In January, Central1 released a discussion paper to all Class A members (credit unions) titled “Capital Call and Double Majority Resolutions”. Central1 t plans to present resolutions to the Central1 AGM in May, based on the two proposals outlined in the paper. Each credit union board will have to determine their credit union’s position on the discussion paper proposals and the potential resolutions to amend the Central1 Constitution and Rules. I prepared these comments for the board at my credit union and I thought they could be valuable to others.
Diverging interest blocks
Credit union consolidation has resulted in ‘bifurcation’ – two distinct types of credit unions; classic credit unions and super-sized credit unions. The former have been built around the traditional concept of a ‘common bond’ of membership – an affinity such as a common employer, a municipality/neighbourhood, an ethnicity, etc.. The very large credit unions employ ‘brands’ that are based upon no such affinity. This has resulted in a divergence in business strategies and interests.
Many large credit unions have become substantial independent enterprises. Notably, large credit unions do not require the services and supports of a Central in the way smaller ones do. Large CUs have the scale to do things ‘in house’ or to independently seek out other suppliers. Over time, the interests of large credit unions have driven a reduction in Central1 services and led to expanded user-pay pricing policies. These large credit unions now dominate by their size and there is significant concentration. The Central1 paper’s appendix shows that 18 of the 100 Class A members (BC and Ontario credit unions) hold 81% of the shares at Central1.
In my opinion, the Central1 discussion paper’s proposals serve the interests of these larger credit unions. First, in the way risk is redistributed and, second, in the way political control is concentrated.
#1 Mandatory vs Voluntary Capital Calls
The Central1 discussion paper provides an overview of the current Central1 Rules that allow the Central1 board to make a capital call if there is an “Extraordinary Event”, one that “would result in Central1 failing to satisfy its capital requirements”. Upon a ‘call’, all Class A members proportionately would be obligated to purchase more shares (to a maximum of “20% of Central1’s Tier 1 capital at the most recent fiscal year end.”). Central1 proposes to replace this with a voluntary capital call.
This current Rule provides Central1 with access to additional capital if needed, or ‘contingent capital’. The concept of contingent capital is integrated into the BASEL III international model for capitalizing banks. The BASEL III framework sees contingent capital such as ‘hybrid’ instruments/securities that are convertible to share capital upon a triggering event; the Mandatory Capital Call is substantially the same.
To rating agencies, creditors, depositors, counter parties, and regulators this contingent capital should be viewed favourably as it provides a level of ‘solvency insurance’. A provision for contingent capital such as this enhances the financial stability and resilience of Central1.
The principal concern driving this Central1 proposal to remove this ‘mandatory capital call’ is the risk borne by Class A member credit unions. Not all credit unions are comfortable with the prospect of a call and the potential for a call “to negatively impact many credit unions’ capital ratios.” It is not clear how many credit unions have expressed this concern.
In this respect, the problem is not well defined. The problem may be better defined as being within those credit unions expressing concern. Those credit unions who perceive undue risk to their capital ratios might consider other capital planning solutions.
Cutting to the quick, in financial terms, the current Central1 Rules give Central1 a set of ‘call options’ on all member credit unions and it appears that some credit unions do not think they are adequately compensated.
Are credit unions fairly compensated for taking on this risk?
- The primary benefit is stability and reliability of Central1 as a business partner;. Central1’s processing of transactions and provision of services day in and day out.
- At this time, Central1 pays nothing explicitly for this contingent capital, it is implicitly priced in Class A dividends, as determined by the board.
Is the Voluntary Capital Call option adequate?
- A voluntary capital call is similar to having no ‘call’ provision at all. This is the brinkmanship option. When needed, commitments would have to be negotiated. Many Class A members would hold back until a certain level of commitment from others is secured, and on whatever terms hammered out. It is potentially awkward.
- This option also likely results in an ‘unbalanced’ share structure, as the paper notes, further degrading the co-operative ownership and governance model at Central1. If, in response to a voluntary capital call, some members decline, Class A shares would not be aligned with credit union assets. This would mean similar size credit unions could have substantially different entitlements in member votes, elections, and the direct appointment of directors.
- Central1 acknowledges that a weak response to a voluntary capital call would likely be one “where regulator and/or government intervention will dictate the path forward for all of us.” Government will see its exposure here, so there are implications such as new higher capital requirements, which could be similarly undesirable for the same concerned credit unions.
The Central1 discussion paper touts an enhanced risk management regime at Central1, asserting that the potential need for additional capital is well controlled. I take this with a grain of salt. Before most financial crises – such as that in 2008 – most risk managers were confident that the risks in their institutions were well managed. And, further, this Mandatory Capital Call measure is only meant for an “Extraordinary Event”, likely one that risk models do not anticipate.
The potential consequences of removing this provision in the Central1 Rules are glossed over. Central1 states that it has not consulted the BCFSA. However, the BC capital adequacy requirements are to be revised by BCFSA this year, to make them more consistent with BASEL III principles. It is not clear why Central1 would pre-emptively remove the Mandatory Capital Call.
Removal of this Central1 Mandatory Capital Call Rule would transfer risk from all Class A members to an unknown number of ‘volunteers’ and government. The prospective volunteers would probably be credit unions that rely most heavily Central1 services, mid-size and smaller ones. I cannot see how these ‘volunteers’ or government would view this proposal positively.
RECOMMENDATION: I recommend the credit union not support this proposal to remove the Central1 Mandatory Capital Call. This is an issue that should be considered within the context of planned BCFSA revisions to capital requirements. And also, as may be appropriate, the issue may be addressed within capital planning at the ‘concerned’ individual credit union level.
#2 Double Majority Requirement
The requirement for a double majority was put in place when ‘proportional voting’ was adopted at BC Central Credit Union in 1984. This provision in the Rules means a resolution to amend the Central1 Constitution and Rules requires 2/3 majority of shares voted AND a 50%+ majority of credit unions voting (one CU – one vote). This rule was intended to provide smaller credit unions comfort and leverage, to prevent a relatively small number of large credit unions from seizing effective control of the Central.
The Constitution and Rules are the core corporate documents that form a contract among member/shareholders and the Rules deal with ‘membership’, shareholdings, board elections, powers delegated to the board, and similar matters. Changes are not frequently required, and the Constitution and Rules do not directly affect business decisions.
The Central1 discussion paper argues that the risk of undue shareholder concentration has been mitigated by the merger of the BC and Ontario Centrals, but that is a short-term view. The continuing mergers of credit unions, and the migration of credit unions to be Federal Credit Unions, will result in a declining number of Class A members at Central1. These trends do potentially leave small credit unions (/minority shareholders) in a less desirable position. The paper’s appendix shows that of 100 Class A members, the largest 5 credit unions control a majority of the shares/votes, the largest 10 represent a 2/3 majority.
The Central1 discussion paper also implies that the double majority has made little difference, “no special resolution has failed to pass… since 2016”. I’d contest that. I think the double majority requirement has caused some potential amendments to be withdrawn. Three years ago, Central1 floated a proposal to reduce the number of directors selected on a one CU-one vote basis, and that would have reduced the potential representation of smaller CUs on the board. The response from smaller CUs was not good and no resolution was presented. This experience seems to support the need for the double majority Rule.
The position of minority shareholders in a central, or any second-tier co-op, is substantially different from those in a publicly traded company. A Class A member is not able to simply sell their shares if they are unhappy with management. A Class A member is not just a shareholder but is also a ‘client’, in a long-term partnership that is fundamental to the co-operative business model. This combination of ownership and client relationships provides a justification for special provisions, such as a double majority requirement regarding substantive changes to the corporate entity.
Strategically, this double majority provision ensures some measure of ‘proportionality’ in the management of services and programs at Central1. It does not prescribe anything in particular, but this Rule provides small credit unions a clear means by which to express displeasure if management is not serving them well. This is most relevant when there are two distinct types of credit unions with differing interests and needs.
To be direct, abandonment of the double majority would make the votes of the smallest 60 credit unions irrelevant. Control would rest with the largest 30 credit unions who own @90% of the shares. Large credit unions could more easily alter the board structure, change share capital requirements, and/or restructure Central1.
Lastly, the discussion paper does not define the ‘problem being solved’. There were no important proposals noted that were upset by the double majority requirement. On the contrary, the current requirement may have resulted in a greater effort being made by Central1 to achieve a broad consensus on special resolutions. From this point of view, the experience has been good.
RECOMMENDATION: I recommend the credit union not support this proposal to remove the double majority requirement for future changes to the Central1 Constitution and Rules. This provision continues to provide community-based credit unions the comfort and leverage they need within Central1, so that their interests receive adequate attention.
These two proposals should be seen in their longer term context. The two Central1 proposals surface the ongoing tension between the two interest groups within Central1. One group looks for robust ‘second tier’ support and the other seeks a cost-efficient, limited scope, service provider. This plays out as a political struggle and these proposals are the latest foray.