Lori Carmichael of Doeren Mayhew
By Lori Carmichael, CPA Shareholder, Doeren Mayhew

With the organic growth of credit unions and the increasing number of mergers and acquisitions, many times the question arises, should management consider secondary capital. To help you make sense of this trending capital alternative and determine if it is right for your credit union, this article will provide insight into what secondary capital is and answer questions you may have regarding it.

Q:  What is secondary capital and who is it available to?

A:  Secondary capital is uninsured, subordinated, convertible debt, or a loan, which counts toward the net worth of a credit union. It must take the form of subordinated debt and the secondary account holder’s claim must come after any other claims from shareholders, creditors and the National Credit Union Share Insurance Fund (NCUSIF). However, not every credit union can obtain secondary capital. Today, only those considered a low-income designated credit union (LICU) are able to obtain it.

Q:  What are the reasons for or against the use of secondary capital?

A:  Secondary capital allows a credit union to build temporary capital from external sources. Its best uses are for supporting profitable growth without diluting capital, expanding products or services, or maintaining positive arbitrage consistent with asset-liability matching. Secondary capital should not be used for avoiding Prompt Corrective Action, expanding or implementing new programs without adequate cost-benefit analysis and planning, or using excessive secondary capital concentrations instead of building net worth through undivided earnings.

Q:  What are the requirements to obtain secondary capital?

A:  According to National Credit Union Administration (NCUA) Regulations 701.34 and 741.204, the following requirements must be met to obtain secondary capital:

  • Investors are limited to non-natural persons (no individuals);
  • NCUA must approve a secondary capital plan before a credit union can receive secondary capital;
  • Secondary capital must have a minimum five-year maturity;
  • Secondary capital is not insured by the NCUSIF and is subordinate to all other claims against the credit union in liquidation;
  • Secondary capital cannot be pledged as security;
  • There are specifically mandated disclosures and contracts;
  • During the final five years of maturity, the secondary capital in a credit union’s determination of regulatory net worth is discounted at 20 percent per year; and
  • NCUA approval is required before the discounted amount of secondary capital can be repaid to the investor.

Q:  What is required by NCUA in the secondary capital plan?

A:  Before secondary capital can be accepted, a secondary capital plan must be approved by the NCUA.  At a minimum, the plan must include the following:

  • State the maximum amount of secondary capital the LICU plans to accept;
  • Explain how the secondary capital will be used and how it will be repaid;
  • Explain how the LICU will manage its repayment;
  • Demonstrate how the capital conforms with the credit union’s strategic plan, business plan and budget; and
  • Include supporting pro-forma financial statements for a minimum of two years.

Q:  Is there a limit on the amount of secondary capital a LICU can hold?

A:  Secondary capital is subject to the limit contained in Section 107 of the Federal Credit Union Act, which is 50 percent of shares and undivided earnings.

Q:  Can a loan be structured to amortize over its term to ease the lump-sum repayment burden or can secondary capital be refinanced at maturity?

A:  According to NCUA Regulations, the loan must be paid in a lump sum unless the credit union is approved for early repayment by the regional director, and the appropriate state supervisory authority if the credit union is state-chartered. If the credit union decides to “refinance” secondary capital, it needs to submit a new secondary capital plan and receive approval from the regional director (and state supervisory authority, if state-chartered) in accordance with Section 701.34 of the NCUA Regulations.

Q:  What does it mean to have the secondary capital discounted?

A:  To promote the building of capital with profitable operations to build retained earnings and not just rely on secondary capital, NCUA requires that secondary capital be discounted as it pertains to the credit union’s net worth.  To accomplish the discounting, the credit union will transfer the discounted portion from a capital general ledger account to borrowed funds.  The discounting of secondary capital that counts as net worth starts at five years from final maturity and is discounted 20 percent each year. Thus, if a credit union obtains secondary capital with a five-year maturity, in the first year only 80 percent of the funds would be considered as part of secondary capital. Additionally, the amount of secondary capital not recognized as net worth (borrowing portion) can only be repaid to the investor at maturity or earlier with NCUA’s written approval.

Q:  What happens with secondary capital in a merger?

A:  If a LICU merges into a non-LICU, the secondary capital will be closed out and paid out to the account investor to the extent the funds are not needed to cover losses at the time of the merger. If the continuing credit union in a merger is a LICU and does not want to keep the secondary capital account, it can request a redemption of the funds.

Q:  What are typical sources of secondary capital?

A:  Sources of secondary capital include, but are not limited to, the following:

  • Self-help group or foundations that share the credit union’s mission;
  • Banks that need the Community Reinvestment Act credit;
  • The credit union’s sponsor;
  • Other credit unions;
  • The U.S. Treasury’s Community Development Financial Institutions Fund;
  • National Federation of Community Development Credit Unions.

In conclusion, used as a net-worth cushion for growth, secondary capital can be an appropriate tool to grow in a safe and sound matter with the proper due diligence in place. A well thought-out plan on how secondary capital will be used should be developed before proceeding. However, it’s important to note it is not a fix for credit unions experiencing financial or operational problems.

Do you have more questions regarding secondary capital and how it may impact your credit union, contact the credit union CPAs at Doeren Mayhew, CPAs and Advisors.


Want to reach the author? Email Lori Carmichael or contact her at 704.341.0970.