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 from the prior year. As usual, the latest version makes for an interesting read, especially as we celebrate the ninetieth anniversary of the Federal Credit Union Act following a volatile 2023.

To the NCUA’s credit, once again the presentation is comprehensive, accessible, and intelligent. As has become the standard, the document is laid out smartly and packed with information.

As Chairman Harper describes in his Message from the Chairman, the NCUA’s focus in 2023 concerned four broad categories:

• Responding to the economic headwinds
• Advancing financial security, economic equity and allyship
• Maintaining cyber resiliency and
• Investing in employees
• 
  

While the 234-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, it is probably best read in conjunction with the recently released 2024 Supervisory Priorities which highlighted the agency’s six most important areas of interest:

• Fraud Prevention and Detection
• Consumer Financial Protection
• Credit Risk
• Information Security (Cybersecurity)
• Liquidity Risk
• Interest Rate Risk
• 
  

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

1.    The NCUA is concerned about the macroeconomic environment for credit unions. And rightly so.

In his Message at the front of the Report, Chairman Harper trumpets the safety and soundness of the industry, but sets a gloomy tone for the industry’s immediate future:

“the NCUA has seen growing signs of financial strain on credit union balance sheets and in household budgets. The loan delinquency and net charge-off rate levels both rose in 2023, returning to pre- pandemic averages. As the lagged effects of elevated interest rates take hold in 2024, we will also see changes in credit union performance, including slower share deposit growth, higher costs of funds, and lower earnings. Additionally, the NCUA has seen growing stress within the system because of the rise in interest rate and liquidity risks, as reflected in the increasing number of composite CAMELS code 3, 4, and 5 credit unions. Sharp rises in and historically elevated levels of credit card delinquencies over the last year also demonstrate growing credit risks for the industry.”[1]

This is perhaps the most important insight of all, as it establishes the lens by which the agency will be reviewing the credit unions under its charge.

While the Report’s later section entitled “Near-Term Economic Outlook” offers a more upbeat projection, particularly with respect to its inflation outlook, the difficulty of the current environment is everywhere you look. At America’s Credit Unions’ recent Government Affairs Conference, for example, there was a general sense of discomfort among the industry’s leaders, as the cheap deposits and lofty loan growth of years past seemed a distant memory.

We do not expect the pressures to abate anytime soon. Trends in cost of funds, delinquencies, charge-offs, return on assets, operating expenses, and net income all present significant hurdles in the near term.

Moreover, as we observed in a recent article, “[a] business that borrows money short and lends money long relies on the natural shape of the normal yield curve to maintain its margins.”[2] In fact, “[a]s long as the curve stays inverted, the country’s financial institutions will not be able to make the ROAs that they have grown used to in recent years.”[3]

2.    There is a creeping emphasis on consumer protection.

The NCUA’s supervisory efforts over the last few years have been aimed at creating a more equitable and legally compliant financial system. That emphasis is clear in the agency’s budget and in its Supervisory Priorities.

Overdraft and non-sufficient fund fees have been a particular focus of the NCUA’s review. It is prudent to expect that examiners will continue an expanded review of overdraft programs, including website advertising, balance calculation methods, and settlement processes. The agency is likely to target credit unions with fees that are not reasonable and proportional, rely on systems that authorize positive and settle negative, or impose multiple representment fees.

In the wake of recent high-profile events, we also expect NCUA fair lending examinations to increase in number and to focus on ensuring that policies and practices are fair and not discriminatory.

Against this backdrop, in December 2023, the NCUA published a draft of amended instructions for the Call Report which, if adopted, would become effective on March 31, 2024. The new version of the Call Report would continue to require credit unions to report their total fee income – but also require credit unions with $1 billion or more in assets to specifically break out how much of that total is attributable to overdraft fees and Non-Sufficient Funds fees, respectively.

3.    The NCUA really wants to regulate third party service providers.

Closely related to its emphasis on consumer protection, the agency remains committed to its long-term desire to regulate credit union vendors. In recent remarks before the Brookings Institution, Chairman Harper remarked as follows:

“[r]isks in the credit union system often lurk in the regulatory shadows beyond the NCUA’s reach, namely within credit union service organizations and third-party service providers, because the NCUA does not have supervisory authority over these third-party vendors, unlike its federal banking agency counterparts.”[4]

Here, the NCUA has latched onto the recent cyberattacks at several of the nation’s credit unions to bolster its case. The agency 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.

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

Credit unions continue to seek the benefits of the 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 portfolios;
• Eligibility for grants and low-interest loans from the Community Development Revolving Loan Fund;
• The ability to accept deposits from non-members; and
• The ability to count subordinated debt (secondary capital) toward net worth.
• 
  

Gaining LICU status can also be a valuable marketing tool for credit unions, particularly those committed to serving low-income or underserved populations. The designation can allow a credit union to build trust with these communities and demonstrate a commitment to financial inclusion and social responsibility.

At YE 2023, there were 2,483 LICUs, representing 53.9 percent of all federally insured credit unions. LICUs had 73.6 million members and $1.1 trillion in assets, compared to 70.9 million members and $1.1 trillion in assets for non-LICUs.

Through consolidation and opportunistic member gathering efforts, we expect more credit unions to seek the LICU designation over time.

5.    Consolidation will be everywhere.

The Inspector General’s Report, which accompanies the Annual Report and addresses Management and Performance Challenges for the NCUA, observes the following:

“Small credit unions face challenges to their long-term viability for a variety of reasons, including lower returns on assets, declining membership, high loan delinquencies, increasing non-interest expenses, and a lack of succession planning for credit union boards and key personnel. If current consolidation trends persist, there will be fewer credit unions in operation and those that remain will be considerably larger and more complex.”[5]

With the nation’s credit unions staring down these economic realities, we have been telling clients for some time: “welcome to the opening ceremonies of the consolidation Olympics.” In fact, in a Whitepaper published in early 2023, Olden Lane observed that “[a] successful path for the industry through today’s challenges will certainly include the formation of a healthy number of strategic partnerships. Such combinations will enable more competitive and financially resilient institutions.”[6]

Lo and behold, 2024 has already seen consolidation return to its 2019 through 2022 upward-sloping trend line. And, with the next round of consolidation now upon us, the Management Discussion and Analysis section of the Report anticipates an additional layer of concern developing on the horizon:

“Large credit unions tend to offer more complex products, services, and investments. Increasingly complex institutions will pose management challenges for the institutions themselves and the NCUA, because consolidation means the risks posed by individual institutions will become more significant to the Share Insurance Fund.”[7]

6.    Cybersecurity will be front and center for the foreseeable future.

The word (or partial word) “cyber” appears an astounding 92 times in the Annual Report.

In 2023, the NCUA rolled out its updated, scalable, and risk-focused Information Security Examination (ISE) procedures. This initiative offers flexibility for credit unions while providing examiners with standardized review steps to facilitate advanced data collection and analysis. The agency hopes that the new ISE procedures will help in protecting the credit union system from cyberattacks.

In addition, the NCUA’s implementation of the cyber incident reporting rule in September has already paid dividends. As the Report summarizes, in the first 30 days after the rule’s implementation, the NCUA received 146 separate incident reports — more reports than received in total in all of 2022. Additionally, the agency goes out of its way to highlight that “[m]ore than 60 percent of these incident reports involved third-party service providers and credit union service organizations.”[8]

7.    The NCUA is contemplating opportunities and challenges in emerging technology, and innovation (including AI).

Over the past several years, one of the most noticeable trends has been the rapid emergence of financial technology, including artificial intelligence and digital assets. These exciting changes are creating exciting opportunities for credit unions to increase speed of service, improve security, and expand products and services. They also bring risks.

To the agency’s credit, in September, the NCUA Board approved a financial innovation final rule that provides flexibility for credit unions to utilize the advanced technologies and opportunities offered by the fintech sector. The final rule specifically provides credit unions with options to participate in loans acquired through indirect lending arrangements and fintech providers. Much like with the Derivatives Rule of a few years ago, the limits previously found in the NCUA’s regulations have given way to a regime that favors a robust policy, responsible due diligence, and sound risk-management requirements that can be tailored to match each credit union’s risk levels and activities.

Here, the agency shows its ability to weigh an acknowledgement of fintech's rapid growth and its impact on credit unions, on the one hand, with a focus on delivering an effective regulatory framework to support credit unions' competitiveness and provision of services for members, on the other.

Later in the Report, the NCUA also notes the competitive threat that credit unions face from alternative financial providers. In response to those threats, third-party vendors and CUSOs have been rapidly developing new technology tools to expand access to affordable, fair, and equitable financial products and services.

Through its Office of Financial Technology and Access, the NCUA is helping credit unions identify opportunities to use technology to meet their members’ financial needs. Examples of technology tools include AI, generative AI, distributed ledger technology, and blockchain technology. Used properly, these tools will allow credit unions to better connect to unbanked and underbanked communities, address communication barriers, and provide needed financial services through digital delivery channels. Again, the agency tries to strike a balance, cautioning that “credit unions must be vigilant in identifying and managing the risks and perils associated with emerging technologies.”[9]

8.    The changes to the examination process have been slow and steady. Emphasis on slow.

The Report trumpets proudly that “[t]he NCUA remains committed to incorporating efficiencies into our supervision program. Strengthening the agency’s data security and IT system safeguards and controls to address emerging threats will continue in 2024 and beyond.”[10]

First, the agency was rather slow in reestablishing onsite examinations following the pandemic only in October of 2022. Unsurprisingly, when they returned, the field staff “found an increase in recordkeeping deficiencies, problems with internal controls, and instances of fraud.”[11]

Second, while the NCUA Board first approved the Virtual Exam Project in 2017, the initiative remains in its R&D stage, with the agency still only committing to identifying “new and emerging data sources and methods to access the data, assesses advancements in analytical techniques, and consider[ing] how other technologies can be harnessed to automate and streamline various aspects of the examination process.” 

The statement that “[a]s the team continues its efforts in the research and discovery phase of the project, they will perform periodic stakeholder outreach, conduct pilots and feasibility testing, and incrementally incorporate procedures and processes into the examination and supervision program”[12] seems little more than was reported in last year’s Report.

Certainly – even with the pandemic-related disruption – more tangible progress would have been desirable this many years into the effort.

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All in all, the NCUA has done a fine job of summarizing its recent accomplishments and offering its perspective on the industry's future. Certainly, the Report is a worthwhile read for any curious credit union professional.

[1] Annual Report 2023, National Credit Union Administration, available at https://ncua.gov/files/annual-reports/annual-report-2023.pdf, at 9.

[2] Michael Macchiarola, The Longest Inverted Yield Curve in U.S. History Continues to Stress Credit Unions, available at https://www.linkedin.com/pulse/longest-inverted-yield-curve-us-history-continues-michael-macchiarola-q21se/?trackingId=nHgSpoj3T3Oz2JCQMCUnSw%3D%3D.

[3] Id.

[4] Todd M. Harper, NCUA Chairman Todd M. Harper’s Remarks at the Brookings Institution: Agenda for Credit Union Regulation, Feb. 6, 2024, available at https://ncua.gov/newsroom/speech/2024/ncua-chairman-todd-m-harpers-remarks-brookings-institution-agenda-credit-union-regulation.

[5] Annual Report 2023, National Credit Union Administration, at 198.

[6] See Strategic Mergers: An Underutilized but Emerging Strategy for Credit Unions, Olden Lane, at 4.

[7] Annual Report 2023, National Credit Union Administration, at 48.

[8] Annual Report 2023, National Credit Union Administration, at 8.

[9] Annual Report 2023, National Credit Union Administration, at 44.

[10] Annual Report 2023, National Credit Union Administration, at 50.

[11] Annual Report 2023, National Credit Union Administration, at 28.

[12] Id.