By Ray Birch
NEW YORK—While secondary capital is seen by many low-income designated credit unions (LICUs) as a lifeline to grow and serve the underserved, a number of sources have told CUToday.info NCUA is slowing the flow of these funds even as demand is expected to increase.
NCUA has responded only with a statement on how the secondary capital process is supposed to work.
LICUs are eligible for infusions of secondary capital, but only after first submitting to NCUA a plan for how the capital will be deployed. The agency must then approve the request before a loan is formally approved by the investor and the funds can be released to the credit union.
Pablo DeFilippi, SVP of membership and network engagement at Inclusiv, which provides secondary capital to LICUs, is among those who said NCUA has been slow to approve secondary capital plans, including turning many plans down.
“It looks like there's some delays; there appears to be challenges for credit unions to go through this process with NCUA,” said DeFilippi. “And it may be a combination of things—it could be the credit union's lack of understanding, the lack of understanding from examiners perhaps about secondary capital, or plans that have not been put together comprehensively enough. But there are delays in terms of NCAA authorizing the acceptance of secondary capital.”
Sources have stated that one of the key issues is NCUA examiners, although not all of them. Those who have worked with the agency said they have found within NCUA’s field team there is a lack of understanding about the use of secondary capital.
Too Conservative?
DeFilippi is concerned NCUA may be too conservative with its treatment of secondary capital for credit unions, and noted how relatively easy it is for banks to get the alternative funding.
“In the banking world, banks get Tier 2 capital all the time and it's not an issue,” said DeFilippi. “But in our industry, there's not enough activity around secondary capital for NCUA and examiners to gain the expertise they need to turn these plans around quickly. I think it’s really a two-way street when it comes to this issue of slow secondary capital plan approval or plans being turned down—you have the issues with NCUA and you have credit unions that are not submitting plans that address all the issues NCUA needs answered—such as how the credit union actually plans to pay this money back.”
Secondary capital must be paid back, including the interest paid on those funds.
“With any loan, the lender looks at your ability to repay,” said DeFilippi. “So as an approver of these plans, NCUA is looking at the credit union’s ability to repay based on how much income it will generate in the future. The expectation is that you're going to increase lending and generate more income so you can pay that loan back and still maintain your capital position. This is a type of product you have to have the platform for, and if you don't it can harm you.”
NCUA’s Response
Pablo DeFilippi
Asked by CUToday.info whether the agency has been slow to approve plans or has been turning many down, NCUA replied with a written statement: “Section 701.34 of the NCUA’s regulations requires the agency to notify a credit union that has submitted a secondary capital plan of its approval or disapproval within 45 days of receipt of the plan. If the agency does not meet that deadline, the credit union may proceed to accept secondary capital accounts pursuant to the plan. The agency cannot comment on the reasons for its decision on a proposed secondary capital plan; however, redacted versions of capital plan appeals are available on the NCUA’s website.”
NCUA did not respond to a CUToday.info request to provide the number of secondary capital plans submitted to the agency by CUs during the last 18 months and the number that have been approved.
Reaching Deeper
DeFilippi contends while secondary capital has been used by credit unions to shore up capital weakness, it is evolving into a source of funding best used to drive growth and help an LICU better serve the underserved and reach deeper and wider into their markets.
He noted that Inclusive, formerly known as the National Federation of Community Development Credit Unions, began providing LICUs with secondary capital in 1997, and has delivered more than $50 million in funding. It was the first organization to provide secondary capital to CUs.
“Although today there’s an emerging marketplace for secondary capital, Inclusiv continues to be the only outlet that channels CRA and socially responsible investments to the industry,” asserted DeFilippi. “Looking back on the evolution of secondary capital within credit unions, when we started deploying it our intention was to help credit unions meet some minimum capital requirement and address (Prompt Corrective Action). But what we're learning with this product is it's a loan that can help you, but also hurt you if you can’t use it to drive growth to generate the income to pay the money back. If you don't have an operation that is growth-oriented, it could sink you. It’s just like when consumers get over-leveraged, it may help you in the short term but in the long run you’re not going to be better off.”
The Ideal Candidates
DeFilippi contends secondary capital loans are best suited for institutions that are growing well and want to accelerate that process. For example, he said when Inclusiv reviews secondary capital plans it focuses on a credit union’s loan demand.
“If they don’t have good loan demand, or at least a plan to quickly increase loan demand, then this secondary capital is going to cost them money,” he said, noting interest rates on secondary capital loans range in the industry from 2%-9%.
“We want to know how quickly can you deploy this money and how much yield will you generate so you can pay that loan back and maintain your capital position.”
Secondary capital pricing depends on a few factors, noted DeFilippi—the funding source, loan term, and profile of the credit union.
“Much of the lower priced capital is from the 2010 U.S. Department of Treasury’s Community Development Capital Initiative,” he said. “That was a pivotal point when credit unions started to notice the true power of this mechanism—48 credit unions received $70 million in long-term capital that resulted not only on preserving access to services in those communities, which was the original intent of the initiative, but also an expansion of those services at a time when most financial institutions were contracting their lending activities.”
A More Expensive Option
Cathi Kim, director of Inclusiv Capital, said credit unions often ask why secondary capital is more expensive than standard member deposits.
“The pricing on secondary capital is different from that of deposits, as they function and are structured differently,” explained Kim. “Secondary capital counts towards regulatory net worth, which can be used to leverage growth. By regulation, secondary capital is at least five years in term.”
One Example
One credit union that has looked outside deposits for growth is the $63.4-million Union Yes Federal Credit Union in Orange, Calif., which was recently approved by NCUA for secondary capital. The credit union is looking to raise $4 million to jump-start its growth prospects, offering subordinated debt with fixed and variable interest rates of 4% to 4.5% and durations of five to seven years.
The credit union’s net worth was 4.49% at the close of Q1 2019. Union Yes has finished in the black over the last five years, making $88,659 through the first quarter of 2019, $379,429 in 2018 and $167,012 in 2017.
Asked about NCUA approving a secondary capital plan from a CU with capital well below the 7% well-capitalized threshold, DeFilippi said he was aware of the capital request by Union Yes, and suggested NCUA will grant secondary capital as a means for a struggling CU to get back on its feet.
“And I have heard that NCUA will permit secondary capital requests, sometimes even write a check themselves, if they determine it would be better for the agency and share insurance fund to infuse the CU with capital rather than eventually liquidate it.”
More Requests Likely
Kim believes NCUA should be readying to deal with more secondary capital requests, telling CUToday.info secondary capital demand has grown tremendously in recent years, which she credited to an adjustment by NCUA to the definition for the low-income designation qualification in 2012, allowing more credit unions to become LICUs.
While this will help more CUs grow, it will also benefit more communities, according to Kim.
Cathi Kim
“Where we have seen the biggest growth in secondary capital is among credit unions looking to have a double impact—both on their bottom line and in the communities they serve,” she said.
The opportunity for expansion of secondary capital among the industry is big, said DeFilippi.
“I think 45% of the movement has the ability to request secondary capital,” he said. “Only 66 credit unions in the entire industry have secondary capital. That’s a very small subset of the movement.”
There's currently $264 million in secondary capital invested in the system among LICUs, reported DeFilippi.
The issue of secondary capital also was part of the recent CUNA Finance Council meeting in New York. During the meeting, Jeff Rendel of Rising Above Enterprises and a former California/Nevada League employee and national bank examiner, said he is starting to see many credit unions explore the use of external secondary capital.
“The pool of investors is small but growing at about $300 million. Secondary capital must be renewed at end of term, can be accessed at up to about 50% of retained earnings,” explained Rendel. “It’s usually a fairly expensive means of accessing capital, so you have to have an immediate, active use to deploy it just to generate the ROI needed. Secondary capital is discounted by 20% every year after the first five years.”
How Funds Are Being Deployed
What are LICUs using secondary capital for?
In many cases, it’s being deployed to support physical market expansion and to reach more low-income members often who often fall prey to payday lenders, said Kim.
“More CUs are using the funding to create small-dollar loan products, ‘Wheels to Work’ programs, and to drive innovation,” Kim said. “For example, one credit union has used its funding to scale an affordable first-time home loan program to grow their first mortgage lending.”
Kim added the funds have also been used for marketing programs, field of membership expansion, and new branches.
“For instance, one credit union in North Carolina is using secondary capital to fund the development of five new locations over the next four years,” Kim said.
At the CUNA Finance Council meeting, Rendel shared an example of a CU he chose not to identify that has used secondary capital.
“The CU had seen significant loan growth of 12% and used the capital for continued growth,” said Rendel. “The credit union said it would take years to build this kind of capital in traditional sense. It’s a viable option for a well-capitalized CU making a strategic investment.”
DeFilippi agreed secondary capital can be tapped to support many initiatives, but emphasized it’s only good “in a healthy body. This funding, we have seen, is best used among institutions that have a plan to grow, wanting to accelerate the growth they already have. This is an emerging market within credit unions, as more and more credit unions understand how to leverage secondary capital there will be more demand.”
A Five-Year Forecast
Kim added that over the next five years Inclusiv expects to see a significant increase in the amount of secondary capital flowing into credit unions, not only in the number of credit unions using the funding but the size of the loans granted.
“Low-income designated credit unions comprise more than 40% of the industry, but the key thing is they are becoming much more diverse in size,” Kim said. “It used to be just the smaller credit unions, but now a lot of the bigger ones are getting involved.”
“Secondary capital is a powerful tool credit unions can use to take advantage of market opportunities and fuel both growth and relevance,” added DeFilippi. “Secondary capital is equivalent to high octane gasoline. Secondary capital has the power to transform our industry and accelerate growth.”
Bank Criticism
Following the NCUA board last month at which it put out for 60-day comment a proposal that would raise the current nonmember deposit limit to 50% from 20%, the Community Bankers of America called CU access to secondary capital a “troubling issue.”
Under the rule, FCUs would be able to accept nonmember and public unit shares up to 50% of paid-in and unimpaired capital and surplus, as CUToday.info reported here.