http://www.lscu.coop/content/download/8943/104423/RegFlexFixedAssetsMBL

Regulatory Comment Call on NCUA’s Proposed Rule on Fixed Assets, Member Business Loans, and Regulatory Flexibility Program April 1, 2010 Executive Summary •

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The National Credit Union Administration (NCUA) Board has adopted a proposed rule to make changes to its Regulatory Flexibility Program (RegFlex) pertaining to fixed assets, member business loans (MBL), stress testing of investments, and discretionary control of investments.

Specifically, the proposal would require RegFlex credit unions to comply with the general limitation of a federal credit union’s investment in fixed assets to no more than 5% of its shares and retained earnings.

In regard to MBL, the proposed rule would subject RegFlex participants to the collateral and security provisions requiring the personal liability and guarantee of the borrower’s principals.

Additionally, RegFlex credit unions would be required to stress test securities in certain instances.

When delegating discretionary control over investments, the proposal would place on RegFlex credit unions the same 100% net worth limitation that applies to all federal credit unions.

Comments are due to NCUA by May 24, 2010; if you would like to share your thoughts with the LSCU so we can incorporate them in our comment letter, please give them to us by May 20, 2010.

Please e-mail your responses to Bill Berg, Vice President of Regulatory Affairs at william.berg@lscu.coop and/or Scott Morris, Director of Compliance at scott.morris@lscu.coop. You may also contact Bill or Scott at 800.342.1266 x1028 or 2165 respectively, if you have questions.

Click here http://edocket.access.gpo.gov/2010/pdf/2010-6391.pdf to access the proposed rule in the Federal Register.

Background Federal credit unions (FCUs) that participate in the RegFlex Program are exempt from certain regulatory restrictions and limitations. Eligibility in the Program is limited to FCUs that have demonstrated sustained superior performance as measured by CAMEL ratings and net worth classifications. An FCU may qualify for the RegFlex program automatically—based on performance indicators such

as, consistent classification as “well capitalized”—or by application to its regional director.

Currently, the RegFlex Program addresses the following areas: • • • • • • • • • •

Fixed assets; MBLs; Discretionary control of investments; Stress testing of investments; Charitable contributions; Nonmember deposits; Zero-coupon securities; Borrowing repurchase transactions; Commercial mortgage related securities; and Purchase of obligations from a federally insured credit union.

Brief Description of the Proposed Rule NCUA’s proposal amends the fixed assets, MBL, stress testing of investments, and discretionary control of investments provisions of the RegFlex rule.

Fixed Assets NCUA’s regulations permit FCUs to invest in fixed assets—such as, office furnishings or a branch office—so long as these investments in the aggregate do not exceed 5% of the credit union’s shares and retained earnings. An FCU that wishes to exceed the 5% limit must submit a written request to its NCUA regional director for a limit increase.

While currently exempt, the proposed rule would require RegFlex credit unions to comply with the 5% investment limit, although they could also apply to their regional director for a waiver.

“Call report data collected by NCUA shows a higher percentage of earnings problems among credit unions with more than five percent of shares and retained earnings invested in fixed assets; the percentage of earnings problems increases as the level of fixed assets increases,” according to the supplemental material to the proposed rule. As additional support, NCUA cites examples of four different FCUs which experienced severe declines in net worth that was attributable—at least in part—to an increase in fixed asset investments by those credit unions.

Member Business Loans The MBL rule requires a credit union making a business loan to obtain the personal liability and guarantee of the borrower’s principals as part of the rule’s collateral and security requirements. Credit unions may request waiver of the

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liability and guarantee requirement from their regional director on a case-by-case basis.

Currently, RegFlex credit unions are exempt from these requirements but have the option of requiring the principals’ guarantee as part of their own underwriting standards and best practices. The proposed rule would rescind the exemption for RegFlex credit unions, although the ability to apply for a waiver would be preserved. NCUA believes this requirement is appropriate for all credit unions and that requiring the principals’ personal guarantee greatly enhances the likelihood of loan repayment, according to the supplemental material.

Discretionary Control of Investments Under NCUA’s investment rule, FCUs are required to retain discretionary control over the purchase and sale of their investments. The rule provides that an FCU will not be deemed to have “delegated discretionary control” to an investment adviser if the FCU reviews all recommendations from the adviser and authorizes any recommended purchase or sale transactions before being executed. As an exception to the general rule, an FCU may delegate discretionary control (1) to an investment advisor registered with the Securities and Exchange Commission, (2) for an investment amount that does not exceed 100% of the FCU’s net worth at the time of delegation.

Under the current rule, RegFlex credit unions are exempt from the discretionary control requirements that pertain to net worth; accordingly, they may delegate control over aggregate investments that exceed 100% of their net worth. Noting the current investment climate and reports of fraudulent practices in the investment banking industry, NCUA has proposed to rescind RegFlex credit unions’ exemption from the discretionary control limitation.

Stress Testing of Investments Under NCUA’s investment rule, FCUs are required to prepare monthly reports that describe the fair value and dollar change from month-to-month for each security they hold with summary information for the entire portfolio. The rule also requires FCUs to prepare quarterly reports that describe the sum of the fair values of all fixed and variable rate securities that include: (1) embedded options; (2) remaining maturities of more than three years; or (3) certain coupon formulas.

If the sum in the quarterly report is greater than the FCU’s net worth, the FCU must conduct stress testing of its securities.

Specifically, the tests require the FCU to estimate the potential impact, in percentage and dollar terms, of an immediate and sustained parallel shift in market interest rates of plus and minus 300 basis points on: •

The fair value of each security in the portfolio;

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The fair value of the portfolio as a whole; and The FCU’s net worth.

Currently, the investment rule does not require RegFlex credit unions to perform stress tests. Resulting from low investment yields due to the current economic environment, many credit unions are incurring additional risk by investing in longterm instruments to increase yield and improve earnings, as noted in the supplemental material. Furthermore, NCUA believes many credit unions are investing in products they do not fully understand and are incurring significant interest rate and liquidity risk.

NCUA has proposed to rescind RegFlex participants’ exemption from the stress testing requirements, noting that stress tests provide credit unions with a clearer understanding of their risk profile and an increased ability to manage risk.

Questions to Consider Regarding the Proposed Rule 1) NCUA relies heavily on the current state of the economy to justify the RegFlex changes offered in the proposed rule. Do you agree that such justification is appropriate? Absent other legitimate reasons cited by NCUA, do you find “the economy” as a compelling reason to adopt these changes? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________ 2) The proposal would rescind RegFlex credit unions ability to invest more than 5% of their net worth in fixed assets—absent waiver by their regional director. Is the 5% limit appropriate? Would some percentage above 5% applicable solely to RegFlex credit unions be more appropriate? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________ 3) The supplemental material notes that borrowers are more likely to repay MBL if the lender obtains the guarantee of the borrower’s principal. Do you agree with rescinding RegFlex credit unions’ exemption from obtaining personal liability and guarantee? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________ 4) Understanding that RegFlex credit unions are generally the most financially sound, is it necessary that they too be subject to stress testing requirements? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________

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5) As support for rescinding the stress testing exemption, NCUA cites that, over the past year total FCU investment with maturities of greater than three years has increased from $38 billion to $50 billion. Do you find this statistic to be a compelling reason for requiring RegFlex stress testing? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________ 6) The proposal would require RegFlex credit unions to comply with the 100% net worth limitation when delegating discretionary control of investments. For RegFlex credit unions that currently delegate in excess of 100%, to what extent would this change impact your operations? Is the 100% limitation for RegFlex participants necessary? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________ 7) Any other questions or concerns regarding the RegFlex proposal? ________________________________________________________________ ________________________________________________________________ ________________________________________________________________

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