Investing under the Reg. 704

By: Tammy Cantrell, SVP, ALM

On October 20, 2010, the NCUA officially posted new Rules and Regulation Part 704 into the Federal Register to provide credit unions with greater protection of corporate credit union capital investments. The NCUA has stated several times since the start of the financial crisis in August 2007, that too little capital, too much leverage and a high concentration in risky assets were the predominate demise of the conserved corporates. The newly inked regulation does a good job of addressing each of these issues going forward in a manner so that corporates could still make a bottom line by addressing the primary concerns many noted in the proposed regulation relating to unrealistic levels of investment portfolio stress that would hinder the ability of corporates to remain profitable.

One of the primary reasons for the lack of liquidity in the corporate network during the economic crisis was the increasing proportion of long-dated assets that were financed by relatively short-dated deposits, and then the degree to which these assets could be sold without significant loss of value. Obviously, the more liquid and salable the assets were, the less a corporate needed to worry about its maturity transformation, since it could pay off withdrawn liabilities with the proceeds of asset sales. The final regulation addresses this risk by limiting the aggregate weighted average life of the investment portfolio to two years and disallowing the purchase of illiquid private-label mortgage-backed and subordinate securities. The regulation also imposes sector concentration limits to eliminate the issue of having all of your “eggs in one basket.”

Additionally, with the adoption of Basel 1 risk-based capital, stronger capital levels are required for corporates going forward, which is similar to capital requirements in the banking industry. As is true today with natural person credit unions, corporate capital over time will be based on the ability to grow and retain earnings as opposed to infusions of capital from members.

With this understanding, many are asking how does a corporate make money on their investment portfolio under this new regulation? Corporate One’s mission going forward will be similar to the mission set out by our forefathers who created corporate credit unions. First, our balance sheet will be more liquid and fee income will remain critical to growing retained earnings (a belief we’ve long held). We feel that in the near future, the composition of our liabilities will be focused on being a great depository of overnight funds and very short-term certificates of deposit (inside two years). To provide more of a duration extension than two years for a credit union’s investment portfolio, our goal is to provide credit unions with off-balance sheet security options at great execution.

Corporate One does not have products and services that are sold as a loss leader; hence, our products and services can stand on their own, with our overall operating efficiency ratio much higher than most of our corporate peers. The result of this efficiency means the net interest income made from our investment portfolio is not used to support or subsidize other operations within the organization.

Taking less risk in the investment portfolio and consequently making less net interest income in the future means that our overall return on assets may be lower, but does not mean that we cannot make a bottom line. And, after reviewing the NCUA’s hypothetical investment portfolio in the preamble, we are confident that we can construct a profitable investment portfolio that rewards our members with competitive market returns, with the overall risk that each member takes by depositing funds with us further reduced, thanks to this new regulation. After such a disastrous financial collapse of the largest corporate credit unions, getting back to the basics of capital preservation is just what the doctor ordered.

Tammy Cantrell
SVP/ALM