Sub-Debt: A Long-Term Tool, Not a Post-COVID Reflex

The use of subordinated debt for supplementing a credit union’s regulatory capital ratio has been available to Low Income Credit Unions (LICUs) since the 1990s but was used lightly in the early years. At first, there was a general lack of understanding about sub-debt. It was only available to LICUs, capital levels were healthy enough without it, and it lacked regulatory emphasis or structure. However, the NCUA has more recently become more supportive of its use for capital management purposes as regulatory capital requirements have evolved in part due to credit unions coming under more capital pressure from the level of growth the industry has experienced.

As an example of the lack of understanding about sub-debt, years ago when I worked in the industry, I was able to qualify my credit union for its LICU designation. After obtaining the designation, I reviewed its advantages to the credit union with the board. When I mentioned the ability to issue subordinated debt to enhance regulatory capital, the initial reaction of the board was that it was somewhat incredulous that debt could qualify as regulatory capital and absorb losses similar to a credit union’s retained earnings.

While seemingly counterintuitive that debt is regulatory capital, historically subordinated debt has been used as a capital management tool in some way, shape or form. Up until the late 1980s when Congress made changes to the capital requirements for banks and thrifts, thrifts were able to issue subordinated debt and include it in their regulatory capital. Banks, with a holding company, sell subordinated debt out of the holding company and downstream the cash raised from the sale to its bank subsidiary. This down streamed cash is added to the bank’s paid-in capital, thereby increasing its capital level.

The NCUA took a major step forward in promoting secondary capital in 2015 when it issued a Secondary Capital Best Practices Guide, which provided significant clarification on subordinated debt terms, structure and the application process. Since then, the NCUA has continued to fine-tune its guidance on structure and who can be investors, and taken steps to streamline the application approval process.

As of June 30, 2021, 82 credit unions have issued outstanding debt totaling $533,895 million, an increase from the $176,650 million issued and outstanding on Dec. 31, 2015. While the average amount issued by institution is approximately $6.5 million, there are a number of institutions that have issued $10 million-plus, with the two largest issuers raising $159 million and $58 million of regulatory capital in multiple issuances of debt.

Reasons to Issue

Many chief credit officers will say that the best applicant to lend money to is one who doesn’t need it. While that hasn’t always been the case – and it begs the question of, if an applicant doesn’t need the money, why do they want a loan? – there is some applicability to a credit union issuing subordinated debt. In reality, the best time for a credit union to be an issuer of subordinated debt may be when it is comfortably “well-capitalized.”

The more recent popularity of subordinated debt is not a post-COVID reflex. It’s a long-term capital management tool that can be utilized to achieve various strategic outcomes and goals for credit unions, such as:

Increase capital ratio: The unexpected organic growth credit unions have experienced throughout the pandemic has been so significant that more credit unions are under abnormal capital pressure and selling subordinated debt can alleviate that pressure. I worked with a credit union that acquired a couple of banks recently, thereby increasing total assets and reducing its capital ratio. It used the issuance of secondary capital to increase its capital ratio to a more desirable level.

Support growth strategy: The NCUA application process for issuing subordinated debt requires a very well thought out strategic plan for the deployment of the new capital raised. One of the major components of the plan, if not the most important component, is your longer-term goals for asset growth. The growth plan is a result of many management decisions, including, among others: Organic growth, mergers and acquisitions, opening new branches and entering new markets.

Improve earnings: It’s all about the math. Sub-debt is generally issued for a 10-year term – there isn’t an arbitrage opportunity to sell sub-debt and reinvest the proceeds at a positive spread. So how does it improve earnings? Let’s say a credit union wants to maintain a minimum capital ratio of 10%. If that credit union sells $10 million in sub-debt, it can grow assets by $100 million and maintain its capital ratio at 10%. The cost of the sub-debt is on its $10 million face value but the earnings are on its asset growth, which is $100 million – it’s this kind of leveraging that creates the improvement in earnings.

Meet regulatory capital requirements: Historically, credit union capital management has been rather straightforward. There have been two capital requirements: A net worth to assets ratio and a rather simplistic, risk-based net worth requirement. As it stands today, starting next year the risk-based net worth requirement will be replaced by a much more complicated risk-based capital requirement based on risk weighting the balance sheet of each credit union, with the well-capitalized threshold being set at 10% of total risk weighted assets. In addition, at its July 2021 meeting, the NCUA approved a proposed regulatory change creating a Complex Credit Union Leverage Requirement, which could be used by a credit union in lieu of the new risk-based capital requirement. While the intent of the proposal may be to simplify a credit union’s capital management, this simplification comes at a cost since the initial capital ratio required to be considered well-capitalized will be 9% and increasing to 10% on Jan. 1, 2024. Many credit unions are going to need additional capital – sub-debt – to meet this proposed new capital standard.

Expand products and services (i.e. digital banking): The financial resources needed to research, develop/invest in and market new products and services requires capital because it generally results in the immediate increase in expenses, but it takes time to build the critical mass necessary to offset those costs with additional revenue. Sub-debt sold can be deployed to offset the negative impacts of growing and expanding products and services until they stand on their own.

The Regulatory Process

The NCUA has been more supportive of the use of sub-debt for meeting regulatory capital requirements and has provided the industry with very specific guidelines for the components of the regulatory application. In addition, the NCUA board has delegated the authority to ­approve sub-debt applications to the directors of its regional offices. Both of these actions are enabling credit unions to obtain regulatory approval in as short of a time table as 90 days, assuming that all application requirements are met.

A credit union can also apply for sub-debt multiple times, and can apply for an issuance amount larger than what it intends to initially issue and complete follow up issuances up to the total amount approved within certain time constraints. In this scenario, if the amount issued falls short of the amount approved, the regulatory approval for the amount of the short fall expires, but this does not prevent the credit union from applying again.

Where We Are Today

The NCUA’s mission is to protect and preserve the insurance fund – and with that in mind, within reason, a credit union can never have too much capital. The more capital, the better position a credit union is in to absorb any negative impacts to its bottom line. The NCUA recognizes the role sub-debt can play in the overall fiscal health of a credit union and is focusing more on making the application and issuance process more straight-forward and efficient.

At the end of the day, the historical cost of capital for a credit union has been zero since retained earnings is the source of the capital, so using sub-debt to supplement regulatory capital does increase a credit union’s cost of capital. However, the proper, strategic use of sub-debt for capital management makes that cost more than manageable.

Dennis Holthaus Managing Director Skyway Capital Markets Tampa, Fla.