By Steven Houle, Catalyst Strategic Solutions Vice President of Advisory Services
Seeking authority to issue secondary capital is not a new endeavor for low income-designated (LID) credit unions, but – with asset growth strong – interest and strategic value for it has increased in recent years. Even though NCUA authorized LID credit unions to count uninsured secondary capital as capital in 1996, the number of credit unions that have issued uninsured secondary capital has been fairly flat until recently.
As of September 2020, 75 credit unions had $344 million in outstanding secondary capital per NCUA’s financial performance reports. This represents an increase of nine credit unions and $50.6 million in outstanding secondary capital since September 2019.
Summarizing secondary capital
Secondary capital is essentially an uninsured loan the issuing credit union is permitted to include as regulatory capital. Although there is currently no regulatory limit on the term of this loan, most – if not all – secondary capital has been issued for 10-year terms, with 20 percent of the original balance repaid beginning the sixth year and the total repaid by the end of the tenth year.
Secondary capital is a valuable strategic option for LID credit unions because it can be used to:
- Restore regulatory capital to a minimum desired level
- Increase regulatory capital to a desired level based on balance sheet risk composition
- Support future asset growth or other member service initiatives
- Enhance earnings and gain operational efficiencies
To issue secondary capital, a LID credit union must submit a secondary capital plan to NCUA and receive approval. There is no one-size-fits-all blueprint, but, at a minimum, NCUA requires that the plan:
- State the maximum aggregate amount of secondary capital to be issued
- Identify the purpose for which it will be used and how it will be repaid
- Explain how the credit union will provide the liquidity to repay the secondary capital
- Demonstrate that the planned use conforms to the credit union’s strategic plan, business plan and budget
- Include supporting proforma financial statements, including off-balance sheet items, covering a minimum of the next two years
Even though a credit union is only required to develop and submit proformas for the next two years, a longer horizon is valuable. This exercise helps formulate and measure the impact secondary capital will have on future balance sheet positions and growth rates. Furthermore, the proformas exercise should include multiple adverse scenarios to assess the impact to earnings, net worth, liquidity and other key balance sheet ratios.
Assessing financial viability
While secondary capital can help a credit union, and in turn its members, this strategic initiative should be thoroughly analyzed to determine its financial viability. As credit unions perform this assessment, they should also consider elements of the NCUA’s new Subordinated Debt rule, which will take effect January 1, 2022. Even though some of the regulatory requirements are the same, a few key differences include:
- In addition to low income-designated credit unions, complex credit unions and new credit unions are also permitted to issue subordinated debt.
- The minimum maturity of the subordinated debt is five years and maximum maturity is 20 years.
- Subordinated debt can only be offered, issued and sold to “entity accredited investors” or “natural person accredited investors.”
- After receiving approval to issue subordinated debt, the new rule requires a credit union to create an “offering document” for each issuance of subordinated debt.
- A credit union is prohibited from being both an issuer and an investor in subordinated debt, with limited exceptions.
For more information regarding secondary capital and to help determine if it is a fit for your credit union, Catalyst Strategic Solutions’ Advisory Service can assist with your assessment. Contact us today.