Prudential Regulation Authority Rulebook

2.1

A credit union will be expected to maintain the relevant minimum capital requirement specified by Rule 8.5 of the Credit Unions Part of the PRA Rulebook at all times. The PRA also expects credit unions to consider whether additional capital should be held above the minimum in order to meet the requirement in Rule 8.1 of the Credit Unions Part of the PRA Rulebook. For example, credit unions that are growing rapidly, providing mortgages, or corporate loans should consider holding additional capital in light of the additional risks to which they are exposed. A credit union providing credit cards would be expected to consider what additional capital is required in order to cover potential claims arising from Section 75 of the Consumer Credit Act 1974.

2.2

Credit unions should expect that the PRA may impose an additional capital add-on (ie via the PRA’s own initiative powers, as provided by section 55M the Financial Services and Markets Act 2000 (’FSMA’) ‘own initiative requirements’ or ‘OIREQ’), where there are specific risks present in a credit union (examples might include credit unions with high risk business models, high arrears, or governance concerns) and where a credit union has not taken up the PRA’s invitation to apply for a ‘voluntary requirement’ (VREQ) as provided by section 55M of FSMA.

2.3

A credit union is expected to notify the PRA immediately should it become aware that it is likely to fall below its relevant minimum capital requirement. It must comply with the immediate notification requirement in Rule 8.6 of the Credit Unions Part of the PRA Rulebook if its capital falls below the relevant minimum. 

2.4

Where a credit union’s capital ratio is below 5%, the PRA expects it to engage more fully with the PRA. In particular, the PRA will expect a credit union to engage on its ongoing sustainability and the PRA will challenge it to demonstrate its ability and capacity to produce, work to, and monitor a viable business plan. As part of that discussion, the PRA will expect it to engage on whether it has a viable future and if not, what plans it has to close in an orderly fashion, which could be by way of insolvent wind-up, solvent wind-down, or the transfer of its engagements to another credit union. 

2.5

Capital acts as a cushion to absorb unexpected losses, for example if members fail to repay their loans, or losses arise from fraud or operational incidents. Broadly speaking, for most credit unions, capital predominantly comprises of retained earnings (reserves). This capital is considered high quality capital (ie highly loss-absorbing) as it does not have any features that make it less able to absorb losses, such as a principal that needs to be repaid or a requirement to pay non-discretionary distributions.

2.6

Credit unions have limited access to a wider range of capital instruments; their capital may also comprise of deferred shares, subordinated debt, and revaluation reserves (see Rule 8.2 of the Credit Unions Part of the PRA Rulebook).

2.7

External capital investment (in the form of subordinated debt or deferred shares) can be important in supporting a credit union’s growth, particularly in the early years when a credit union is first established, to help it recover from financial shocks in the short term and to support growth plans or the expansion of services in a sustainable manner.

2.8

Subordinated debt is considered lower quality capital given the principal needs to be repaid (which carries refinancing risk) and coupons (the annual interest payments) are paid to service the debt rather than being returned to members as dividends.

2.9

Deferred shares, while they do not carry refinancing risk, usually carry a perpetual coupon although in some cases this can be discretionary and non-cumulative.

2.10

However, the PRA holds concerns that the use of material amounts of subordinated debt and interest-bearing deferred shares could have the potential to threaten the sustainability of a credit union if not used appropriately and prudently. Credit unions utilising such instruments must be able to demonstrate they are acting in the best interests of members, particularly if the capital arrangements mean that operating profit is in a large part used to service the capital coupons rather than serving as returns to members. Credit unions should carefully plan their approach to such instruments with a view to operational sustainability and viability. 

2.11

The PRA expects credit unions utilising such instruments to manage the associated risks: for example, the refinancing risk of subordinated debt and the perpetual nature of a coupon attached to deferred shares. For the avoidance of doubt, a credit union should not raise external capital in order to service capital coupons.

2.12

There is also concern regarding potential conflicts of interest arising from externally-influenced business models. Capital sourced from third parties should not have conditions attached that give preferential treatment to the third party. Credit unions should ensure that any potential conflicts of interest arising from the provision of capital are managed adequately.

2.13

For credit unions with total assets over £50 million, the PRA expects them to not hold more than 50% of their minimum capital requirement as subordinated debt; and that no more than 75% of the minimum capital requirement be comprised of subordinated debt and interest-bearing deferred shares. There may be circumstances where these limits may be exceeded. In such instances, the PRA would expect the credit union to provide sufficient details to satisfy supervisors of the credit union’s arrangements for managing the associated risks before proceeding with their plans to raise external capital above these limits.

2.14

Factors the PRA will take into account when reviewing such plans are:

1. (i) whether the capital arrangements provide investors with external influence over the credit union;
2. (ii) evidence that the interest rate and liquidity risks are being managed adequately;
3. (iii) the reasonableness and credibility of the credit union’s plans for growth (including how it would service the capital investment through distributable profits as opposed to raising further capital to pay coupons);
4. (iv)whether the credit union is contractually able to defer coupon payments and/or whether such payments are cumulative;
5. (v) whether the investment (for example, the rate of interest offered) represents a reasonable and justified risk-reward proposition; and
6. (vi) whether the credit union has provided a robust and credible plan for reducing reliance on external capital investment.

2.15

The capital instruments should not have any features that hinder recapitalisation such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified timeframe.