In 2015, Big Society Capital and the Association of Credit Unions Limited (ABCUL), asked Social Finance to review the credit union landscape in order to understand the potential for social investment to help grow the sector and make it more sustainable.
Following an analysis of 25 credit unions, along with conversations with investors, Social Finance has concluded that there is an opportunity for social investment. At present, in the form of impact first debt investment, with potential to include patient equity in the future.
To broaden their appeal to social investors, credit unions need to better articulate their social impact and develop more financially sustainable growth plans. In addition, regulation allowing equity investment opportunities which are more attractive to investors should be developed.
Social investment covers a wide spectrum of activity in which capital is provided with the specific intention of generating a social and financial return. At one end of the spectrum, investors seek commercial investment opportunities with clear social purpose, while at the other end the investment is closer to philanthropy (albeit with the expectation that at least the principal amount would be returned). For all social investors, there is a distinct interest in the social impact that their money is able to achieve, and the understanding that the potential for this affects the relationship between risk and return. Social investment sits in a unique space within the financial landscape, with recent reports suggesting that there may be up to £1.5bn social investment in the UK, of which we estimate that approximately a third is still waiting to be deployed.
Financial inclusion itself underpins a range of subsequent social benefits. Recent randomized control trials indicate that formal financial services such as microcredit, savings, insurance and mobile payments can have a positive impact on a variety of microeconomic indicators, including self-employment, business activities, household consumption and well-being.2 Yet, historical investment in credit unions has been uncommon and limited to a small pool of investors who place a high value on social impact.
A partnership between credit unions and social investment should be natural: credit unions play an important role in providing a community finance alternative to mainstream banks and building societies, and in the process offer inclusive and affordable financial services to lower income individuals.
The majority of credit unions do not presently have funding issues, but they may experience challenges with capital reserve levels. What they are grappling with, is how to continue to lend as their asset base grows. Although this implies that there is no urgent need for extra cash, it must be recognised that the challenge faced by credit unions is a lack of long term investment to help them address entrenched operational issues restricting growth, such as outdated IT infrastructure or marketing strategies. Investors should be willing to provide patient investments that allow credit unions to develop but that do not necessarily generate an immediate return.
Subordinated loans of 5–10 years in tenure have been approved to credit unions on a handful of occasions. These long term loans are a useful way of providing a credit union with access to sustainable capital for growth, as these loans must remain outstanding a minimum of five years to count towards regulatory capital. The investments we encountered in our research were made by investors who valued the (implied, if not explicitly reported) social impact of the credit union, known as impact first investors. Our research suggests that if credit unions could achieve a significant increase in member loan volume, without eroding the interest rate paid by borrowing members, there could be an opportunity for these types of instruments to be used by many more to support capital ratios during growth spurts.
Deferred shares are another means by which credit unions can raise cash outside the traditional deposits of their members. Our research did not uncover any examples of deferred share investments. We know that a few credit unions outside the 25 analysed have issued deferred shares. A deferred share is currently considerably less attractive to an investor than a subordinated loan. While deferred shares are transferable, a shareholder would only be able to monetise them in very limited circumstances. But deferred shares should be viewed as the patient equity investment that credit unions need: an investment that enables the conservation of cash in the near term and allows the credit union to focus on growth. This highlights the case for regulatory shifts, which could create a more favourable landscape for investment in credit unions. The current requirement of a deferred share investor to become a member of a credit union prohibits investment funds from buying deferred shares. This would ideally be made more flexible (e.g. member of any credit union can invest in another credit union), with the lack of exits addressed by encouraging over-the-counter trading on secondary platforms.
Similarly, we believe that other incentives could be developed to attract investment into credit unions. These could include tax reliefs to individual investors (e.g. community credit union deferred shares qualifying for the existing Social Investment Tax Relief) and other investor groups. Additionally, sector regulatory changes could also increase the attractiveness of investment in credit unions. Our research suggests that total assets should be the main driver of capital adequacy regulation, which would allow the majority of credit unions to achieve a better capital adequacy position, and a better level of surplus generation year on year. The number of retail deposit holders in a bank is not the driver of its reserve requirements, and so it is not clear why the number of members is a driver for a credit union.
If these adjustments are made, capital flow could be stimulated. However, if credit unions are to engage with a wider spectrum of social investors—both more of the impact first investors and others—they will need to articulate, measure and report the long term social impact generated from their activities and expected by this type of investor. This should incorporate a narrative explaining the need to focus on both higher and lower income loan members to safeguard surplus generation and sustainability. Reporting on impact would ideally be integrated into the IT infrastructure to reduce any additional work. It is hoped that the DWP’s Credit Union Expansion Project (CUEP) and the related Transformation Project, explained in more detail in the following pages, could go some way to improving this infrastructure.
This report illustrates the circumstances in which a credit union could make use of social investment to further growth. This will require a combination of efforts from the credit union sector and from social investors. Credit unions must implement growth plans that include better loan penetration and credible business plans to support them, probably including a better use of technology, along with a robust demonstration of social impact. To appeal to a larger universe of investors and unlock further pools of money, credit unions and important stakeholders (e.g. the Association of British Credit Unions Limited (ABCUL) and Cornerstone, Big Society Capital, Prudential Regulation Authority, Big Lottery Fund, the wider social investment intermediary community and trading platforms) should work together to address both strategic and investment readiness questions, as well as improve the features of existing investment instruments (particularly deferred shares) to enable more patient capital for ambitious credit unions.