Could Alternative Capital Unleash CUs' True Potential?

Lack of access to alternative capital could constrain CUs' long-term growth.

September 1, 2010


Alternative capital


• Fallout from the economic crisis increases the need for alternative capital.
• Even well-capitalized CUs are limiting growth due to fear of capital constraints.
 Board focus: To use alternative capital, CUs would have to demonstrate management savvy and discipline.

When asked about a future credit union world without alternative capital, Jim Updike paints this picture: Large, sophisticated credit unions will recognize they need more capital to grow and serve members. The current way credit unions build capital, through retained earnings, takes too long in a low-earnings environment. This hinders growth, the introduction of new services, technology investments, and other improvements.

As a result, these institutions will conclude the credit union charter no longer meets their needs and will seek alternative charters—mutual savings banks or stock institutions.

The smallest credit unions will retain this charter. But before long, capital constraints will cause them to merge or otherwise cease operations.

So much for trade associations and regulators—no need for them in a quickly contracting industry.

That’s it. Curtain closed. No more credit union movement.

Lack of access to alternative capital and the absence of capital reform “would be the death knell of the credit union movement,” says Updike, president/CEO of $524 million asset Honda Federal Credit Union, Torrance, Calif. “If
you want an example of this, look at the savings and loan industry.”

Alternative, or supplemental, capital could allow credit unions to raise money from outside the institution and use it as a capital buffer, explains Mike Schenk, vice president, economics and statistics, for the Credit Union National Association (CUNA). It could take three forms: voluntary patronage capital, mandatory membership capital, and subordinated debt.

U.S. credit unions, besides those with low-income designations, are among the only financial institutions in the world lacking access to capital beyond retained earnings.

Fallout from the economic crisis has brought the issue to the forefront. “Credit unions haven’t been immune to the economic downturn,” Schenk notes. “Some credit unions, especially those in the ‘sand’ states—California, Florida, Nevada, Arizona—have come under a great deal of financial strain through no fault of their own. And now, many are recognizing a need to rebuild capital. That can be a time-consuming process, especially when earnings are low and when assets are growing.”

Gaining access to alternative capital would require congressional action—no easy task. But it’s “certainly within the realm of possibility and it’s something we’re fighting very hard for,” Schenk says. “It makes good public policy sense to increase the safety and soundness of the credit union system without asking the taxpayer to chip in. Taxpayers already have paid a high price to help bankers out of the mess they created.”

“We’ve seen very little growth in credit union market share during the past 20 years,” notes CUNA President/CEO Bill Cheney. “To remedy that, capital reform will have to be one of our top priorities. We have to be able to define our own future.”

Next: Why the need?

Why the need?

Even though credit union capital levels are strong overall—the average net worth ratio is 10%, CUNA reports—a National Credit Union Administration (NCUA) supplemental capital white paper released in April acknowledges “the unprecedented economic crisis in this country and the toll it is taking on every facet of the financial services industry.”

This has led to painfully low net income. As a result, some credit unions are taking drastic steps to maintain capital levels.

“We have credit unions that are paying members to take money out of the institution. That’s absolutely criminal,” Updike says. “I don’t blame these credit unions: They don’t have much choice if they want to maintain their capital ratios.”

Even healthy, well-capitalized credit unions are pulling back and limiting growth due to fears of inadequate capital, he says. That’s resulting in lost opportunities.

“Consumers are responding to what happened in the banking industry,” Updike says. “They’re saying, ‘I’ve had enough of banks and I’m looking for an alternative.’

“That alternative is credit unions,” he continues. But we’re not in a position to say, ‘yes, bring us that business’ because of margin compression, assessments for corporate stabilization, and bolstering the insurance fund. Without alternative capital, all we can do is shrink our balance sheet or not grow so we don’t run afoul of things like prompt corrective action [PCA].”

“There’s never been a time when trust and integrity have been more important to the American public,” agrees Tom Dorety, president/CEO of $5.4 billion asset Suncoast Schools Federal Credit Union, Tampa, Fla. “Credit unions have that, but we can’t take advantage of it.”

With a net worth ratio of less than 6%, Suncoast Schools Federal isn’t in a position to use alternative capital even if it were available. West Florida’s job and housing markets are among the nation’s worst, and one-third of the credit union’s loans are real-estate based.

Suncoast Schools Federal has implemented a vigorous net worth restoration plan, changing how it operates, reducing the credit union’s size, and aggressively setting aside funds for provision expenses and allowance accounts.

By 2012 or 2013, when Dorety expects the credit union to be well-capitalized, access to member capital and subordinated debt would help Suncoast Schools Federal provide more value to members.

“We’d grow to become more efficient, add more products and services, and be more convenient to members,” he says. “If done correctly, there’s no downside to alternative capital. It gives us more options. Our board and management need as many options as we can get to serve members in the best way possible.”

Credit unions that don’t want to raise alternative capital wouldn’t have to, Dorety adds. Those that do would follow regulators’ stringent safeguards governing the use of this tool.

“Let us prove our case that it’s something we can use and benefit from—and, more important, that our members could benefit from,” he says. “It’s not just about trying to grow, and we’re not begging to be bailed out. It’s all about giving us options down the road and serving members.”

Capital constraints and adhering to PCA makes it more difficult to serve members due to requirements that restrict deposit inflows and prohibit making certain loans.

“These aren’t just short-term measures. [New deposits and loans] help in the long run,” Dorety says. “They give you the opportunity to add sustainable member relationships that could serve the credit union for a long time. When you can’t offer attractive products, it’s much harder to grow, build for the future, maintain your brand, and do all those things that made the credit union successful for the past 50 years.”

It’s also expensive to have low net worth. Many agencies and vendors—the Federal Reserve, Federal Home Loan Bank, and Fannie Mae, among others—take net worth into account when dealing with credit unions.

“They give you a greater haircut on collateral, they expect you to fund transactions quicker, and they expect you to set aside reserves” when capital levels are low, he says. “Those things take money and resources we wish we didn’t have to spend. If we had alternative capital, those entities would recognize us as being in a better position and we’d be saving the credit union a lot of money.”

Next: Alternative capital in action

Alternative capital in action

Updike presents another scenario about how alternative capital would help credit unions: A credit union’s sponsor plans to build a new plant and hire thousands of employees. It wants the credit union to serve the new facility.

The credit union wants to do so but recognizes the effort will cause it to grow 10% per year for three years, affecting its capital level.

The credit union approaches the sponsor with a business plan: Lend us subordinated debt so we can boost our capital and improve our return on assets. That way, the credit union will be able to repay the debt after five years while maintaining a positive capital position.

“Without that supplemental capital, this credit union risks being less than well-capitalized,” Updike says, “and the regulator will say, as it probably should, ‘This isn’t a good situation. Your capital level is going in the wrong direction and we don’t want you take advantage of this growth opportunity.’ ”

This scenario is similar to one Honda Federal faces with its sponsor. Honda has a plant in Ontario, and legislation is pending in Canada that would allow cross-provincial-border operations. This raises Updike’s hopes that Canada will someday allow operations crossing international boundaries.

But Honda Federal—a well-capitalized credit union with 8% net worth—probably couldn’t take advantage of that opportunity because it can’t build capital with anything but retained earnings.

“Honda looks at us as a strong employee benefit,” Updike says. “It would be very supportive of us expanding to the plant in Canada, and certainly would be in a position to loan us subordinated debt. But I’m not sure we have the capital to 1) afford the expenses in doing that, and 2) accommodate that growth.”

'We've seen the enemy'

Passing legislation solely to give credit unions access to alternative capital isn’t likely, says Ralph Swoboda, principal for The ProCon Group. But he sees promise for including an alternative capital provision in a larger financial services bill.

“It probably will be next year before there’s another major piece of financial legislation,” he says. “That would be the vehicle for doing this. When Congress passes a law as big and comprehensive as the recent financial services legislation, it’s a sure bet they got something wrong, so they’ll have to correct it.”

To find the biggest barrier to obtaining alternative capital, Updike suggests looking inward. “We’ve seen the enemy and it’s us. For years I’ve heard people within the industry say that having alternative capital would jeopardize our mutuality. But all we have to do is look to other countries—especially Canada and Australia—which have had alternative capital for decades. They’ve put safeguards into those instruments that protect their positions as mutual organizations. There’s nothing to prevent us from doing the same thing.”

Dorety agrees. “Almost every not-for-profit cooperative in the world has access to capital other than retained earnings. None of them would tell you their membership has been diluted or reduced. If you use alternative capital from the proper voting and ownership perspective, there’s no way it would dilute credit unions’ member-owned cooperative structure.

“That mindset is narrow thinking based on fear of change,” he adds. “That’s the nice way to put it.”

Next: Alternative capital options

Alternative capital options

A supplemental capital white paper NCUA released in April outlines three possible models for alternative capital, each of which is uninsured and subordinate to the National Credit Union Share Insurance Fund:

• Voluntary patronage capital. This would allow members to contribute capital in the form of a long-term, uninsured, noncumulative capital instrument. It would be optional for natural-person members but not available to institutional members/investors. It would count toward both the net worth ratio and risk-based net worth ratio, subject to certain maturity and risk considerations.

• Mandatory membership capital. This would be a condition of membership and would allow credit unions to convert the par value share required for membership into capital. It would count without limit toward the net worth ratio and risk-based net worth ratio, and would highlight members’ ownership stake in the credit union.

• Subordinated debt. Limited to institutional investors, this debt would have a five-year minimum initial maturity with no early redemption option. Investors would have no voting rights or involvement in the credit union’s management or affairs. Fifty percent of these instruments, including retained earnings, would count toward the net worth ratio.

Subordinated debt is an attractive option because it’s a straightforward commercial transaction with fewer disclosure and reporting requirements than consumer investments, says Ralph Swoboda, principal for The ProCon Group. “You’re paying higher rates for that money but the investor is taking on the risk. Obviously, you have to generate more loans so you can afford the capital. But that’s a positive discipline that pushes you toward efficiency, not just making profits.”

Another plus: Institutional investors are more knowledgeable about potential risks than consumers. “If you sell subordinated debt to an insurance company or pension fund, they’re expected to understand the risk before they take it on,” he says. But it’s far different “when widows and orphans suffer a loss.”

A promising form of capital not mentioned in NCUA’s white paper is the payment of bonus dividends, based on members’ lending and saving activity, paid in the form of equity shares, Swoboda says.

“There’s no cost to it because you’re essentially transforming retained earnings into equity capital,” he explains. “You end up with the same bottom line and capital as if you’d kept the money as retained earnings. But it reinforces the idea that ‘it’s a cooperative; I own it.’ ”

Alternative capital, however, isn’t for every institution. Credit unions must be able to demonstrate they have the internal structure to measure and mitigate risk, a high level of sophistication regarding disclosures, and the ability to create business plans that support the extra capital.

NCUA reports a “mixed” experience with uninsured secondary capital in low-income credit unions. It identified four practices “that frustrate the good faith use of uninsured secondary capital”:

• Poor due diligence and strategic planning in connection with establishing and expanding member service programs;
• Failure to adequately perform a prospective cost/benefit analysis of these programs;
• Premature and excessively ambitious concentrations of uninsured secondary capital to support unproven or poorly performing programs; and
• Failure to identify and curtail programs that, in the face of mounting losses, don’t meet expectations.

Whatever form alternative capital would take, NCUA says there should be three key guiding principles: preservation of the cooperative mutual model, robust investor safeguards, and prudent safety and soundness requirements.

“We’d have to be perfectly clear that this money isn’t federally insured, it’s at-risk, and if the credit union were to go under, that money could be lost,” says Mike Schenk, CUNA’s vice president, economics and statistics. “There was some experience with secondary capital-like instruments in the savings and loan industry where this wasn’t made clear. Congress is aware of that, so part of the sales process will be convincing them this will be transparent.”


•  CUNA’s 2010-2011 Credit Union Environmental Scan Report
•  The ProCon Group, Middleton, Wis.