Banks are worried about NCUA’s new sub debt rule. Should they be?

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A plan to let more credit unions raise secondary capital is unlikely to set off a sudden surge of activity.

While the National Credit Union Administration is considering letting hundreds of additional credit unions issue subordinated debt, there is a growing belief among industry observers that investor appetite might be limited.

“There’s a real question about what the demand is going to be for credit union issuance and what the cost is going to be,” said Peter Duffy, a managing director at Piper Sandler.

Since January 1996, only low-income credit unions have been allowed to access secondary capital.

But a subordinated debt rule, which the NCUA’s board approved for comment last month, would extend that authority to complex credit unions — those with more than $500 million in assets — and to newly formed institutions. Credit unions that expect to achieve a low-income designation or complex status within two years would also be allowed apply.

The NCUA estimates that nearly 300 more credit unions would receive debt authority on day one of the new scheme. But very few appear eager to take advantage of the opportunity, Duffy said, noting most of those credit unions already have net worth in the 11% to 13% range.

For credit unions without the low-income designation, net worth is calculated by dividing retained earnings by total assets. Low-income credit unions get to add subordinated debt to their numerators.

“You go by the reasons why an institution would raise capital — to support organic growth, mergers and acquisitions or both, or to supplement earnings that aren’t able to keep up with growth,” Duffy said.

“None of those things are really in place," Duffy added. "We know an awful lot of credit unions" with more than $1 billion in assets. "In our conversations, with very few exceptions, they have not indicated" that adding capital "is an important need.”

Crucially, the proposed regulation doesn’t expand the number of credit unions able to include subordinated debt in net worth calculations, said Dennis Dollar, principal partner at Dollar Associates.

“Only low-income credit unions can count it as net worth,” Dollar said.

“Complex credit unions that are not low-income designated can issue it, but they can only use it for risk-based capital purposes, not net worth," Dollar added. To be sure, the regulation "will provide much more clarity as to what NCUA expects from a subordinated debt application and should result in more approvals — but it will not create much appetite where there isn’t one already.”

Banking groups have consistently opposed any new powers for credit unions, and subordinated debt is no different. The American Bankers Association and Independent Community Bankers of America denounced the proposal the day the NCUA’s board approved it.

Both groups highlighted provisions that for the first time let credit unions sell debt to accredited investors, a prospect bankers claim could undermine credit unions’ cooperative ownership structure.

While some low-income credit unions have been bringing in more secondary capital, the overall amount remains relatively low. At Sept. 30, secondary capital on credit unions' books totaled $290 million, against assets of $1.54 trillion.

Michael Edwards, an Upper Marlboro, Md., lawyer with extensive experience representing credit unions, said most of the debt issuances he’s handled involved charitable foundations making low-interest loans to help new, low-income credit unions establish themselves.

By contrast, the subordinated debt rule requires credit union debt issuances to take on more of the appearance of bank deals, with robust disclosures and an offering document.

As that happens, credit unions “could begin to attract more investors looking for a return,” Edwards said. Credit union debt markets in Australia, Canada and Europe are dominated by investors, “and the same could be true in the United States.”

Still, the fact that most credit unions are barred from counting subordinated debt as net worth limits its usefulness, Edwards said.

“I think probably, on day one, things will stay mostly the same,” Edwards said.

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