Credit Union Exam Solutions Presents With Flying Colors

Hello, I'm Mark Treichel, and
you are listening to With Flying

Colors, the podcast where I
interview subject matter experts.

to provide credit union leaders with tips
on how you can achieve success with NCUA

and pass your exam with flying colors.

Today, I'm joined by Steve Farr to
talk about credit union capital.

Steve, before we jump in for folks who
are just meeting you for the first time,

could you share a little bit about who you
are And your career experience with NCUA.

Thanks, Mark.

Yeah, I look forward to being able to
talk about capital and credit unions

because it is a subject I spent a great
deal of time on my history with NCUA.

They started as an examiner clear back
in 1987, spent most of my career as a

problem case officer and as a problem case
officer, I had the opportunity to work

in conservatorships, number of workouts.

liquidations, assisted mergers.

So it got well rounded and worked
throughout the nation on those.

Then around the year 2000, I went into
the central office where I worked on

assisted mergers throughout the regions.

I'd help them with the plans
that they put together on that.

Prepared a number of supervision
letters that many of you credit unions

have probably read was involved in the
corporate resolution as many of us were

that were in the office at that time.

I always referred to that that age to me
very, very much the capital rulemaking.

I started on that.

In . So that had a long incubation period.

I worked on a number of postmortems,
which is always kinda interesting

looking at the, uh, failures at
NCOA because I worked to solve these

problem credit unions and postmortems.

I was always associated with failures in
NCOA, but hopefully in a good way, . I

spent time as the vice president of the
CLF, and one of the things that I did is.

Responsibility is vice president of CLF
is we're looking at how much capital

should the CLF hole because we wanted
to be able to return as much as we

could back to the memberships, but
still hold their responsible amount.

So that helped me to do a calculation of
which I was asking credit unions to do.

So hopefully we'll benefit from that
experience as we move into this subject.

Great, Steve.

I wrote a few things down that
made me chuckle and smile, but

yeah, the corporate resolution.

I remember when you were the guy at
NCUA who had to work with the CPAs

about how NCUA needed to allow for
that on NCUA's books and records.

And that's when you taught me about
what Monte Carlo simulation was.

I think he used as some
of the backdrop there.

Yeah.

Those were interesting times.

And as you mentioned that you talked
about being VP of the CLF, that might

be something we could do a podcast on
separately, cause that's not a lot of

people who understand the CLF probably.

And you've left the agency, Owen Cole,
who used to be the president recently

retired, and that might be a topic that
we could talk about later, but yeah.

And see, so you and I have known
each other for over 30 years.

I believe we met.

Enter around San Francisco at one
of those NCOA training classes,

and we may have gone out and had
dinner and maybe a beer or two.

And then we worked very closely.

You were very modest about
being a PCO for a long time.

You were, if not the best problem
solver at NCOA in those years,

you were number one or number two.

And you taught me a lot about
my new job when I came out

there to be your supervisor,
the director of special actions.

So those were good times.

It doesn't seem like that was so
long ago, we learned a lot back then.

Also you spoke to the fact that you
Took a heavy interest in this and were

involved in it in 2014 on the failures
that you were Involved with where credit

unions cost the insurance fund money.

And so having you involved in that with
your background You were really the

right hand guy for the E& I director
back in 2014 and all that when these

rules were coming out One of the
things that I talk about with clients

is inside baseball, different things
about NCOA, and there's things that,

I think about how this came about that
probably nobody other than maybe Larry

Fazio can remember from back in the day.

So I'm really looking forward
to chatting with you about this.

So before we start talking about
capitals, what would you say the

purpose of regulatory capital is?

What can we glean from the
purpose of regulatory capital

that will lead this discussion?

It always helps to start
with why regulatory capital,

and it's really consistent.

Same with how any business would
want capital, but for banks

and credit unions, the same.

It's there to absorb those losses, but
because we have deposits of which the

public man puts into the institutions,
we need to have public confidence

and they look at the capital ratios.

It restricts excessive growth.

Because if you're limited to certain
capital ratios, you can't grow

exponentially very quickly, which would
be putting risk into your balance sheet.

And I was near and dear to how
I thought my main responsibility

was protect the insurance fund.

Like they talk about people
that play at the NFL, their

symbol is protect the shield.

And mine was always, we
need to protect the fund.

And capital is a big protector
of the insurance funds.

But beyond that, we really expect credit
unions to go beyond the regulatory capital

requirement and hold the appropriate
capital based on their unique risk, and

they need to have the ability to identify,
measure, monitor and control those risks.

So we'll cover that part of the capital
a little bit later, but adequate capital.

For safety and soundness
purposes is the key part for

undercapitalized credit unions.

They result in failures And those failures
result in losses to the insurance fund

Probably the most recent one that people
will be aware of is the losses are

incurred from concentrations of credit in
credit union medallion loans If we go back

in history, we've had failures a long time
ago based on mortgage servicing assets

and Investments in properties in Florida
by credit unions in the upper Midwest.

So that's what, capital
saves insurance fund in the

institution from failing itself.

But then there's that risk
of over capitalization.

And that's the one that can really
start to bother me personally.

And I know Bob Fenner at NCO
used to really be upset about.

When the credit union had too much
capital and people would look at that

and try to say, how can I turn this into
personal gain for myself or for my group?

When people would convert the credit union
charter to something of which they were

in a position to gain on that and take
the funds that really were the membership,

those are always really disheartening.

So as I caution credit unions against,
you don't want to be over capitalized

because you want to be returning as
much as you can back to the membership.

So that's the purpose.

Sure.

Both regulatory capital and capital.

And by having above average capital,
whether that's to associate to

mitigate your risks, and you're,
we're going to get into that.

The other thing, when you have the
extra capital, it's free money.

And while they're not paying high rates
on anything right now to attract money,

it does help subsidize loan rates.

As well as things like that.

Next, I think we're going to talk a little
bit about the net worth ratio when PCA and

things like that and when that came into
play, but I'm reminded of a story back

before we had PCA and you and I were PCOs
and we could allow credit unions to go

below the certain levels that PCA created.

I remember you telling me a story.

About one of your credit unions that you
had that had very low capital and had

some challenges tied to that, but they
were reborn like the Phoenix because

of the great efforts they put forward.

And it was one of those situations that I
enjoyed the most was when you had a credit

union that you were able to work real
closely with, to deal with the problem,

and it almost became like a partnership
of working to be reborn, like the Phoenix.

And as if I recall, there was a credit
union that liked how much you helped them

in that process that you might be the
only NCUA retiree that has a boardroom

that is named after you because of all
the work you did at that credit union.

Am I remembering that right?

Yeah, it's funny because
we always talked about.

Credit unions were building a lot of
crazy looking buildings back then and

when they finally had gotten Situated
where they could build a the building that

they needed Of course, we built a really
square efficient building and that's nice

because a few of those credit unions I
did Workouts in when they were actually

in negative retained earnings positions.

Many of them are still around a few
have been merged into other entities

or Because they took on other ones, but
there's a few of them that they're still

around today I do take a lot of pride in
those absolutely No, that's, I can think

of some where I did the same and it's,
that's when everything's working perfectly

from the regulatory side and the credit
union side and really good cooperation.

And that's fun to see.

And it's fun to participate in.

All right.

So net worth ratio, why don't you
speak to the net worth ratio as it

relates to credit union capital?

This starts NCUA's history with
capital, there really only dates

back to the year 2000, there was
different capital regulations that

were in effect before the year 2000.

It was like, I thought about looking
it up, but it's not going to go there.

It was too long ago.

So it was real novel though when
credit union started to have to do

the net worth ratio, it was very
controversial and everybody, a lot

of people are really upset about it.

But it was based on and required
from the prompt corrective action

regulation that went into effect and
that we had to put this measure that

was consistent with what the banks had.

So we ended up with just using
a simple leverage ratio and call

it the net worth ratio because.

It has in its numerator, mostly GAAP
retained earnings type items in capital,

but it has the unique item dealing with
mergers and that we take pre acquisition

retained earnings and count that part
of capital available to observe losses.

Which really isn't quite that way, but so
it has this kind of unique numerator and

then the denominator is just simply being
assets and when we wrote the regulation,

we allowed a lot of definitions of assets
so that if you were growing rapidly,

you wouldn't have a fall short term fall
in your net worth ratio, because you

could use averaging to bring it down.

But in the end, credit unions,
Took to that pretty well.

We had very few that were
initially impacted by it.

But if we go back and look at
this measure, it was 7 percent or

greater to be well capitalized.

Now, recall that the bank similar
major on their tier 1 ratio is 5%.

So going back to what was the
reason for the 2 percent difference?

1 percent was due to the NSU SIF and
that that's still on the books of

the credit unions versus for banks.

They've expensed all of that money
that's in their insurance fund.

The other 1 percent was really
there because Credit unions

rather limited ability to raise
capital, except through earnings.

With now this increased use and
availability of secondary capital,

that's probably somewhat mitigated.

And I haven't heard a lot of
discussion on that, but we started

with the net worth ratio and
that was the initial measure and.

been in effect since 2000 and now we're
going to move forward to what really

were the changes that start January 1st.

Got it.

And so if I'm interpreting you right, so
the 1 percent buffer for the NCUSAF, I

get that, and the other 1 percent because
credit unions couldn't raise capital, as

you referred to, limited income credit
unions can get secondary capital, and then

under risk based net worth, there's some
opportunities for other credit unions.

It sounds like.

If you were still at NCUA, you would be
open to maybe well capitalized being able

to be a little bit less that or at least
re evaluating that one percent buffer

potentially for all credit unions or for
low income or am I over interpreting that?

You might be over interpreting
that, but I will make a comment

on that when we talk about the
complex credit union leverage ratio.

Okay, great.

Then let's talk about the new
complex credit union leverage ratio.

This final rule was approved by the
NCB board in December, just absolutely

this past December, providing
a simplified measure of capital

adequacy for complex credit unions
went into effect on January 1st.

The first measurement of this
will take place in March.

It's modeled after the community bank
leverage ratio, which was implemented

by FDIC in November of 2019.

So credit unions that satisfy
eligibility do not need to calculate.

The risk based capital ratio, which
we'll talk about in a little bit by

maintaining a higher net worth ratio,
about 690 credit unions with assets

over 500 million, which makes them into
the definition of complex and of able

to use the credit union in a complex
credit union leverage ratio, but they

have an average net worth ratio of 10.

16%.

So on average, everybody has a 1
percent buffer above the amount needed.

And the really, the only
thing you get there is.

They wouldn't have to compute
the risk based capital.

The minimum is set at 9%.

Same as it is for the banks.

So basically, it's the net worth ratio
9 percent same net worth ratio, the

7 percent to be well capitalized.

So that 2 percent difference that there
used to be between FDIC measures and NCLE

measures on the simple leverage ratio.

Is essentially gone.

It goes away under the complex credit,
Under the complex credit, okay, you'd

be a little bit remiss to say It's
exactly comparable because it's really

not the kareans did get a benefit.

It just really probably wasn't worth
the amount of People that had comments

about a negative about bringing that up
again at this point in time I think nine

percent is a pretty fair measure for
leverage Of just basically pure equity

for the most part amount available to
cover losses so that this measure is

good because it's still 4 percent above
the amount needed to be well capitalized

so it does create a significant
buffer above the net worth ratio.

And so Steve if someone's at 9.

4%.

So they're billion dollars, so they're
over the 500 million threshold.

They're at 9.

5%.

Thanks a lot.

net worth ratio.

The advantage they have with this
new regulation is that because

they're over the nine and a half
percent, they're well capitalized.

And so they don't need to do all those
other calculations tied to how much

they have in member business loans, how
much they have in real estate loans.

While they can do the calculation,
the one that NCUA Now we'll grade

them on is being over the 9%.

Am I summarizing that right?

That's correct.

As long as you are a qualifying
institution that you don't have a

significant off balance sheet exposures
or greater than 2 percent of assets

basically and tied up in goodwill, which
generally isn't available to cover losses.

So there are.

Just the four qualifying criteria.

Okay.

You reminded me of someone
who's still at NCUA.

When I would restate something and get
it mostly right, but off a touch, and

they would clarify it, they would start
by saying, that's roughly correct.

And that always made me smile.

So adding those caveats to what
I said, make that accurate.

Okay.

Got it.

Anything else on the complex
credit union leverage ratio?

No, it is fairly straightforward.

Very good.

Very good.

Let's speak to risk based capital.

This is another one that
just comes into effect.

First measurement of be on the call
report that's been drafted in is out

there for credit unions to look at
starting with the measurement in March.

I'd say, don't be afraid of this ratio
because even though very few credit

unions is, we're talking about the
complex credit unions, and ones that

aren't going to use the leverage ratio to
not have to compute risk based capital.

It is a valid measure that takes into
account the uniqueness of your assets.

So when we put together those risk
weights, they're pretty much the same

as in the other banking agencies.

We did manage to get some things in
there dealing with concentrations

of assets because those would
have led to credit union failures.

So there are.

Additional risk higher risk weights when
you get above higher levels of real estate

loans and especially commercial loans.

As I say, even if you're not going
to end up having to calculate the

risk based net worth requirement.

I would want to be aware of it because it
is a nice and another measurement tool.

The credit unions would have available
to themselves to see where they stand

in capital under a risk weighted basis.

Sure.

And so it's a tool that gives them some
context compared to other measurements.

And then theoretically, another reason
to pay attention to it would be like

with COVID unexpected growth, the
capital ratio, going back to what you

said at the beginning, part of the
reason to have capital restrictions.

Is to prevent excessive growth.

Over the last couple of years, a
lot of credit unions experienced

excessive growth that they really
could do nothing about race for zero.

And it was just funneling in because
of the world that we lived in.

And that could drop you down below
the 9 percent net worth ratio.

And then all of a sudden, six months
ago, you weren't being measured

on it, but now you are, which is
a reason to continue to watch it.

Yeah, that's a very good point.

The other one coming into that is.

If credit unions have had a lot of this
share growth that's come in on a risk

based capital basis, where are they
putting Those assets and predominantly

if you're unable to put it in loans,
you're probably putting it into lower risk

weighted assets So you might find that
risk based capital Ratio isn't fluctuating

as much because the risk weighted assets
Aren't changing as rapidly because

they're being put into lower risk assets.

That makes sense.

And the other thing I like about
the risk based capital is that the

numerator is really purely gap and it
has the deductions that work on these

items inside the balance sheet are not
going to be available to cover losses.

So it's a more precise measure
of what is available to cover

losses in the event of failure.

And so an example of what's excluded
in the numerator, would that be the

merger and acquisition category or what
it's not in there because if you do a

combination or merger and you have a
gain on that transaction in which you

are not having to record additional
goodwill that goes directly into equity.

So we don't have that.

Non gap item that just sits there and
could become problems at some point

in time, but so far so good on that.

It hasn't raised a lot
of problems with it.

The calculations takes into account
goodwill intangibles, and it also

takes into account the end to SF
deposit and that we do reduce it

from the numerator and denominator.

So then that measure is more comparable
against the other banking agencies,

which is the risk based capital
threshold for well capitalized of 10%.

You and I talked about
management of capital.

You want to speak to what
management of capital does and is?

Yeah, because there's the
regulatory requirement for

capital that sets the minimum.

Now, institutions, large and small need
to be able to discuss with their examiner.

What their capital goal is
and why it's where it is.

So in order to get there, you'd have
to have probably some measurement

beyond regulatory capital approaches.

There are many ways to do it out there.

The economic capital is
one measure of doing it.

And that is the.

Calculation I did for doing the CLF
and they looked at all of our assets

and you figure what's the probability
of default and with the investments

to see if I could do very low and then
that loss given default and then the

amount of the exposure you have it.

It's not a real complicated transaction,
but it is another way of looking at

your balance sheet and then identifying
those risk items that are in there.

What you can always look at for
a tool is those credit unions

over 10 billion in assets.

They have another regulatory
requirement to basically to do this.

They have the requirement for
stress testing and they have the

requirement for a capital plan.

And if you look at the elements of those.

Not all of them would be something that
you'd have to use for the credit union

that you're particularly in because
you don't have the complexity of the

larger ones, but that does provide
some reference as to what items of

that appear to be appropriate for your
credit union and that you could use.

I think the hard thing is, like
I say, when I always go to a

credit, and they go, well, our
board set a net worth ratio of 9%.

Then my answer is like, why?

Well, what was the peer average for
credit unions in our state of our size?

It's like very good, but your assets
are exactly the same as theirs.

The environment you're
operating in, is that the same?

I look at it like I like
to do the SWOT analysis.

Strengths, weaknesses,
strengths, weaknesses.

Opportunities and threats.

I think that that is always another way of
okay, this is why we would believe that we

are safe holding closer to the regulatory
minimum amount of capital versus that

it's okay for accrediting to be aggressive
and to be out there and do risk because

it might be what their membership needs.

But you can do that, but you just need
to be able to hold appropriate capital

for what you're doing and use of
these tools like economic capital and

stress testing and capital sensitivity
testing, reverse stress testing.

All provide value, but you need to be able
to have those and be able to understand

what it is that you are getting, because
you can't just assign it off to a 3rd

party and say that's all great and good.

But just tell us what that means.

You need to have at least some people
on staff that are very comfortable with

that discussion to the examiner says near
the regulatory minimum is good for us.

where we decide that we need to bump
it up x percentage point because

right now we're taking on these risks.

The other thing you need to look
at the future because merger and

acquisition opportunities are generally
going to result in at least a short

term decrease in your regulatory
capital measures as you can see.

So if that's in your future, You
need to take that into account.

So there's lots of items
that take place in there.

What we've looked for is that
credit unions have done analysis

and additional work, so they're
really comfortable for why that

capital goal is their capital goal.

This is a great topic.

And as you're talking, I'm getting a
lot of things that run through my head.

Steve, if you think back on the consulting
work, you and I have done it for some

of my clients over the last year, this
topic has been there more than others.

The fact that, okay, NCOA is questioning.

Their capital regime, if you will,
and wanting them to better explain

why, if they're just over well
capitalized, why that makes sense.

How that relates to where they've been
and some of the tools you've mentioned

here are things that we've suggested
to some of the clients we've had.

But if you find yourself having capital
type questions, reach out to me and I'll

explain how to reach out to me later.

But this is something that Steve and I
would love to try and assist a credit

union with to walk through some of this.

And then two other things that you said
that I want to touch on, as you said, look

to what credit unions over 10 billion.

are asked to do, and I can
imagine credit unions out there

hearing that have a heavy side.

Like I'm 400 million.

I'm not 10 billion.

I can't afford to do that.

I'm a billion.

I'm 25 million.

Of course, somebody who is at nine billion
certainly has to be getting ready to

transfer over from regional control to the
Office of National Exam and supervision.

And so there's this You know,
into a comes out with something.

And one of the things that can happen is
it's expected at a higher level and then

it can start to bleed into lower levels.

And you're not saying to let it bleed.

You're just saying, look to it,
understand it, take from it.

What might make sense.

And as you read through what larger
institutions are asked to do, you might

have an aha moment that says, okay, that
makes sense for me as it relates to you.

The part of the country I'm in and the
risks that I could have while I do that

SWOT analysis and you can raise the
bar of what you're doing capital wise

without really having to comply with the
rule, anything you want to add to that?

Yeah, that's a really good point to make.

And we don't want to make
great unions go too far.

But as you do additional
calculations of how much capital

you think you should have, It's
all related to your risk tolerance.

So if you're, low risk tolerance, credit
union operating fairly well below the

10 billion requirement, we shouldn't be
asking for a lot and you don't need a lot.

But if you're have a fairly healthy
risk appetite, You're in the market for

some merger and acquisition activity.

Certainly you want to be moving
your process and sophistication up.

Makes sense.

And then you talked about one other thing
you mentioned under this last discussion

was having assistance from a third party.

And so there's a lot of good third
parties out there that can assist in

a lot of different things from ALM,
NEV, capital planning and everything.

But the point I want to reiterate
that you are making is N.

C.

U.

A.

Wants to make sure that while you
have that third party that you own

it, that whatever suggestions they
might have, maybe they come back and

they say, we suggest these 10 things
and you evaluated internally say

seven of these make sense for us.

And the words I think you said
were somebody within the walls of

the credit union that understands
that and then can speak to N.

C.

U.

A.

With that language so that N.

C.

U.

A.

understands that the credit
union didn't just farm it out.

They actually get it exactly.

Yeah, exactly.

You brought up the stuff about
the corporate resolution.

Yes, the accounting for the reserve
on that was extremely complicated.

And we did use third parties.

These third parties had a lot
of initials after their names.

And I did have to spend a great deal
of time sitting down with them and

saying, Okay, this is how you say we
do explain it to me again, so that I

could make sure that I could explain it.

And number one, that I
understood it and agreed with it.

I couldn't.

Yeah, you were, that's a great comparison.

You were that guy at NCA who understood
that and then explained it to the board,

explain it to Maryanne Woodson, the chief
financial officer and the CPAs who had

to buy into the concept of Yeah, yeah.

We had our own people doing our audit,
like the NCA audit, and they had to.

Be in the room with them and be able
to confidently explain to them how

that calculation worked and why we
were comfortable with the results.

Very good.

One last thing on this topic.

I know Steve, you and I had helped
a couple of credit unions with

net worth restoration plans.

That's something you're
fantastic at with that.

I've got some experience with as
well, and we were able to help

those credit unions achieve success.

Maybe at some juncture, that's
not a lot of credit unions have to

do it when they do have to do it.

It can be a heavy lift to get approval.

And that's something we'll
talk about down the road.

I know you and I have some
other topics we're going to be

talking about in future episodes.

So this was great.

I want to thank you for being my
guest here today on the podcast.

And in closing, I want to mention that.

I do listen to a lot of podcasts.

I enjoy podcasts myself and
a lot of different topics.

And one of my favorite podcasts
at the end of episodes, they will

tack on questions that came up from
previous podcasts, so no doubt.

There might've been something that Steve
said here, or that I said that triggered

a follow up question that you might have.

And if you do have such questions about
what we talked about today, I'd like

you to reach out and let me know so
that we can address those questions

that maybe provide some clarification
or a follow up podcast on this topic.

And then lastly, if you'd like
to talk to me about how Steve and

I can assist you and your credit
union, you can reach out to me at my

email, which is cu exam solutions.

So the letters see you exam
solutions at mark trickle.

com or via my website, which is www.

marktreichel.

com.

All right, everybody.

That's it for today.

I'm Mark Treichel, and I hope
you will join me again next

time for with flying colors.