Compliance Blog

Happy Monday! Sometimes, regulator publications give a hint of what might be coming next, and today’s blog focuses on an example of that which has implications for how NCUA examines for concentration risk and loan underwriting. As background, NCUA’s Office of Inspector General is required to conduct “material loss reviews” (MLRs) in cases where a credit union failure led to a loss of $25 million or more to the share insurance fund. Fortunately, in recent years these reports are relatively infrequent. However, OIG reports, including MLRs, can provide a sense of possible future changes at NCUA. Why? OIG often makes recommendations to NCUA for regulatory changes or adjustments to examinations. For example, when NCUA started asking for audits directly from the supervisory committee, this policy change stemmed from a recommendation from the OIG (more details in this NAFCU Compliance Blog post).

Fortunately, MLRs are few and far between – OIG went nearly two years between MLRs. But a recent MLR published on March 29, 2019 focuses on credit unions that had high concentrations of taxi medallion loans and contains some recommendations that indicate change is coming to the way NCUA examines for concentration risk.

Specifically, this recent MLR addresses losses relating to three credit unions: Melrose Credit Union; LOMTO Federal Credit Union, and Bay Ridge Federal Credit Union. These three CUs had “significant concentrations” in taxi medallion loans, which OIG determined was one of the reasons the CUs failed. Other contributing factors included:

·        Unsafe and unsound lending practices, “in particular inadequate loan underwriting and monitoring of taxi medallion loans,” and

·        Weak board and management oversight and inadequate risk management practices, including being “unresponsive to repeated issues raised by examiners.”

OIG also noted that NCUA “may have mitigated” losses to the Share Insurance Fund (SIF) if examiners had taken a “timelier and aggressive supervisory approach” including acting more aggressively to seek enforcement actions for repeated Documents of Resolution (DOR).

While the CUs at issue were heavily involved in taxi medallion lending, OIG made two “observations” and three recommendations to NCUA that are broader than this specific type of lending. These are found towards the end of the report, and have implications for how NCUA may act in the future.

First, OIG indicated that examiners were not comfortable taking more forceful action after repeated DORs or other safety and soundness concerns. These are found on page 25 of the MLR:

Observation #1. OIG noted that when NCUA decides to use enforcement actions, the actions should be “executed aggressively and in a timely manner.”

Observation #2. If informal supervisory action that addresses a credit union’s safety and soundness are ignored or repeated during exam, formal enforcement action may be necessary even if a credit union is still profitable and well-capitalized. OIG reported that in the case of these material losses to the SIF, examiners apparently felt they had “insufficient grounds” for a formal enforcement actions if a CU had a strong capital position and was profitable.

What about OIG’s more direct recommendations to NCUA management? In an MLR, OIG makes recommendations but also shares NCUA management’s response to that recommendation. This gives some indication of steps NCUA is taking to make changes as suggested by OIG – our “tea leaves” so to speak.

Recommendation #1 – Introduce Thresholds for Risk Concentrations. While net worth levels are driven by statute, OIG recommended that NCUA implement a formal process to “regularly identify, analyze, and document concentration risk issues” in credit unions or groups of credit unions. This would include setting thresholds for different risk concentrations that might pose a higher chance of causing losses to the SIF.

NCUA agreed with this recommendation and is already evaluating “ways to enhance their processes” as part of the agency’s Enterprise Risk Management. NCUA will consider setting thresholds “as part of a process that will be in place by December 31, 2020.”

Recommendation #2 – Revise Examination Quality Control Procedures. OIG also recommended that NCUA revise its exam procedures and create “risk responses” for credit unions with high levels of concentration risk. This would include “escalated review” of repeated actions for previously unresolved recommendations and using formal enforcement action when a situation presents safety and soundness concerns.

NCUA also agreed with this recommendation and has initiated an “enhanced quality assurance program.” Also by December 31, 2020 this will include a “more robust” review of exam reports prior to releasing these reports to credit unions.

Recommendation #3 – Update Annual Exam Scope to Include Lending Procedures – Finally, OIG recommended that NCUA include reviewing CUs’ lending procedures in their annual exam scope requirements. Specifically, OIG noted that examiners should take note of whether credit unions are doing enough to consider borrowers’ ability to repay a loan particularly where there may be “undue reliance” on the value of the collateral.

NCUA also agreed with this recommendation. By January 31, 2020, NCUA plans to update their internal instructions on examination scope to make sure there is an “emphasis on reviewing credit union underwriting practices” for ensuring borrowers can pay the debit.

Another interesting tidbit can be found in OIG’s analysis of the concentration risk exception in Part 723 of NCUA’s regulations (member business loans). OIG noted that the three CUs that were the subject of this MLR were all eligible for an exception from the MBL limits. These CUs did not have to follow the aggregate cap on MBLs because they were “chartered for the purpose of” making MBLs. OIG made note of the fact that it “found no evidence” that NCUA had ever made a recommendation to Congress to “rescind or modify” this exception to the MBL cap. Is this another tea leaf? Time will tell whether this is something NCUA will take into account in the future.

While concentration risk is already a priority for NCUA this year, it looks like NCUA may take steps to be more aggressive when examiners see possible safety and soundness issues in this area in coming years. For now, here are some of the core NCUA guidance documents on concentrations of credit:

·        NCUA Examiner's Guide : Chapter 10: Loans - General Loan Review, Credit Risk, Delinquency, & Charge Offs; Commercial and Member Business Loans;

·        Letter to Credit Unions 10-CU-03, “Concentration Risk”; and

·        Letter to Credit Unions 10-CU-15, “Indirect Lending and Appropriate Due Diligence.”