NCUA Board Member Todd M. Harper Remarks - Women in Housing and Finance Policy Lunch

As Prepared for Delivery on September 10, 2019

Thank you to Women in Housing and Finance for hosting this event, Mary Martha Fortney for the invitation, and everyone for joining me at today’s luncheon. It’s a pleasure to be with you all.

It has been almost six months since the Senate confirmed me to a seat on the NCUA Board. As a result, I have had time to consider the issues affecting financial institutions better, including credit unions, thrifts, and banks. Accordingly, I will today share with you some of my observations about developing risks for our financial institutions.

I will begin by briefly reviewing my regulatory philosophy and priorities before focusing on the issues of emerging risks to financial institutions broadly, and consumer financial protection briefly.

Regulatory Philosophy

My professional experiences over two decades in Washington have shaped my views on financial institutions regulation. In brief, I believe that financial institutions regulators need to be:

• Fair and forward-looking;
• Innovative, inclusive, and independent;
• Risk-focused and ready to act expeditiously when necessary; and
• Engaged appropriately with all stakeholders to develop effective and efficient regulation.

Put them all together and you get the acronym: FIRE. Let me now turn to each of these features of financial institutions regulation.

Fair

Effective regulators must apply the rules without favoritism. We need to learn from the mistakes of the former Office of Thrift Supervision, which allowed the backdating of capital at IndyMac and other financial institutions to retain their well-capitalized status. In unfairly applying the law, they made the financial system riskier and showed a preference for some financial institutions over others. That’s why a good financial institutions regulator must fairly apply the rules to each entity it regulates.

Forward-looking

Good financial institutions regulators must also be forward-looking. Far too often, financial institutions regulators focus on the lessons learned during the last financial crisis. While it’s important to develop new rules and revise old regulations based on the lessons learned in the last crisis, it’s at least equally as important to look ahead at the risks coming over the horizon. Put another way: regulators need to look into the future and have foresight for the year 2020, not just 20/20 hindsight, when carrying out their duties.

Accordingly, I’ll shortly speak some more about some of the risks that I see for our financial system, but some of them include the need to expeditiously implement a risk-based capital rule, monitor liquidity risks, and respond to ongoing generational shifts and potential market disruptions, among other matters.

Innovative

Just as the world changes, a regulator must also itself innovate in response to new marketplace and technological developments. It must also revise the rules affecting the institutions it regulates accordingly.

One way in which the NCUA is currently innovating is through the implementation of the new MERIT exam system, which we are beginning to implement this fall. This Modern Examination and Risk Identification Tool will help the agency to better perform its functions, apply better analytics, and lead to fewer hours conducting onsite examinations.

In innovating, the NCUA Board must also consider how fintech is affecting the credit union system and whether additional reforms are needed. I am currently working with my colleagues on the NCUA Board to do just that.

Inclusive

An effective financial institutions regulator must also be inclusive. The demographic makeup of the United States is changing, and the NCUA and credit unions must change with it.

Research has proven that businesses that prioritize the creation of a more diverse and inclusive workplace experience greater staff motivation, improved customer service, and higher employee retention, all of which lead to better financial performance. To be successful, financial institutions, therefore, should bring more points of view to their decision-making and operations. Additionally, the NCUA must work to improve its diversity performance by striving to hire and promote people of all backgrounds and to give minority- and women-owned business the chance to compete for agency contracts.

With respect to supplier diversity, the NCUA is the most successful financial institutions regulator. In all, 45 percent of our contracting dollars in 2018 went to minority- and women-owned businesses. We need to continue this momentum going forward.

Independent

To guard against political interference that could undermine regulation and supervision, Congress established financial institutions regulators as independent agencies. Accordingly, I believe, we need to protect the agency from outside political interference.

Risk-Focused

In reviewing the books and operations of a financial institution, regulators also need to focus on whether risk has been mitigated or hedged appropriately.

Ready to Act

In those instances when risks have been ineffectively mitigated, financial institutions regulators need to be ready to act.  

In the case of the recently failed taxi-medallion credit unions, the NCUA’s Inspector General found that the agency should have taken a timelier and more aggressive supervisory approach. Had the NCUA acted more expeditiously, credit union management may have made improvements to address inadequate lending practices and risk management policies, thus reducing the losses to the National Credit Union Share Insurance Fund.

Engaged Appropriately with All Stakeholders

Actively seeking the views of all stakeholders can help to improve the development of regulation and inform the decisions on the right balance for any regulation. That’s why regulators and decision-makers need to engage with stakeholders.

As such, I’ve been working since joining the NCUA Board to get in the field to meet with state regulators, credit union trades and leaders, small credit unions, their members, and many others. I’ve already traveled to six states during my first five months on the NCUA Board, and I have plans to travel to five more states before the end of the year.

Effective and Efficient Regulation

Finally, I believe in the need for regulators to consider the size, scale, and scope of their regulated institutions when developing rules. That’s why stakeholder engagement and prudent analysis is so important. Together, they can help us to develop effective and efficient regulation. We need to work regularly to determine the effectiveness of regulation and supervision, and we need to seek to be efficient in completing our work.

Regulatory Priorities

Having outlined my regulatory philosophy, I now want to address my priorities on the NCUA Board.

As an NCUA Board Member, one of my priorities is to safeguard the safety and soundness of federally insured credit unions. Accordingly, I am keenly focused on the issues of capital and liquidity.  I will speak to each of these points in a bit.

I am also deeply focused on cybersecurity. Credit unions, their vendors, and the NCUA need to work to protect against cybersecurity threats proactively. Additionally, the NCUA not only has safety and soundness responsibilities, but it also has consumer financial protection responsibilities for credit unions with less than $10 billion in assets. Consistent with the law, in my view, we need to work to increase uniformity in our consumer financial protection supervision and oversight of credit unions.

Finally, by law, the credit union system has a mission to promote thrift and serve people of modest means. As such, the NCUA should foster an environment that increases access to financial services for the unserved and the underserved with appropriate guardrails. The agency should also support the work of small credit unions, minority depository institutions, and low-income credit unions, who are often focused on serving these audiences and which face the challenges of increased competition, limited resources, and difficulties in achieving economies of scale.

Risks to the Financial System

As noted earlier, one of the elements that makes up my regulatory philosophy is the need for the NCUA to be forward-looking. I, therefore, want to spend most of my time today discussing some of the emerging risks to the financial system as I see them. These emerging risks include topics like capital and liquidity levels, market-disrupting changes in areas like auto lending, and societal structural shifts, among several others.

Rising Recession Risk and Risk-Based Capital

While the consensus economic forecast remains positive for credit unions and other financial institutions, such projections are rarely perfect.

We now have experienced more than a decade of economic growth after the Great Recession. It is the longest period of economic growth in U.S. history. This expansion has been good for credit unions, thrifts, and banks as the economic environment is a key determiner of financial institutions’ performance. But, history has regularly shown that all good things come to an end.

For example, we saw the strong economic performance of the 1960s lead to the stagflation of the 1970s, and eventually, the savings and loan crisis. And the steady economic gains experienced at the start of the current century were ultimately followed by the collapse of the housing bubble, the global financial crisis, and the Great Recession from 2007 and 2009.

Moreover, the uncertainty in international trade, the contraction of manufacturing activity in August, recent increases in credit card delinquencies, and the inversion of the yield curve this year each highlight the real need for the NCUA and the other banking agencies to prepare for the next recession. As noted in the NCUA’s current annual performance plan, “A recession would likely be associated with rising delinquencies, reduced loan demand, and, potentially, an increase in shares as consumers move funds from riskier investments into safer, insured credit union deposits.”

While we don’t know when the next downturn will occur or how severe it will be, financial institutions and their regulators need to be forward-looking in their regulatory actions. Such vigilance will protect the resilience of our financial system from any growing vulnerabilities.

For the NCUA, it follows that we must ensure that federally insured credit unions and the Share Insurance Fund have the capital needed to withstand the next downturn.

For the long-term good of the industry, we must also ensure that the right rules are in place to protect credit unions and their members, including implementing the NCUA’s long-delayed, risk-based capital standard at the start of 2019. In my view, robust capital cushions are a key component of protecting against financial institutions’ failures and losses.

The agency’s supervisory efforts, therefore, should focus on the institutions and activities posing the greatest risk to the Share Insurance Fund, such as concentration risk on credit union balance sheets. As such, I believe that all financial institutions backed by federal share or deposit insurance should hold capital commensurate with the risks held on their balance sheets.

In the case of federally insured credit unions, such capital will protect taxpayers and credit union members by helping to either prevent credit union failures or mitigate losses to the Share Insurance Fund when a credit union fails. Additionally, putting in place safeguards like the revised final risk-based capital rule before the next recession or financial crisis occurs is good public policy. After all, it’s better to repair a roof before it rains than to patch it while it rains.

Moreover, the recent losses at several federally insured credit unions that concentrated heavily in taxi-medallion lending highlight the importance of why we need to implement swiftly, not further delay, the agency’s risk-based capital rule.

These failed credit unions held significant concentrations of taxi-medallion loans on their books, as much as 97 percent of all loans in at least one instance. According to the NCUA Inspector General’s recent material loss review, the failures of Melrose Credit Union, LOMTO Federal Credit Union, and Bay Ridge Federal Credit Union resulted in an estimated loss of $765.5 million for the Share Insurance Fund.

This figure does not include additional losses the fund would have borne at other taxi-medallion credit unions that are now closed or merged. Cumulatively, system-wide losses from excessive concentration in taxi-medallion loans, therefore easily exceeded a billion dollars.

Is it fair that the remaining 99.9 percent of all credit unions had pay one through the Share Insurance Fund for the bad decision-making by the bottom one-tenth of one percent of all credit unions?  I do not believe so.

Therefore, after many years of work on a new risk-based capital regime, the Great Recession, and the recent taxi-medallion credit union failures, it is time for us to move ahead to protect the Share Insurance Fund before there is a problem, rather than assessing premiums after the fact as we did during the Great Recession.

Remaining Liquidity Risk

In the short term, I am also concerned about the liquidity of federally insured credit unions, and how they might respond to the next economic contraction. The loan-to-shares ratio for federally insured credit unions bottomed out in 2012 and 2013 at approximately 66 percent. This ratio has since rebounded and exceeded 85 percent at the end of 2018. Although the metric fell to 83.3 percent at the end of the second quarter of 2019, I continue to watch the loan-to-share ratio quite closely.

During times of economic stress, such as those caused by a recession, financial institutions need to have sufficient liquidity to meet their cash demands. But when a financial institution’s assets are held in illiquid long-term assets like long-term loans, it may be difficult to sell those assets at normal prices and obtain needed cash.

Fortunately, the NCUA Board recognized the critical need for credit unions to have a sound policy and process for managing liquidity risk when approving a final rule in 2014 requiring federally insured credit unions to take specific steps to ensure appropriate risk management and access to liquidity. While this rule should help credit unions institutions to maintain ample liquidity to withstand unexpected emergencies, the NCUA must nevertheless remain watchful in its supervision to ensure the rule is effectively applied going forward.

Rising Consumer Debt

While increases in consumer loans are generally a good thing for financial institutions, a recent analysis in the Wall Street Journal at the start of August highlighted the risks posed by consumer debt for middle-class families.

To maintain the middle-class lifestyle, many households are increasingly taking on debt. Not counting mortgages, consumer debt has risen to $4 trillion, the highest it has ever been, even after accounting for inflation. While this level of consumer debt should be sustainable in the near term, it could become unmanageable in the longer term if a recession occurs and unemployment rises. The end result could be a rise in consumer loan delinquencies and charge-offs, which could result in losses for credit unions and other financial institutions.

As a result, financial institutions need to take a proactive stance in preparing for such a possibility, including carefully evaluating credit risks when making new loans and hedging those risks appropriately.

Growing Deficits and National Debt

And just as there are consequences when households spend beyond their means, big problems can arise when governments — like ours — are binge spenders.

This year alone, the federal budget deficit is expected to reach nearly $1.1 trillion. As we learned in prior decades, big deficits can put upward pressure on interest rates and, in doing so, “crowd out” productive investments by private enterprise. This is bad because most economists believe that private enterprise drives most economic growth.

Another danger of big deficits and a growing federal debt is that investors may become more hesitant to lend to the government. This generally will mean higher debt-servicing costs paid by the government and taxpayers. At best, increasing outlays for federal debt servicing take away from economic growth, limit spending on other governmental priorities, and hamper the government’s ability to respond to future crisis with prudent expenditures. At worst, debt-related expenditures can spiral out of control and ultimately pose a significant risk to the stability of the overall economy.

Although it may seem remote to some American households, a growing federal debt can affect families and thus credit unions, thrifts, and banks.

Obviously, to the extent that interest rates are above what they otherwise would be because of government deficits, low-income borrowers, in particular, may suffer, leading to reduced demand for credit union financing. To the extent that consumers are worrying about the growing debt and debt-servicing costs in the future, they also may pull back from getting the loans that are facilitated by our financial system. Thus, a large and growing national debt generally creates significant uncertainty.

Accordingly, consumers, financial institutions, and regulators like the NCUA must be watchful against these emerging risks.

Ongoing Low-Interest Rates and Slowing Economic Growth

With respect to the broader U.S. economy, we have experienced some volatility in recent months that could ultimately manifest as slower economic growth. If a pattern of slower economic growth takes hold, job creation and inflation could expectedly fall.

Slower economic growth would also likely dampen deposit and membership growth, reduce credit union loan demand, and lead to increased credit risk, especially in the case of a recession when unemployment increases and the value of assets declines. And the continuation of the current, low-interest-rate environment presents other risks to credit unions.

Credit unions that rely primarily on investment income may find their net income remaining low or falling. In addition, credit unions could “reach for yield” by adding long-term and higher-risk assets to their portfolios. Finally, the sluggish economy that would likely be associated with continued low-interest rates could raise credit risk for almost all types of private instruments.

The NCUA, other banking agencies, and all financial institutions must remain vigilant against such risks and adjust accordingly.

Emerging Technological Advances and Market Disrupters

Another area that I am closely watching is the evolution occurring in financial technology. New financial products that mimic deposit and loan accounts, such as mobile payment systems, pre-paid shopping cards, and peer-to-peer lending have emerged. These products pose a competitive challenge to all financial institutions, regardless of charter type.

Financial institutions also face a range of challenges from fintech companies in the areas of lending and the provision of other services. For example, underwriting and lending may be automated at a cost below levels associated with more traditional financial institutions, but may not be subject to the same regulations and safeguards that credit unions and other traditional financial institutions face.

The emergence and increasing importance of digital currencies may pose both risks and opportunities for credit unions.

As these fintech institutions and products gain popularity, financial institutions may have to be more active in marketing their products and services and rethink their business models. Technological changes outside the financial sector may also lead to changes in consumer behavior that indirectly affect credit unions.

For example, the increase in on-demand use of auto services and public transit, the rise in households opting to go car-free, and the potential for pay-as-you-go on-demand vehicle rental could reduce purchases of consumer-owned vehicles. Analysts expect these trends to accelerate and think that significant change is coming within the next decade. That could lead to a slowdown or reduction in the demand for vehicle loans, which now constitute nearly 35 percent of the credit union system’s loan portfolio.

The future of vehicle ownership — and credit union auto financing — will depend on the degree to which vehicles are owned or shared and the extent to which vehicles become autonomous. But, changes in the auto industry could also create opportunities for lenders to develop products that support new consumer experiences and mobility. These services might include financing vehicle subscription services for individuals and increasing lending to commercial borrowers as the number of consumer borrowers shrinks.

Shifting Demographics

Changes in the composition of the U.S. population also pose emerging risks for financial institutions. The U.S. Census Bureau forecasts that the share of the population reaching retirement age in the United States will continue to rise for the immediate future. In 2050, experts project that the population over the age of 65 will be 83.7 million Americans, nearly double the level in 2012. As the population ages, financial institutions may see shifts in growth trends and members’ demand for certain products and services.

For example, an aging population may increase the demand for savings and interest-bearing accounts, and lower the demand for auto loans and mortgages, but potentially increase the demand for reverse mortgages. Because they are less prepared for retirement than recent generations, older Americans may also need access to loan products to help them cover costly medical and dental bills over time. Additionally, some credit unions with small fields of membership may find their potential membership declining, restricting their opportunities to grow.

As the U.S. population ages, it will also become more diverse over the next several decades. Accordingly, to continue to thrive, credit unions, thrifts, and banks may need to adapt the products and services they offer to ensure they can communicate effectively with and serve the needs of potential new members and customers.

I am also watching for generational shifts in consumer behavior beyond older Americans. Some analysts believe that millennials’ approach to personal finances differs from those of previous generations in key ways, and these differences will persist as they age. These analysts suggest that, for example, millennials may be less interested in ownership of big-ticket items like houses and vehicles. If true, this may undermine credit unions’ current business models, which tend to be dominated by loans secured by these assets. New types of loans, new types of deposit accounts, and new types of member services may be required to meet millennials’ needs.

Additionally, some analysts anticipate that millennials’ familiarity with technology will make them less attached to conducting business at physical branches. Research by the FDIC has found that roughly a third of households use a bank teller as their main banking method.

This use varied markedly by age group, however. About one in six households younger than 45 said their main banking method was a bank teller, while almost half of households older than 65 relied mostly on bank tellers. At the same time, less than 8 percent of households 45 or older rely primarily on mobile banking, compared to 25 percent of households between 15 and 24.

If over time, consumers conduct more of their business through electronic and mobile services, credit unions, thrifts, and banks may need to find alternatives to the branch-based, in-person interactions with members that they are known for traditionally in order to remain competitive.

Evolving Cybersecurity Risks

One final risk that I would like to explore relates to the increasing exposure of our financial system to cyber-attacks. Malware, ransomware, distributed denial of service attacks, and other forms of cyber intrusion affect financial institutions of all sizes, and will require ongoing measures for containment. These trends are likely to continue, and even accelerate, over the next two years.

That’s why the NCUA is working diligently to:

• Mature our cybersecurity examination program by advancing consistency, transparency, and accountability;
• Stimulate due diligence of third parties within the credit union system;
• Support credit unions with training, informational resources, and grants aimed at improving operational preparedness and resilience; and
• Ensure the security of NCUA’s systems and collected information.

The banking and payment systems remain attractive targets to cyber criminals because they provide more direct cash-out opportunities. Cyber risk in this area is generally better understood and fraud indicators are in place; however, cybercriminals are focusing more on smaller institutions’ websites and supply chain networks.

Regardless of size, financial institutions of all sizes must take a strategic risk management approach, which includes continual hardening and improving the security of their networks, as well as a thorough review and mitigation of risk with their respective supply chains.

Consumer Financial Protection

Before close my remarks, I would like to speak briefly about consumer financial protection, credit unions, and the need for improved examinations and enforcement.

Since returning to the NCUA as a Board Member, I have spent some time exploring how the agency conducts consumer financial protection compliance reviews. My interest in this issue was sparked by news stories concerning lapses in consumer financial protection by individual credit unions during the last several years.

In general, I have found that the NCUA’s current method for examining and enforcing consumer financial protection laws and regulations in credit unions with less than $10 billion in assets that it supervises is not comparable to our sister agencies, which complete regularly scheduled risk-focused consumer compliance reviews and assign a separate consumer compliance rating outside of the CAMEL process.

NCUA’s different approach to consumer financial protection reviews runs counter to the congressionally mandated mission of the Federal Financial Institutions Examination Council, which works to “prescribe uniform principles, standards, and report forms” across all types of financial institutions.

Decades ago, the NCUA conducted full consumer financial protection compliance reviews as part of its examination program, but the agency has increasingly focused on safety and soundness over time. This policy may have worked well when the NCUA oversaw a large number of small credit unions serving a limited field of membership with only a few basic financial products, but today’s credit unions are larger and more complex.

Today, 576 federally insured credit unions have more than $500 million in assets, and 317 credit unions exceed $1 billion in assets. Accordingly, the NCUA should evolve its approach to consumer financial protection. We should also increase guidance to the credit union system to improve compliance with consumer financial protection laws.

In recent years, the NCUA has made some progress in this area, such as establishing in 2010 an office responsible for consumer compliance policy, program, and rulemaking, as well as consumer complaint processing. And starting in 2013, the NCUA has utilized selected consumer compliance reviews during its safety-and-soundness regulations, but we can still do better in this area.

Although credit unions are owned by their members, management’s actions may not always align with the consumers’ best interests and the requirements of federal regulations. That’s why I believe that the NCUA Board should work to ensure greater consistency in supervising consumer financial protection matters. In doing so, we will better safeguard member interests; especially as credit unions grow in size, scale, and scope.

In raising this issue today, I’m hoping to start a constructive conversation within the credit union system about how the NCUA should evolve its consumer financial protection efforts. Such changes, in my view, should take into account the unique nature of credit unions, their mission, and ownership structure and operations. I invite anyone interested in these matters to reach out to me and share their concerns and solutions. In doing so, we can build a stronger credit union system to serve everyone in the future better.

Conclusion

In sum, thank you again for joining me here today to discuss emerging threats to the financial system and consumer financial protection. By getting ahead of emerging risks and better protecting consumers, the NCUA will have 2020 foresight and not 20/20 hindsight.

I’d be happy to answer any questions you may have.