Secondary Capital for CUs? Mission Accomplished!

Last month a credit union tried to buy a bank in order to gain market share, obtain economies of scale, and to diversify its loan portfolio. Good strategy, but the effort failed because federal law prohibits federally insured credit unions from counting anything but retained earnings as regulatory capital, and the credit union needed more regulatory capital to do the deal.


Last month a credit union tried to buy a bank in order to gain market share, obtain economies of scale, and to diversify its loan portfolio. Good strategy, but the effort failed because federal law prohibits federally insured credit unions from counting anything but retained earnings as regulatory capital, and the credit union needed more regulatory capital to do the deal.

The same law might prevent certain credit union mergers since proposed GAAP accounting rules require a merger to be treated as a purchase transaction, requiring the retained earnings of the target to be reclassified. For some, the impact might cause pro forma capital to be below regulatory minimums.

Managers at fast growing credit unions, large and small, are anxiously following developments related to secondary capital and GAAP. Those hovering around 7% capital levels are learning that NCUA must act decisively to penalize violations - it's the law. Credit union trade associations are offering ''hope'' that ''secondary capital'' is a possibility by encouraging state and federal legislation to allow it. Congress, however, is unlikely to change public policy on this issue since in 1998 it already voted and passed an alternative to allow credit unions access to secondary capital (more on this later). Additionally, for safety and soundness reasons, policy makers at many agencies remain opposed to allowing nonprofit institutions (credit unions) access to secondary capital.

Even if ''secondary capital'' became a reality for credit unions, a critical question remains unanswered. Who would buy these uninsured investments? Members? Other credit unions? Corporates? The answer is none of the above.

Members: offering the investment to members, would likely be possible only after following strict disclosure rules established by the Securities and Exchange Commission (SEC). Offerings of this sort are likely to be economical for only the largest credit unions, say over $100 million, because of cost and liquidity considerations, and only to the wealthiest members, because of SEC rules. During the savings and loan crises a certain California thrift, that failed, offered ''secondary capital shares'' to depositors and many bank customers suffered. Congress is unlikely to set the stage for a replay. Even if it did, credit union directors and CEOs may want to think long and hard about the risks of this scheme. The CEO of the unnamed California thrift spent time behind bars.

Other Credit Unions & Corporates: No again. The Federal Reserve Board and other policy makers would oppose a NCUA sponsored program to ''daisy chain'' insured deposits into credit union capital. Banks are prohibited from such activities because of the systemic risk to the FDIC insurance fund. The concept of ''I'll invest in your capital if you invest in mine'', has been thought of before. And, like the NCUA proposal to allow credit unions to swap business loan participations to avoid the business lending cap, policy makers should oppose these schemes because of the public relations debacle that would result after a high profile failure.

Potential sources of capital might include, public investors, insurance companies, foundations, trusts, mutual funds, etc. However, these investors are often prohibited from owning more than 5% of any single investment offering with the dollar amount limited to no more than 5% of the investor's funds; minimum investment levels and industry concentration limitations may also apply. Consequently, obtaining suitable amounts of investment capital, from these sources, will involve a significant distribution effort; and since credit unions remain largely unknown and misunderstood among investors, the amount of lifting to go from the concept of ''secondary capital'' to the reality could be paramount.

It's already been done.

Congress, in 1998, as part of HR-1151, voted to allow credit unions access to secondary capital by converting to the mutual bank charter. In addition to having access to secondary capital, mutual banks only need a 5% capital ratio (vs. 7% for credit unions) to be well capitalized. The 40% difference results in a competitive advantage - eliminating the credit union ''hidden tax'' that impacts market share and competitive scale.

Mutual banks currently have the ability to increase regulatory capital in a number of ways. As a mutual bank, subordinated debt may be offered, but it only counts as capital to meet the risk based capital requirement - not the ''core'' well capitalized minimum of 5%. A mutual bank, however, may form a subsidiary (REIT) funded with mortgages and offer investments in the subsidiary with the result of generating ''core'' capital. From a cost, liquidity, and marketing perspective, the minimum size offering Wall Street pays attention to is $20 million; and since the offering generally can't exceed 25% of resulting ''core'' capital, only the near billion dollar credit unions could play in this game.

The most common path for mutuals to raise capital involves organizing a mutual (non-stock) holding company (HC) [some former credit unions have done this with the help of CU Financial Services] which would own all the stock of the subsidiary stock bank. The HC then forms a ''trust''. The ''trust'' offers (directly or by pooling with others) shares to institutional investors, and down streams the proceeds to the subsidiary bank creating ''core'' regulatory capital. Another alternative is for the HC to get a ''commercial loan'' from a bank, insurance company, wealthy investor, or pension fund (by pledging the stock of the subsidiary bank) and the money could then be down streamed into the subsidiary bank, thus boosting ''core capital''. Some limitations exist, but the dollar amounts of borrowing and transaction costs are manageable - even for deals in the million dollar range.

Also, the bank or the HC can sell publicly traded stock in a member approved IPO. If a HC retains 51% of the stock, member ownership continues, with the board of directors elected (like a credit union board) by the depositors of the subsidiary bank.

In conclusion, if your institution is expecting ''secondary capital'' to be a part of the solution for your future development, you should take steps to convert to the mutual charter now. The process of going from a credit union to the marketplace for regulatory capital requires sound strategic planning, experienced advisors, and time to execute. To get the facts about these and other opportunities for your institution, including joining a ''federation'' of former credit unions with economies of scale and ready access to capital, please call Alan D. Theriault at (800) 649-2741




April 14, 2003


  • Very deceptive headline.
  • Alan presents some excellent insights. I don't agree that members would not be a good source. I also think uninsured shares could be a good opportunity to ESOP like alternatives. I do agree the political battle seems uphill all the way.
  • Clearly an excellent consulting opportunity for a credit union consulting firm.
  • Seems like a rather self-serving article aimed at generating consulting business. If secondary capital were to become available, I'll just bet CUNA Mutual and Leagues would want to be involved. Converting to a bank? I'd rather merge with another CU!