The second and third quarters of 2021 have shown a significant uptick in the number of subordinated debt offerings by Northeast community banks’ mutual holding companies, as favorable interest rates have prompted capital raises that qualify as Tier 2 capital for the mutual holding company issuing the debt but the proceeds of which can be contributed as Tier 1 capital to the subsidiary bank.  

The strategic rationales for mutual holding companies to issue subordinate debt range from a desire to support organic loan growth in its existing market, a plan to expand into new markets, including through mergers or acquisitions, and a desire to fund investments in financial technology. The increased reliance on online banking over the course of the past decade and the challenge that financial technology poses to traditional banking methods have required banks to seek more technologically advanced innovations to keep pace. At the same time, banks have also faced the need to invest in better cybersecurity mechanisms sophisticated enough to adequately protect depositors and customers, which has proven difficult as hackers and other security threats become more advanced.  

A Low-Risk, Low-Cost Solution 

Banks are highly regulated and have traditionally been limited to a select number of mechanisms for raising capital to finance these developments, sometimes at the expense of their mutuality or their existing shareholders and depositors.  

The issuance of subordinated debt at the mutual holding company level is often seen as a low-risk solution for raising capital to finance activities such as organic loan growth, expansion into new banking areas and cybersecurity and technological improvements to online banking without sacrificing mutuality by raising capital without engaging with the public market. The nature of subordinated debt is designed to ensure that ownership of the mutual banking company remains with the corporators, while providing the mutual holding company and the bank with an opportunity to increase its Tier 2 and Tier 1 capital, respectively. 

Additionally, the U. S Government’s extraordinary fiscal and monetary support, the financial markets’ reaction to the COVID-19 pandemic and significantly lower interest rates have made subordinated debt a relatively low-cost mechanism for increasing capital. Subordinated debt typically has a 10-year term, with the interest rate fixed during the first five years. Recent subordinated debt financings in the spring and summer of 2021 have seen fixed interest rates during the first five years ranging from 3.25 percent to 3.75 percent. Low interest rates provide an enticing incentive to raise capital required to meet the ever-expanding need for banking institutions to evolve with depositors and customers. 

Subordinated debt transactions typically involve the engagement of an investment banking firm that will conduct financial due diligence to gain a better understanding of the issuer. Investment banking firms are familiar with the expectations of institutional investors that typically purchase subordinated debt and will help the issuer present itself to investors. Recent deals have involved limited pools of institutional investors, many of which are similar financial institutions in the same geographic region as the issuer. 

Regulatory Requirements 

In order to ensure that the capital raised in a subordinated debt offering is eligible to qualify as Tier 2 capital for the mutual holding company, subordinated debt instruments must meet certain regulatory requirements outlined by the institution’s primary regulator. For instance, if the issuer is an MHC, the subordinated debt must adhere to the requirements set forth by the Federal Reserve in 12 C.F.R. § 250.166: 

• The debt must be subordinated in right of payment to the claims of the holding company’s general creditors (and in effect the subordinated debt is structurally subordinated to the subsidiary bank’s depositors); 
• The debt must be unsecured; 
• The debt must clearly state on its face that it is not a deposit and is not insured by a federal agency; 
• The debt must have a minimum average maturity date of five years; 
• The debt must not contain provisions that permit the debtholders to accelerate payment of the debt principal prior to the maturity date, except in the event of the MHC’s bankruptcy; 
• The debt must not contain or be held to any covenants, terms or restrictions that would be inconsistent with the general safety and soundness of the bank; and 
• The debt must not be credit-sensitive. 

As subordinated debt continues to gain popularity amongst financial institutions seeking to raise capital, prospective issuers should be mindful of the particular legal requirements to be met in order to utilize this mode of financing as effectively as possible. Prospective issuers should also consult with their primary regulators to ensure that the regulators are comfortable the proposed use of proceeds from the subordinated debt offering will not be deployed in a manner that could reasonably be expected to jeopardize the safety and soundness of the MHC or its subsidiary bank.  

(tag)Thomas J. Curry is a partner in Nutter’s corporate and transactions department. Kate Henry and Armand J. Santaniello are associates in Nutter’s corporate and transactions department. Curry is former U.S. comptroller of the currency and all are members of the firm’s banking and financial services group.