This letter provides information about the authority of low-income designated credit unions (LICUs) to offer secondary capital accounts and establishes a consistent framework for the analysis and approval or denial1 of secondary capital plans submitted to the NCUA for approval.2
A federally chartered LICU generally has the authority to offer and issue secondary capital accounts to non-natural persons, whether or not they are members of that LICU, and to treat these accounts as regulatory capital under certain conditions. A federally insured, state-chartered LICU’s authority to offer and issue secondary capital accounts depends on applicable state law and regulation. Before any LICU may make any such offer, however, it must first receive regulatory approval.3 The NCUA will deny a secondary capital plan that it determines, in its sole discretion, to be out of compliance with applicable law or regulation, or constitutes an unsafe or unsound practice. Furthermore, the NCUA will generally deny a LICU’s secondary capital plan if that LICU is otherwise engaging in unsafe and unsound practices at the time of submission of the plan.
The guidance in this letter applies to the NCUA’s analysis and approval of a LICU’s request to offer secondary capital accounts. Field staff should consult the Examiner’s Guide and the National Supervision Policy Manual (NSPM) for additional information on examining and supervising LICUs, including those with outstanding secondary capital accounts. In the case of conflict between this letter and either the NSPM or the Examiner’s Guide, field staff must rely on this letter until the NSPM and/or Examiner’s Guide have been updated.
Field staff should also note that this letter is intended as a resource guide on secondary capital plans, and is not a substitute for applicable laws and regulation. In the case of a conflict between this letter and any applicable laws or regulations, field staff must rely on the applicable laws and regulations.
It is paramount that field staff remember that each LICU’s secondary capital plan is unique to that LICU. There is no “one size fits all” plan that will work for every LICU. As emphasized throughout this letter, a myriad of considerations inform and drive both a LICU’s decision to enter the secondary capital market and the NCUA’s decision to approve or deny a secondary capital plan. The NCUA’s analysis of a secondary capital plan is intended to ensure that a LICU complies with applicable laws and regulations and that its secondary capital plan represents a safe and sound endeavor for the credit union. The NCUA’s analysis is fact-specific to each LICU’s situation at the time a LICU submits its secondary capital plan for approval. Accordingly, a LICU should not assume that the NCUA’s approval of another LICU’s secondary capital plan implies that a similar plan will be approved by the NCUA for any other LICU.
Please direct any questions you have regarding this letter to your immediate supervisor.
In 1996, the NCUA Board (the Board) finalized § 701.34 of the NCUA’s regulations to permit LICUs to issue secondary capital accounts.4 The Board issued the 1996 rule to provide an additional way for a LICU to build regulatory capital in order to serve two specific purposes: (1) support greater lending and financial services in the LICU’s community; and (2) absorb losses to prevent the LICU from failing.5
In 1998, as part of the Credit Union Membership Access Act,6 Congress amended the definition of “net worth” in the Federal Credit Union Act (the FCU Act) to include secondary capital issued by a LICU, provided the secondary capital was uninsured and subordinate to all claims against the LICU, including the claims of creditors, shareholders, and the National Credit Union Share Insurance Fund (Share Insurance Fund).7
In 2006,8 the Board further amended § 701.34 to require regulatory approval of a LICU’s secondary capital plan before the LICU issues secondary capital. In the preamble to the final 2006 rule, the Board noted that LICUs had sometimes used secondary capital to achieve goals different from those for which it was originally intended. The Board also highlighted a pattern of “lenient practices” by LICUs issuing secondary capital, which contributed to excessive net operating costs, high losses from loan defaults, and a shortfall in revenue.9 The Board stated:
“These practices include: (1) Poor due diligence and strategic planning in connection with establishing and expanding member service programs such as ATMs, share drafts and lending (e.g., member business loans (“MBLs”) real estate and subprime); (2) Failure to adequately perform a prospective cost/benefit analysis of these programs to assess such factors as market demand and economies of scale; (3) Premature and excessively ambitious concentrations of USC to support unproven or poorly performing programs; and (4) Failure to realistically assess and timely curtail programs that, in the face of mounting losses, are not meeting expectations. When they occur, these lenient practices contribute to excessive net operating costs, high losses from loan defaults, and a shortfall in revenues (due to non-performing loans and poorly performing programs)—all of which, in turn, produce lower than expected returns.”10
The Board also stated:
“Promoting diligent practices in place of lenient ones cannot help but improve the safety and soundness of LICUs. Requiring prior approval of a USC Plan will strengthen supervisory oversight and detection of lenient practices in several ways. First, it will prevent LICUs from accepting and using USC for purposes and in amounts that are improper or unsound. Second, the approval requirement will ensure that USC Plans are evaluated and critiqued by the Region before being implemented. Third, for both NCUA and the LICU, an approved USC Plan will document parameters to guide the proper implementation of USC, and to measure the LICU's progress and performance.”11
A. Role of Regulatory Capital and Secondary Capital
Regulatory capital can protect a credit union against future losses and serve as a foundation for a credit union’s strategic initiatives and growth. Specifically, regulatory capital:
- Enables a credit union to deal with future uncertainties such as asset losses and adverse economic cycles,
- Allows a credit union to grow safely,
- Provides a means by which a credit union can meet competitive pressures as they arise,
- Facilitates access to liquidity sources should a LICU experience a sudden outflow of deposits,
- Provides confidence to credit union members that financial services will continue, and
- Protects depositors and the Share Insurance Fund.
Because secondary capital accounts generally count as regulatory capital for a LICU, these accounts can help a LICU achieve or maintain a prudent or desired level of capitalization more quickly than may be possible through building retained earnings. Secondary capital can also enable a LICU to expand lending and other services to underserved communities and can serve as a basis for the LICU to grow and achieve better economies of scale.
Such motivations may prompt a LICU to seek regulatory approval to offer secondary capital accounts. A LICU’s board of directors ultimately decides the credit union’s strategic reason(s) for seeking secondary capital authority. A LICU should base its decision on a prudent, strategic purpose that involves a financially sound approach with an appropriate risk-management framework.
B. Secondary Capital Account Requirements
While this letter focuses primarily on the requirement that a LICU submit a secondary capital plan for regulatory approval, § 701.34 of the NCUA’s regulations contains additional regulatory requirements related to secondary capital, which are briefly summarized below.12 The information below is not a substitute for the complete regulatory requirements contained in §§ 701.34(b), (c), and (d) of the NCUA’s regulations.
In relevant parts, § 701.34 provides that secondary capital accounts must:
- Be established as an uninsured secondary capital account or another form of non-share account,
- Have a minimum maturity of five years,
- Not be insured by the Share Insurance Fund or any governmental or private entity,
- Be subordinate to all other claims against the LICU, including those of shareholders, creditors, and the Share Insurance Fund,
- Be available to cover losses that exceed the LICU’s net available reserves and, to the extent funds are so used, a LICU may not restore or replenish the account under any circumstances.13 Further, losses must be distributed pro-rata among all secondary capital accounts held by the LICU at the time the loss is realized,
- Not be pledged or provided by the investor as security on a loan or other obligation with the LICU or any other party,
- Be evidenced by a written agreement between the investor and the LICU that reflects the terms and conditions mandated by § 701.34 and any other terms and conditions not inconsistent with § 701.34,
- Be accompanied by a disclosure and acknowledgment agreement as set forth in the appendix to § 701.34,
- Not be repaid, including any interest or dividends earned thereon, if the Board has prohibited repayment thereof under §§ 702.204(b)(11), 702.304(b) or 702.305(b), because the LICU is classified as critically undercapitalized; or if a LICU is new (as defined under § 702.2), as moderately capitalized, marginally capitalized, minimally capitalized, or uncapitalized,
- Be recorded on the LICU’s balance sheet,14
- Be recognized as net worth in accordance with the schedule for recognizing net worth value in § 701.34(c)(2),
- Be closed and paid out to the account investor in the event of a merger or other voluntary dissolution of a LICU, to the extent the secondary capital is not needed to cover losses at the time of the merger or dissolution (does not apply in the case where a LICU merges into another LICU), and
- Only be repaid at maturity,15 except that, with the prior approval of the NCUA, a LICU may repay any portion of secondary capital that is not recognized as net worth.16
In the 2017 advanced notice of proposed rulemaking, which in part discussed secondary capital, the Board noted that secondary capital would likely be considered a security for purposes of federal and state securities laws.17 Any LICU that issues a security must comply with all applicable federal and state securities laws and, therefore, may need to consult with securities counsel.
C. Secondary Capital Plan Regulatory Requirements18
Sections 701.34(b)(1) and (2) of the NCUA’s regulations (i) defines the requirements related to the submission of a secondary capital plan, (ii) identifies the minimum information a LICU must include in such a plan, and (iii) outlines the timeframe for the Regional Director to review and render a decision on plans submitted by a federally chartered LICU.19 Section 741.204(c) requires a federally insured, state-chartered LICU to submit a secondary capital plan required by § 701.34(b)(1) to both the applicable State Supervisory Authority (SSA) and the NCUA for approval.20 See “Federally Insured, State-Chartered LICU Secondary Capital Plan Requirements, Submission, and Review Deadline” in this letter for more information about the approval process for federally insured, state-chartered LICUs.
Before offering secondary capital, a LICU shall adopt, and forward to the NCUA (or, if applicable, to both the NCUA and the applicable SSA) for approval, a written secondary capital plan that at a minimum:21
- States the maximum aggregate amount of uninsured secondary capital the LICU plans to issue,
- Identifies the purpose for which the aggregate secondary capital will be used, and how it will be repaid,
- Explains how the LICU will provide for liquidity to repay secondary capital upon maturity of the accounts,
- Demonstrates that the planned uses of secondary capital conform to the LICU's strategic plan, business plan, and budget, and
- Includes supporting pro forma financial statements, including any off-balance sheet items, covering a minimum of the next two years.
It is important to note that the regulation specifically states that the above requirements represent the minimum information a LICU must include in a secondary capital plan.22 The reason the NCUA requires these items in the regulation is to determine whether the LICU’s plan complies with all applicable laws and regulations and is safe and sound. Therefore, implicit in these minimum requirements are the safety and soundness principles on which the NCUA’s analysis is grounded.
The NCUA may require a LICU to submit additional information depending on a variety of factors, including, but not limited to, the complexity of a proposed plan, the amount of secondary capital proposed to be issued, and the overall condition of a LICU. For example, the NCUA may request to review the proposed security to be issued, along with the identities of any potential investors and any applicable disclosures. In addition, the NCUA expects LICUs to provide supporting due diligence documentation that adequately captures all aspects of the financial strategies associated with the deployment of secondary capital in the plan. A LICU’s failure to provide the requested information to the NCUA in a timely manner could result in the NCUA’s denial of the plan.
Purpose and Maximum Aggregate Amount of Secondary Capital
A LICU’s secondary capital plan must identify the purpose for the secondary capital.23 To satisfy this requirement, a LICU typically needs to provide more than general statements about its purpose for using secondary capital. A LICU needs to articulate the specific reason(s), or strategy, behind the planned use of secondary capital.
There are a variety of sound reasons LICUs accept secondary capital accounts. Each LICU’s intended reason, or strategy, for using secondary capital should be the primary basis for the maximum aggregate amount a LICU states in its plan. If the stated maximum aggregate amount of secondary capital in a LICU’s plan significantly exceeds a level that corresponds with its stated purpose, the NCUA will typically deny the plan or approve a lesser amount of secondary capital that is consistent with the stated purpose. If the NCUA denies the plan or approves a lesser amount of secondary capital than requested by a LICU, the LICU may appeal such decision under Appendix A of Part 746 of the NCUA’s regulations.24
Outstanding secondary capital is included with other forms of borrowing for purposes of the maximum regulatory borrowing authority permitted under § 741.2 of NCUA’s regulations.25 Therefore, a LICU must ensure its plan will not result in an aggregate borrowing level that exceeds the regulatory limit. A LICU must also ensure that its secondary capital plan would not cause a credit union to be in violation of any other applicable regulatory limits or requirements (such as the maximum allowable limit of nonmember shares under § 701.32 of the NCUA’s regulations),26 or any written agreement or other approved plan with the NCUA.
When determining a maximum aggregate amount of secondary capital, a LICU needs to consider any other borrowing needs, as well as contingent liquidity needs, over the life of the secondary capital accounts. The NCUA typically will deny the LICU’s plan, or approve a lesser amount of secondary capital, if the credit union’s plan would cause the credit union to reduce its borrowing capacity to an unsafe level over the life of the secondary capital accounts.
The complexity of secondary capital strategies ranges from straightforward plans (for example, those that call for a one-for-one redeployment of secondary capital proceeds into cash, loans, and/or investments of the same aggregate amount) to more complex plans that reflect a combination of additional borrowings and asset redeployments, increasing risk and/or the size of a LICU’s balance sheet.
Specific examples of reasons a LICU might use secondary capital, and related considerations, include (but are not limited to):
- Restore regulatory capital to a minimum desired level. A LICU’s regulatory capital ratios may have declined due to unexpected losses, or because the credit union experienced strong and sustained asset growth that outpaced its ability to build regulatory capital through retained earnings. The NCUA recognizes that LICUs can experience financial setbacks, and that prudent use of secondary capital can help overcome them. However, the NCUA will generally deny a secondary capital plan for this purpose if the NCUA identifies material safety and soundness concerns. Examples of such concerns include, but are not limited to:
- A LICU does not have financial losses and risks within its asset portfolios under control.
- A LICU’s true financial condition cannot be determined at the time it submits its secondary capital plan for approval because of concerns about the accuracy of financial statements or sufficiency of loss reserves under GAAP.
- Retained earnings levels are so low as to expose a LICU to a high risk of having to charge any future losses to the secondary capital accounts, creating legal, reputational, and other risks for the LICU.
- A LICU has, or is engaging in, an unsafe growth strategy.
- A LICU’s projected earnings are insufficient to build or maintain retained earnings over time, which may force the LICU to increasingly rely on even greater levels of secondary capital if retained earnings were to remain very low or continue to decline over an extended period of time. Under these scenarios, a LICU would be exposed to a high degree of risk if it cannot issue suitable replacement secondary capital in the future.27
- Increase regulatory capital to a desired level based on risk. A LICU’s board of directors and senior management may determine the institution’s regulatory capital ratios are not high enough to support the credit union’s level of risk or risk tolerance. While this is not otherwise unsafe, the LICU’s risk profile may have changed due to changes in the economy, other external factors, or changes in the composition of the credit union’s balance sheet that occurred over time. A LICU’s board of director’s risk tolerance may also have decreased.28 Thus, the board of directors may prudently desire to increase the LICU’s regulatory capital commensurate with the credit union’s risk or the board’s lower risk tolerance. To the extent the costs and risks associated with the level of secondary capital desired are significant to a LICU, in particular, the NCUA will consider in the efficacy of a LICU’s capital plans and associated analysis supporting the need for additional regulatory capital.
- Increase regulatory capital to a desired level to support future growth or other member service initiatives. A LICU’s board of directors and senior management may determine they should increase regulatory capital ratios in advance of future growth or member service initiatives. For example, a LICU may want to grow to achieve operational efficiencies through economies of scale, want to expand the type of lending or member services it provides, or increase the risk (such as taking higher credit risk) of existing member services. This can be a prudent use of secondary capital, provided a LICU:
- Has sound future growth plans or member service initiatives that do not create undue risk to the credit union,
- Clearly understands the net overall impact on earnings over time (considering all costs and risks) under a plausible range of positive and negative scenarios, and
- Will manage any growth plans or new initiatives effectively. 29
Because the incremental increase in risk taken by a credit union can be significant, the NCUA generally views growth strategies that involve a high degree of leverage as higher risk.30 When adopting such a strategy, a LICU should carefully assess its plan to identify any material risks to earnings and net worth, and properly identify and measure the degree of risk posed by the strategy. When conducting such an assessment, 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. An assessment should have a two-year horizon at a minimum; assessing over a longer period may yield important results. In addition, analyses should address the sensitivity of any key underlying assumptions to reasonable changes in their amount/degree.
In particular, the NCUA will closely scrutinize any secondary capital plan that involves new products and services that a LICU does not have experience with, and any plan to significantly increase the level of risk of existing activities (such as granting existing loan products to low credit quality borrowers). The NCUA will generally deny any plan that would subject a LICU to a high degree of uncertainty about the credit union’s ability to handle any material financial and operational risks associated with the secondary capital plan.31
The NCUA also generally considers a secondary capital plan unsafe and unsound if it puts a LICU at a high risk of being increasingly dependent on secondary capital going forward to meet minimum regulatory capital standards under Prompt Corrective Action, or would result in a LICU’s failure if suitable replacement secondary capital cannot be issued in the future.
- Enhance earnings. A LICU can use secondary capital to increase regulatory capital. The higher regulatory capital, typically in combination with other funding sources, can increase the level of lending or investing a LICU could otherwise achieve. In some cases, a LICU can use the leverage created by this strategy to have the incremental revenue exceed the incremental expenses. This contributes to a net increase in earnings, which a LICU can use to build retained earnings at a faster rate. The leverage (funding) may raise assets more than it does earnings, resulting in a lower return on average assets ratio. However, this can still result in a higher accumulation of retained earnings compared with earnings over the same period without the leverage in place. The successful design of such strategies can be difficult to achieve, and come with a variety of risks (for example, credit, interest rate, and liquidity risks). The NCUA takes particular care to review a LICU’s related financial projections and scenario analysis for these types of secondary capital plans. The NCUA will generally deny a secondary capital plan for this type of strategy if it:
- Is not supported by comprehensive projections and scenario analyses that are commensurate with the complexity and size of the proposed leverage strategy, and that includes a well-documented and realistic range of assumptions, or
- Subjects a LICU to a high degree of uncertainty about the credit union’s ability to handle any material financial and operational risks associated with the plan.
Pro Forma Financial Statements
A LICU’s secondary capital plan must include pro forma financial statements, including any off-balance sheet items, covering a minimum of two years. Pro forma financial statements generally show the effects of proposed transactions as if they actually occurred. Pro forma financial statements are a routine, yet essential, tool for documenting and testing the soundness of the assumptions a credit union relies on to project future performance.32 Depending on a variety of factors that include, but are not limited to, the complexity of a proposed plan, the amount of secondary capital proposed to be issued, and the overall condition of a LICU, the NCUA may require a LICU to submit pro forma financial statements for a period longer than two years.
Secondary capital accounts can have a significant impact on a LICU’s revenues and expenses. Such accounts are interest bearing and can have a higher cost than most forms of borrowing because they are uninsured and subordinate to all other claims. There are also other potential costs associated with a LICU’s safe and sound oversight of secondary capital (for example, staffing needs, expanded credit union systems, third-party assistance, and other costs associated with expanding services).
A LICU needs to determine if the aggregate amount of secondary capital, coupled with other planned uses identified in its secondary capital plan, is appropriate given the institution’s risk-management processes and staff experience. Both the people and the processes should be prepared to handle the use of secondary capital. A LICU’s board of directors should ensure that the credit union can manage the volume and/or complexity of planned activities, especially in cases where such activities represent a material increase above what has been managed historically.
A LICU must determine if it can afford the secondary capital and associated plan. When combined with other growth and risk-taking activities, the potential impact on earnings and regulatory capital can be significant and difficult to measure. The rigor and complexity of the LICU’s supporting analysis should be commensurate with the amount, scope, and complexity of planned risk activities.
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. In addition, analyses should address the sensitivity of any key underlying assumptions to reasonable changes in their amount/degree. Forecasting earnings and regulatory capital under different market risk factors is a sound practice for credit unions. To properly identify and measure the range of potential outcomes, a credit union needs to conduct scenario analysis to see how different key assumptions affect earnings and net worth for a variety of plausible scenarios.
The rigor and sophistication of such analyses can range from basic to complex; a LICU’s secondary capital plan should reflect an analysis commensurate with the amount, type, and complexity of risk. Not all secondary capital strategies are complex. If a LICU is not pursuing high-risk or complex strategies, the LICU’s supporting analysis may only need to be relatively simple. The riskier or more complex a plan becomes (for example, heightened leverage, high yield strategies, etc.), the higher the expectation for the LICU’s analysis. Moreover, the more robust a LICU’s analysis, the easier it is for a credit union and the NCUA to evaluate and understand the impact and appropriateness of the proposed secondary capital use.
The NCUA expects a LICU to use sound practices when producing pro forma financial statements. When evaluating a LICU’s secondary capital plan pro forma financials, the NCUA will consider in particular whether a LICU:
- Performed a cost/benefit analysis (including impact on balance sheet and operations) for any new products or services.
- Developed pro forma financials that take into account a range of plausible assumptions (optimistic and pessimistic) for both growth and portfolio performance metrics.
- Used reasonable and supportable underlying assumptions to generate scenario analysis.
- Used underlying assumptions and treatment of assets and liabilities consistently across the various supporting analyses. For example, a LICU should be consistent, where appropriate, across the various risk assessments and forecasts, such as projected activity levels, interest rates on assets and liabilities, measures of on-balance-sheet liquidity, and underlying assumptions about growth and performance of assets and liabilities (defaults, prepayments, maturities, replacement of maturities, etc.).
- Addressed its ability, under pessimistic scenarios, to respond to adverse event risks under its contingency funding plan strategies (for example, credit deterioration in a recessionary environment, unmet growth objectives, adverse rate environments, etc.).
- Modeled the risk characteristics of increased borrowings and/or adding higher risk loans and investments to portfolios (if relied on in the secondary capital plan) adequately for credit, liquidity, and interest rate risk purposes.
In addition to the NCUA’s existing knowledge about the financial strength and management of a LICU, the NCUA will evaluate the supporting scenario analysis and pro forma financial statements to determine if a credit union has sufficiently identified, measured, and reported risks to the LICU’s board and incorporated them into the secondary capital plan materials.
Ability to Repay the Secondary Capital
A LICU’s secondary capital plan must explain the credit union’s ability to have sufficient liquidity to repay secondary capital obligations at maturity.33 Secondary capital plans generally involve a combination of new services and balance sheet activities, which introduce the potential to increase risk to earnings and capital if they are not adequately identified, measured, monitored, and controlled. A LICU should also guard against an additional key risk area: future threats to its liquidity. The ability to reliably estimate liquidity needs and changes in the LICU’s liquidity positions that result from secondary capital plan activities, over a multi-year horizon, is necessary to understand the potential future threats.
For example, a LICU that uses a leveraged growth strategy that significantly increases its credit, interest rate, and liquidity risks may find it has potentially excessive liquidity risk under some adverse scenarios. Excessive liquidity risk can arise from large increases in nonperforming loans and/or significant unrealized losses on investments. A LICU should understand how these risks arise, what drives such risks (for example, unmet growth targets, rising unemployment, recession, rapid changes in interest rates, etc.), and understand whether the risks could pose a threat when a secondary capital obligation comes due.
Under adverse economic conditions, a LICU’s portfolio can weaken, which can diminish its ability to raise liquidity in desired amounts quickly and at an affordable cost. This is why the regulation requires a LICU to explain how it will provide for liquidity when the time comes to repay a secondary capital account.
A LICU’s reliance on secondary capital can be destabilizing if the LICU fails to replace the secondary capital with net worth (typically by building its retained earnings) over time. If secondary capital matures during a time when a LICU is experiencing financial distress and is in a weakened capital position, the LICU may not be able to replace secondary capital with a new issuance. The market for a LICU’s issuance could disappear, leaving the LICU with an abrupt decline in loss-absorbing capital when it is most needed.
A LICU’s ability to replenish secondary capital depends on the credit union’s financial strength and liquidity at the time it seeks to reissue. A LICU cannot assume that investors will be available, or that the cost and terms of such debt will be the same as those of a maturing instrument. This underscores why a LICU needs to have a reasonable and supportable projection of its future liquidity positions under a variety of plausible scenarios.
The NCUA places a high importance on the quality of a LICU’s contingency planning, especially with regard to liquidity. When reviewing a secondary capital plan, the NCUA will determine whether a LICU’s supporting documentation adequately describes how it will provide liquidity to repay the obligation. When a LICU’s analysis demonstrates that it has sufficient capacity to handle liquidity needs under a range of outcomes, it is likely to meet the expectation that it can provide the liquidity to repay the obligation at maturity.
A LICU that fails to properly estimate liquidity needs under a range of possible economic conditions may need to submit additional information, or its secondary capital plan may be found deficient for safety and soundness reasons. For example, adding new types of loans or investments that increase the amounts of credit, liquidity, and interest rate risk above what a credit union has historically entertained can have a material impact on a credit union’s ability to repay secondary capital obligations under adverse conditions. It is imprudent to limit a risk analysis to a single expected scenario, especially if that scenario is based on overly optimistic assumptions for growth and asset quality.
As noted previously, the NCUA will typically deny a LICU’s plan, or approve a lesser amount of secondary capital, if the plan would cause a credit union to reduce its borrowing capacity to an unsafe level over the life of the secondary capital accounts.
Conformance to the LICU’s Strategic Plan, Business Plan, and Budget
A LICU should have a clear business objective for offering secondary capital as envisioned and must explain how the additional costs and risks are acceptable and consistent with the institution’s business model. The plan must explain why the secondary capital plan is consistent with the LICU’s mission, budget, and strategic goals.34 A LICU must also explain how (when necessary) its strategic plan, business plan, and budget will need to be updated if the secondary capital plan is approved.35 As part of this endeavor, a LICU will need to make clear that the credit union has the expertise to safely and soundly manage the planned use(s) of secondary capital or has budgeted to obtain the necessary expertise and will secure it before deploying an approved secondary capital plan. If a LICU does not clearly provide this information, the NCUA may request additional information or may find the secondary capital plan deficient.
II. Secondary Capital Plan Review Procedures
This section describes how Regional Directors and their staff review a LICU’s request for approval of a secondary capital plan. Additional procedures for processing secondary capital account plan requests are included in the NCUA’s National Supervision Policy Manual (opens new window).
A. Regional Office Responsibilities
Regional Directors are responsible for approving or denying secondary capital plans for federally chartered LICUs and concurring with the SSA’s approval for federally insured, state-chartered LICUs. A Regional Director is not obligated to approve a secondary capital plan they determine is unsafe or unsound or not in compliance with applicable laws and regulations. The regulatory requirements establish the minimum information a LICU must submit. 36 Regional Directors are responsible for reviewing and evaluating the information a LICU provides, and, when necessary, requesting additional information to ensure each plan represents an endeavor that is safe and sound and supported by appropriate due diligence.
When determining whether to approve secondary capital plans, Regional Directors assess a LICU’s financial and managerial strength and the suitability of its secondary capital plan. This assessment includes a determination of the quality of management, the credit union’s financial and operational condition, adequacy of risk management processes, and capacity to handle new and/or greater amounts of products and services—from both the operational and risk management perspectives. The decision to approve or deny a secondary capital plan accounts for all of these factors, in addition to the plan itself.
Because Regional Directors are responsible for evaluating a LICU’s secondary capital plan and capabilities, they should not provide specific advice or counsel about how a credit union should conduct its analysis, consult in any way on whom a LICU should rely upon for any third-party assistance, or provide detailed recommendations on how to resolve noted deficiencies.
When a Regional Director receives a request for approval of a secondary capital plan, regional staff will assess whether a LICU has developed a plan that is consistent with its stated mission, financial goals, and overall strategic objectives. Appendix A of this letter includes questions field staff will consider when assessing a credit union’s secondary capital plan.
When reviewing a secondary capital plan, regional staff may need to conduct calls and/or meetings with LICU management to discuss concerns with the plan or obtain additional supporting information. The purpose of such discussions is to obtain the information necessary to reach a determination. While general feedback from the regional office to an applicant throughout the process is expected, a LICU needs to demonstrate that it has (or can retain) the knowledge and expertise to design, explain, and support its plan.
Regional Directors only approve secondary capital plans if the acceptance and use of the secondary capital does not create an unsafe and unsound condition, or result in a violation of laws or regulations. A Regional Director will make a final determination to approve or deny a plan when they have fully assessed whether a LICU’s secondary capital plan identifies, measures, and controls the planned risk activities adequately based on the plan submitted and knowledge about the credit union.
B. Federally Insured, State-Chartered LICU Secondary Capital Plan Requirements, Submission, and Review Deadline
Section 741.204(c) of the NCUA’s regulations contains regulatory requirements for a federally insured, state-chartered credit union to issue secondary capital. The rule requires a federally insured, state-chartered credit union to:
- Have a low-income designation,
- Issue secondary capital in accordance with the terms and conditions authorized for federal credit unions pursuant to § 701.34(b)(1), to the extent such terms and conditions are not inconsistent with applicable state law and regulation, and
- Submit the plan required by § 701.34(b)(1) to both the SSA and the NCUA for approval.37
As indicated in § 741.204(c), a federally insured, state-chartered LICU may only issue secondary capital if it is permitted to do so under applicable state law.38 If the state in which a federally insured, state-chartered LICU is chartered does not permit secondary capital, the NCUA does not have the authority to permit a federally insured, state-chartered LICU to circumvent state law.
While a federally insured, state-chartered LICU seeking authority to issue secondary capital is required to submit its secondary capital plan to both its SSA and the NCUA, the applicable SSA must first decide whether to approve or deny the secondary capital plan. However, if that SSA decides to approve the secondary capital plan, it must obtain concurrence from the Regional Director.
Any timeframes associated with the approval of a federally insured, state-chartered LICU’s secondary capital plan are governed by state law and are not subject to the 45-day time limit applicable to the NCUA’s review of a secondary capital plan submitted by a federally chartered LICU. After an SSA has reached its decision on a federally insured, state-chartered LICU’s secondary capital plan, the SSA must obtain the NCUA’s concurrence if the SSA intends to approve the secondary capital plan. The NCUA is not required to issue its concurrence within 45 days from either the receipt of a secondary capital plan from a federally insured, state-chartered LICU or the receipt of an SSA’s decision to approve a federally insured, state-chartered LICU’s plan.
Finally, because the NCUA only concurs with an SSA’s decision, there is no regulatory requirement for the NCUA to issue any correspondence directly to a federally insured, state-chartered LICU in response to a submitted secondary capital plan. Any correspondence from a Regional Director to a federally insured, state-chartered LICU regarding its secondary capital plan is strictly a matter of courtesy and does not impact any deadlines that may be imposed on an SSA by applicable state law.39
C. Assessing Secondary Capital Plans and Due Diligence
This section provides additional context about how the NCUA assesses secondary capital plans. The information provided is not intended to be an exhaustive list of all factors the NCUA may need to consider in evaluating a credit union’s secondary capital. Each secondary capital plan is unique to the applicant LICU, and the evaluation of secondary capital plans is a fact-specific engagement that varies based on the unique characteristics of each LICU.
As a reflection of the unique characteristics of each institution, the NCUA does not expect LICUs to submit identical or nearly identical plans. Submission of a plan that is not specific to the credit union may be indicative of a lack of due diligence on the part of the credit union’s board of directors and management and may result in NCUA denying the plan.
As with any risk-taking activity resulting in material exposure, a LICU has a responsibility to conduct adequate due diligence as part of a planned secondary capital issuance. Some LICUs may rely on the assistance of third-party vendors to produce a secondary capital plan, including the supporting due diligence analysis. The use of third parties can be an effective way for a LICU to augment its analysis, develop an appropriate plan, and connect with potential buyers for secondary capital obligations. A LICU with limited resources or expertise may determine a vendor is a suitable way to assess whether secondary capital makes sense for the institution. The NCUA respects a LICU’s right to seek third-party assistance, and views the decision to engage third-party assistance as a business decision of the credit union.
The NCUA will assess the extent of credit union management’s involvement in the development of the plan and whether a LICU relied on third-party vendors in supporting its analysis. 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 union’s legal and business interests. To do so, the NCUA needs to understand the terms of the third-party agreement, including whether the:
- Vendor prepared the plan and/or its supporting analysis.
- LICU will continue to use the third party for ongoing management and reporting of risk.
- LICU performed an adequate third party due diligence review (see NCUA Letters to Credit Unions, 01-CU-20, Due Diligence over Third Party Service Providers and 07-CU-13, Evaluating Third Party Relationships).40
- LICU is contractually obligated to conduct any future business transactions with the vendor (for example, analytical services, funding commitments, asset purchases or sales, loan participations, etc.).
- Vendor has any financial or other conflicts of interest regarding the LICU’s planned use of secondary capital (for example, the extent to which a vendor will be compensated based on a credit union’s use of secondary capital could call into question the objectivity of the plan and its supporting analysis).
The NCUA needs to determine whether a third-party arrangement adequately preserves a LICU’s legal and business interests.
When assessing a LICU’s secondary capital plan, regional staff confirm that each of the elements required by § 701.34(b)(1) of the NCUA’s regulations have been submitted and support the safe and sound use of secondary capital. As part of their assessment, Regional Directors will also consider a credit union’s financial condition, operational condition, risk management practices, and board oversight.
In evaluating a LICU’s request to offer secondary capital, the NCUA evaluates the credit union’s current and prospective financial condition. If a LICU is already experiencing serious financial difficulties, it may not have the financial or operational capacity to handle any additional challenges associated with secondary capital plans, especially riskier or more complex plans. In particular, the NCUA will evaluate secondary capital plans to determine whether:
- Planned activities potentially result in a concentration of high-risk characteristics (credit, liquidity, or interest rate risk) that can pose an undue threat to the LICU’s earnings or regulatory capital,
- Planned activities potentially worsen factors and trends that are contributing to existing safety and soundness concerns that have not yet been resolved, and
- The LICU has a reasonable exit strategy if its actual growth and financial performance were to fall short of necessary breakeven levels.
In evaluating a LICU’s secondary capital plan, the NCUA also considers its existing knowledge of the credit union’s current operational condition, its track record in managing new programs successfully, and prior experience (if any) with secondary capital. A key consideration is whether a LICU has the resident knowledge, experience, expertise, and resources necessary to handle any higher levels of risk. This includes having personnel in the right positions, as well as having staff with adequate experience and knowledge.
The NCUA will also evaluate whether management and the board have demonstrated the ability to promptly and successfully address existing and potential problems and risks, and the potential need to recruit additional staff or outsource specific activities to a third party.
As part of its assessment of a secondary capital plan, the NCUA will determine if a LICU is venturing into new or higher-risk programs and activities that appear to be outside the institution’s prior experience. A LICU should also assess this and explain how it intends to address any material gaps in the adequacy of technical staff and managerial oversight, and any lack of experience with the proposed strategies and activities in the secondary capital plan.
If a LICU is contemplating an increase in risk limits (and exposure) above its historical tolerance levels, it is critical that the board of directors has been adequately informed. The LICU board may also need to authorize changes in other board-approved policies. A LICU’s secondary capital plan should clearly and conspicuously acknowledge the risk implications and reflect a commitment from the board that any necessary changes to policies, procedures, and personnel (or third-party support) will be approved.
NCUA regional staff will appraise the quality, capability, and leadership expertise of the individuals who guide and supervise a credit union. To do so, examiners ask key questions, including (but not limited to):
- Does the credit union operate in compliance with laws and regulations?
- Does the credit union perform satisfactorily in key areas, such as its capital level, asset quality, earnings, liquidity, and interest rate risk management?
- Does the board of directors appropriately govern the credit union’s operations, including the establishment of its strategies and the approval of budgets?
- Does the board understand the key risks facing the credit union?
- Are management decisions consistent with the direction set by the board of directors?
- Does management respond quickly to address shortcomings resulting from failed internal control processes, audits, and examinations?
- Does management implement policies and a culture that promotes the safe and effective operation of the credit union?
- Does management inform the board of its progress in executing strategies and performance against budget?
These questions speak to the capability of a credit union’s leadership team, which are reflected in the Management (M) component of a credit union’s CAMEL rating. The Regional Director uses this information when considering a request for approval of a secondary capital plan because a credit union’s leadership is crucial in overseeing risk management for planned activities.
Risk-Management Processes and LICU Board Oversight
A credit union’s board of directors is responsible for establishing an adequate risk management framework through its policies, procedures, and risk limits. Policies and practices need to be consistent with the credit union’s business strategies and reflect the board’s risk tolerance, taking into account the credit union’s financial condition. In reviewing a LICU’s secondary capital plan, Regional Directors need to determine whether the credit union has or will take appropriate steps to address:
Existing policies and procedures that will need to be updated, and/or new policies and procedures that will need to be adopted,
The necessary staff expertise and qualifications to handle new activities are in place or will be retained, and
The impact of any planned borrowing and increased balance sheet leverage will be integrated properly into the credit union’s risk reporting and contingency funding plan.
While a LICU’s board of directors is ultimately responsible for the credit union’s strategic direction and policies, it is expected that they generally delegate the responsibility for executing and maintaining an appropriate risk management framework to senior management. Senior management then becomes responsible for both an initial assessment and the subsequent governance of secondary capital activities.
Board members should ensure that the types and levels of risk inherent in the secondary capital plan are within their approved tolerances, and direct senior management to revise a plan when appropriate. Ultimately, the board should approve the secondary capital plan for submission to the NCUA (and SSA, if applicable). The board ensures that their LICU is staffed appropriately to handle the planned activities, and should understand the associated risks. They should remain informed by being briefed periodically by responsible staff. This is consistent with NCUA expectations for governance over any major risk activity.
Credit unions may appeal material supervisory determinations, including a denial of a secondary capital plan or approval of a lesser amount of secondary capital than requested by a LICU, as outlined in Part 746, Subpart A of the NCUA regulations.41
Since 2018, several LICUs have appealed secondary capital plan denials. A record of such appeals is available on the NCUA.gov website. Plans that were the subject of appeals were generally deficient in documenting how a LICU would safely and soundly implement and manage its plan. As noted in the appeals decisions found on www.NCUA.gov, various Supervisory Review Committee panels agreed that the approval of a secondary capital plan requires the Regional Director to review the safety and soundness concerns that a plan raises.
IV. Additional Guidance Relevant to Secondary Capital Plans
This document outlines the unique attributes of secondary capital, and builds on previously issued NCUA guidance, including:
- 12 C.F.R. § 741.12, Liquidity and Contingency Funding Plans (opens new window)
- 12 C.F.R. § 741.2, Maximum borrowing authority (opens new window)
- 12 C.F.R. § 741.21, Administrative Actions and Appeal Process Regulation (opens new window)
- Appendix A to Part 741, Guidance for an Interest Rate Risk Policy and an Effective Program (opens new window)
- Interagency Policy Statement on Funding and Liquidity Risk Management (opens new window) (March 17, 2010)
- NCUA Letter to Credit Unions, 10-CU-01, Supervising Low Income Credit Unions and Community Development Credit Unions, (January 2010)
- NCUA Letter to Credit Unions, 07-CU-13, Evaluating Third Party Relationships (December 2007)
- NCUA Letter to Credit Unions, 05-CU-01, Supervising Community Development Credit Unions (February 2005)
- NCUA Letter to Credit Unions, 01-CU-20, Due Diligence over Third Party Service Providers (November 2001)
- NCUA Examiner’s Guide (opens new window)
Please direct questions on the information presented in this letter to your immediate supervisor or regional management.
Office of Examination & Insurance
A LICU should be prepared to discuss the following questions with their examiner and address them in its written plan and supporting due diligence materials. These questions are designed as a job aid; the answers will not serve as the sole basis for a regional director’s decision to approve or deny a secondary capital plan. The information collected through the use of this job aid will assist the NCUA in its analysis of a LICU’s secondary capital plan. It is paramount that field staff remember that each LICU’s secondary capital plan is unique to that LICU.
A myriad of considerations inform and drive both a LICU’s decision to enter the secondary capital market and the NCUA’s decision to approve or deny a secondary capital plan. The questions in this Appendix should not be used as a substitute for the considerations contained in the preceding supervisory letter or in applicable law and regulation.
- Does the secondary capital plan satisfy all regulatory requirements? (§ 701.34(b))
- Do planned borrowings under the secondary capital plan exceed the maximum borrowing authority? (§ 741.2)
- Has the LICU assessed its Liquidity and Contingency Funding Plan (CFP) to incorporate the proposed secondary capital plan activities, and is its CFP still adequate to identify and mitigate the projected changes to liquidity risk? (§ 741.12)
- Do all other planned activities under the secondary capital plan comply with NCUA regulations?
Staff Knowledge, Experience and Depth
- Is the LICU venturing into new types, or increased amounts, of services or borrowing and/or loan and investment activities outside of its current experience?
- If yes, does the LICU currently have adequate experience, knowledge and capacity to handle higher levels of risk?
- Is the new activity in line with the LICU board’s historical risk tolerances?
- What are the experience sets and staff resources available to actively manage any new or increased amounts of products and services?
- Is there a need to recruit and retain new staff to handle the planned activities?
- Was senior management involved in the development of the secondary capital plan and, if so, how?
- Does the LICU rely on third-party vendors for the supporting analysis presented in the secondary capital plan, and/or ongoing management and reporting?
- If engaging a third party, is the LICU contractually obligated to conduct any future business transactions with them (analytical services, funding commitments, asset purchases or sales, loan participations, etc.)?
- Has the LICU determined how planned activities align with its existing risk management policies, and are changes necessary? How will changes be made, if so?
- Has the board of directors been informed of any necessary changes to policy that result from planned activities, and have they approved them?
Due Diligence Considerations
- Did the LICU do a cost/benefit analysis, including the impact on its balance sheet and operations for any new products or services?
- Does the LICU have the staff and an effective process to analyze branch, product, and member data to understand how a growth strategy, supported in part by secondary capital accounts, will affect earnings and capital over time and in adverse financial environments?
- Did the LICU develop pro forma financials that take into account a range of plausible assumptions, both optimistic and pessimistic, for both growth and portfolio performance metrics?
- What underlying assumptions did the LICU use to generate a scenario analysis, and is the analysis reasonable and supportable?
- Are the underlying assumptions and treatment of assets and liabilities consistent across all financial applications the LICU uses to generate its risk management and pro forma results?
- Do the LICU’s pessimistic scenarios address the credit union’s ability to respond to adverse event risks under its contingency funding plan strategies (for example, credit deterioration in a recessionary environment, unmet growth objectives, adverse rate environments)?
- If the LICU’s secondary capital plan relies on increased borrowings and/or adding higher risk loans and investments to its portfolios, did it adequately model the risk characteristics of these transactions for credit, liquidity and interest rate risk purposes?
- Did the LICU consider other liquidity alternatives in the event planned liquidity sources are no longer available or additional liquidity is needed? What liquidity alternatives were considered?
- Does the planned activity potentially result in a concentration of high-risk characteristics (credit, liquidity, or interest rate risk) that can pose an undue threat to the LICU’s earnings or capital?
- Does the planned activity potentially worsen factors and trends that are contributing to existing safety and soundness concerns that have not yet been resolved?
- Does the LICU have a reasonable exit strategy if its actual growth and performance were to fall short of necessary breakeven levels?
Supervisory letters are official agency examination policy. These letters communicate guidance to NCUA field staff on regulations and exam procedures. Each supervisory letter focuses on a specific topic, providing background information and outlining any related regulatory and statutory requirements. Supervisory letters may also require field staff to perform certain procedures during an examination; in these cases, the letter will provide instructions to help field staff implement the procedures. Supervisory letters are intended to provide a framework for more consistent application of staff judgment with respect to conclusions about a credit union’s financial and operational condition, and related CAMEL and risk ratings. These letters also provide a consistent approach for evaluating the adequacy of a credit union’s relevant risk-management processes. Supervisory criteria detailed in a supervisory letter are not strict requirements, unless noted as required by law or regulation. The supervisory criteria contained in these letters are used by field staff to evaluate a credit union’s condition based on the preponderance of relevant factors. Generally, supervisory letters are shared with the public as an attachment to a Letter to Credit Unions.
1 The NCUA’s denial of a secondary capital plan does not prohibit a LICU from submitting a revised secondary capital plan. Alternatively, a LICU may appeal a denial under Appendix A of Part 746 of NCUA’s regulations. 12 C.F.R. §§ 746.101-746.113.
2 Secondary capital accounts are typically subordinated debt instruments, offered by a LICU, that serve as a temporary form of regulatory capital for the credit union. Regulatory capital for federally insured credit unions means financial statement elements that are included as net worth in the net worth ratio, and/or qualifying capital or net worth in the risk-based net worth requirement.
3 Under § 701.34 of the NCUA’s regulations, which governs secondary capital, a federally chartered LICU must receive approval of its secondary capital plan by the applicable NCUA Regional Director (including the Director of the Office of National Examinations and Supervision, each a Regional Director) before it may offer secondary capital accounts. Under § 741.204 of the NCUA’s regulations, a federally insured, state-chartered LICU must receive approval of its secondary capital plan by the applicable state supervisory authority (SSA), with concurrence by the NCUA, before it may offer secondary capital. See the “Federally Insured, State-Chartered LICU Secondary Capital Plan Requirements, Submission, and Review Deadline” section in this letter for more information.
4 61 FR 3788 (Feb. 2, 1996).
6 The Credit Union Membership Access Act of 1998, Pub. L. No. 105-218, 112 Stat. 913, 9299 (codified at 12 U.S.C. § 1790d(o)(2)(C)).
8 The last substantive amendments to the NCUA’s secondary capital regulations came in 2010 with the addition of language regarding secondary capital received under the Community Development Capital Initiative of 2010. 75 FR 57843 (Sept. 23, 2010).
9 71 FR 4234, 4236 (Jan. 26, 2006). Before 2006, a LICU was required to submit a copy of its secondary capital plan to the NCUA, but it was not required to obtain preapproval.
10 “USC” is an acronym for “unsecured secondary capital.”
11 71 FR 4234, 4237 (Jan. 26, 2006).
12 12 C.F.R. §§ 701.34(b), (c), and (d).
13 This generally means that when net operating losses exceed retained earnings, a LICU needs to use the secondary capital funds to cover the excess amount.
14 While § 701.34 requires a LICU to record secondary capital accounts on its balance sheet as “equity accounts,” Generally Accepted Accounting Principles (GAAP) require secondary capital accounts to generally be recorded as “debt.” See FASB (Financial Accounting Standards Board), ASC 942-405-25-3 and 25-4. The instructions to the 5300 Call Report require all credit unions to report any secondary capital in the Liability section of the Statement of Financial Condition.
15 Thus, a LICU may not issue a secondary capital account that amortizes over its stated term.
16 See 12 C.F.R. § 701.34(d). Also, provided the terms of the account allow for early repayment.
17 82 FR 9691, 9696 (Feb. 8, 2017).
18 Discussions in this section about how the NCUA approaches analyzing secondary capital plans must be read in conjunction with other requirements and expectations discussed throughout this letter.
19 12 C.F.R. § 701.34(b)(1).
20 Id. at § 741.204(c).
21 A LICU is not authorized to exceed what was provided for in the secondary capital plan approved by the NCUA or the SSA. If a LICU seeks additional authority, it must submit a new secondary capital plan. For example, a LICU was approved to issue $5 million in secondary capital. Once the LICU issues the $5 million in secondary capital, it may not issue additional secondary capital to replace any part of the approved $5 million that has matured, been redeemed, or extinguished. To do so, the LICU would need to submit a new secondary capital plan for approval.
22 12 C.F.R. § 701.34(b)(1).
23 Id. at § 701.34(b)(1)(ii).
24 Id. at §§ 746.101-746.113.
25 Id. at § 741.2.
26 Id. at § 701.32.
27 The probability of this occurring increases as the credit union depletes retained earnings, or when retained earnings becomes very small relative to the size of the credit union.
28 In this context, the LICU would maintain the level of risk inherent in its operations but hold more regulatory capital against the risk to lower its overall residual risk.
29 While it is preferable that the net financial impact over time of any new programs is positive, a well-designed plan could involve some level of a negative net return the LICU can afford to achieve some strategic objective valued by the credit union.
30 For the purposes of this letter, “leverage” refers to funding activity outside a credit union’s customary deposit base.
31 For example, the NCUA may deny a LICU’s secondary capital plan if the plan called for a high concentration of complex new loan products that the credit union did not have the historical experience or projected capacity to manage in a safe and sound manner.
32 71 FR 4234, 4237 (Jan. 26, 2006).
33 12 C.F.R. § 701.34(b)(1)(iii).
34 Id. at § 701.34(b)(1)(iv).
35 A LICU does not need to explicitly incorporate the secondary capital plan into its board-approved strategic plan, business plan, and budget until the plan is approved by the NCUA, and then only to the extent it is necessary and material enough to warrant a change to the credit union’s approved plans and budget.
36 12 C.F.R. § 701.34(b)(1).
37 12 C.F.R. at 741.204(c).
39 The NCUA will copy the federally insured, state-chartered credit union on the Regional Director’s written decision not to concur with the SSA’s approval.
40 NCUA Letters to Credit Unions 01-CU-20 (Nov. 2001); 07-CU-13 (Dec. 2007).
41 12 C.F.R. §§ 746.101-746.113.
42 NCUA Letters to Credit Unions, 01-CU-20 (Nov. 2001); 07-CU-13 (Dec. 2007).