Most U.S. credit unions generate capital entirely through retained earnings. But many financial services cooperatives around the world effectively use subordinated debt that counts as capital and doesn’t violate cooperative principles.
“Supplemental capital can enable individual credit unions to grow even if capital has been drawn down,” says John Lass, CUNA Mutual Group’s senior vice president of strategy and business development, speaking Monday during an America’s Credit Union Conference Discovery breakout session. “There are many examples of financial cooperative systems around the world that have effectively used alternative capital to build sustainable financial models.”
|Watch John Lass discuss the sustainability of the CU business model.|
Lass answered some common questions credit unions ask about the use of supplemental capital as a strategy to build a sustainable business. As part of the discussion, he explored the potential benefits and costs associated using subordinated debt to strengthen a business.
Lass cited Desjardins, which is based in Quebec and is the largest Canadian cooperative, as an example of financial cooperatives that have used subordinated debt to strengthen their businesses and gain market share.
Other cooperatives such as DZ Bank of Germany, Rabobank of the Netherlands, and the Farm Credit system in the U.S. have also tapped the capital markets to infuse their businesses with capital.
“As with any other debt, a business’s subordinated debt has expenses tied to it in the form of interest rates that are determined by the capital markets,” Lass says. “If a credit union is going to raise supplemental capital it must have a solid business plan in place to show an ability to repay the cost of the debt.”
For federally insured, natural-person credit unions, only those with a low-income designation currently may include debt capital as part of their regulatory capital. Low-income designated credit unions comprise only 15% of all federally insured credit unions and 4% of assets.
Lass says supplemental capital comes with certain costs and tradeoffs. In addition, because credit unions are tax-exempt, they don’t benefit from interest payment tax deductions enjoyed by for-profit institutions.
There are also nonfinancial costs associated with raising supplemental capital. Lass says subordinated debt may involve restrictive covenants that constrain future management options.
“The important thing to remember about raising alternative capital is that it’s not an end-all silver bullet,” he says. “In order for it to even be an option, a credit union must have the combination of a strong financial structure and a strong value proposition to [current] and prospective members.”