Compliance Blog

Jan 18, 2019

“Concentrate on Concentration, it’s a Priority!”

Hello, compliance friends, I hope your 2019 has gotten off to a strong start. Unfortunately, with the government shut down and rising interest rates, we may also be noticing some new and increased risks in our economic environment. With that being said, this may be good a time for credit unions to review NCUA’s concentration risk guidance and NCUA’s rules on loan limits. Pursuant to NCUA’s supervisory priorities, examiners plan to look more closely at credit unions’ loan concentrations with more scrutiny for higher concentrations of specific risk characteristics. Today’s blog highlights key points from NCUA’s supervisory letter on concentration risk and reminds credit unions about NCUA’s lending limits for single borrower, commercial and member business loans (MBLs).

Concentration Risk Guidance

According to NCUA, credit union officials and management have a fiduciary responsibility to identify, measure, monitor and control concentration risk. The Basel Committee on Banking Supervision defines risk concentration as, “any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a [credit union’s] health or ability to maintain its core operations. Stated more simply, every asset, liability, product, service, and third party provider presents a risk of loss to the credit union under varying conditions or events.

To measure and identify concentration risk, a credit union may want to perform a risk assessment which demonstrates their understanding of the risk of each product or service, quantifies the potential loss exposure, and documents a rational business decision on the acceptable concentration level based on the analysis. To assist credit unions with identifying concentration risk, NCUA has suggested credit unions focus on maintaining comprehensive and accurate data, implementing objective and sensitive risk rating tools, and ensuring periodic and timely reporting.

Furthermore, NCUA has advised that implementing sound risk management practices is the key to managing concentration risk. The ultimate responsibility for setting the concentration risk level rests with the board of directors. Subsequently, senior management is responsible for maintaining concentration risk within the parameters set by the board of directors. According to NCUA, the board of directors must establish a policy that addresses its philosophy on concentration risk, sets limits commensurate with net worth levels, and provides the rationale as to how the limits fit into the overall strategic plan of the credit union. The parameters set by the board should be specific to each portfolio and should include limits on loan types, share types, third party relationship exposure, etc.

Loan Limits

Furthermore, to mitigate losses to the National Credit Union Share Insurance Fund, NCUA has statutory and adopted limits to better facilitate safe and sound lending practices. To begin, NCUA has established a single borrower limit pursuant to NCUA’s lending regulation, section 701.21(c)(5), the credit union may not advance to a member in the aggregate more than 10% of the credit union’s total unimpaired capital and surplus.

Also, in regards to a single borrower, pursuant to section 723.4, a credit union may not allow the aggregate dollar amount of any secured, unsecured, and unguaranteed commercial loans to any one borrower or group of associated borrowers to exceed the greater of 15 percent of the federally insured credit union’s net worth or $100,000, plus an additional 10 percent of the credit union’s net worth if the amount that exceeds the credit union’s 15 percent general limit is fully secured at all times with a perfected security interest by readily marketable collateral. See, section 723.4 for additional details.

Moreover, there is also a statutory limitation for MBLs. Remember, NCUA makes a distinction between commercial loans and MBLs, please see this NAFCU Compliance Monitor article for additional guidance. With that being said, section 107A of the FCU Act states, in part, that no insured credit union may make any MBL that would result in a total amount of such loans outstanding at that credit union at any one time equal to more than the lesser of “1.75 times the actual net worth of the credit union; or 1.75 times the minimum net worth required under section 1790d(c)(1)(A) of this title for a credit union to be well capitalized.” See, 12 U.S.C. § 1757a(a). This language has also been codified in section 723.8, which discusses aggregate member business loan limits. Note, only statutorily-defined “member business loans,” are subject to the MBL cap.

Now, it is important to note that “net worth” and “total unimpaired capital and surplus” are separate measurements of the credit union, and both relatively technical accounting concepts. Definitions for both terms can be found in section 700.2.

First, the definition of “net worth” found in section 700.2 cross references section 702.2(f), which provides a more helpful explanation.

§702.2 Definitions.

Except as provided below, the terms used in this part have the same meanings as set forth in FCUA sections 101 and 216, 12 U.S.C. 1752, 1790d.

[ … ]

(f) Net Worth means

(1) The retained earnings balance of the credit union at quarter-end as determined under generally accepted accounting principles, subject to paragraph (f)(3) of this section. Retained earnings consists of undivided earnings, regular reserves, and any other appropriations designated by management or regulatory authorities;

(2) For a low income-designated credit union, net worth also includes secondary capital accounts that are uninsured and subordinate to all other claims, including claims of creditors, shareholders and the NCUSIF; and

(3) For a credit union that acquires another credit union in a mutual combination, net worth includes the retained earnings of the acquired credit union, or of an integrated set of activities and assets, less any bargain purchase gain recognized in either case to the extent the difference between the two is greater than zero. The acquired retained earnings must be determined at the point of acquisition under generally accepted accounting principles. A mutual combination is a transaction in which a credit union acquires another credit union or acquires an integrated set of activities and assets that is capable of being conducted and managed as a credit union.

(4) The term “net worth” also includes loans to and accounts in an insured credit union established pursuant to section 208 of the Act [12 U.S.C. 1788], provided such loans and accounts:

(i) Have a remaining maturity of more than 5 years;

(ii) Are subordinate to all other claims including those of shareholders, creditors and the National Credit Union Share Insurance Fund;

(iii) Are not pledged as security on a loan to, or other obligation of, any party;

(iv) Are not insured by the National Credit Union Share Insurance Fund;

(v) Have non-cumulative dividends;

(vi) Are transferable; and

(vii) Are available to cover operating losses realized by the insured credit union that exceed its available retained earnings.

The definition for “unimpaired capital and surplus” found in section 700.2 also cross-references another term found in the same section, which provides a more helpful explanation.

700.2 Definitions.

As used in this chapter:

[ ]

Paid-in and unimpaired capital and surplus means shares plus post-closing, undivided earnings. This does not include regular reserves or special reserves required by law, regulation or special agreement between the credit union and its regulator or share insurer. “Paid-in and unimpaired capital and surplus” for purposes of the Central Liquidity Facility is defined in §725.2(o) of this chapter.

Remember, the limits operate independently and must be separately calculated. All loans to a single borrower must be included in the calculation for section 701.21 and section 723.4. However, only loans which qualify as an MBL are included in the calculation under section 723.8.

Programming Note. NAFCU’s offices will close at noon on Friday, January 18th in observance of Martin Luther King, Jr.’s Birthday. We will resume business as usual on Tuesday, January 22nd.