President and CEO Lucy Ito Testifies on OTR During the 2022 NCUA Budget Briefing

 

PREPARED REMARKS OF
NASCUS PRESIDENT & CEO LUCY ITO

2022 BUDGET BRIEFING OF THE NCUA BOARD
DECEMBER 8, 2021

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The National Association of State Credit Union Supervisors (NASCUS)[1], its regulator members who represent all state agencies that administer a state credit union charter, and state-chartered credit unions across the country thank you, Chairman Harper, Vice Chairman Hauptman, and Board Member Hood, for holding today’s briefing on NCUA’s proposed 2022 budget.  This represents the sixth year that NCUA has held these briefings since resuming public briefings in 2016.  Over time, this annual dialogue has enabled NCUA and its stakeholders to gather our collective learnings and NASCUS welcomes the opportunity to foster greater transparency in NCUA’s budgeting process.

As we have stated during previous briefings, NASCUS has historically held the position that a regulatory agency is in the best position to know the resources it needs to maintain a safe and sound supervisory program.  Accordingly, we do not typically reflect on specific budgetary expenditures; however, we do wish to make several observations with respect to NCUA staff’s proposal for financing NCUA operating and capital costs from the National Share Insurance Fund (NCUSIF) through the overhead transfer rate (OTR) mechanism.  NASCUS’s prepared remarks address:

• Why It’s Important for Stakeholders to Understand the OTR
• Counterintuitive Aspects of 2022 Draft Budget & OTR Implementation
• Recommendations for Strengthening NCUSIF Governance & OTR Transparency

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Why It’s Important for Stakeholders to Understand the OTR

At best, the overhead transfer rate (OTR) makes credit union stakeholders bleary-eyed.  At worst, the OTR lulls credit unions into a deep, deep coma.

The reason why it is important for both state and federally chartered credit unions to understand and closely monitor the OTR is:  Every dollar that is transferred from the NCUSIF to fund NCUA expenses is one dollar not available to cover losses in the system and subsequently a dollar that may need to be replenished in the NCUSIF by the charging of a premium.  Indeed, every NCUSIF dollar that NCUA uses to cover its expenses is one dollar less in the F’s equity level.  This is the fundamental reason why both state and federal credit unions should take serious interest in the OTR.

A second equally important reason is that the inverse relationship between using the OTR to transfer funds from the NCUSIF versus charging federal credit union (FCU) chartering fees to cover its expenses has the potential to imbalance the dual chartering system by disadvantaging the state system.  This is a threat to both state and federal credit unions because the dual charter framework is the credit union system’s most dynamic source of innovation and charter modernization.  A robust state system benefits federal credit unions just as a robust federal system benefits state-chartered credit unions.  The two systems rely on a symbiotic relationship to maximize the relevance of credit unions in an increasingly competitive marketplace teeming with banks and an exploding array of digital and non-depository consumer finance options.

To be clear, costs associated with administering the Fund should be allocated to the Fund. However, when costs are over-allocated to NCUSIF through the OTR, artificially lowering the cost of the federal charter, the state charter is weakened and the competitive balance of the dual chartering system is skewed without the corresponding benefit of regulatory or supervisory innovation that advances the entire system. Rather than lift all boats, it ultimately impedes the system.

A third reason credit unions should pay attention to the OTR is the equity level of NCUSIF and the NCUA Board’s current contemplation of raising the Normal Operating Level (NOL) in anticipation of the uncertainties associated with navigating the various effects of the COVID-19 pandemic.  Given the NCUA Board’s deliberations on raising the NOL to bolster NCUSIF equity, it behooves credit unions to monitor the OTR  rate and NCUA’s allocation of additional expenses to be paid out of the SIF through the OTR mechanism.  To repeat, every dollar transferred out of the NCUSIF represents one dollar less in NCUSIF equity.

In 2020, NCUA issued a request for comments on its OTR methodology with “no” proposed changes and its methodology for determining its Operating Fee Schedule which included a significant change that moves 100% of NCUA capital budget to be covered by the NCUSIF.  This proposed rule was finalized and beginning in the 2021 budget year, NCUA’s capital budgets costs are borne by the NCUSIF:

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NCUA Capital Budget Costs Paid by NCUSIF via OTR

*Proposed in 2022-23 NCUA Staff Budget Justification

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Over the three budget years of 2021-23, $28.3 million is slated to be transferred out of NCUSIF.  The transfer during these three years, alone, represents a 15 bps decrease in the equity level of the NCUSIF based on its current $19 billion balance.  This reminds us that NCUA’s fiduciary duty extends to protecting the NCUSIF from both (a) marketplace and operational risks faced by insured credit unions and (b) risks associated with the transfer of funds out of NCUSIF to cover NCUA’s program costs.

Since late 2017 when NCUA first implemented the current OTR methodology in its budgeting process, the OTR has moved down and up—and the FCU Operating Fee has inversely moved up and down—as depicted here:

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Primary Drivers of Change in OTR & FCU Under Current Methodology

Sources:  2018-2022 NCUA Budget Justifications & 2018-21 NCUA OTR Summaries

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In the initial 2018 implementation of the OTR methodology, the OTR went down because NCUA no longer used NCUSIF dollars to cover 100% of both its insurance and prudential roles with respect to FCUs.  Consequently, the FCU operating fee increased substantially in 2018.  In 2019, 2020, and 2021, the OTR has fluctuated up and down within a relatively modest range of 0.08% – 1.0%.  Notably, however, the primary driver (both up and down) in those three years was “exam and supervision time for FISCUs”—or federally-insured state-chartered credit unions.  For 2022, NCUA staff propose a 1.1% increase in the OTR due to an anticipated increase in exam and supervision of “FICUs”—or federally-insured credit unions including both FCUs and SCUs.  NCUA further notes costs associated with “certain credit unions” that are slated for annual exams and other costs related to exam scheduling and scope requirements.

Understanding the primary drivers of the OTR is critical because these drivers reflect NCUA’s cost allocations and, more importantly, NCUA’s assumptions in completing its workload analysis.  NCUA explains that its OTR “analysis starts with a field-level review of every federally insured credit union to estimate the number of workload hours needed for the current year.…The workload estimates are then refined by regional managers and submitted to the NCUA central office for the annual budget proposal.” (NASCUS emphasis.)  To repeat one of our observations at last year’s briefing, the problem is that NCUA’s “primary driver” explanation statements do not provide sufficient detail to enable validation of the assumptions that drive NCUA’s workload analysis

NCUA’s cost allocation and OTR calculation processes are missing two critical elements:

• State supervisory authority (SSA) validation of NCUA’s regional workload estimates for state-chartered credit union examinations and
• Independent, objective review of NCUA’s workload analysis.

Adding these two steps to NCUA’s budgeting process would go a long way towards fostering greater transparency and accountability by assuring that NCUA’s dual role as the regulator of FCUs and as the insurer of both state and federal credit unions is not inadvertently affecting its cost allocations between NCUSIF and FCU operating fees.

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Counterintuitive Aspects of  2022 Draft Budget & OTR Implementation

NASCUS does not question NCUA’s authority to transfer funds from the NCUSIF to cover some of its operational and capital costs.  However, we note several counterintuitive outcomes that make us question the appropriateness of the Principle 1 50% allocation of FCU examination and supervision costs to NCUSIF and NCUA’s application of both Principles 1 and 2 for allocating costs of evaluating third party vendor and CUSO risk in FISCUs and FICUs.

Relative NCUA Workload between FCUs and SCUs

Total assets and insured shares of state-chartered and federally chartered credit unions are essentially equal:

Distribution of Federally Insured Credit Union (FICU) Insured Shares, Assets, CU Units

Source:  NCUA 2022 Draft Budget Justification and NCUA 2022Q2 Call Report Data

In its insurance role, NCUA has more than 1,000 more FCUs than SCUs to monitor.  Given the equal amount of insured shares and assets between federal and state-chartered FICUs, one would expect NCUA’s insurance-related and FCU chartering workload to be significantly higher for FCUs than for SCUs.

Under Principle 1 of the OTR formula, NCUA’s time spent examining and supervising FCUs is allocated as 50% insurance-related implying that the cost of the OTR is borne equally between FCUs and FISCUs even though FISCUs only comprise 37.5% of the total number of credit union units subject to insurance review by NCUA.[2]  Put more simply, FISCUs pay half of the NCUSIF costs but are only 37.5% of the work.  Indeed, the Draft Budget Justification states, “The number, size and health of federal and state credit unions affects the NCUA’s workload budget, which in turn is one of the variables in the OTR methodology.” (Page 55; NASCUS emphasis)

As the NCUA does not publish its OTR workload analysis, it is not possible to challenge nor verify the intuitive perception that NCUA physically spends far more of its time on FCUs.  Given the greater workload that NCUA assumes with the sheer number of FCUs versus SCUs, the allocation of NCUA time spent on FCU exams and paid for by the NCUSIF should be less than the 50% “compromise” allocation that was developed when the OTR methodology was re-invented in 2017.

Beyond the sheer unit-based physical demands that FCUs place on NCUA, the 2022 Draft Budget Justification notes the primary driver of the increase in the OTR is staff’s proposed increase in exam & supervision for FICUs—not FISCUs, alone—from staff draft budget proposals to conduct annual exams for “certain credit unions,” and other program obligations associated with exam scheduling & scope requirements.  We presume that “certain credit unions” relates to the increase in regional credit union examiners of +29 FTEs on page 31.  Staff explains, “Therefore, it is prudent to expand the criteria for credit unions that meet the requirements for an annual examination to include (1) credit unions with assets between $500 million and $1 billion that have otherwise previously qualified for an extended examination cycle based on other current Exam Flexibility Initiative criteria, and (2) credit unions with assets more than $250 million and evaluated as facing a higher risk of business or economic challenges.” It would be helpful to be able to review NCUA’s workload analysis to determine the relative burden of FCUs and SCUs that will be subject to more frequent examination under NCUA’s plan to examine more FICUs on an annual basis despite their possible eligibility for an 18-month exam cycle.  If there are more FCUs to be affected than SCUs, it suggests, again, that the 50% allocation of Principle 1 is in need of a refresh.

NCUA’s 2022-26 Draft Strategic Plan Implies Growing Costs for NCUA’s Role as Prudential Regulator of FCUs Relative to Its Insurance Role.

NCUA’s 2022-26 Draft Strategic Plan describes several new initiatives that the agency will be undertaking in 2022 and beyond including:  climate-related financial risks, consumer financial protection, and ACCESS—Advancing Communities through Credit, Education, Stability, and Support.  While climate change risk would seem to be an element of both NCUA’s insurer and prudential regulator role, consumer financial protection and ACCESS seem to be 100% related to NCUA’s Title I prudential regulator function.

The proposed budget details the new costs associated with consumer financial protection, ACCESS and  BSA/AML compliance and enforcement which includes the following 8 new staff positions:

• Small Credit Union Program Officers:  +2 FTEs
• Fair Lending Analysts: +3 FTEs
• Fair Lending Supervisor:  +1 FTE
• Financial Inclusion & Outreach Analyst:  +1 FTE
• Bank Secrecy Officer:  +1 FTE

NASCUS commends NCUA for its new initiatives and its commitment to compliance and enforcement.  We presume that these costs are allocated to the NCUSIF at 0% consistent with Principle 3.[3]  Given the growing costs associated with NCUA’s prudential regulator function, we would have expected a greater portion of NCUA’s budget to be covered by Operating Fees and commensurate adjustments to reflect these added costs.  Perhaps other new staff positions and the surplus in the operating fund are factors that offset these cost allocations to Operating Fees.  Again, publication of staff’s workload analysis would make NCUA’s budget justification much clearer.

Capital Budget Allocation 100% to NCUSIF

While the change in allocation of NCUA’s capital budget to the NCUSIF first occurred in the FY2021 budget, NASCUS wishes to draw attention to the manner in which the change in NCUA’s process and practices was made.  On the one hand, NCUA did give notice of the proposed change in its Operating Fee Schedule calculation methodology when the agency issued its 2020 request for comment on both the OTR and the Operating Fee.  On the other hand, NCUA also indicated that it was making “no changes” to its OTR methodology[4].  Technically, it is true that the setting of the OTR rate was not changed; however, it strikes the State credit union system as a bit disingenuous that while NCUA stated there was no change to the OTR methodology it was able, through the backdoor of the Operating Fee Schedule, to allocate 100% of its capital budget to the NCUSIF with the stroke of a pen.  As outlined above, allocating NCUA’s capital budget represents a substantial depletion of NCUSIF equity totaling a projected $45 million in NCUA’s first three years of applying this practice.  NASCUS’s comment letter on this matter indicated that we agreed that apportioning a proportionate share of the capital budget to the NCUSIF is consistent with the 2017 OTR methodology; however, we also noted that allocating 100% of the costs to the NCUSIF via the OTR would not be equitable under the percentages currently defined for the OTR methodology.  For example, the acquisition and maintenance of laptops for NCUA examiners is 100% allocated to the NCUSIF.  Why would the costs of capital equipment be allocated 100% when NCUA needs to furnish its examination force and central office staff with equipment to carry out NCUA’s prudential regulator functions?  At very least, these costs should have been allocated under Principle 1 (which is currently set at a 50% cost allocation which we have argued, above, is too high). Incidentally, the NCUSIF previously provided state examiners with laptops but that practice ended in 2021. This raises the question of why NCUSIF now covers laptops for NCUA examiners but no longer does for state examiners.

In the 12/16/20 Board Action Memorandum (BAM) requesting approval of the agency’s 2021 budget, NCUA staff stated, “The OTR calculation ensures that only the insurance-related portion of these costs is funded by the SIF. The cost distribution among charter types for these expenditures is based on each charter’s proportion of insured shares to total insured shares.”[5]  However, that explanation presumes insured shares is the only relevant metric by which to distribute costs.

From the State credit union system’s perspective, there was no existing principle that contemplated capital investments within the existing OTR methodology; yet, NCUA proceeded to allocate 100% of these costs despite concerns expressed during the notice and comment process. NASCUS and its member state regulators believe there would be great value in a mechanism that places checks and balances in the overall NCUA budgeting process to enable the NCUA Board to affirm its fiduciary duty of protecting the NCUSIF from direct NCUA access to the SIF to finance its programs.

NCUA’s Conflation of Principle 1 & Principle 2 with Respect to Monitoring Third Party and CUSO Risk

NCUA’s allocation of 100% of its capital budget to the NCUSIF is not the only questionable exercise of NCUA’s authority to tap NCUSIF funds via the OTR.  NCUA’s treatment of cost allocations associated with third party and CUSO risk is curious.

Principles 1 and 2 of the OTR formula read:

1. Time spent examining and supervising federal credit unions is allocated as 50 percent insurance related.
2. All time and costs the NCUA spends supervising or evaluating the risks posed by federally insured, state-chartered credit unions or other entities that the NCUA does not charter or regulate (for example, third-party vendors and Credit Union Service Organizations (CUSOs)) are allocated as 100 percent insurance related. [NASCUS emphasis.]

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The 2022 Draft Budget Justification (page 56) reads:

CUSOs are at times subject to review during the examination of a federally insured credit union. The OTR methodology captures CUSO-related time within the scope of the examination and supervision of federally insured credit unions under Principle 1 for federal credit unions and Principle 2 for federally insured state-chartered credit unions. The time designated for separate, standalone reviews of CUSOs and third-party vendors is accounted for separately in the NCUA’s workload budget and is covered by Principle 2 only. The standalone review of CUSOs and third-party vendors is to identify and address risk to federally insured credit unions.  [NASCUS emphasis.]

While we agree with NCUA that the costs of associated with monitoring third party vendor and CUSO risk in FCUs is not 100% as suggested by Principle 2, our interpretation of the OTR principles, as drafted in 2017, is that Principle 2 applies to costs associated with both FISCUs and FCUs.  Documenting our interpretation of Principle 2, we disagreed with this aspect of Principle 2 and suggested amendments. Thus, while we agree with NCUA’s actual application of Principle 1 to FCU third-party vendor and CUSO risk review activity, we believe this contradicts what is stated in Principles 1 and 2.  We believe the OTR principles need to be formally reviewed and amended including this clarification as well as revisiting the appropriateness of the 50% allocation of NCUA’s time spent with FCUs under Principle 1.

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Recommendations for Strengthening NCUSIF Governance & OTR Transparency

NCUA has fiduciary duty to protect the NCUSIF not only from risks in the credit union marketplace but also from NCUA’s own direct access to NCUSIF funds to pay for its programs.

In the shared interest of strengthening NCUSIF governance, reviewing the appropriateness of the four 2017 OTR allocation principles, and enhancing the transparency of NCUA’s implementation of the OTR methodology, NASUS makes the following recommendations:

• Add independent review of NCUA’s workload analysis by an acceptable neutral entity to assure the NCUA Board that the agency is fulfilling its fiduciary duty to protect the NCUSIF not only from marketplace and credit union operational risk but also from risks of NCUA’s direct access to NCUSIF as a funding source to pay for its operations and capital expenditures.
• Reverse the 11/19/15 NCUA Board decision to delegate calculation and administration of the OTR. Given the foundational importance of proper cost allocation and the Board’s duty to both FCUs and SCUs, this authority should not be delegated.
• Add SSA validation of regional workload estimates as a step in the OTR calculation process.
• Add NCUA’s workload analysis as a standing appendix to the Staff Draft Budget Justification so that increases/decreases to the OTR and actual costs paid by the NCUSIF are easily reviewed by stakeholders.
• Adjust the amount of NCUA’s capital budget allocated to the NCUSIF OTR mechanism from 100% to <50%, as rationalized by open and transparent publication of NCUA’s workload analysis.
• Amend Policy 1 to better reflect the relative burden on NCUA’s time. Add percentage of credit union units to percentage of insured shares as added pertinent basis for distributing costs among charter types. If NCUA believes it does account for relative burden of credit union units, publish incontrovertible workload analyses to affirm NCUA’s methodology is sound and credible.
• Amend NCUA Policies 1 and 2 to assure that NCUA’s treatment of costs associated with reviewing third-party vendor and CUSO risk for FICUs and FISCUs is consistent with Principles 1 and 2 as stated/amended.
• Revise the 2022 Budget Justification for NCUA Board approval to include these minor but important edits:
  1. Footnote 24: Delete “and equipment”. The SIF no longer pays for SSA laptops or other equipment.
  2. Page 56 Graphic: Add note to graphic show distribution of NCUA operating budget costs to clarify that just as FCUs pay operating fees to NCUA, “State-chartered credit unions separately pay analogous fees to their respective State Supervisory Authorities.”

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Closing Remarks

The overarching difficulty with the 2017 OTR methodology, and the methodologies that came before is this: The Federal Credit Union Act (FCUA) clearly contemplates that the NCUSIF should benefit from the exam work NCUA is doing as the Title I administrator of the federal charter. All of NCUA’s various formulas turn this Congressional intent on its head and shift the benefits from the SIF to the NCUA’s Title I chartering functions. Until that simple, but foundational premise is revised, the OTR will remain flawed.

NCUA Board and Staff:  My comments today were made in the spirit of State-Federal regulator collaboration and  in support of our shared objectives to foster a vibrant dual charter system that increases consumer access to safe and sound cooperative financial institutions.  It has been a genuine honor to serve with all of you over the many years.  I, the NASCUS Regulator Board, NASCUS Credit Union Advisory Council, NASCUS staff,  state credit union regulators, state-chartered credit unions, and our state and federal stakeholders, thank you for your collegiality and commitment to forging a robust federal system and a robust state system.  Together, our dual credit union systems are stronger and better positioned to serve and protect consumer-members.  Thank you.

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[1] NASCUS is the professional association of the nation’s 45 state credit union regulatory agencies that charter and supervise nearly 2,000 state credit unions. NASCUS membership includes state regulatory agencies, state chartered and federally chartered credit unions, and other important stakeholders in the state and federal credit union systems. State chartered credit unions hold half of the $2 trillion assets in the credit union system and are proud to represent nearly half of today’s 129 million credit union memberships in the United States.

[2] Footnote 35 of the Draft Budget Justification explains that the 50% allocation mathematically emulates a program design wherein NCUA would alternate exams and/or conduct joint exams between its insurance function and its prudential regulator function as if they were separate units within NCUA.  The footnote further explains that the construct is consistent with the alternating exams the FDIC and state regulators conducted for insured state-chartered banks.  The flaw in Footnote 35 is that NCUA, in practice, does not separate its insurance function from its prudential regulator function and NCUA is not FDIC.  NCUA is a combination of FDIC and the OCC.  Furthermore, NCUA relies heavily on SSA examinations of state-chartered credit unions.

[3] Principle 3 reads: “Time and costs related to NCUA’s role as charterer and enforcer of consumer protection and other non-insurance based laws governing the operation of credit unions (like field of membership requirements) are allocated as 0 percent insurance related.”

[4] From NCUA’s call for comments: “The Board finds the current OTR methodology to be fair and equitable, more transparent and less complex than prior methodologies, reduced administrative costs related to the OTR, and recognizes that safety and soundness is not the sole domain of the NCUA as insurer. As a result, the NCUA Board does not propose any changes to the methodology at this time.”

[5] https://www.ncua.gov/files/agenda-items/AG20201218Item2a.pdf