As Prepared for Delivery on January 23, 2020
In a legal career approaching 40 years, I have witnessed a number of financial crises.1 Although credit unions and the NCUA were not involved in each of these events, it is nevertheless important for credit unions and their regulators to appreciate the common denominators underlying this disparate array of financial disasters that created widespread economic pain and, with respect to the Financial Crisis of 2008–2009, the most severe economic downturn since the Great Depression.
Each of these events was caused, in substantial part, by the over-concentration of banking and other financial assets in narrowly circumscribed areas of lending and investment activity, such as commercial and residential real estate. Simply put, the banking and financial communities stuffed too many eggs in one basket and then proceeded to drop the basket with the expected result. Unfortunately, main street consumers took the brunt of the financial pain while Wall Street banks and related participants often escaped under the rubric of too-big-to-fail. Regardless of the over-concentration of financial resources and the resulting asset bubbles, the adverse economic consequences arising from these events would have been substantially mitigated if the relevant financial institutions had held sufficient levels of regulatory liquidity and capital.
Although I am confident that financial regulators have identified and appropriately addressed many nascent asset bubbles and other emerging issues, the vexing question remains as to what safety net exists if these regulators fail to address an acute market aberration in a timely manner. After all, at the time of excess, the economy is often booming, and market participants want the profitable financial activity to continue unabated. As history regrettably indicates, it is occasionally challenging for financial regulators to appreciate when a financial bubble is developing, and yet another well-touted business model is beginning to fray in a stealthy manner. At such time, naysaying, yet insightful, regulators are often chided as “not getting it” or being “old school” in their thinking.
With these reflections and perspectives as guidance, both the regulators and the regulated must at all times remain mindful that in a financial crisis or economic downturn, the fate of a financial institution depends upon its levels of liquidity and capital. At the height of a financial crisis, when asset values may have fallen or collapsed precipitously, nothing matters more than liquidity or the ability of a financial institution to pay its debts and other obligations as they come due. In tandem with the role of liquidity, capital serves as a buffer to absorb the losses booked from declining asset values that inevitably follow an economic downturn and the often dramatic and unexpected end of myopic financial activity and a bursting asset bubble.
As bedrock philosophy, prudent regulators operate with the following two fundamental mantras: more liquidity is better than less liquidity, and more capital is better than less capital.
Regarding the latter, however, under the Federal Credit Union Act credit union authority to raise capital for both the risk-based net worth ratio and the net worth ratio tests is materially limited. First, under the Federal Credit Union Act, credit unions are limited to issuing debt, as opposed to equity instruments. Stated another way, the Federal Credit Union Act does not authorize credit unions to issue equity capital in a private placement or a public offering.2 Second, even where the act provides the authority to issue debt, the permissibility of counting that debt towards the risk-based net worth ratio or the net worth ratio is statutorily limited to complex credit unions, low-income credit unions, and new credit unions.3 Under current NCUA regulation, non-low income credit unions may only build regulatory capital through the retention of earnings.
As a safety and soundness, prudential regulator, these limitations present formidable challenges to the NCUA that are not faced by the other financial institution regulators. Banks, by contrast with credit unions, may issue both equity and debt capital in public offerings and private placements for regulatory capital purposes and community banks may often avoid corporate-level income taxation by making a taxpayer-subsidized S corporation election under the Internal Revenue Code.4
In order to address the safety and soundness issues arising from the fundamental importance of credit union regulatory capital in a financial crisis or economic downturn, the NCUA Board, today, is presented with a proposed subordinated debt rule, the primary purpose of which is to permit credit unions without a low-income designation to raise regulatory capital for purposes of the risk-based net worth ratio test in full compliance with the Federal Credit Union Act. In addition, consistent with the act, the proposed rule does not permit non-low-income credit unions to raise regulatory capital for the net worth ratio test.5
While the proposed subordinated debt rule offers credit unions enhanced regulatory flexibility, it is not without meaningful limitations. Subordinated debt, by definition, represents non-equity capital that is deeply subordinated to the other obligations of the issuing credit union. In contrast with the common stock equity that is issued by money-center, regional and community banks to their shareholders, the instruments governing subordinated debt must obligate the issuer to pay interest and principal pursuant to contractual terms that may also include affirmative, negative and financial covenants, representations and warranties, events of default, and remedial and indemnification, among other rigorous, exacting provisions. The issuance of subordinated debt will also require the investment of management time as well as the employment of legal, accounting, financial, and investment banking resources.
Although subordinated debt is expensive and not easy to issue and maintain, its use may offer interested credit unions, in full compliance with the Federal Credit Union Act, with the ability to:
- Enhance their lending and other member-oriented activities;
- Assist the unserved, underserved and those of modest means better;
- Build their fields of membership; and
- Enrich their community service activities while also supplementing their regulatory capital.
If prudently underwritten and managed, subordinated debt will serve as a partial safety net from the adverse economic consequences that will inevitably follow from future asset bubbles, economic downturns, and poor lending and investment practices. Even though credit unions did not cause the Great Recession of 2007–2009 and the resulting taxpayer-subsidized bailout of Wall Street and the banking industry under the Troubled Asset Relief Program, both credit unions and this agency should remain mindful of the strict statutory limitations placed on the ability of credit unions to raise regulatory capital for safety and soundness purposes. It is long overdue that the NCUA propose a subordinated debt rule that will afford credit unions without a low-income designation the ability to supplement their regulatory capital in strict compliance with the Federal Credit Union Act. After all, from a safety and soundness perspective, more capital is better than less capital.
The decision to issue subordinated debt will ultimately reside with each individual credit union’s analysis of how the proceeds generated from issuance will fit into its specifically tailored business model. While some credit unions will refrain from issuing subordinated debt, others will consider it in the best economic interest of their institution and members to do so. In the final analysis, it is entirely a business decision provided the issuing credit union complies with the final regulations adopted by the Board and the issuance of the subordinated debt does not create a safety and soundness or consumer protection issue.
The proposed subordinated debt regulations are complex with a relatively steep learning curve for those who are not well versed in the issuance of debt instruments and compliance with securities law. It is critical that members of the credit union community and other interested parties review the proposed rule and offer comments. While our principal objective is to ensure the safety and soundness of the National Credit Union Share Insurance Fund and the credit union system itself, we are also keenly interested in better understanding the market viability and economic feasibility of Subordinated Debt instruments issued under the proposed regulations. We welcome and anticipate a rigorous round of comments.
As a safety and soundness, prudential regulator, I have advocated on behalf of a subordinated debt rule since joining the NCUA Board in 2014. As such, I wish to express my gratitude to those former NCUA Board members and others within and outside the credit union community who have enthusiastically supported the ability of credit unions to employ subordinated debt. In closing, I also wish to thank the NCUA staff for their prodigious and tireless efforts in drafting and vetting these proposed rules in a thoughtful and transparent manner. If approved today, please appreciate that this undertaking represents a work-in-progress with much time and effort remaining.
1 An abbreviated sojourn through recent financial meltdowns includes the following:
(i) The S&L debacle in the late 1980s was triggered by an over concentration of commercial real estate lending and a shortage of regulatory liquidity and capital.
(ii) The leveraged buyout, or LBO, crisis that followed soon thereafter developed from an over concentration of corporate lending and a shortage of regulatory liquidity and capital.
(iii) The lesser developed country, or LDC, crunch that hit the so-called money-center banks, arose from an over concentration of sovereign debt lending and a shortage of regulatory liquidity and capital.
(Iv) The dot.com crisis that greeted us at the turn of the millennium developed, in part, from an over concentration of tech lending and a shortage of regulatory liquidity and capital.
(v) The Financial Crisis of 2008/2009 that devastated Main Street and necessitated a gargantuan bailout of Wall Street was spawned by an over concentration of dubiously underwritten and sketchily securitized residential real estate loans and a shortage of regulatory liquidity and capital.
2 We have not canvased state law to determine how a particular state may treat this issue with respect to its federally insured state-chartered credit unions.
3 This highlights the limited exceptions where debt raised may be counted towards regulatory capital or used to determine if action under prompt corrective action is warranted. This may occur in the following instances: (1) LICUs - the FCUA requires that subordinated debt (secondary capital) count toward a LICU’s net worth under 12 U.S.C. 1757a(c)(2) and 1790d(o)(2); (2) Complex Credit Unions (defined as credit unions with more than $500 million in assets) - under 12 U.S.C. 1790d(d), the Board must establish regulations that “shall include a risk-based net worth requirement for insured credit unions that are complex, as defined by the Board based on the portfolios of assets and liabilities of credit unions”; this permits, but does not require, inclusion of subordinated debt in the RBNWR requirements for complex credit unions; note that a complex credit union can also be a LICU; and (3) New Credit Unions (defined by statute as those in existence for less than 10 years and with $10 million or less in assets) - under 12 U.S.C. 1790d(b)(2), the Board must prescribe a system of prompt corrective action for new credit unions; this permits the Board to consider subordinated debt issued by a new credit union when imposing prompt corrective actions, but it does not allow the subordinated debt to be directly counted toward net worth; for example, if a new credit union falls within a certain prompt corrective action category that might otherwise require certain corrective actions, the Board could consider the subordinated debt of the new credit union in deciding whether to forgo application of the action that would otherwise apply.
4 The FCUA also places limits on credit union growth through the field of membership, member business lending, investment authority, and other statutory restrictions. These limitations explain why very few banks elect to convert to a credit union charter, even though credit unions are not subject to federal income taxation. That is, the quid pro quo for the credit union tax exemption imposes severe statutory restrictions on the ability of credit unions to raise regulatory capital and conduct their business operations in a manner parallel to that of banks. The idea that banks are queued around the NCUA headquarters in hope of converting to credit union status is an urban legend. Specifically, banks - particularly those community banks that avoid corporate level income taxation by making a taxpayer subsidized S corporation election under the IRC – are, understandably, loath to voluntarily accept any of the following four competitive disadvantages to and statutory constraints on their business models and operations merely in return for a credit union charter:
(i) relinquish their ability to raise common stock and other equity capital under the FCUA capital restrictions,
(ii) materially limit their customer base under the FCUA’s field-of-membership restrictions,
(iii) restrict their commercial and corporate lending activity, and the fees generated thereby, under the FCUA Member Business Lending restrictions, and
(iv) narrow their profitable investment activity under the FCUA’s investment authority restrictions.
In contrast, credit unions and the NCUA must operate strictly within, among others, these four statutory limitations in a fully accountable and transparent manner. Simply put, if the credit union tax-exemption was of such value to community banks relative to the four distinct competitive advantages granted to community banks by Congress, many more community banks would have converted to credit union status a long time ago.
5 Interestingly, this latter restriction, although limiting to credit unions, serves as a mathematical check on the ability of credit union’s to over-lever their balance sheets by issuing subordinated debt.