The next five years are going to be a challenge leading to a rocking good time for the financial institution (FI) that is both focused on building market share and capable of taking advantage of the very real and very large growth opportunity presenting itself in most local markets.
The imbalance of supply and demand (too many lenders) gives the consumer pricing power, which has led to the commoditization of the business and an erosion of income. CUs of greater than $100 million in assets, for example, have experienced a 46% decline in ROA at a time when loan-to-share has increased 21% (1995-2007 NCUA call report data).
Banks (in the same asset range as CUs above) are down 14% on ROA during the same time and generate a 440 basis point after-tax income advantage versus CUs as measured by ROE (return on equity). The bank income advantage is being invested in growth initiatives such as branching (they've added seven times more branches than CUs in the last three years) and advertising. As a result, in the size category mentioned above, banks have grown 70% faster than CUs over the last five years.
Most of the income advantage can be attributed to the difference between bank and CU laws and regulations. Statutes and regulations have evolved to allow banks to grow faster while preserving more earnings. By contrast, CURIA (Credit Union Regulatory Improvement Act) has not been enacted at a time that will decide the fate of many FIs-not just CUs. And now many FIs need access to capital, a regulatory shortfall for CUs not addressed in CURIA/CURRA.
Growth and earnings are difficult for all FIs, and this reality has led some managers to make decisions leading to asset quality problems. As a result, most markets will have many FIs whose loan problems will either keep them on the sidelines as they repair their balance sheet or force them into shotgun weddings. We've seen this already, and we are not at the end but the beginning of experiencing the damage resulting from America's consumption binge of the last eight years (consumer debt increased 250% from 2000 to the present).
Clearly, many FIs will be distracted and unable to compete. For evolving (no longer single-sponsor) CUs, the charter's restrictions on growth and earnings compound the challenge and limit remedies.
The long-term future of the individual FI will be determined in the next three to five years based on the following characteristics and related levels of competitive readiness, which I term "State of Readiness," and which are listed below from highest to lowest.
5. The FI with a manageable asset-quality problem that deals with it aggressively and quickly will be able to get re-focused on growth, but with less ammunition (earnings and capital).
4. The FI with no credit problem has a distinct advantage. FIs without the distractions and costs associated with the shakedown crews of recovering from loan problems will be able to muster "all hands" (and dollars) on deck for building market share.
3. The FI practiced in the regimen of capital utilization with good asset quality will have a competitive advantage. However, most CUs are behind the curve in using capital, having "held back" capital in response to a required minimum 40% higher than banks.
2. The FI with no (or repaired) asset quality, practiced at capital utilization and access to secondary capital has an additional competitive advantage. Thus, the highest "State of Readiness" for CUs at level three.
1. The FI with No. 2s characteristics while producing better earnings performance is in position to dominate the market if its marketing differentiates it in a manner that brings in new relationships while building on current ones.
Bottom line: the FI with a severe asset quality problem is mortally wounded.
When one considers the commoditization of the business, the deciding factors for success become people (their leadership, focus and execution) and capital management, which has reached a level of importance never before seen in our business.
With no innovation in product and with pricing virtually the same amongst FIs, growth and earnings will become a function of how effective leadership becomes in hiring, developing and compensating people to out-think and out-execute the competition in the following areas that still offer differentiation:
1. Marketing, branding and selling.
2. Maximizing earnings while limiting risk.
3. Capital management; the willingness to use capital and the smarts to use it to add customers.
Competitive readiness is only half the equation. A credit union must both recognize "the opportunity before us" and possess the desire to take advantage of it. Market leaders will measure success based on market share (adding households and increasing household penetration), ROE and the efficiency ratio. This is paramount in a commoditized business populated by customers empowered to shop for the best deal.
Thus, a full menu of products that are competitively priced and delivered by nice people who give good service is the cost of entry in the FI industry.
This brings us to a final consideration. Five years from now I believe the managements and boards of FIs that put the culture of the organization, customer relationship, growth, earnings and good judgment above all else will be the ones thriving and enjoying a rocking good time.
By doing so, these leaders will have dispelled some powerful myths about the FI industry and how CUs see themselves within their local market.
Likely, they will also share three characteristics that helped separate them from their local competition and peers: a willingness to recognize the truth (no matter how unpleasant); an intense desire to improve; and an unwillingness to wait for others.
Peter Duffy is associate director with Sandler O'Neill + Partners L.P., New York, and can be reached at pduffy
