What examples exist of supplemental capital for credit unions or other cooperative financial institutions in other countries?
After the 2008 global financial crisis, international agreements, such as Basel III, standardized capital requirements for any institution taking public deposits. While aimed at large international stockholder banks, these frameworks provided a more rigorous framework for cooperative or mutual financial institutions. Under Basel III, Common Equity Tier 1 (CET1) capital must meet the tests of either common shares or retained earnings. Basel III does not list instruments that fall within capital classifications. Basel III provides a 14-point checklist to test whether an instrument will qualify as CET1 capital. Since credit unions cannot raise capital by issuing common shares, how can credit unions raise additional capital beyond retained earnings?
Basel III notes that, “[This] criteria also apply to non-stock companies, such as mutuals, cooperatives or savings institutions, taking into account their specific constitution and legal structure. The criteria should preserve the quality of the instruments by requiring that they are deemed fully equivalent to common shares in terms of their capital quality as regards loss absorption and do not possess features which could cause the condition of the bank to be weakened as a going concern during periods of market stress.”
In many Latin American countries, credit union regulators set rules under which member shares qualify as CET1. To do so, they must meet tests of (1) ability to absorb losses and (2) permanence. Credit union CET1 shares must cover losses after retained earnings are exhausted and are subordinated to other claims.
To recognize paid-in shares as equity capital, the member cannot withdraw the shares. Doing so would likely threaten the institution’s stability, when it needs the stabilizing influence of capital most. The credit union must have the right to refuse the redemption. The shares are redeemable only at the credit union’s option, and then only under limited circumstances and without creating an expectation that the instrument will be bought back. The institution’s capital level should not decrease as a result of the redemption. Shares that would be redeemed at the member’s option without any limitations would not qualify. (See: Credit Union Shares as Regulatory Capital Under Basel III (August 2012))
In Europe, the European Union’s Capital Requirements Directive IV (CRD IV) recognizes that CET1 shares must be redeemable where national law includes the right of redemption of cooperative shares. The ensuing European Commission Credit Requirements Regulation (CRR) sets specific rules for financial cooperative institution cooperative shares as CET1 capital. The key is that the credit union must be able to refuse or limit the redemption of the member’s cooperative shares. One approach is to make the redemption out of the proceeds of newly issued shares. Exiting members can withdraw their shares by getting in the queue for new entering members to purchase them. Another approach is to allow share redemption up to a threshold, where the credit union remains above the minimum regulatory capital requirement. One other approach is to limit share redemptions to no more than 10% of shares. In these cases, share redemptions can only occur after year-end financial closing and compliance with capital requirements. (See: www.woccu.org/policyadvocacy)
In the United Kingdom, policy allows cooperative or mutual financial institutions to offer Core Capital Deferred Shares (CCDS). These are fully paid-in, permanent (non-redeemable) and subordinated to member shares. Distributions are fully discretionary, non-cumulative and determined each year by the board with a capped upper limit. These deferred shares are listed as standard equity instruments on the London Stock Exchange without voting rights. The cost for these deferred shares tends to be prohibitive for smaller mutuals. (See: Martin Stewart. “New Capital For Mutuals in a Basel III World.” 2014 World Credit Union Conference.)
In Australia, credit unions have operated with Basel III rules since early 2013. Credit unions and mutual building societies can issue a supplemental capital instrument called “Mutual Equity Interests.” If a “trigger event” occurs, such as the institution’s losses exceeding its retained earnings, a conversion clause allows the supplemental capital to convert to CET1 capital with a lower face value. For example, in a conversion, the supplemental capital holders could receive $3 in CET1 for every $10 held in supplemental capital prior to the trigger event.
Basel III is the framework in which many countries’ credit unions and regulators have established instruments for supplemental capital to support expansion of credit union services to underserved populations—beyond that which capital based on retained earnings allows. The two basic principles that drive the design of such instruments include the ability to absorb losses and permanence. Such instruments, by their nature, tend to be expensive to reflect their risk. While some are available to non-members, others of same or similar principles have also found market demand limited among membership.