EQ2: An enhanced CRA credit for bank investors
The Equity Equivalent, or EQ2, is a capital product for community development financial institutions (CDFIs) and their investors. It is a financial tool that allows CDFIs to strengthen their capital structures, leverage additional debt capital, and, as a result, increase lending and investing in economically disadvantaged communities.
For investors in general, the EQ2 is a vehicle for facilitating greater impact in economically disadvantaged communities. For bank investors in particular, the EQ2 is a mechanism for receiving investment test credit or enhanced lending test credit under the Community Reinvestment Act (CRA). Most EQ2 investments nationally are made by banks, as the favorable CRA treatment is a primary motivating factor.
“This special debt investment is a precedent-setting community development debenture that will permit ‘equity like’ investments in not-for-profit corporations.”
Comptroller of the Currency, Administrator of National Banks, Jan. 23, 1997, concerning Citibank’s Equity Equivalent investment in National Community Capital Association
EQ2s are based upon the Equity Equivalent investment pioneered by Citibank and the Opportunity Finance Network, which received a favorable opinion letter in January 1997 from the Comptroller of the Currency, Administrator of National Banks.
- An EQ2 is a fully subordinated debt-with-equity-like character investment in a nonprofit CDFI such as the New Hampshire Community Loan Fund.
- In for-profit finance, a similar investment vehicle might be structured as a form of “convertible preferred stock with a coupon.”
- EQ2s are usually written as 10-year rolling term notes, with automatic renewal for each of those first 10 years – effectively making them 20-year obligations – unless the Community Loan Fund ceases its normal operations.
Primary benefits for banks
- Through the EQ2, banks have an efficient, effective, and high-impact means to meet the investment needs of low-income people and communities in their business areas.
- EQ2 investments provide an enhanced CRA credit for banks and enable banks to meet credit and investment obligations in a very safe and efficient way.
- The bank has the option of applying the EQ2 for CRA lending or for investment test credit.
- EQ2s allow for a multiplied CRA lending test credit: that is, the bank gets credit for a pro-rata share of the Community Loan Fund’s total lending.
- Examiners regard EQ2 investments as innovative, thus providing for more favorable CRA assessment.
- The Community Loan Fund’s strong equity position (approximately 20% of lending capital) provides excellent protection to its EQ2 investors.
- This increased lending by the Community Loan Fund can result in a higher pro-rata share for a bank using the lending test credit. Moreover, it can expand the bank’s market, should the bank build upon Community Loan Fund commitments to make loans of its own for particular projects.
- The typical investment pays 3% annual interest, and return of principal can occur after 20 years.
This is an unsecured investment. It is not insured by the FDIC, nor by any governmental or private entity. Investments with the Community Loan Fund are not liquid assets: They cannot be redeemed or traded before maturity. While the Community Loan Fund has not lost any lender's funds, past performance is no guarantee of future performance.
- The EQ2 is a general obligation of the Community Loan Fund that is not secured by any Community Loan Fund assets. The Community Loan Fund’s equity capital stands as protection for banks’ investments.
- The EQ2 is fully subordinate to the right of repayment of all other Community Loan Fund creditors.
- The EQ2 does not give the bank the right to accelerate payment unless the Community Loan Fund ceases its normal operations (i.e. changes its core line of business or becomes insolvent).
- The interest carried by the EQ2 is not tied to any income received by the Community Loan Fund.
- The EQ2 has a rolling term, and therefore an indefinite maturity (minimum 20 years).
- The EQ2 is carried as an investment on the bank’s balance sheet in accordance with Generally Accepted Accounting Principles (GAAP).
Banks have treated the Equity Equivalent as an investment in accordance with GAAP and account for it as a “social investment” under “other assets” on their balance sheets. Banks have expensed the annual difference between the interest rate earned on the investment and its higher costs of funds. The difference is shown as a reduction in net earnings income.
Impact for the Community Loan Fund
- The EQ2 acts as an infusion of capital available for our core lending activity, supporting community development throughout New Hampshire by providing the financing (along with education or technical support) people need to own homes, have quality jobs and child care, and become financially independent.
- The EQ2 strengthens our overall financial position and strengthens our position for a variety of grant and loan requests.
- The EQ2 directly leverages an increase of regular debt capital, especially among our largest lenders who, as a matter of policy, are limited in the amount of capital they can lend to us relative to our total capital. The EQ2 also increases our ability to attract new regular debt lenders by adding to the “insurance” (increased subordinate debt capital) against possible loss of their own loan capital – an especially important consideration because loans to the Community Loan Fund are not FDIC insured.
- The EQ2 supports our efforts to meet performance goals for federal grant awards, thus strengthening our position for future grant evaluations.
- The EQ2 infuses the Community Loan Fund with needed long-term loan capital, better matching the increased amount of long-term loans our borrowers need to sustain their projects.
- The Community Loan Fund has invested more than $150 million in New Hampshire’s communities, leveraging more than $450 million.
To discuss how your financial institution can invest in an EQ2 with the Community Loan Fund, please contact shatch [at] communityloanfund [dot] org (Sally Hatch).