NCUA), the four federal banking agencies, the major credit union, bank, and thrift trade associations, consumer groups, and credit union officials. We made on-site visits, and we sought and received public comments. As specifically required by Congress, we assembled an interagency team of experienced federal bank and thrift examiners to assist us in our evaluation of the ten largest corporate credit unions. We published our report last December.

A. The Treasury’s Legislative Recommendations to Strengthen the Safety and Soundness of the Credit Union System

Our report found that credit unions and their deposit insurance fund appear to be in strong financial condition. We did make several recommendations for Congressional action to strengthen the long-term safety and soundness of the credit union system.

1. Capital Requirements and Prompt Corrective Action

Strong capital requirements and prompt corrective action are foundations of modern safety and soundness supervision of federally insured depository institutions. Capital requirements help ensure that such institutions have a sufficient buffer to absorb unforseen losses without in turn imposing losses on depositors or the deposit insurance fund.1 Prompt corrective action is a capital-based approach to supervision aiming to resolve capital deficiencies before they grow into large problems. As a federally insured depository institution’s capital declines below required levels, an increasingly more stringent set of safeguards applies. The goal is to minimize (and, if possible, avoid) losses to the deposit insurance fund. Prompt corrective action has applied to all FDIC-insured depository institutions since 1992, and the results have been good.

Although credit unions hold over $300 billion in federally insured deposits, they are not currently subject to capital requirements in the sense of needing to have a given ratio of capital to assets in order to be in good standing. Credit unions must set aside as regular reserves (a form of retained earnings) a small percentage of their gross income until their regular reserves reach a level approximating 4 percent of total assets. But this is not a capital requirement; credit unions need not reach or maintain that level. The rule in question is perhaps best described as an earnings-retention requirement.

Nor are credit unions subject to a system of prompt corrective action. The NCUA has informal policies analogous to some aspects of such a system, but has no regulations or even formal guidelines for taking corrective action regarding a troubled credit union.

We recommend that Congress require federally insured credit unions to have 6 percent net worth to total assets in order to be in good standing.2 We also recommend that credit unions set aside, as retained earnings, a small percentage of their gross income if they have less than 7 percent net worth.

Credit unions’ balance sheets indicate that credit unions themselves recognize the wisdom of maintaining such capital levels. Of the federally insured credit unions operating at the end of 1996, 96 percent had more than 6 percent net worth, and those credit unions held 98 percent of total credit union assets. Moreover, 93 percent of credit unions had more than 7 percent net worth, and those credit unions held 93 percent of total credit union assets.

We also recommend that Congress establish a system of prompt corrective action for credit unions. This system would be a streamlined version of that currently applicable to all FDIC-insured institutions, and would be specifically tailored to credit unions as not-for-profit, member-owned cooperatives. It would thus, for example, not include provisions keyed to the existence of capital stock, since credit unions have no capital stock.

Such a system of prompt corrective action would protect the National Credit Union Share Insurance Fund and the taxpayers who stand behind it; it would also benefit credit unions and the credit union system. It would reinforce the commitment of credit unions and the NCUA to resolve net worth deficiencies promptly, before they become more serious. It would promote fair, consistent treatment of similarly situated credit unions. It should reduce the number and cost of future credit union failures. In so doing, it should conserve the resources of the Share Insurance Fund, make the Fund even more resilient, and make more money available for lending to credit union members. And it would respect and complement the cooperative character of credit unions.

2. Other Capital-Related Reforms

a. Risk-Based Capital Requirement for Complex Credit Unions

We recommend that Congress direct the NCUA to develop an appropriate risk-based capital requirement for complex credit unions. This risk-based requirement would supplement the simple 6 percent net worth requirement and could take account of risks -- such as interest-rate risk or contingent liabilities -- that may be appreciable only at a small subset of credit unions.

b. Treatment of Certain Equity Investments in Corporate Credit Unions

Corporate credit unions are specialized financial institutions that provide services to, and are cooperatively owned by, their member credit unions. They serve their members primarily by lending or otherwise investing their member credit unions’ excess funds. They also provide services comparable to those offered by bankers’ banks or to the correspondent services that large commercial banks traditionally provided to smaller banks. U.S. Central Credit Union is a corporate credit union serving 38 of the 40 other corporate credit unions.

The three-tier cooperative structure of the credit union system -- regular credit unions, corporate credit unions, and U.S. Central -- creates an interdependence risk among the various levels. Specifically, a credit union’s deposits at its corporate credit union, and its equity investment in that institution, are assets on its books. At the same time, the credit union’s corporate credit union carries these funds on its balance sheet as deposits (largely uninsured) and capital, respectively. If a corporate credit union were to fail, its member credit unions could face losses on their deposits or equity investments, which would reduce their own capital. This interdependence means that each level of the credit union system must have sufficient capital for the risks undertaken so as not to pose a risk of losses cascading to the level below it.

Accordingly, we recommend that federally insured credit unions deduct from their net worth (for purposes of regulatory capital requirements and prompt corrective action) paid-in capital issued by a corporate credit union and some portion of member capital accounts at a corporate credit union. Paid-in capital is the lowest priority instrument issued by a corporate credit union. If the corporate credit union were to fail, holders of paid-in capital would have to stand in line behind all creditors, all depositors, and all other equity holders; they would receive nothing unless all these other claimants received payment in full. Membership capital is the second lowest priority instrument issued by a corporate credit union. Holders would stand in line behind all creditors, all depositors, and all equity holders other than holders of paid-in capital.

3. Reforms Related to the National Credit Union Share Insurance Fund

We propose a series of reforms relating to the National Credit Union Share Insurance Fund.

First, we recommend requiring more timely and accurate calculation of the Fund’s equity ratio -- i.e., the ratio of the Fund’s reserves to the total amount of the deposits that the Fund insures -- the standard measure of the Fund’s health. We are concerned that the NCUA’s method of measuring the equity ratio generally overstates the reserves actually available. The NCUA calculates the equity ratio monthly by dividing the Fund’s reserve balance for the month by the previous year-end total of insured deposits. Thus each year-end equity ratio is calculated using a denominator that may be up to 12 months old, which tends to inflate the ratio. For example, at year-end 1996, the Share Insurance Fund had $3.4 billion in reserves and insured $275.5 billion in deposits, which implied an equity ratio of 1.24 percent. However, the NCUA calculated the Fund’s year-end 1996 equity ratio as 1.3 percent by dividing the year-end 1996 total Fund reserves by the year-end 1995 total insured deposits.

Because the NCUA must, under current law, distribute dividends to member credit unions whenever the Share Insurance Fund’s equity ratio exceeds 1.3 percent, the NCUA’s procedure has led it to pay dividends when the Fund’s equity ratio, properly measured, was actually less than 1.3 percent. Paying dividends under such circumstances dissipates the Fund’s reserves without good reason. We accordingly recommend that Congress require the NCUA to correct this non-contemporaneous measurement of the equity ratio.

Second, we recommend not permitting distributions to dissipate the Fund’s reserves when the Fund’s ratio of high-quality, liquid net reserves to the total deposits that the Fund insures (the available-assets ratio) falls below 1 percent. The equity ratio, unlike the available assets ratio, does not reflect the actual composition of the Share Insurance Fund’s assets. When credit unions come under stress (e.g., during an economic recession), illiquid assets acquired from failed or troubled institutions will tend to increase at the expense of liquid assets -- leaving the Fund less able to provide cash assistance to other ailing credit unions. We recommend that Congress require the Share Insurance Fund to maintain an available assets ratio of 1.0 percent of insured deposits. Should the available assets ratio fall below this level, the NCUA would not be permitted to pay dividends even if the Fund’s equity ratio were to exceed 1.3 percent.

Third, we recommend requiring federally insured credit unions with more than $50 million in total assets to adjust their 1 percent deposit in the Fund semi-annually (instead of just annually). Such institutions account for just 12 percent of all credit unions but hold 76 percent of total credit union deposits. Semi-annual adjustments by such credit unions will help ensure that the 1 percent deposit keeps pace with their deposit growth.

Fourth, in place of the current rule that fixes any insurance premium at 1/12 of 1 percent of insured shares, we recommend giving the NCUA some discretion to adjust the premium rate according to the Fund’s financial needs.

Fifth, we recommend imposing a premium if the Fund’s equity ratio falls below 1.2 percent, in keeping with the NCUA’s longstanding practice.

Sixth, we recommend giving the NCUA discretion to let interest on the Fund’s reserves increase the Fund’s equity ratio to 1.5 percent. The Federal Credit Union Act currently imposes a rigid 1.3 percent ceiling on the Fund’s reserve ratio. The change proposed here would permit the Fund to accumulate additional investment earnings in good times that would increase its resiliency during economic downturns. This flexibility would likewise better enable the NCUA to protect the Fund -- as well as protect credit unions’ 1 percent deposit -- from possible future losses. The NCUA would, of course, remain free to distribute as dividends any reserves above 1.3 percent (and any interest earned on those reserves). It could also use part of the earnings to increase the reserve ratio and distribute the rest.

4. Credit Unions’ Access to Emergency Liquidity

Our final major legislative proposal involves credit unions’ access to emergency liquidity. During normal times, credit unions with excess cash deposit that cash at their corporate credit union, and credit unions that need additional cash borrow it from their corporate credit union. The corporate credit union system does a good job of reallocating excess liquidity among credit unions.

But we are concerned that during a financial crisis (whether in the financial system generally or in the credit union system specifically) the credit union system would have only limited access to outside liquidity. The sort of systemic demand for liquidity that we have in mind is an extraordinary event. Our financial system is healthy -- as healthy as it has been in years -- and even in the future such a crisis would be unlikely. But the potential for such an event is still sufficiently real that Congress, the Administration, and the NCUA have a responsibility for making sure that it could be handled if it did arise. Corporate credit unions are not set up to handle such a systemic crisis.3

Recognizing the potential vulnerability of the credit union system, Congress created the Central Liquidity Facility (CLF) in 1978 to serve as a governmental lender of last resort for credit unions.4 But we are concerned that the CLF itself could not handle such a crisis.

First, the CLF has little capital of its own. The statute establishing the CLF contemplated that credit unions would invest directly in the CLF, but few credit unions actually joined. So during the 1980s, the CLF implemented the so-called redeposit program, which allows credit unions to join the CLF through their corporate credit unions without anyone putting up any cash. Through a complex series of accounting transactions involving corporate credit unions, U.S. Central, and the CLF (diagramed on page 121 of the Treasury report), entries are recorded to show stock purchases, although no funds actually change hands. These transactions artificially inflate the parties’ balance sheets, without giving the CLF any real capital.

Second, Congressional appropriations Acts have allowed the CLF to lend no more than $600 million to credit unions. Considering that credit unions hold over $300 billion in deposits, the CLF would need billions upon billions of dollars in lending authority to be assured of having the resources to carry out its original purpose.

Even as the CLF faces these constraints, credit unions have access to a governmental lender of last resort with unlimited borrowing authority: the Federal Reserve System. In 1978, when Congress created the CLF, credit unions had no access to the Federal Reserve discount window. But now any credit union that offers checking (share draft) accounts is eligible to borrow at the discount window.

Against this background, our report recommends that Congress discontinue the CLF. We also recommend that credit unions, particularly larger credit unions, take the modest steps needed to line up discount window access. This simply involves filing some paperwork with the Federal Reserve bank; credit unions need not pre-pledge collateral. Our basic idea is that if a systemic crisis involving widespread demand for liquidity did arise, large credit unions could turn to the Fed, leaving corporate credit unions free to provide liquidity to small credit unions. It is just this type of emergency -- a systemic crisis involving widespread demand for liquidity -- that the CLF cannot handle.

We also recommend that Congress direct the NCUA to (1) periodically assess federally insured credit unions’ potential needs for liquidity and their options for obtaining it, and (2) share with the Federal Reserve banks information relevant to making discount-window advances to such credit unions.

B. Other Pertinent Recommendations

1. Retaining the NCUA’s Role in Administering the Share Insurance Fund

Congress required us to evaluate the potential costs and benefits of having some entity other than the NCUA administer the Share Insurance Fund. Some potential may exist for conflict between the NCUA’s mission as a charterer or regulator of credit unions and the NCUA’s responsibilities for the Share Insurance Fund. However, in our view, any such potential conflict is best handled by applying a system of prompt corrective action. Such a system would impose an important and highly constructive discipline on the NCUA’s supervisory and insurance functions. This discipline should, to a significant degree, offset any potential for conflicts of mission. Accordingly, we recommend against moving the Share Insurance Fund out of the NCUA.

2. Continuing to Permit Credit Unions to Treat Their 1 Percent Deposit in the Share Insurance Fund as an Asset

Congress also required us to evaluate whether the 1 percent deposit that federally insured credit unions have made into the Share Insurance Fund should continue to be treated as an asset on credit unions’ books or whether credit unions should, instead, expense that deposit. Let me first take a moment to explain how the 1 percent deposit works, and more generally, how the Share Insurance Fund is financed.

Under current law, each federally insured credit union must maintain on deposit in the Share Insurance Fund an amount equal to 1 percent of the credit union’s insured deposits. Thus, for example, if the credit union has $50 million in insured deposits, it must keep $500,000 on deposit in the Fund. The credit union’s deposit in the Fund counts as an asset on the credit union’s books. It also counts as reserves of the Fund, and is available to protect depositors at failed credit unions. Because this accounting treatment involves some double-counting of the same money, some have called for credit unions to write off the 1 percent deposit, so that it would no longer count as an asset on their books.

We concluded that better ways of protecting the Fund are available. Three reforms that I outlined earlier are particularly relevant here: the 6 percent capital standard; the requirement that credit unions with less than 7 percent net worth set aside some of their income as retained earnings; and a system of prompt corrective action. We believe that these measures, coupled with existing safeguards, would fully offset any double counting and assure adequate protection of the Fund. By contrast, requiring a writeoff of the 1 percent deposit would not provide nearly as much protection. Accordingly, we recommend against requiring credit unions to write off their 1 percent deposit.

C. The Importance of Enacting These Safety and Soundness Reforms Now

Over the past two decades, most key legislation regarding the safety and soundness of federally insured depository institutions has been enacted in time of crisis. The Depository Institution Deregulation and Monetary Control Act of 1980, the International Lending Supervision Act of 1983, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, and the FDIC Improvement Act of 1991 all fit this pattern. Because Congress waited to act until it faced a crisis, the changes involved, although ultimately beneficial, increased the short-term stress on many depository institutions.

A better approach is to enact needed safety and soundness safeguards while times are good. Such safeguards will reduce the potential for a future crisis. And depository institutions can make any necessary adjustments from a position of strength, with appropriate transition periods.

Congress has such an opportunity to act now. Credit unions are flourishing. On average, their net worth exceeds 11 percent of total assets. And the Share Insurance Fund is fully capitalized. The changes we propose involve little cost or burden to credit unions today, yet they could pay enormous dividends in more difficult times.

Although most credit unions remain relatively small institutions with simple product offerings, a growing number are large and have extensive product offerings. These credit unions commonly compete head-on with other depository institutions. As credit unions increase in size and complexity -- competing directly with banks and thrifts and taking on similar financial risks -- policymakers need to ensure that comparable safeguards apply to credit unions’ risk-taking. The safeguards applicable today fall short of being comparable. Moreover, if the ultimate outcome of the current debate over the common bond is to provide greater flexibility, allowing the continued emergence of larger, less closely knit credit unions, the safety and soundness enhancement traditionally provided by a tight common bond diminishes, and the incentives for growth and added risk-taking may increase.

We risk being unprepared for future problems if we do not act now to update applicable safety and soundness safeguards in light of a changing industry. It was just this lack of preparation that compounded taxpayer losses during the thrift crisis -- as the thrift industry changed, safeguards did not keep up with those changes.

II. THE COMMON BOND OF CREDIT
UNION MEMBERSHIP

Let me now turn to the requirement that members of a credit union share a common bond.

In discussing this requirement, I will: describe what we at the Treasury believe to be the distinguishing characteristics of credit unions -- the features that set them apart from banks and thrifts; summarize the common bond requirement for federal credit unions; identify the key market dynamics that have prompted credit unions to pursue liberalization of the common bond requirement; set forth six principles that the Treasury believes should guide policy relating to the common bond requirement; and provide some general comments on what Congress may wish to consider in this area.

A. The Common Bond Requirement as a Distinguishing Characteristic of Credit Unions

Credit unions have several characteristics that, taken together, distinguish them from banks and thrifts.

First, credit unions are member-owned cooperatives. They do not issue capital stock, and instead derive their capital from accumulated retained earnings.

Second, credit unions generally rely on unpaid, volunteer boards of directors elected by, and drawn from, each credit union’s membership.

Third, credit unions do not operate for profit.

Fourth, credit unions have a public purpose. As declared in the Federal Credit Union Act, this purpose involves "mak[ing] more available to people of small means credit for provident purposes." Of course, other depository institutions also operate under statutes that delineate public purposes, so the distinction here involves the emphasis on providing services affordable to people of modest means.

Fifth, credit unions generally have limitations on their membership -- limitations based on some affinity among members. These limitations are known as the common bond requirement. Thus, unlike other depository institutions, a credit union generally cannot serve just anyone from the general public.

We see the common bond requirement as a distinguishing characteristic of credit unions -- one that helps set credit unions apart from other depository institutions. In our view, the common bond requirement is not merely a convenient organizing principle. The affinity among a credit unions’ members, as reflected in a common bond, reinforces credit unions’ other defining characteristics.

B. The Different Types of Common Bonds

The Federal Credit Union Act of 1934 limits "federal credit union membership . . . to groups having a common bond of occupation or association, or to groups within a well-defined neighborhood, community, or rural district." Thus, the Act recognizes three types of credit unions: those based on a common bond of occupation or association and those based on a well-defined geographic community. Most credit unions have traditionally had occupational or associational common bonds, although community credit unions have become more common in recent years.

In an occupational common bond, a credit union’s members share a common employer. The NCUA has required that occupational fields of membership include a geographic definition.

In an associational common bond, a credit union’s members come from some recognized association. The NCUA’s policy is to charter associational credit unions at the lowest organizational level that is economically feasible. The policy permits a charter for a widely dispersed membership only where such a charter is clearly demonstrated to be in the best interests of the associations’s members and credit unions.

The Federal Credit Union Act restricts a community credit union to "a well-defined neighborhood, community, or rural district." The NCUA has interpreted this to mean a single, geographically well-defined area where residents interact. Generally, the NCUA recognizes four types of affinity on which to base a community credit union: affinity based on living, worshiping, studying, or working in the community.

C. Market Dynamics

Let us briefly consider the market forces that encourage credit unions to expand beyond their original membership group. We have identified four types of forces. They involve technology, demographics, safety and soundness, and management.

1. Technological Factors

Many credit unions -- to meet customer demand and compete with other depository institutions -- now offer such technology-based services as ATMs and computer and telephone banking. The information and communications technology needed to provide such services involves substantial fixed costs. Adding more membership groups makes such investments more economical by allowing a credit union to spread these fixed costs over more members.

2. Demographic Factors

Demographic factors also contribute to credit unions’ desire to add new membership groups. For example:

  • Worker mobility today makes credit unions’ membership base less stable than in the past, when many credit union members had a career-long relationship with their employer and their credit union.
  • Downsizing or closings at manufacturing firms, military bases, and other large employers have shrunk the membership base of many occupational credit unions.
  • NCUA policy requires a new credit union to have at least 500 persons eligible for membership, and some believe that the economics of starting a credit union today may actually require 1,000 or more such persons. Thus people who work at firms with fewer than 1,000 workers may not, as a practical matter, be able to form their own credit unions.

3. Safety and Soundness Factors

A tight common bond requirement can have mixed effects on a credit union’s safety and soundness.

The affinity among members sharing a single, focused common bond helps limit loan defaults. In a credit union with a single common bond, a member would be less likely to default on a loan commitment because of the effect that the default would have on friends, neighbors, or coworkers, and because of the shame associated with the default. Because the credit union is a not-for-profit cooperative, it may also be more willing to develop an acceptable workout plan than would an impersonal, profit-maximizing financial institution.

On the other hand, the more that a credit union’s membership shares a common bond of employment or otherwise has similar exposure to plant closings or other economic risks, the less diversified its exposure to credit risk. Diversifying the credit union’s membership base tends to make the credit union more resilient in the face of problems experienced by any one local employer. Plant closings during the late 1970s and early 1980s led to numerous credit union failures because an individual plant typically sponsored a credit union and the credit union’s membership consisted of the plant’s workers. Such failures played a key role in prompting the NCUA’s 1982 policy change.

4. Managerial Factors

Managerial factors may create incentives for credit unions to grow by adding new membership groups. A credit union board of directors seeking to attract high-quality, professional managers may find it easier to do so if the credit union is large, or has growth opportunities. Moreover, as credit unions are non-profit cooperatives, they do not remunerate their managers based on profit or stock performance. Instead, management compensation often reflects a credit union’s size and product offerings. This may give managers an incentive to increase the credit union’s size, and adding new membership groups would be an obvious method for doing so.

D. General Principles

Between the polar-opposite outcomes of having no common bond requirement and requiring all members of a credit union to share a single, tightly defined common bond, are an array of possible policies. We suggest that Congress consider possible policies in light of the following principles:

1. Reaffirm Credit Unions’ Role in Serving People of Modest Means

Credit unions have historically had a special role in serving people of modest means. The Federal Credit Union Act reflects this public purpose: it is an "Act . . . to make more available to people of small means credit for provident purposes."

We believe that federal policy towards credit unions should continue to promote this objective. Credit unions have played, and should continue to play, an important role in serving the underserved. Low-income credit unions have charters that specifically reflect their mission of serving the underserved. But more broadly, credit unions help make financial services more affordable for (and in some cases, geographically available to) people of modest means.

2. Correct Perverse Incentives to Abandon Occupation- and Association-Based Federal Credit Union Charters

In response to a 1996 injunction against federal credit unions adding new membership groups, hundreds of federal credit unions have moved to convert to state charters or to community-based federal charters. Yet a stringent federal common bond requirement serves no public purpose if it merely prompts credit unions to switch to state charters with a looser common bond requirement (or none at all). Similarly, a stringent occupational or associational common bond requirement serves no public purpose if it simply prompts credit unions to switch to broad, geographically based charters (e.g., anyone who lives, works, or worships in Fairfax County, Virginia) with less real affinity than their old occupation or association-based charters. Left unchanged, the Supreme Court’s ruling will tend to produce such perverse results.

The debate over the common bond requirement has thus far centered on federal credit unions. Current federal law imposes no common bond requirement on state-chartered credit unions (although some states choose to tie their own requirements to federal law). Yet state-chartered credit unions receive essentially the same benefits as federal credit unions, including federal deposit insurance and exemption from federal income taxation. We believe that public policy should avoid creating perverse incentives to seek one type of credit union charter over another, particularly if the upshot is to encourage credit unions to select charters that weaken the affinity among their members.

3. Preserve a Meaningful Common Bond as a Characteristic of Credit Unions

As I mentioned earlier, we see the common bond requirement as a distinguishing characteristic of credit unions, and one that reinforces credit unions’ other characteristics.5 A sense of affinity among members encourages credit unions to serve all their members, even those whose business may be unremunerative. For example, a hallmark of credit unions has been their willingness to make small unsecured loans -- loans so small that banks generally have little interest in the business. Yet the less members have a sense of affinity with one another, the less willing they may be to maintain such "unprofitable" services in the face of other opportunities. The more impersonal a credit union becomes -- and the more its members see each other as strangers -- the less the credit union is likely to distinguish itself from other depository institutions. A lack of meaningful membership restrictions may make credit unions highly competitive and flexible, but may also make them increasingly like banks operating under another name.

One cannot be certain in advance what effect weakening the common bond would have on credit unions’ distinctive character. However, reducing the affinity among credit union members might well put strain on credit unions’ cooperative, not-for profit orientation, including their willingness to pay special attention to members of lesser means (who may be relatively costly to serve).

4. Assure Safety and Soundness

Since credit unions serve an important role for many Americans, especially those of modest means -- and since federal deposit insurance protects the $300 billion in credit union deposits -- public policy should help assure the safety and soundness of credit unions. As credit unions grow larger and more impersonal, formal safeguards and effective supervision become all the more important.

5. Take Account of Market Dynamics

Most of the market dynamics described earlier justify giving credit unions reasonable flexibility to move beyond a single common bond. To recapitulate: economies of scale in providing technology-based services, downsizing, the large number of workers at firms too small to support their own credit union, and the safety and soundness benefits of diversification lend weight to permitting credit unions to expand beyond a single membership group. Yet other market factors -- such as the credit risk-reducing influence of a sense of affinity, and the dubious managerial incentives for growth -- suggest limits on the economic case for attenuating the common bond requirement. Flexibility on the common bond requirement should be tempered by the other principles I have outlined.

6. Protect Existing Credit Union Members and Membership Groups

Since 1982, the NCUA has permitted credit unions to add unrelated membership groups to existing credit unions. Both the NCUA and the credit unions involved operated in good faith. Although the Supreme Court has found such actions to have gone beyond the bounds of the Federal Credit Union Act, we believe that disenfranchising existing credit union members or membership groups would not serve the public interest.

E. Next Steps

Congress has time this year to consider carefully the proper course of future policy in this area. Whatever policy change Congress makes regarding the common bond issue will affect credit unions for many years to come, and will also affect the dynamic between credit unions and other financial institutions.

The Treasury looks forward to working with the Committee to develop legislation dealing with the common bond requirement. To begin, we would like to suggest that such legislation should: grandfather all existing credit union members and membership groups added before the Supreme Court ruling, and permit such membership groups to add new members; include the safety and soundness reforms outlined in the Treasury report; and preserve a meaningful common bond requirement while providing reasonable flexibility for credit unions to include additional groups within their membership.

III. CONCLUSION

In closing, let me summarize our four main conclusions and recommendations.

A deliberate, thoughtful approach is needed. We should keep in mind that our actions will affect credit unions, their members, and others for years to come.

Safety and soundness reforms should be part of any credit union legislation. In particular, a system of prompt corrective action, which has been so successful in bank and thrift supervision, should be enacted for credit unions.

Credit unions should be permitted to grow, and consumer access to credit unions should be enhanced in a manner consistent with the principles outlined here.

To-date, the common bond debate has been framed as an all-or-nothing contest in which one side wins at the expense of the other. An appropriate balancing of legitimate but competing interests requires careful deliberation and something other than a winner-take-all outcome.

We look forward to working with the Committee on these issues. I would be pleased to answer questions.

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1Requiring depository institutions to have adequate capital also helps counteract the moral hazard of deposit insurance (i.e., the tendency of deposit insurance to permit or encourage insured depository institutions to take excessive risks -- risks that they would not take in a free market). Capital is like the deductible on an insurance policy: the higher the deductible, the greater the incentive to avoid loss. Adequate capital gives a depository institution’s owners incentives compatible with the interests of the insurance fund because the fund absorbs losses only after the institution has exhausted its capital and thus eliminated the economic value of the owners’ investment.

2This statutory requirement would not apply to new credit unions that had not existed for a given number of years or reached a specified asset size.

3During such a crisis, liquidity would become scarce. Deposits at corporate credit unions would fall, as their member credit unions withdrew money to meet their own needs for cash -- thus reducing corporate credit unions’ lending capacity even as demand for liquidity increased. Potential outside sources of liquidity, such as lines of credit at other financial institutions or access to the capital markets, would be of uncertain reliability during such a crisis. And most corporate credit unions are generally not eligible to borrow from the Federal Reserve discount window because they avail themselves of the bankers’ bank exemption from reserve requirements.

4The CLF is a mixed-ownership government corporation within the NCUA. The CLF has authority to borrow over $17 billion, and the Justice Department’s Office of Legal Counsel has stated that the full faith and credit of the United States backs such borrowing.

5The common bond is widely recognized as a characteristic of credit unions. The International Credit Union Operating Principles of the World Council of Credit Unions (an affiliate of the Credit Union National Association), declare that "membership in a credit union is voluntary and open to all within the accepted common bond of association." These operating principles "are founded in the philosophy of cooperation and its central values of equality, equity and mutual self-help." This suggests that the World Council sees a connection between credit unions’ values and an operating environment in which credit union members share a common bond.



 

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