Eight Takeaways from the NCUA’s Annual Report

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Each March, the NCUA releases its Annual Report, summarizing the agency’s performance in meeting its strategic goals and objectives. As usual, this year’s report makes for an interesting read, particularly given the industry’s recent volatility. 

At the outset, the NCUA should be commended for putting together such a comprehensive, accessible, and intelligent presentation. Last year’s Annual Report won the prestigious Certificate of Excellence in Accounting Reporting award from the Association of Government Accountants. It would not be a surprise if this year’s presentation is a repeat winner. The document is laid out smartly and packed with information. 

Overall, the NCUA’s focus in 2022 concerned five broad categories:

·        Responding to evolving economic and financial challenges;

·        Strengthening the credit union system’s capital levels;

·        Increasing cyber resiliency;

·        Supporting small credit unions and minority depository institutions; and

·        Fostering greater diversity, equity, inclusion and belonging.

While the 244-page Report is largely an accounting of last year’s initiatives, it also provides a peek into what is top-of-mind at the NCUA going forward. In this regard, a March 22 article from the Credit Union Times offered a succinct takeaway: “What lies ahead appears to be a number of challenges and potential risks to the system as a whole, according to the report.”[1]

Below, we list our eight most significant observations after reading the Report. A brief summary follows each observation.

1.      Interestingly, despite ample discussion of risks, the NCUA did not mention the potential for rising rates to create losses in the AFS portfolios of credit unions.

Certainly, the NCUA has been sounding the trumpet on interest rate risk for some time. In recent years, the agency’s tangible efforts have included (1) the liberalization of the derivative rules to encourage credit unions to consider hedging, (2) inclusion of IRR in the 2022 Supervisory Priorities Letter, and (3) a September 2022 update to the regulatory framework to ease the pressure of the Supervisory NEV Test on credit unions and to increase clarity and flexibility for both examiners and credit unions.

Not surprisingly, the Annual Report’s presentation was also focused on interest rate risks for credit unions in a rising interest rate environment. For all its warnings, however, the duration risk that a significant number of credit unions were carrying was simply absent from the discussion. Instead, the NCUA seemed focused on the potential for margin compression as deposits repriced faster than incremental loan rates if the yield curve remains inverted. For example, the Report warned that “[e]xpected changes in the interest rate environment suggest short-term interest rates could be higher than long-term rates next year, squeezing credit union net interest margins.” (Page 29)

The duration risk embedded in AFS portfolios was a significant miss, as the industry more than doubled its exposure to securities in the 5-to-10 year category in the five quarters from Q4 2020 through Q1 2022. Similarly, investments longer than 10 years in maturity more than doubled across the industry during the year 2020 alone.

2.      Although short on measurables, the agency remains committed to its Virtual Exam Project

While the pandemic certainly upset the pace and progress of the NCUA’s efforts, the project has been underway for quite a while, absent some measurable progress. The NCUA describes its progress as follows:

“The NCUA Board approved this project and associated resources in 2017. Currently, the project is in the research and discovery phase. During this phase, staff identifies new and emerging data sources and methods to access the data, assesses advancements in analytical techniques, and considers how other technologies can be harnessed to automate or streamline various aspects of the examination process.” Next, they expect to perform “periodic stakeholder outreach” and “conduct pilots and feasibility testing.” 

Certainly, the COVID episode has been informative and has likely expanded the possibilities for this project. Overall, however, the jury remains out on whether this will have a meaningful impact on the quality and style of the agency’s examinations and its overall supervision. (Page 28) 

3.      2022 was a busy year for regulatory updates 

In a section of the Annual Report labeled “Delivering an Effective and Transparent Regulatory Framework," the agency catalogs “six substantive changes to the NCUA’s regulatory structure to help credit unions stay competitive in the changing environment and continue to provide financial services to their members and communities.” The changes include:

· Succession Planning Rule

· Subordinated Debt/Secondary Capital Rule

· Earnings Retention Waivers and Net Worth Restoration Plans

· Cyber Incident Notification

· Member Expulsion Rule

· Financial Innovation Release 

Now that the benign interest rate cycle of the last several years has been replaced with a more volatile market for deposit gathering and loan origination and a host of anticipated stresses that could lead to credit deterioration are on the horizon, the NCUA is likely to have less time for rulemaking in 2023. 

4.      Supervisory compliance is likely to increase

Overall, The number of total outstanding enforcement actions for federally insured credit unions decreased from 166 at the end of 2021, to 141 at the end of 2022. In its presentation, the NCUA makes no hesitation in asserting that “[t]his trend will likely not continue in future years.” (Page 30) The agency points to the return to onsite examinations and supervision as a catalyst for stepped up compliance efforts. The NCUA also highlights that field staff have found an increase in recordkeeping deficiencies, problems with internal controls, and instances of fraud and will be aggressive in rooting out such instances in an effort to protect the Share Insurance Fund. Certainly, market volatility will accelerate situations where credit unions functioning with lax policies, procedures and controls find their way into trouble. 

5.      The NCUA remains committed to regulating third party service providers

It seems that the agency is likely to use the recent market turmoil to bolster its argument in favor of regulating credit union vendors. The NCUA minces no words in asserting that “the NCUA’s lack of authority to supervise third-party vendors that provide services to credit unions remains a regulatory blind spot that could trigger cascading consequences throughout the credit union industry and the financial services sector.” The NCUA seems particularly concerned that the amount and type of data that third parties hold – beyond the current scope of regulation – poses a particularly worrisome risk.

6.      The number of low-income designated credit unions (LICU) should continue to grow

The low-income designation is a critical component of the NCUA’s efforts to support credit unions. To qualify as a low-income designated credit union, the majority of a credit union’s membership must meet certain low-income thresholds based on data from the American Community Survey done by the U.S. Census Bureau.

There are several benefits for credit unions that carry a low-income designation, including:

·        An exemption from the statutory cap on member business lending, which expands access to capital for small businesses and helps credit unions diversify their portfolios;

·        Eligibility for grants and low-interest loans from the Community Development Revolving Loan Fund;

·        The ability to accept deposits from nonmembers; and

·        The ability to count subordinated debt (secondary capital) toward net worth.

More generally, LICU status can bolster a credit union’s community development bona fides, signaling the credit union’s commitment to promoting community development, financial inclusion, and economic empowerment, particularly for individuals and families who may not have access to traditional banking services. And, gaining LICU status can also be a valuable marketing tool for credit unions, particularly those that are committed to serving low-income or underserved populations, allowing them to build trust with these communities and to demonstrate a commitment to financial inclusion and social responsibility.

At Q4 2022, there were 2,627 credit unions with the low-income designation, representing 54 percent of all federally insured credit unions. LICUs had 71 million members and $1.07 trillion in assets at the end of 2022, compared to 66 million members and $1.12 trillion in assets for non-LICUs.

Because gaining LICU status can provide credit unions with broader access to funding, regulatory benefits, opportunities for community development, and marketing advantages, we expect more to find their way to the designation over time.

7.      One way or another, market consolidation is likely to continue

Credit union consolidation is a complex topic that can be influenced by a variety of factors, including economic conditions, regulatory changes, and shifts in consumer behavior. While it's difficult to predict the future with certainty, there are plenty of reasons to believe that credit union consolidation will pick up in the current economic environment:

Increased competition: Credit unions are facing increasing competition from banks, fintech startups, and other financial services providers. This competition can put pressure on credit unions to consolidate in order to remain competitive and to achieve economies of scale. These pressures are likely to become more acute in an economic environment with increasing deposit competition and tightening credit boxes.

Cost pressures: Credit unions are facing rising costs associated with compliance, technology investments, and other operational expenses. These issues are also trickier in an environment that has grown increasingly comfortable with remote work and where a labor market remains remarkably tight. Consolidation can be a way to achieve cost savings through economies of scale, shared resources, and streamlined operations.

Changes in consumer behavior: Consumers are increasingly turning to digital channels for their financial needs, and this trend is likely to continue. Credit unions that are unable to keep up with these changes may be at a disadvantage, which could make consolidation an attractive option.

Regulatory changes: Changes in regulations can also influence consolidation. For example, as the economic environment becomes more difficult, regulatory requirements may become more stringent, making it difficult for smaller credit unions to comply. This could lead to further consolidation as smaller credit unions seek to merge with larger institutions that have the resources to keep up with the evolving regulatory landscape.

Demographic shifts: The aging of the credit union membership base is another factor that could influence consolidation. As older members retire or pass away, credit unions may find it difficult to attract younger members, who may have different preferences and expectations for financial services. Consolidation can be a way to address this challenge by creating a larger institution that can appeal to a wider range of members.

The data from 2022 presented in the Annual Report highlight an observable trend toward fewer credit unions.  Among the trends are:

Declining membership in small CUs: The NCUA observes: “While overall credit union membership continues to experience strong growth, about half of federally insured credit unions had fewer members at the end of 2022 than a year earlier. This is a long-term trend, as smaller credit unions often lack the resources to provide technology, products, and services that many consumers expect from a financial provider.” (Page 51)

Industry Consolidation: The NCUA observes: “As the consolidation trend continues there will be fewer credit unions in operation, and those that remain will be considerably larger and more complex.” For example, in Q4 2022, there were 709 federally insured credit unions with assets of at least $500 million, a 34 percent gain from five years earlier. (Page 52)

Anemic New Charters: Meanwhile, new charters have been granted at an anemic pace and are never going to replace the charters disappearing each year. In 2022, for example, the NCUA reported four new credit union charters. (Page 35)

8.      Liquidity, Liquidity, liquidity 

The recent failures of Signature Bank and Silicon Valley Bank highlighted idiosyncratic risks of those institutions and were not necessarily reflective of broader liquidity issues facing the credit union industry. However, credit unions are facing liquidity challenges due to various factors, including:

Changes in interest rates: Credit unions rely heavily on the interest rate spread to generate income, and changes in interest rates can affect their profitability and liquidity. For example, if interest rates rise, credit unions may experience an outflow of deposits as members seek higher yields elsewhere, while at the same time experiencing a decrease in the value of their investment portfolio.

Deposit growth: Credit unions need to have a sufficient level of deposits to fund their lending activities, but if deposit growth slows or declines, this can put pressure on liquidity. In recent months, credit unions have seen government stimulus payments sunset as interest rates have risen, competition from other financial institutions has increased, and consumer behavior has shifted towards alternative savings vehicles.

Asset quality: Credit unions need to manage their loan portfolios carefully to ensure that they are not taking on excessive risk that could lead to losses or liquidity issues. If credit quality deteriorates, credit unions may have to set aside more funds to cover potential losses, which can put additional pressure on liquidity.

Regulatory changes: Changes in regulations, such as those related to capital requirements or liquidity standards, can also impact credit union liquidity. For example, if capital requirements are increased, credit unions may need to hold more capital, which could reduce their ability to lend and put pressure on liquidity.

The NCUA has liquidity on its radar and liquidity issues are likely to remain an important part of the backdrop for all that they do for the foreseeable future. Certainly, most of this reality is dictated by the recent maelstrom in the market for deposits and the interest rate swings of the past several months. The agency also knows that the quality of its decision making in the coming months will go a long way to protecting the industry’s credit unions (and the Share Insurance Fund) from excess losses. 

The NCUA also noted concern about the lack of access to emergency liquidity sources for credit unions generally. More specifically, the NCUA sounded the alarm regarding the expiration of the Central Liquidity Facility’s agent-membership provision at the end of 2022, noting that it resulted in 3,322 smaller credit unions losing access to an important source of emergency liquidity and asking that Congress consider restoring this authority. (Page 10)

[1] Michael Ogden, NCUA Annual Report Shows CU Industry Is on Solid Ground, Credit Union Times (Mar. 22, 2023).