Bon­ing up on al­ter­na­tive cap­i­tal

As NCUA con­tin­ues work on cre­at­ing an­other av­enue for build­ing cap­i­tal, credit unions need to bone up on what the dif­fer­ent terms mean and the po­ten­tial im­pact.

Credit Union Journal - - Front Page - BY THERAN COL­WELL

CHANGE IS CON­STANT, RARELY EASY and im­por­tant for con­tin­u­ous im­prove­ment. Dur­ing change, such as the evolv­ing cap­i­tal reg­u­la­tions for nat­u­ral per­son credit unions, we need to lis­ten to di­verse opin­ions.

More than 800 com­ments were sub­mit­ted on the Na­tional Credit Union Ad­min­is­tra­tion’s ad­vance no­tice of pro­posed rule­mak­ing (ANPR) on al­ter­na­tive cap­i­tal by the May 9 dead­line. As NCUA as­sesses com­ments and de­ter­mines its next steps, I want to high­light some thoughts and in­spire credit unions to model their own po­ten­tial im­pacts of al­ter­na­tive cap­i­tal.

The terms “al­ter­na­tive,” “sec­ondary” and “sup­ple­men­tal” cap­i­tal have been used syn­ony­mously to de­scribe cap­i­tal from debt or bor­row­ings. In NCUA’S Al­ter­na­tive Cap­i­tal Board Brief­ing and ANPR, th­ese terms were uniquely de­fined.

Al­ter­na­tive cap­i­tal is an um­brella term re­fer­ring to any debt or bor­row­ing in­stru­ment that any fed­er­ally in­sured credit union can use to count to­ward either net worth or risk-based cap­i­tal ra­tio. Sec­ondary cap­i­tal re­fers to such an in­stru­ment that al­ready ex­ists but only for low-in­come credit unions. Sup­ple­men­tal cap­i­tal would be avail­able to all fed­er­ally in­sured credit unions but could only count to­ward risk-based cap­i­tal.

Note that any low in­come-des­ig­nated credit union (LICU) — about 40 per­cent of all credit unions — can is­sue sec­ondary cap­i­tal to­day. The ANPR sought feed­back on the cur­rent reg­u­la­tion and con­sid­ers au­tho­riz­ing CUS to is­sue sup­ple­men­tal cap­i­tal in­stru­ments that would only count to­ward risk-based net worth re­quire­ments.

Model var­i­ous al­ter­na­tive cap­i­tal sce­nar­ios for your credit union. Our in­ter­nal anal­y­sis shows most LICUS, un­der rea­son­able as­sump­tions, would find sec­ondary cap­i­tal ac­cre­tive to their fi­nan­cials. Here’s a sim­ple sec­ondary cap­i­tal ex­am­ple for a $1 bil­lion credit union lever­ag­ing $5 mil­lion in cap­i­tal. The credit union could grow its as­sets by more than $61 mil­lion, in­creas­ing ROE by 60 ba­sis points while main­tain­ing its net worth ra­tio. How­ever, sup­ple­men­tal cap­i­tal would have a dif­fer­ent im­pact.

For is­su­ing sup­ple­men­tal cap­i­tal, con­sider po­ten­tial ef­fects on net worth and RBC ra­tios. Un­der pro­posed guide­lines, sup­ple­men­tal cap­i­tal would not count to­ward the net worth ra­tio and would ac­tu­ally worsen the ra­tio for any credit union that does not qual­ify as a LICU. Con­sider a $500 mil­lion credit union with a 10 per­cent net worth ra­tio that is­sues $10 mil­lion of al­ter­na­tive cap­i­tal. If is­sued as sec­ondary cap­i­tal, its net worth ra­tio would rise to 11.76 per­cent, but if is­sued as sup­ple­men­tal cap­i­tal, its net worth ra­tio would fall to 9.80 per­cent.

In both cases, the credit union added a layer of cap­i­tal to pro­tect mem­bers and the Na­tional Credit Union Share In­sur­ance Fund from losses. In the lat­ter case, its net worth ra­tio would not re­flect its im­proved cap­i­tal po­si­tion. Con­se­quently, we be­lieve only well-cap­i­tal­ized credit unions are likely to pur­sue sup­ple­men­tal cap­i­tal, even though it would pro­tect mem­bers from losses and in­crease the credit union’s loss-ab­sorb­ing ca­pac­ity.

Given asym­met­ric ben­e­fits sup­ple­men­tal cap­i­tal would pro­vide, we en­cour­age NCUA to con­sider of­fer­ing al­low­able in­cen­tives to credit unions that se­cure sup­ple­men­tal cap­i­tal (e.g. al­low credit unions to take sup­ple­men­tal cap­i­tal into ac­count when con­sid-

er­ing its abil­ity to en­gage in cer­tain in­vest­ment ac­tiv­i­ties, eval­u­at­ing a credit union’s over­all fi­nan­cial health, etc.).

While is­suance of sec­ondary cap­i­tal has been lim­ited, we sense a grow­ing in­ter­est and aware­ness of al­ter­na­tive cap­i­tal ben­e­fits, driven by the grow­ing num­ber of LICUS and up­com­ing RBC re­quire­ments for com­plex credit unions. De­vel­op­ing a strong mar­ket will re­quire balancing is­suer and in­vestor needs, such as: • Al­low­ing sec­ondary and sup­ple­men­tal cap­i­tal to be pledged by the ac­count in­vestor as se­cu­rity for a loan or other obli­ga­tion. • Grant­ing in­vestors and credit unions the dis­cre­tion to de­ter­mine whether to re­deem a sec­ondary cap­i­tal ac­count in the event of a merger. Pre­pay­ment and call pro­vi­sions are im­por­tant levers for is­suers and in­vestors and should be al­lowed but not re­quired. As­sum­ing a prag­matic bal­ance of needs, lim­ited reg­u­la­tion and low is­suance costs, we see a num­ber of po­ten­tial pur­chasers of al­ter­na­tive cap­i­tal, in­clud­ing in­sur­ance com­pa­nies, pen­sion funds, as­set man­agers and other in­sti­tu­tional in­vestors.

We also need to ed­u­cate po­ten­tial in­vestors on the value, safety and sound­ness of credit unions. For ex­am­ple, avail­able FDIC (failed bank list) and NCUA (NCUSIF re­ports show­ing failed credit unions) data from 2008 to Q1 2017 shows three times more bank fail­ures than credit union fail­ures. In­vestors want sta­bil­ity and a high de­gree of con­fi­dence they’ll get paid back. The credit union mar­ket is rel­a­tively pre­dictable, sta­ble, and in our view, • of­fers a strong risk-ad­justed re­turn for po­ten­tial in­sti­tu­tional in­vestors.

Mod­ern­iz­ing cap­i­tal reg­u­la­tions to pro­vide credit unions ro­bust and di­verse ways to man­age their cap­i­tal has started. Ad­di­tional work lies ahead, so be ready to share your per­spec­tives when NCUA is­sues its no­tice for pro­posed rule­mak­ing.

THERAN COL­WELL is vice pres­i­dent of lend­ing loan growth for CUNA Mu­tual Group. Con­tact him at Theran. Col­[email protected]­na­mu­, or 608.665.8541.

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