'First, do no harm.' NCUA Board Member Todd M. Harper shares his thoughts on the agency’s proposed subordinated debt rule at the January 23 open Board meeting.
As Prepared for Delivery on January 23, 2020
Introduction
Larry, Tom, Julie, and Justin, thank you for your informative presentation on this much-anticipated and long-awaited proposed rule. In my view, capital is king. Clarifying the ability of certain credit unions to issue subordinated debt will better protect federally insured credit unions, their members, and taxpayers from losses to the Share Insurance Fund. A well-structured regulatory system of subordinated debt also has the potential to expand access to financial services for underserved communities.
Overall, the proposed rule before us strikes the right balance. In my view, staff have done a very good job of constructing a workable and appropriate regulatory structure that will well serve low-income, complex, and new credit unions. In short, the proposal resulting from their hard work deserves our approval today, so that industry stakeholders and other interested parties may now offer their comments on these matters.
Safeguard the Access of Low-Income Credit Unions
With this proposed rule, we would create an overarching framework that would govern the subordinated debt issued by low-income credit unions, complex credit unions, new credit unions, and credit unions anticipating becoming complex or low-income within 24 months of issuing the subordinated debt.
For nearly 25 years, low-income credit unions have prudently used secondary capital, a form of subordinated debt incorporated within the proposed rule, to increase regulatory capital levels to protect against future losses and serve as a foundation for strategic initiatives and growth. These funds have served as a valuable resource to some low-income credit unions, enabling them to provide much-needed lending and other member services to underserved communities.
Therefore, in expanding the use of subordinated debt within the credit union system, my first guiding principle was to ensure that as Hippocrates, the Father of Early Medicine, once advised his students: “First, do no harm.” We need to heed that advice. Consistent with the law, this proposal would preserve the access of low-income credit unions to secondary capital.
Despite our considerable study, I nevertheless recognize that there may be unintended consequences resulting from the proposal. I therefore invite those low-income credit unions that have previously issued secondary capital to review and comment on the proposed rule. If we need to refine the proposal to preserve access to secondary capital for low-income credit unions, I am very open to considering those changes, so long as they are consistent with the Federal Credit Union Act, securities law, and other statutory requirements.
Preserve the System’s Cooperative Structure
In reviewing the proposed rule, another principle guided my thinking: the need to preserve the mutual, cooperative one-person, one-vote structure of the credit union system. The introduction of funds into complex credit unions from parties outside of the credit union system has the potential to undermine the basis for the federal tax exemption.
Accordingly, the proposal before us would appropriately limit that outside funding to debt. By limiting the type of instrument to debt, we are protecting against the erosion of the mutual structure of the credit union system. Purchasers of the debt will lack voting rights and ownership in the issuing credit union. Moreover, the provisions in the proposed rule that would prohibit negative covenants ensure that the investors in subordinated debt cannot interfere in the operation of the credit union or impose conditions that would affect the safety and soundness of the credit union or the NCUA’s authority as a regulator and insurer.
In reviewing the proposal, I hope that commenters will share their views on the need to preserve the credit union’s cooperative structure and provide their thoughts on whether we need to modify the proposal to better protect the foundation of the cooperative system.
Protect the Investors Purchasing Subordinated Debt
One final issue was at the top of my mind when reviewing this proposal: the need to protect the investors in subordinated debt. This proposal would expand who can purchase subordinated debt from certain institutions to a broader group of investors, including natural persons who meet certain tests.
Subordinated debt has real risk attached to it. In the best case, investors can expect a steady stream of income for a period of time. In the worst case, investors may lose their entire investment. I am concerned that investors like the elderly retiree are protected. As such, the disclosures that would be provided with any issued subordinated debt need to be transparent, accurate, and verifiable. They also need to be absolutely clear that the subordinated debt product is not federally insured.
In my view, the investor disclosures contained in this proposed rule are strong, but I recognize that we may be able to do better. In this regard, I hope that stakeholders and investor advocates will provide their thoughts about whether we need to further strengthen these written notices. Additionally, given the lack of fiduciary duty owed by broker-dealers to investors, I am interested in learning whether we might need to adopt additional sales safeguards to protect natural persons who invest in subordinated debt.
Other Important Aspects of the Proposal
There are several other aspects of this proposed rule that I like and which are good public policy. For example, I like that the proposal would prevent the creation of inflated capital whereby two credit unions issued and sold subordinated debt to each other. Said another way, this proposal would prevent the creation of capital mirages.
In preventing a credit union that issues subordinated debt from purchasing the subordinated debt of other credit unions, the proposal would also protect against loss transmission that could occur if one credit union fails, leading to a domino effect whereby other credit unions in the chain of transactions fail. As we know far too well from the corporate credit union crisis, the downstream effects of a failure at one institution have the potential to magnify and grow if not properly abated in advance through sound regulatory policy.
Additionally, in terms of the review and approval process by the NCUA, I like that this proposed rule would extend the time horizon of submitted pro forma financial statements from two years to five years. I also like that this proposal would preserve the ability of the NCUA to ask for additional information and documents, when needed, to assess the viability of the overall transaction. This reservation of authority is appropriate.
Finally, I appreciate the conflict-of-interest rules contained in this proposed rule. The proposal would prevent the senior management and board members and their immediate families from purchasing the subordinated debt of the credit union at which they work or volunteer. The proposal would also codify a prohibition of the payment of direct or indirect compensation in the form of commissions, bonuses, or similar payments to any employee of the issuing credit union or a credit union service organization that assists in the marketing and sale of the issuing credit union’s subordinated debt. These are important limitations to include in the rulemaking.
In sum, this proposed rule is an important one for us to consider and seek input on. If implemented as proposed, the rule would affect 55 percent of all credit unions holding 90 percent of the total assets in the system. This proposed rule, therefore, has the potential to transform the credit union industry over the long term. As such, I hope that we will receive robust responses from a broad array of stakeholders and interested parties during the forthcoming comment period.