Despite short-term regulatory relief, credit unions should prepare to respond to likely DORs and LUAs if the current economic slide worsens.
The National Credit Union Administration and state regulators have taken a variety of actions to grant credit unions regulatory relief during the COVID-19 pandemic. Most of those regulatory relief actions, however, are short-term measures will not significantly help credit unions that incur significant credit losses during a COVID-19 recession. While it is too early to comprehend fully COVID-19’s economic impact on credit unions, if a recession does materialize, credit unions should prepare for a wave of enforcement actions brought by NCUA and state credit union regulators.
NCUA has taken several broadly applicable supervisory actions to address the short-term impacts of COVID-19, including guidance allowing federally insured credit unions to treat loans as current if the credit union grants the borrower a COVID-19-related loan forbearance or modification that suspends loan payments for a few months. On May 21, the NCUA Board also issued an interim final rule on COVID-19-related prompt corrective action changes that, until the end of 2020, allows federally insured credit unions that are “adequately capitalized” to stop making normally required transfers to their retained earnings and allows streamlined net worth restoration plans for federally insured credit unions that become “undercapitalized” primarily because of increases in members’ share balances related to COVID-19. NCUA’s COVID-19 loan loss guidance and interim final rule on COVID-19 prompt corrective action should somewhat insulate credit unions from COVID-19-related loans losses and prompt corrective action restrictions in the short term.
The NCUA guidance and interim final rule do not truly mitigate, however, the impact of net worth ratio reductions from losses incurred when borrowers are unable to repay their loans over the long term. A significant proportion of COVID-19-related job losses are likely to be permanent and many small businesses will have trouble surviving the coming months. Virtually all credit unions are likely to be exposed to loan losses stemming from their members’ job losses. Credit unions that make member business loans are also likely to be exposed to losses resulting from small business failures.
NCUA appears poised to treat credit union net worth ratio reductions resulting from incurred COVID-19-related loan losses like any other situation involving a credit union with a weakening loan portfolio, just as the agency did during the last financial crisis 10 years ago. Like in that recession, NCUA and state supervisors are likely to use a variety of enforcement tools to address the safety and soundness concerns, including documents of resolution, letters of understanding and agreement, net worth restoration plans, and other supervisory actions, such as cease and desist orders, regional director letters or fines.
DORs and LUAs are perhaps the most critical supervisory actions for credit unions to be prepared for because the credit union has at least some ability to negotiate the terms of a DOR or LUA, and DORs and LUAs can stave off more serious enforcement actions.
According to NCUA’s National Supervision Policy Manual, DORs are an informal enforcement action and “[e]xaminers will ask credit union management to develop an acceptable corrective action plan, or plans, to resolve the problem(s) identified in a DOR.” This gives the credit union’s management an opportunity to influence the DOR’s requirements. Problems included in a DOR must be significant enough that an examiner would recommend escalating the issue to the next level of elevated enforcement action, like a regional director letter or an LUA, if the problem is not corrected, meaning that a credit union that fails to resolve a DOR within the DOR’s required timeframe can expect to be asked to agree to an LUA or face another formal enforcement action.
It is critical for credit unions to have a game plan for dealing with a possible supervisory request to agree to an LUA. For example, credit unions should make sure leadership team members understand that LUAs are voluntary contracts between credit unions and their regulators, so a credit union is never required to agree to one even if the consequences of not agreeing to the LUA, such as facing a cease and desist order or civil money penalty, might be worse. Once the credit union agrees to the LUA, however, it is stuck with what it agreed to until the LUA expires or is lifted by the regulator. Although LUAs are usually kept confidential, NCUA can publish LUAs and the agency can enforce a credit union’s compliance with a published LUA in the same way that it can enforce compliance with a regulation.
In addition, the credit union should take time to evaluate the proposed LUA, think of what edits it would like to propose and try to negotiate for those changes. While examiners can threaten to take other enforcement actions if the credit union does not agree to the LUA, the credit union should insist on having at least a few days to consult with its board of directors and legal counsel so that it can evaluate the draft LUA and develop proposed changes. At a minimum, the credit union should make sure that the LUA’s factual findings are accurate, the LUA is clear in terms of the remedial actions it requires the credit union to take, the LUA states the legal basis for those requirements, the LUA has a reasonable timeframe for the remedial actions, and the LUA has an expiration date.
The full financial impact of COVID-19 on the credit union system will not be clear until at least the end of 2020 but, in a recession, most credit unions are likely to incur loan losses and declining net worth levels that would not be mitigated by NCUA’s COVID-19-related regulatory relief. Credit unions should use the ideas in this article to prepare for any requests for DORs and LUAs so that they will be ready to negotiate for the best possible outcome.
Michael S. Edwards is an attorney-at-law with extensive experience representing credit unions, community banks and credit union organizations in the United States and around the world on a wide range of regulatory, compliance and other legal matters. Now with his own law firm based in the Washington, D.C., area, Edwards previously served as SVP/advocacy and general counsel of the World Council of Credit Unions and was senior assistant general counsel in the regulatory advocacy section of the Credit Union National Association.