Mutual Capital Certificates — A Potential Solution for a Pressing Need

Mutual banking organizations offer unique benefits to their communities but also face certain challenges that do not exist for stock institutions. One of these challenges is few options to raise capital beyond retained earnings and subordinated debt. Mutuals have long desired the ability to issue instruments with equity-like features and Tier 1 capital treatment. There are only a small number of recent issuances of mutual capital certificates fitting such description.

Hoping to help foster the nascent market for certificates, the Federal Reserve recently issued term sheets for certificates that would qualify for treatment as common equity Tier 1 capital (CET1 certificates) or additional Tier 1 capital (AT1 certificates), as well as updated frequently asked questions. These term sheets provide for certificates that are perpetual, represent paid-in capital and qualify as equity under generally accepted accounting principles standards.

Key Certificate Terms
The following are the key features of certificates as proposed by the Fed:

• Distributions. Certificates may pay noncumulative, nonmandatory distributions. CET1 certificate distributions cannot be based on a specific distribution rate specified at issuance. AT1 certificates may have a specified distribution rate, however, such rate can neither reset based on the mutual’s credit quality nor contain any feature that creates an incentive to redeem the certificate early.
• Redemption. Certificates would not have maturity dates and holders would not have rights to require redemption. The mutual may redeem the certificates with regulatory approval. AT1 certificates may be callable after a minimum of five years, with regulatory approval required to exercise the call option.
• Subordination. CET1 certificates are unsecured instruments that must be subordinated to all liabilities and other obligations of the mutual with respect to distribution payments and in receivership or liquidation. AT1 certificates are unsecured instruments that must be subordinated to depositors, general creditors and subordinated debt holders with respect to distribution payments and in receivership or liquidation.
• Liquidation rights. AT1 certificates may have liquidation rights to receive an amount per certificate, plus any declared but unpaid distributions, provided the mutual has assets available for distribution after payment of more senior obligations. No liquidation rights were specified for CET1 certificates.
• Preemptive rights. AT1 certificates may not have features that limit or discourage additional issuance of capital by the mutual, including provisions that would require existing certificate holders to receive compensation if a new instrument is issued at a lower price. No preemptive rights were specified for CET1 certificates.
• Voting rights. Certificate holders can be granted voting rights to the extent permitted by the mutual’s charter and applicable law.
• Purchase restrictions. Certificates cannot be purchased by the issuing mutual or any of its subsidiaries. 

Potentially More Issuers Than Investors
There is a high degree of interest by mutual banking organizations to issue certificates. Certificates may be particularly helpful for mutual holding companies with over $3 billion in assets, which cannot receive Tier 1 capital treatment for subordinated debt offerings at the holding company level. Certificates are also an attractive option for mutual organizations that wish to raise capital from members of the communities they serve who would like to feel that they have a greater stake in their community-based bank. 

For there to be an issuer of a capital instrument, there must also be a pool of interested investors. This is where the challenge remains for certificates. As proposed by the Fed, certificates cannot receive advantageous capital treatment while also offering investors reasonable expectation of both an attractive return and the ability to liquidate their investment. These restrictions may prevent institutional investors, who would be instrumental in promoting a robust market for certificates, from viewing such certificates as attractive investments. 

Regulatory Relief Needed
The Fed and other bank regulators could make certificates more appealing to investors by allowing certificates to have clearer redemption options, including fixed terms, and providing clarity on the redemption approval process. Additionally, given the community-based role that mutual ownership conveys, certificates could be deemed a qualifying investment under the Community Reinvestment Act to provide an incentive for other financial institutions to invest in certificates. Without such additional relief, it is not clear that certificates are poised to supplant subordinated debt as mutuals’ preferred method of raising capital. 

Conclusion
The openness of regulators to certificates and the issuance of term sheets with proposed terms was a helpful step toward addressing the need for mutuals to have other capital raising options. Further regulatory relief would encourage the development of a robust market for such instruments.