Alternative Capital – Not A Panacea

Alternative capital may not be a panacea for the capital woes of credit unions.

In a December 7, 2009 letter to Chairman Barney Frank, NCUA Chairman Deborah Matz noted a trend where some well-capitalized credit unions were discouraging consumer deposits because rapid deposit growth could negatively impact their net worth ratio subjecting the credit unions to prompt corrective action. With the exception of low income credit unions, the only vehicle for credit unions to build capital or net worth is retained earnings. Chairman Matz proposed allowing qualified credit unions to issue some form of alternative capital to supplement retained earnings.

What is alternative capital?

Alternative capital may include – uninsured certificate of deposits, subordinated debt, membership capital shares (MCS), and members’ paid-in capital.

However, under Basel capital rules, uninsured certificates of deposit and subordinated debt would not count as core capital, but rather as tier 2 capital. This would not provide the capital relief that credit unions are seeking.

The capital instruments that would most likely be viewed as core capital are membership capital shares and members’ paid-in capital.

Membership capital shares have some of the prerequisites to be counted as core capital: MCS can only be withdrawn, when membership is terminated. Moreover, credit unions have a legal right to refuse to pay out these minimum amounts if net worth levels are inadequate. However, MCS are currently covered by federal insurance from the NCUSIF, which disqualifies MCS as core capital. To be counted as capital, membership capital shares would have to become uninsured.

Therefore, member paid-in capital appears to offer the best prospect as a source of core alternative capital. Member paid-in capital is permanent, perpetual, and uninsured. Also, dividends would be treated as non-cumulative. Since, these funds are at risk, credit unions would have to pay a significantly higher dividend rate to compensate these investors for their risk.

However, several aspects may make members’ paid-in capital unattractive to credit unions.

First, in general, depositors are risk-averse. Therefore, credit union members are unlikely to put their money at risk.

Second, members’ paid-in capital is illiquid, because this investment cannot be sold.

Third, members’ paid-in capital may attract professional depositors who would want to force the credit union to go public.