Do’s and Don’ts of Secondary Capital

On September 16, the National Credit Union Administration (NCUA) published updated guidance outlining the criteria and procedures by which the agency’s Regional Directors will consider secondary capital plans submitted by low income designated credit unions (LICUs). A copy of Supervisory Letter 19-01 (the “Supervisory Letter”) is available on the NCUA website here.

More recently, the NCUA Board released a pair of decisions denying the appeals of credit unions seeking to raise secondary capital. The Board embraced the guidance of the Supervisory Letter and rejected an overly formulaic interpretation offered by the credit unions which would have frustrated the ability of the Regional Directors to consider safety and soundness as part of their deliberations.

LICUs have been permitted to accept uninsured secondary capital from institutional investors for more than twenty years. This alternative form of capital is intended (i) to provide an alternative for credit unions to support the provision of additional lending and financial services in their communities, and (ii) to absorb potential losses, thereby reducing the potential for failure.

The NCUA has highlighted the following specific examples of reasons for a LICU to raise secondary capital:

• Enhancing earnings;
• Restoring Regulatory capital to a minimum desired level; and
• Increasing regulatory capital to a desired level based on risk or to support future growth or other member service initiatives.

At Olden Lane, we assist credit unions, big and small, in their secondary capital efforts. Based on our experience and a survey of NCUA pronouncements on the subject, including the most recent guidance, we have developed this list of Do’s and Don’ts of a Secondary Capital Plan:

The Do’s

1. Be sure to Due Diligence Any Third Party Vendors. The Supervisory Letter warned: “The NCUA assesses the use of third parties when reviewing a plan from a LICU that has engaged the services of a vendor to evaluate due diligence to determine whether any third-party agreements adequately preserve the credit unions’ legal and business interests.”
2. Tie your Secondary Capital Plan to your CU’s broader overall strategy and its Annual Budget and Strategic Plan. The regulation authorizing secondary capital requires that a credit union requesting secondary capital demonstrate that “the planned uses of secondary capital conform to the LICU's strategic plan, business plan and budget.” The NCUA takes this requirement seriously. A recent NCUA decision on a secondary capital appeal found that: “[n]otwithstanding the credit union’s 90+ page Plan, failing to ensure basic financial information correlates to the credit union Strategic Plan and projections, renders the Plan inadequate.”
3. Address your Credit Union’s Financial and Operational Condition. The recent Supervisory Letter makes clear that “[i]n evaluating a LICU’s request to offer secondary capital, the NCUA evaluates the credit union’s current and prospective financial condition” and “…current operational condition.
4. Ensure sound, ongoing risk management processes and Board oversight from the Plan’s inception. The recent pronouncement of the NCUA’s Supervisory Review Committee in a secondary capital related appeal says it all: “During the oral presentation, the CEO noted that the credit union’s management plans to revise policies and risk limits after receiving approval to accept uninsured secondary capital. This is not sound risk management. If management has sound procedures in place, and accountability to their board, they will develop strategic and business plans that are within the credit union board’s existing risk policies.”
5. Engage management and the Board in the Secondary Capital planning. In our experience, the best plans are inclusive and done as part of a deliberate, ongoing and thoughtful process. It is almost impossible to be successful otherwise. In a recent appeals decision, the NCUA criticized a credit union for only providing its Board with a generic presentation that “discussed the pros and cons of secondary capital generally,” but not “the pros and cons of the specific proposal” that the credit union submitted to the agency for approval.
6. Include analysis and consideration of a range of plausible assumptions (optimistic and pessimistic) for both growth and portfolio performance metrics. The NCUA has consistently held that it will assess a plan based on its safety and soundness. It is incumbent upon a LICU applicant to makes its case that its plan can pass muster. As the Supervisory Review Committee recently noted in a secondary capital appeal decision: “the general forecasting aspect of the plan does not obviate the need for the credit union’s application and plan to correlate to and directly reflect essential aspects of the approval consideration and supporting financial information in all material safety and soundness respects.” The recent Supervisory Letter added that: “When developing pro forma financial statements, a LICU should include projections of expected earnings in a variety of plausible scenarios, including both optimistic and pessimistic assumptions, over measurement horizons that align with the credit union’s expected activities.”
7. Include scenario analysis addressing various risk assessments and forecasts. LICU applicants should be sure to model the risk characteristics (credit, liquidity and interest rate) of any increased borrowings and/or the effects of adding any higher risk assets (if relied on in the secondary capital plan). A LICU should understand how these risks arise and what drives these risks. Finally, a LICU should address whether the risks could pose a threat when a secondary capital obligation comes due.
8. Include liquidity assessments under pessimistic scenarios. The NCUA is particularly interested in liquidity. Separate and apart from secondary capital, the agency has long been focused on liquidity issues. After the financial crisis the NCUA joined the Interagency Policy Statement on Funding and Liquidity Risk Management and offered that a credit union “should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.” The agency’s Letter to Credit Unions 13-CU-10 was “designed to restore liquidity access, individually and system-wide, to a more prudential level.” And, the NCUA’s most recent rule change to more than double the limit on nonmember funding is intended to encourage credit unions to have robust and resilient liquidity strategies. In our experience, the agency will have little patience for a secondary capital plan that compromises that momentum.
9. Make management available to answer any NCUA questions during the 45 day review period. If the NCUA reaches out to request additional documents or engage management during the 45 day review period, it is typically a good sign.
10. Enjoy the process. In our experience, a secondary capital request forces a credit union to review its ongoing operations at 360 degrees. And, this is a good thing. To tie a plan out correctly and meet the standards of both 701.34 and the NCUA’s most recent guidance, a credit union will have to engage in a fulsome effort that examines the credit union as it is and imagines it as it can be. In our opinion, those credit unions that embrace the process and keep an open mind, will get the most out of it. 

The Don'ts

1. Leverage third party funding sources at unnecessarily high levels. The Supervisory Letter warns explicitly that “the NCUA generally views growth strategies that involve a high degree of leverage as higher risk.” Also, the five secondary capital plans that have been rejected in the NCUA appeals process were all cited for engaging in inappropriately high risk leverage strategies.
2. Be overly aggressive in the size of your first application. We encourage credit unions to walk before they run. Our FOIA requests continue to reveal that the NCUA is more likely to approve a smaller plan. For example during the period November 1, 2018 through July 8, 2019, the average approved plan was $1.95 million and the average denied plan requested $8.8 million of secondary capital.
3. Introduce new products and services as part of a plan without including a developed cost/benefit analysis of the strategy. The NCUA will specifically ask whether a LICU applying for secondary capital performed a cost/benefit analysis, including the impact on its balance sheet and operations for any new products or services that are expected to be launched following the infusion of secondary capital dollars. The agency has long identified the launch of new products and services without proper preparation as a lenient practice to be weeded out. The Supervisory Letter offered that “the NCUA will closely scrutinize any secondary capital plan that involves new products and services that a LICU does not have experience with.”
4. Submit more material than is required. Believe it or not, the NCUA does not enjoy reading superfluous materials. Submissions should be as fulsome as is required to address the standards of the secondary capital rules and satisfy the standards articulated in the most recent guidance. When it comes to secondary capital plan writing, bigger is not necessarily better.
5. Be inflexible in taking the NCUA’s feedback. We find that successful secondary capital candidates often improve on a denial with a resubmission. And so, we encourage our clients to be open to any feedback from the agency throughout the process.