During the November NCUA Board open meeting, the Office of Examination and Insurance estimated that a share insurance premium of 3 to 6 basis points will be necessary in 2017 to restore the Share Insurance Fund’s equity ratio to the normal operating level of 1.30 percent.
Insured share growth in credit unions combined with a continuing low interest-rate environment is causing the Share Insurance Fund’s equity ratio to decline. The equity ratio as of the end of the third quarter was 1.27 percent, down from 1.29 percent in the third quarter a year ago.
The proposed premium range is provided only for credit union budgeting purposes. Credit unions should not actually accrue for a premium until one is approved by the NCUA Board, which typically would occur at the February or July Board meeting to align with regular billing cycles.
“Just like a homeowner who checks the roof and makes repairs before the storm comes, NCUA and credit unions must do the same for the Share Insurance Fund before the next economic downturn,” Metsger said. “In recent years, the economy has stabilized, and credit unions as a whole have experienced considerable growth in insured shares. To ensure the fund continues to have the resources it needs, credit unions next year may need to pay their first share insurance premium since 2010. Such an investment would prudently protect member deposits.”
Understanding the Share Insurance Fund’s Equity Ratio
The Share Insurance Fund is approximately $13 billion in total, made up of $2.8 billion in retained earnings and approximately $10 billion in contributed capital, which are included in the numerator of the equity equation. Income, mostly from yield on investments, operating expenses and insurance loss expenses drive retained earnings. Contributed capital is the 1 percent of insured shares deposited by each credit union into the fund. Increases to retained earnings or contributed capital will increase the equity ratio, with all other things being equal.
The denominator of the equity ratio consists of insured shares within the industry. This factor is completely independent of NCUA, meaning that unless there is a statutory change to the insured share limit, NCUA has almost no influence over insured share growth. The higher growth in insured shares, the lower the equity ratio, all other things being equal.
Based on a $13 billion fund, to raise or lower the equity ratio by 1 basis point, you would need:
- A $100 million change in the numerator; or
- A $30 billion change in the denominator.
The current equity ratio is 1.27 percent, which means the real loss absorbing equity of the fund is only $2.8 billion before calling on credit union capital to absorb losses from failed institutions. Any incident, like significant failures, that drops the equity ratio below 1 percent would result in a direct expense to credit unions through the impairment of the 1 percent deposit, which they show as an asset on their financial statements.
Statutory Requirements for Managing the Share Insurance Fund
The NCUA Board sets the normal operating level for the Share Insurance Fund, which is currently at 1.30 percent and has been at that level since December 2007.
The best way to think about the equity ratio and normal operating level is to start with the outer bounds established by Congress. The equity ratio floor is set by the Federal Credit Union Act at 1.20 percent. This section mandates the Board assess a premium to restore the fund to at least 1.20 percent, unless the Board has approved a restoration plan within 90 days of the ratio dropping to 1.20 percent or if the ratio is projected to drop to 1.20 percent within 6 months. Generally, the restoration plan must restore the fund to 1.20 percent within 8 years. However, under extraordinary circumstances the Board can approve a longer timeframe for reaching the 1.20 percent level. The plan also must be published in the Federal Register, along with a detailed analysis of the factors considered and the basis for the actions taken.
The ceiling for the Share Insurance Fund is set in law. Specifically, the normal operating level “shall not be less than 1.20 or more than 1.50 percent. Additionally, the NCUA Board may not assess a premium if the equity ratio exceeds 1.30 percent. Therefore, even though the equity ratio could be allowed to go as high as 1.50 percent, it can only get above 1.30 percent through earnings, not premiums.
Given these statutory requirements, NCUA has historically managed the fund to have an equity ratio of between 1.20 and 1.30 percent. Given current economic conditions, there really is no way for the fund to generate enough earnings to increase the equity ratio organically without a premium.
Maintaining an Appropriate Equity Ratio Going Forward
A review of industry trends and risk profiles suggests the normal operating level should remain at least 1.30 percent.
The risk profile of the credit union system has evolved significantly over time, particularly within the last two decades because of the following combination of factors:
- Consolidation within the credit union system has led to fewer, but larger and more complex, credit unions that offer a broader span of loan products and other activities.
- Increased reliance on third parties for a variety of traditional and new products and services.
- Changes in the marketplace, especially related to technology and new loan and investment products.
- The evolving business model of credit unions, which are increasingly converting to community-based fields of membership that have a different risk profile than the traditional single-sponsor or employee group-based membership.
- A sustained low-rate environment, which creates incentives to take on longer durations or more credit risk to pick up yield to fund operations and overhead costs.
- Expansion of the authorities permissible to credit unions and other forms of regulatory relief, such as the authority to engage in derivatives and removal of fixed-asset limitations, to name a few.
- Adoption of a flexible examination cycle that extends the time between examinations for credit unions with under $1 billion in assets, the level set by Congress for banks.
In an enterprise risk-management context, NCUA must consider the cumulative effect of the changing risk profile given all of the above and then determine what compensating controls, risk-mitigation measures or both—such as holding sufficient equity in the fund—are therefore warranted to account for the potential for increased risk.
Short- and Long-term Equity Ratio Projections
NCUA uses three approaches for modeling the equity ratio: the standard projection, a Board-approved stressed approach, and an economic-stress analysis. Each approach uses various assumptions for the four main drivers of the equity ratio: investment returns, insurance losses, expense growth and insured share growth.
The standard projection produces a range of outcomes using a base scenario, a base-plus scenario, which includes assumptions that are slightly more optimistic than the base case, and a base-minus scenario that includes assumptions slightly more pessimistic than the base case. These scenarios produce a range of likely outcomes based on current conditions and are used to project the equity ratio over the next 6 months to ensure we are meeting our statutory requirement outlined in the Federal Credit Union Act, which requires the Board to develop a restoration plan if the equity ratio is projected to fall below 1.20 percent within 6 months. We also use it to project the equity ratio for the next 12–18 months, allowing us to forecast a range of potential premiums for the following year. This projection covers the five-year period of our strategic plan, providing for overall management of the fund.
The assumptions used in the standard projection for the base-case scenario are current trends or recent averages with slight increases or decreases in the base-plus and base-minus scenarios, as shown in the table on page 13.
In the Board-approved stress approach, we stress tested the fund to determine how much equity the fund needs going into a two-year period of strain so the equity ratio comes out no lower than 1.20 percent. The analysis shows that the equity ratio needs to be 1.32 percent to bottom out at 1.20 after two years of severe stress.
Finally, we conduct an economic-stress analysis to project the equity ratio under a range of plausible economic scenarios.
Standard Projection Drivers and Assumptions
|DRIVER||BASE||BASE – MINUS||BASE – PLUS|
|Investment Returns||Flat rates for five years||Rates decline from base for next five years||Rates increase using the forward yield curve for the next five years|
|Insurance Losses (Proxy for projected expense)||Five-year average loss||Highest annual loss in the last five years, then five-year average||Average of the lowest three years of losses in the last five years|
|Insured Share Growth||Average insured share growth||Base plus standard deviation||Base minus standard deviation|
|Expense Growth||Current budget growth||Current budget growth plus 2 percentage points||Current budget growth plus 2 percentage points|
The economic-stress approach starts by linking the four main drivers of the Share Insurance Fund to economic variables. Then we see how the drivers would change under a range of different economic scenarios and use these projections of the drivers to simulate how the Share Insurance Fund would perform.
Once these equations are in place, we use the economic assumptions from the Federal Reserve’s Dodd-Frank Act stress tests as the economic scenarios. For context, in the baseline, the unemployment rate stays just under 5 percent for the next five years, house prices grow just under 3 percent per year, and the 10-year Treasury rate rises to almost 4 percent by 2021. This means a relatively modest level of losses, increased returns on the fund assets, and continued growth in insured shares.
The adverse scenario is a moderate recession, where the unemployment rate rises to about 7.5 percent before retreating to just over 6 percent in 2021. House prices fall about 10 percent over the five-year projection, and the 10-year Treasury rate remains low for a couple of years, but rises to 3.2 percent at the end of five years. That means, relative to the base, higher losses, lower fund returns and, initially, a rise in insured share growth.
The severely adverse scenario is close to a replay of the Great Recession. The unemployment rate rises to nearly 10 percent in the first couple of years of the projection, before falling to about 7.5 percent at the end of five years. House prices fall by about 30 percent through the end of five years. The 10-year Treasury rate falls below 1 percent for a couple of years, before rising to 2.5 percent at the end of five years. That means, relative to the base, a lot more losses, very low returns on fund assets and a jump in insured shares.
Starting from roughly 1.27 percent, the equity ratio falls to about 1.22 percent in the baseline at the end of five years. In the adverse scenario, the equity ratio falls to about 1.15 percent over that same time. Finally, in the severely adverse case, at the end of five years the equity ratio falls to just over 1.07 percent.
All of the approaches used to model the equity ratio show a continued decline over the next five years, even if trends remain the same, or improve slightly from current conditions.
In sum, our standard projections through the end of 2017 indicate that the equity ratio will fall to somewhere between 1.24 and 1.27 percent. To restore the equity ratio to the normal operating level of 1.30 percent, a 3 to 6 basis point premium would be necessary. As we’ve discussed, based on the trends, the equity ratio will continue to drop and has no reasonable prospect of otherwise reaching the normal operating level. These projections also do not account for extraordinary losses or an unforeseen economic downturn that may result in additional losses and the need for an additional or higher premium.
Again, this range is for budgeting purposes only and does not represent an actual decision by the NCUA Board to declare a premium. The Board would still have to decide sometime in 2017 whether to declare a premium.
While a premium of 3 to 6 basis points may be necessary to restore the Share Insurance Fund’s equity ratio to 1.30 percent, we do not anticipate a separate Stabilization Fund assessment in 2017.