By Michael C. Macchiarola
In a Sept. 16 Supervisory Letter, NCUA published new guidance for evaluating secondary capital plans. With an impressive level of detail, the guidance outlines the criteria and procedures by which the NCUA will consider secondary capital plans submitted by low-income designated credit unions (LICUs). A copy of the Supervisory Letter is available on the NCUA website here.
LICUs have been permitted to accept uninsured secondary capital from institutional investors for more than twenty years. According to the NCUA, secondary capital is intended to provide an alternative for credit unions to support the provision of additional lending and financial services in their communities, and 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 LICUs typically grow at higher than average rates. Second, the high cost to serve a consumer 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.”
2015 Amendment
In 2015, the NCUA even amended its Supervisory Manual to streamline the application process in an effort to encourage more LICUs to consider the alternative source of capital. Despite these efforts, the number of credit unions taking advantage of secondary capital has steadily declined since the change.
The latest guidance from the agency seems aimed at boosting those numbers by unclouding much of the mystery that has surrounded the secondary capital application process in recent years. A letter from Chairman Rodney Hood accompanying the Supervisory Letter trumpeted the efficacy of this regulatory relief, commenting that “[m]any LICUs have a record of prudently using secondary capital to increase regulatory capital levels to protect against future losses and serve as a foundation for strategic initiatives and growth.”
The chairman added that secondary capital has been instrumental in “enabling them to provide much needed lending and other member services to underserved communities.”
We agree with the NCUA’s premise, expressed in the Supervisory Letter, that “[e]ach secondary capital plan is unique to the applicant LICU.” We also agree that “the evaluation of secondary capital plans is a fact-specific engagement that varies based on the unique characteristics of each LICU.” Regardless, the Supervisory Letter clearly and comprehensively articulates the standards that have been in place for some time. And, this publication is likely to improve the application process for applicants and the regulator alike. In fact, we regard it as the most significant development in the secondary capital space since 2015.
Minimum Steps
Section 701.34 of the NCUA’s Rules and Regulations codifies the rules for secondary capital. The section provides that before offering secondary capital, a LICU must gain NCUA approval of a written secondary capital plan that, at a minimum:
- States the maximum aggregate amount of uninsured secondary capital the LICU plans to issue
- Identifies the purpose for which the aggregate secondary capital will be used, and how it will be repaid
- Explains how the LICU will provide for liquidity to repay secondary capital upon maturity of the accounts
- Demonstrates that the planned uses of secondary capital conform to the LICU's strategic plan, business plan, and budget
- Includes supporting pro forma financial statements, including any off-balance sheet items, covering a minimum of the next two years.
In the Supervisory Letter, the NCUA reiterates its long-held position that Section 701.34’s requirements represent only the “minimuminformation a LICU must include in a secondary capital plan,” because the safety and soundness principles on which the NCUA’s analysis is grounded are “implicit in the minimum requirements.”
Position Makes Sense
While this position has faced some criticism, it generally makes sense. Those who insist otherwise are simply too technical in the reading of the secondary capital regulation. Ensuring the safety and soundness of insured credit unions must be embodied in everything NCUA does. Besides, the 2006 amendments to the secondary capital regulations granted approval authority to the Regional Directors, in large part, to root out the “lenient practices” of those who had taken secondary capital. It is equally inappropriate, however, to read the provisions to allow the Regional Directors unfettered authority to deny approvals out of hand.
The guidance from the NCUA also offers a series of requirements not explicit in Section 701.34. These include scenario analysis, liquidity assessments and better modeling of the risk characteristics attendant to any change in strategy accompanying a plan. The Supervisory Letter is also chock full of additional detail on a number of smaller issues.
Continued Caution is Urged
We continue to caution our clients and potential clients that secondary capital is not for everyone. And, the process is anything but simple. In our experience, successful candidates (1) incorporate secondary capital as part of the credit union’s broader overall strategy, and (2) engage in thorough preparation and a deliberate, ongoing and thoughtful process. Finally, we applaud the NCUA for the Supervisory Letter. And, we remind all involved that the articulation of a consistent, logical and thoughtful framework is only the first step. Now, it is up to the LICU applicants to tailor their plans to address the NCUA’s ideals. And, for the NCUA to live by them.
Michael C. Macchiarola is CEO of Olden Lane LLC, Chatham, N.J. For info: www.oldenlane.com.