By Theran Colwell
How capital is defined for most U.S. natural-person credit unions is unique compared to other financial institutions in the U.S. and globally. Most financial institutions worldwide, both for-profit and not-for-profit, can use various sources to grow capital and aren’t limited to just retained earnings.
However, a growing subset of natural-person credit unions with a low-income designation (LID), can raise secondary capital by issuing subordinated debt to nonmembers. Despite this powerful capital-raising ability, few LIDCUs have acquired secondary capital. Fortunately, the ingredients for a more robust capital market are coming together, and we may be witnessing the formation of an exciting and powerful new market. Here’s why:
A Growing Subset of Eligibility
The percentage and number of LID credit unions has grown significantly. In 2008, 15% of CUs had the designation, today it’s 44%. Larger credit unions also now have the designation. Of the more than 430 credit unions with greater than $200 million in assets, 40 have assets over $2 billion.1
Growth in the number and size of credit unions increases potential demand and helps with scale. Costs exist for both issuers and investors to bring a secondary capital note to close (underwriting, servicing, materiality/impact of funding). On a non-subsidized basis, we estimate the average note size would need to be around $3-5 million to balance the interests of both parties.
Strong Market/Economic Factors
Asset and loan growth have been very strong for an extended period (5th year of 10%+ annual growth), helping fill the balance sheets of many credit unions. While there’s room to keep growing, in the near future, continued asset growth beyond a CU’s ROE isn’t sustainable without additional means of raising capital.
Other factors include historically low interest rates, with the 10-year treasury around 2.6%, along with low borrowing costs on both a retail and wholesale basis. Spreads on non-rated financial institution subordinated debt have also tightened over the last couple of years to around 450 bps.3
Historical data has shown that credit unions could provide a good risk/return for investors. In fact, data from 2008 to Q4 2017 on failed banks and credit unions from the FDIC and NCUA, respectively, shows three times more bank failures than credit union failures. Investors want stability and a high degree of confidence they’ll get paid back.
Regulatory Factors and Market Interest
The NCUA has suggested possible regulatory reforms by issuing an Advanced Notice of Proposed Rule make on Alternative Capital. In addition, a handful of larger credit unions are now using secondary capital with several recent issues at more than $5 million per note.
All these ingredients point to increased potential demand and a tailwind for secondary capital. That’s great news for LID credit unions and the system as a whole. Capital is the foundation on which all assets, innovation and risk management are built! An established and maturing credit union secondary capital market would bring myriad benefits: enhanced ability to manage growth, market-driven risk assessments, improved efficiencies, support for de novos, and reduced systemic risk within the system.
Theran Colwell is VP of B2B Planning for CUNA Mutual Group. He can be reached at 608.665.8541 or theran.colwell@cunamutual.com.