More credit unions should have secondary capital. Why don't they?
Since 1996, low-income designated credit unions (LICUs) have been allowed to accept uninsured secondary capital from institutional investors. And, in 2015, the National Credit Union Administration (“NCUA”) amended its Supervisory Manual to streamline the application process in an attempt to make the secondary capital process easier for investment. Yet today, more than two decades after its secondary capital vision was first implemented, the NCUA concedes that its success “has been mixed.” And, the program’s reach has, undoubtedly, been less than many had hoped. In fact, the number of credit unions (CUs) taking advantage of secondary capital has steadily shrunk from an all-time high of 80, in 2012, to 67. This begs the question: why do only 67 credit unions have secondary capital?
At Olden Lane, we believe the answer is two-fold. First, many credit unions struggle in navigating the regulatory process associated with secondary capital. Second, raising capital can be an unfamiliar and daunting exercise for credit unions generally.
What is Secondary Capital?
Secondary capital is intended (i) to provide an alternative for credit unions to support the provision of additional lending and financial services in their communities, and (ii) to absorb potential losses, thereby reducing the potential for failure.
LICUs typically face a twofold growth challenge. First, the unmet need among their target population is so great that they typically grow at higher than average rates. Second, the high cost to serve a customer segment with relatively modest balances and smaller transaction sizes tends to squeeze ROE. To meet growing demand, therefore, LICUs must find sources of equity capital beyond their own earnings. Enter secondary capital.
The NCUA has described secondary capital as “an important regulatory benefit” for LICUs, framing their challenge as follows:
“Without secondary capital, the growth rate of low-income credit unions is constrained by their ability to add capital only through retained earnings. If assets grow at a rate faster than capital grows internally, the credit union’s net worth ratio declines. This constraint on the ability to add capital can also adversely affect a credit union’s expense ratio by making it more difficult to achieve economies of scale.”
Importantly, secondary capital funding for LICUs also has the potential to bring tangible societal benefits. Because credit unions have “reach and accessibility to a broad spectrum of typically underserved populations,” dollars earmarked for secondary capital provide a significant boost to low-income, minority and female communities.
Why Have Approvals Been So Difficult to Come By?
The ability for LICUs to acquire secondary capital is subject to several conditions in NCUA Rules and Regulations. And, thus far, surprisingly few CUs have been able to manage the process properly to funding. Broadly speaking, the Regulations impose requirements on the type of lender and the term and subordination of the debt. Most importantly, before accepting secondary capital, a LICU must gain NCUA approval of a written “Secondary Capital Plan” that satisfies a set of minimum standards laid out by the agency.
Recently, much has been made of this approval process, with one market commentator complaining that the “NCUA is slowing the flow of these funds even as demand is expected to increase.”
In our experience, the regulator is not at all involved in a purposeful slowdown. Nevertheless, the application process has remained enough of an obstacle that participation in secondary capital has remained stunted. In fact, our market intelligence tells us that credit unions filing plans with the NCUA over the last two years have been approved roughly only half of the time. NCUA Rule 701.34 prescribes the minimum standards of a secondary capital request in basic terms. The Rule implies a more deferential process than has been the case. Common mistakes often sink applications or mire well intentioned efforts in frustration.
We have seen failures in several flavors, four of which are highlighted below:
1. Too Big, Too Ambitious
Just because the regulations allow a credit union to request up to “50 percent of shares and undivided earnings” in secondary capital, does not mean that a credit union should ask for nearly that much. Instead, secondary capital plans should be modestly sized. We typically suggest that our credit union clients should aim for an amount that supports the projected loan growth anticipated over the next 12-18 months without compromising net worth. As a rule of thumb, we have found 1% of total assets or 10-15% on net worth to be reasonable back-of-the-envelope sizing levels for medium sized CUs. Of course, each institution’s needs and story are unique.
2. Too Little Detail
In our experience, the NCUA is reluctant to approve plans that are not fully thought through. The agency has cited poor due diligence, inaccurate cost benefit analysis and weak strategic planning as reasons for denial.
In its Best Practices Guide, the NCUA summarizes its approach:
“The key is adequate planning. Management must ensure the credit union will achieve adequate profitability, accumulate enough retained earnings and maintain adequate liquidity. Failure to do so could result in a capital or liquidity crisis for a credit union when the secondary capital matures.”
3. Too Reliant on Wholesale Funding Sources
When it comes to liquidity, we have found the NCUA to be particularly concerned with secondary capital plans that rely too heavily on third party sources of funding. If FHLB borrowings or non-member funding are integral to the LICU’s ability to repay secondary capital at maturity, there will be significant skepticism at the NCUA.
4. Inconsistent with the CU’s Strategic Plan and Budget
Secondary capital regulations require that a borrowing CU “[d]emonstrates that the planned uses of secondary capital conform to the LICU's strategic plan, business plan and budget.” We have seen the NCUA deny plans pretty regularly when they fail to meet this standard.
Avoiding these mistakes can vastly improve a CU’s prospects for accepting secondary capital. We recommend that any LICU considering this important form of regulatory relief take time to research the process and speak with experts familiar with it.
How Can A Credit Union Make Approval of its Secondary Capital Plan More Likely?
LICUs seeking secondary capital are well served to pay careful attention to avoid the four pitfalls highlighted above. Additionally, in our view, the most successful candidates embrace secondary capital as part of a long-term strategy.
We have seen too many credit unions that have stretched and applied for far too much capital. Predictably, this has made approval less likely. Like any responsible regulator, the NCUA would prefer that a CU cut its teeth with a modest amount of capital before shooting for the moon.
Finally, CUs that have faced denials are far better served by a sober consideration of the NCUA’s comments instead of doubling down on a plan with flaws. In our experience, throwing rocks at the agency will get you nowhere. Those CUs who have sought reconsideration and appeals have not found success. In fact, several unsuccessful appeals of secondary capital are available for all to see on the NCUA website. And, they should serve as a cautionary tale.
Wasting unnecessary dollars and countless months digging in on a denied plan is a poor strategy. CUs are better served by taking a giant step back and viewing the initial application as the first step in a process that can ultimately leave to a successful plan that satisfies the regulator and better ensures safety and soundness.
In the end, a CU’s application should solve for any immediate net worth issues it is facing. And, it should be supported by a very well-articulated strategy for deployment of the capital infusion and its ultimate repayment. The strategies articulated in the plan submitted to the NCUA should also be tailored to fit squarely with the CU’s overall strategy and budget.
What About Raising Secondary Capital?
The unfamiliar challenge of raising capital is another reason why we believe participation in secondary capital has been limited. The notion of secondary capital begs the question: “Where will our credit union get the capital from?” In fact, many credit unions likely shy away from the endeavor if the answer is not apparent.
Secondary capital is an instrument largely defined by NCUA regulations and limited to investments from institutional investors. Investments in secondary capital are generally in the form of subordinated, unsecured promissory notes. The secondary capital note proceeds and interest accrued are available to cover any operating losses that exceed the CU’s net available reserves (exclusive of secondary capital and allowance accounts for loan and lease losses). To the extent funds are so used, the CU may not restore or replenish the secondary capital account under any circumstances. NCUA rules set forth specific requirements in respect of term, repayment, ranking, documentation and consequences of a merger, dissolution or prompt corrective action.
As cooperatives, credit unions traditionally do not incorporate capital raising as a component of their business model. Identifying investors for such a specialized asset can be a challenging task and most credit unions are not equipped for such an exercise. Occasionally, a credit union’s sponsor or a nearby peer credit union may be a practical source of investment. Industry associations can also provide funding or a credible lead for a source of secondary capital. However, substantial secondary capital plans generally require participation of broker-dealers or other agents to accomplish funding. Typical investors in secondary capital tend to be other lenders like banks and credit unions or organizations with a special interest in the societal impact of credit unions such as certain foundations and endowments. Because secondary capital is still a small and esoteric market, CUs should seek the assistance of firms with special knowledge of secondary capital.
Why is Secondary Capital Important?
Secondary capital enables borrowing LICUs “to do more of what they do best; extend credit and provide quality financial services to underserved individuals who may not otherwise have access to them.” At the same time, it offers lenders a compelling opportunity to capture an attractive yield and make a meaningful contribution to the credit union industry and to the low-income communities that CUs serve.
At Olden Lane, we are committed to assisting credit unions better access secondary capital if and when it makes sense within a broader strategy. We work with credit unions in all phases of the secondary capital process – from plan writing to fund raising.
As the secondary capital market matures and consistency takes hold, the NCUA and CUs will better understand how to separate a good plan from a bad one. And, more investors will take note of these investments and begin to participate in the market. We fully expect that secondary capital will become a more utilized tool to enable responsible growth. And, we look forward to doing our part to help the industry understand its possibilities.
 See 12 CFR 701.34. Credit unions are designated as a LICU if a majority of the credit union’s membership (50% plus one) qualify as low-income members.
 See Streamlined Secondary Capital Approval Offers Benefits to Credit Unions, Investors (Apr. 6, 2015) (describing the two goals of the Manual’s update as “expediting the approval of secondary capital requests by regional offices and making it possible for credit unions that have secondary capital to return portions of the loans that no longer count towards net worth.”), available at
https://www.ncua.gov/newsroom/Pages/NW20150406NSPMSecondaryCapital.aspx. See also NCUA updates to Supervisory Policy Manual regarding secondary capital, CU Insight (Apr. 8, 2015) (describing the revisions as providing “clear and objective measures by which credit unions can apply and be approved for pre-payment of secondary capital”); Nicholas Ballasy, NCUA Eases Secondary Capital Supervision, Credit Union Times (Apr. 6, 2015).
 See generally National Credit Union Administration, Secondary Capital Best Practices Guide (hereinafter “Best Practices Guide”), at 4, available at https://www.ncua.gov/services/Pages/small-credit-union-initiatives/Documents/secondary-capital-guide.pdf.
 See generally NCUA updates to Supervisory Policy Manual regarding secondary capital, CU Insight (Apr. 8, 2015) (commenting that “[t]hough secondary capital loans have existed for over a decade, they remain largely underutilized”).
 See generally Best Practices Guide, supra note 3, at 2.
 Best Practices Guide, supra note 3, at 2.
 The CDFI Data Project, Providing Capital, Building Communities, Creating Impact, Fiscal Year 2007 (7th ed.) (hereinafter “CDFI Data Project”), at 9.
 See CDFI Data Project, supra note 7, at 9 (observing that 76%, 69% and 58% of credit union customers are low income, minority or women, respectively).
 See Ray Birch, Some Say Funds Are a “Lifeline,” But…, CUToday (Jun. 2, 2019).
 See generally Federal Credit Union Act § 107.
 Best Practices Guide, supra note 3, at 5.
 See NCUA Allows Community Development Credit Unions to Raise Secondary Capital, National Credit Union Administration (1996).