The Big Margin SQUEEZE

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Many within credit unions are drawn to the cooperative financial structure because of the unique intersection of numbers, finance and people's dreams. Credit unions help members finance a home, a car or a college education, and in a world ruled by ambiguity, numbers provide a degree of certainty and solace. But lately, the numbers provide little comfort. Credit union ROA and profitability are declining and membership growth is both stagnant and graying. Younger members are avoiding the credit union's doors.

The credit union financial engine is showing signs of wear and starting to sputter down the American highway, according to interviews by The Credit Union Journal with a group of 17 financial experts, CEOs and executives. They generally agree with the causes for the slowdown, but disagree as to whether the engine needs a tune-up or an overhaul.

In this report, we'll look at the reasons behind the uncertain performance, the evolving financial services industry and new profitability models. And we'll examine three credit unions that are bucking the trend with innovative services and healthy balance sheets.

First a word on profitability and philosophy. In the past, the word profitability was viewed by credit unionists as a dog regards a fire hydrant. A select few still consider profits as anathema to the philosophy of a financial cooperative. Many of the experts interviewed for this report consider the term apt as credit unions are evolving and need to ensure that all aspects of their operation are profitable to remain relevant. A profitable credit union can provide better rates as well as superior services and products to members. The words of Roy Bergengen in February 1928 gain purchase, "A credit union is first of all a business."

The return on average assets (ROA), which is one measure of a credit union's profitability, has been steadily declining since 2002. That year marked the last time the CU community's average ROA was above 100 basis points; in 2005 it dropped to 85 basis points. If fees and other income are subtracted from ROA, you are left with a negative 40 basis points for year-end 2005 as shown in the chart below.

Industry average ROA dropped to 81 basis points at the end of the first quarter 2006, according to Callahan & Associates (see chart, below). As of first quarter 2006, non-interest income was 1.19% of average assets so the difference dropped further to a negative 38 basis points.

The Current Slowdown

The current slowdown is a frayed mosaic that most credit unions would rather hang in their closet instead of the lobby. The malady starts with a flat yield curve that signals a decline in interest income and shrinking margins. The yield curve is the difference between short- and long-term interest rates that are tracked from one point in time to another.

As depository institutions, the traditional source of credit union earnings is the margin-the difference between the earnings received on loans and dividends paid on savings. The margin should pay for the operations of the credit union, but as the yield curve flattens, interest margins are shrinking and many credit unions are failing to make a sufficient margin to pay for operations. They are becoming dependent on fee income, which can be, well, addicting, according to Jeff Farver, CEO of the $1.9-billion San Antonio Federal Credit Union.

"Many credit unions are living on fee income," said Farver. "My concern is that we are addicted to fees-fees are the crack of financial institutions."

This report will discuss fee income later. In normal circumstances, long-term rates are substantially higher than short-term rates. An inverted yield curve - short-term rates exceeding long term rates - has usually, but not always, been a bellwether for a coming recession. The current situation is unusual and likely temporary - a flat yield curve where the difference between short-term and long-term rates is minimal; short-term rates are higher than normal.

"In the last 10 years, the spread between two-year Treasuries and 10-year Treasuries has been as high as 250 basis points and averaged roughly 90 basis points; now the spread is two basis points," observed Todd Smith, SVP Client Services with CNBS, LLC in Lenexa, Kan.

The dilemma for credit unions is that they have failed to increase loan rates substantially, even though the highly competitive loan market is doing so. On the savings side, credit unions have been equally slow to increase rates. Members can go online and get from 4% to 5% APY on an Internet bank savings account without a required minimum balance. Historically, credit unions could trumpet the fact that their savings and loan rates were the best in the local market; that claim can no longer always be made.

Another reason for the slowdown is the end of the mortgage refinancing boom. Mortgage refinancing was a significant source of income through origination fees. In the recent past, credit unions that sold their 30-year mortgages on the secondary market experienced income gains. In today's climate, if a credit union sold a 30-year mortgage booked one or two years ago, it would likely experience a loss. Credit unions that hold 30-year mortgages at low rates are nervously watching their cost of funds inch up, further shrinking their margins.

"The cost of funds is up 36 basis points from 2004 to 2005; money is more expensive for credit unions," observed Dave Colby, CUNA Mutual Group chief economist.

Should the credit union community, regulators and others be worried about the declining ROA for the near future? This is a source of disagreement among those interviewed. Bill Hampel, CUNA's chief economist, said that there isn't cause for concern since an appropriate level of net income is not constant and credit unions are well-capitalized. From 2004 to 2005, the credit union net worth ratio increased from 10.9% to 11.1%.

"For the past 10 years, credit unions have been well capitalized; 85% of all credit unions are 200 basis points above the Prompt Corrective Action minimum of the 7% net worth ratio," said Hampel. "You don't need, and you don't have to force a 1% ROA; with current slow asset growth, for most credit unions, a net income target much lower than 1% is plenty."

It is true that credit unions are flush with capital; indeed, there is about $32 billion in excess capital-the amount above the 7% net worth ratio minimum. Some CEOs consider capital "free money," since it is earned and interest is paid on it. According to Hampel, once you get it, it's free money, but maintaining a high capital ratio is expensive. The traditional cooperative view held that excess capital should be used to benefit members in the form of improved services and products. This view is evolving as it's now considered prudent to build and maintain some excess capital, but how much is another source of disagreement.

Arguing For A New Net Worth Target

Hampel has been one of an increasing number of voices in industry circles arguing for a net worth ratio in the target area of 8% to 9%. At normal asset growth rates, an ROA of 1% is too high to achieve that net worth ratio range. For many credit unions, an ROA target of closer to or even below 50 basis points is more appropriate. Of course, these targets will vary for individual credit unions and their circumstances.

Capital requirements depend on the risks in the balance sheet and the appropriate ROA is a function of growth and the difference between current and targeted capital ratios. But as a general statement, Hampel said credit unions are overreacting to what is probably a temporary, downward pressure on ROA-a flat yield curve.

"If you have a lower ROA, say 50 basis points, it opens up a lot of possibilities," said Hampel. "It is not a license to be less efficient. You could give more to members in savings, improve services, add branches and charge less on fees."

But, for the journey ahead, most told The Credit Union Journal that they agreed that the credit union financial engine needs attention. They differed in the degree needed, ranging from a mild tinkering to a complete overhaul.

The reasons cited for profitability slump include hyper-competition, regulatory imbalance, inadequate pricing, and failure to attract young members or increase membership growth.


Hyper-competition is the foremost challenge for credit unions today, according to SACU's Farver. And the competition is aggressive, especially from the mega banks and credit card companies. "In the 1970s, 40% of our loan portfolio was unsecured loans; today it is 10%," said Farver. "The credit card companies are so aggressive and so successful."

Farver said that SACU is developing its strategic market plan for five to 10 years out, and noting as part of the process that Wachovia Bank is planning to build 20 new branches and Washington Mutual is planning 30 new branches in their markets. "We don't have the financial resources to keep up with the aggressive marketing by big banks to buy market share."

Credit unions are also competing with business models that didn't exist a few years ago, while members have more access to information; they are literally shopping the globe for rates on deposits and loans.

"Your best members will shop the world and come back to the credit union and ask if you can match this rate," observed CUNA Mutual's Colby. "If someone wants to gain market share, they can do it by offering the lowest rate."

The advent of Internet banks has introduced a business model that is relatively new in the United States and causing fitful nights for some executives.

ING Direct, one of the more prominent, provides quick, easy and most importantly-secure services.

It takes about 10 minutes to open an account online. To access a savings account, customers enter their identification numbers, answer a personal question, and then enter letters that correspond to a pin number on an online keyboard.

ING Group, the parent company based in Amsterdam and which operates in eight countries, opened up for business in the United States in 2000. It had more than an 80% growth rate from 2003 to 2004, jumping from $18 billion to $33 billion in assets. In June 2006, a no minimum savings account paid 4.25% APY; CDs without minimums paid more than 5% APY.

ING Direct's business model doesn't rely on the highest return or cross selling. In a June 3, 2006 interview with the New York Times, Chairman Michel Trilmant said that "we have a product that has no commissions, no minimums, and no tricks."

"For us, cross-sell is not what we want to do, because we want to keep it simple... the largest pool of earnings in the banking world comes from savings and mortgages-those are the only two things we want to do. If you try to cross-sell too many products, you confuse the clients about what you are and your costs escalate exponentially."

Trillant concedes that the ING Direct business model is unorthodox when compared to branch banking networks.

Branch networks add a cost "that can only be justified by cross-selling. We have chosen another distribution alternative, which is much more cost efficient but also requires that we focus on what we try to do."

Too Many In The Stew

Most of those interviewed said that there are too many providers in the lending stew. Consumers can get financing from an endless number of lenders, ranging from Ford dealerships to Home Depot. These providers already have their fixed costs covered and no loan officer salaries to pay. They also have access to secondary capital on the capital markets, which credit unions lack. Credit unions have just one means of obtaining capital-through net income.

Finance companies and captive lenders have additional advantages. Credit unions normally hold car loans to maturity, even when they become unprofitable. Finance companies are selling loans to the secondary market after they book the origination fees. Some credit unions, however, are starting to sell loans on the secondary market and are taking advantage of loan participations.

"There is an imbalance of supply and demand with too many lenders," said Peter Duffy, associate director with New York-based Sandler, O'Neill & Partners, L.P. "There's not enough business-borrowers and depositors-to satisfy all of the supply. When there are plenty of choices, consumers are not going to pay top dollar."

A Regulatory Imbalance

A consensus emerged among those interviewed-credit union regulations are a damper on profitability. NAFCU and CUNA have been aggressively lobbying to pass the Credit Union Regulatory Improvement Act (CURIA), but its passage isn't likely in the near future. One industry observer said that the passage of HR 1151, the Credit Union Membership Access Act, in 1998, and maintaining the tax-exempt status translated into a belief at Capital Hill that credit unions have sufficient legislation and that no regulatory relief will be coming soon.

Consider the differences in regulatory approaches for banks and credit unions. The regulatory goals for banks focus on credit risk and ensuring that banks make good loans. For credit unions, the regulatory goals are more centered on interest rate and operational risk. The difference in regulations affect profitability because credit unions have more burdens and more "moving parts to contend with, they need to constantly verify and validate," said Brian McVeigh, SVP of NuUnion Credit Union and Chair of CUNA's CFO Council.

Regulatory boundaries are tighter for credit unions in three areas-net worth ratios, income simulations and loan portfolio diversification, noted McVeigh. "In a well-structured balance sheet, 30-year mortgages would be OK, but regulators sometimes object to 30-year mortgages."

Banks are considered by their regulators to be "well capitalized" with a 5% capital ratio and adequately capitalized with a 4% ratio. Credit unions are considered "well capitalized" with a 7% capital ratio and adequately capitalized between a 6% and 7% capital ratio. Banks can acquire capital through sale of stock or subordinated debt. Credit unions are limited to the capital they can set aside from net income. They have no access to secondary capital.

Credit unions that are close to the 7% capital threshold are compelled to add capital. According to the Filene Research Institute's Secondary Capital Products: An Assessment of Member Interest study in 2006: "Even though most credit unions have adequate capital, those dropping to the threshold 7% level of PCA capital requirements are forced to pursue a higher net worth ratio, sometimes at the expense of the members' best interests."

Lingering Paternalism

With the average net worth ratio of credit unions at 11.1%, some suggest it can be reasonably concluded that regulators are nudging capital to unnecessarily high levels at the expense of members and profitability. Dave Colby said that he was aware of one credit union with a 24.2% net worth ratio and the next year it fell to 24%. The regulator wrote up the credit union for a deteriorating capital ratio.

"Bank regulations enable the banks to make better use of their capital and manage their money," said Duffy. "The FTC and OTC understand the business of banks and thrifts; they let banks manage interest rate risk. The reality is that interest rate risk and capital earnings are more at risk when rates go down."

There may be a lingering sense of paternalism among regulators, which dates back to an earlier time when credit unions were considered bit players with uneven financial management skills. That scenario has lead some observers to question whether credit unions are managed for the members and the market or for the regulator and regulations. The 12.25% loan portfolio limit on business loans, for instance, inserted as part of the Credit Union Membership Access Act in a compromise with the bank lobby, is another drag on the balance sheet and profitability that is difficult to justify. If a credit union has a healthy business lending program and is performing due diligence in its business lending portfolio, there is no reason for this limitation, several analysts told The Credit Union Journal.

"Why does there have to be a limit on business loans?" asked McVeigh. "It's like saying there has to be a limit on the number of car loans."

More regulation continues to mean greater costs and declining profits, according to McVeigh. Since Sept. 11, 2001, the Patriot Act and the Bank Secrecy Act have increased costs. "It's mostly an increase in people costs; we've added staff to make sure we're compliant," said McVeigh. "You have to make sure you know who you are dealing with and ensure the proper ID."

Pricing Blues

When costs go up, most firms tend to raise their prices faster than when their costs go down. As the cost of funds is currently rising for all financial institutions, one would expect that credit unions would be raising their rates to match the increase in costs. This has not necessarily been the case.

A case can be made that credit unions have historically underpriced-or ineffectively priced-their products and services. While much of the evidence in the past has been anecdotal, there is now solid research to back up the notion that credit unions do not generally price in a profit-maximizing manner, especially in comparison to banks. Researcher William Jackson confirmed that commercial banks tend to lower their rates on their deposits faster when market rates are falling than they raise them when market rates are rising. In his Filene Research Institute study in 2005, Pricing Movements and For-Profit Behavior: A Comparison of Banks and Credit Unions, Jackson wrote: "Credit unions do not exhibit this type of profit enhancing pricing behavior. Credit unions adjust savings rates downward at the same speed as they adjust them upwards."

According to Filene Research Director George Hofheimer, a study by Jackson to be released in 2006 confirms the non-profit pricing mechanism at work with credit unions. "I'm not sure if this means credit unions are under-pricing, perhaps they are passing off their tax-exemption to members," said Hofheimer, "which many would argue is a good thing."

It may not be an issue of under pricing, but it is clear that credit unions often fail to price effectively. This is especially critical today when credit unions are competing against finance companies, captive auto financing, credit cards and retailers. Effective pricing depends on local conditions, individual circumstances and an analysis of all costs. Since most credit unions have high capital ratios-or excessive capital ratios depending on one's point of view-they can afford to set higher rates on savings and lower rates on loans.

Crying Foul

Some within the credit union community may cry foul, however, when one compares credit unions to banks according to pricing and other metrics such as ROA and net income-it's like comparing apples to avocadoes. This gains some validity as banks and credit unions have different business models; banks have substantial business deposits; credit unions don't. But the credit union member, who is also often a bank customer, fails to take this difference in account while comparing loan and savings rates. And when that member asks his credit union to match a bank's rates, he doesn't care if a bank has competitive advantages.

Todd Smith said that the pricing process is a major reason for declining profitability and credit unions often fail to perform sufficient analysis for their pricing models. "Many credit unions price by what they see on the market, rather than the cost of funds and profit," said Smith. "Credit unions need a better pricing model and a good grasp of what is profitable and the organization's goals."

Credit union consultant Tom Glatt said that paying dividends on checking accounts is a pricing model that needs to be examined. "We should not be paying anything on checking accounts; it doesn't make sense for the credit union to pay 35 basis points on checking. If you have a lot of funds in checking, it should be moved to a savings or money market account."

Glatt stresses the importance of checking accounts to the credit union for developing the long-term relationship. "Credit unions need checking accounts, and they need NSF fees, courtesy pay, and debit card and interchange fees."

Meanwhile, credit union membership in the United States in recent years has begun to gray as the average age of membership is 47 years old. What is more disturbing is the fact that young adults are simply not embracing credit unions as they did in the past-in 2002, 18- to 24-year-olds represented 10% of the membership; by 2006 that number dropped to 6%, according to numbers from the Credit Union National Association.

That, of course, has a direct correlation to declining profitability as well as future viability for the industry. It is not a matter of survival; credit unions will survive. "My concern is not that credit unions will fail, but that they will become irrelevant," said SACU's Farver.

Young members are needed to replace older members. And the younger members tend to be borrowers while older members tend to be savers.

The need among young adults for education, relevant information, and trust-credit union core operating values-are all evident in the two research studies. The pertinent question is whether credit unions can deliver on these unmet needs during the next few years. Several analysts have noted that young consumers tend to be idealistic and seek organizations that reflect their humanitarian and environmental values. They further note that is a natural alliance and fit with credit union core values, but somehow the case for this values compatibility has yet to be made.

Profitability Starts with Young Members

An argument can be made for an improved profitability model that starts with improving the delivery of services to young members. These members often lack a credit history or have credit blemishes.

"At 19 years old, you want three things from your credit union: a credit card, an unsecured loan and a used car," said Tom Glatt. "Credit unions have made it as difficult as possible for young people to get these things. We don't welcome young people, we put up barriers."

Glatt said that serving young members is the first part of a profitability model that emphasizes loans and manages risk. This is especially suited to the current environment, since credit union delinquencies and charges-offs are relatively low. In recent years, credit unions have changed the mix of the lending portfolio and avoided unsecured loans.

In an interview for "Build Credit with Y," a Filene Research Cool Solutions Report published in 2006, Glatt said that credit unions made an "unconscious decision" to drop young adults, who represent a large market for unsecured loans, such as credit cards. And competitors like the mega-banks are gaining market share in the credit card market.

"Credit unions have traded yield for safety," said Glatt. "We used to make more unsecured and credit card loans, now we make mortgages and home equity loans. We are seeing margins shrink and have to look at other forms of income."

Glatt said that when it comes to offering credit card programs, many credit unions are adopting a risk-avoidance strategy rather than electing to exercise sound risk management.

Some credit unions will cite fears of bankruptcy filings, plastic fraud and identity theft as reasons to avoid offering young consumers a credit card.

Focus on Profitability

The new profitability model has three components, according to Glatt: Focus on profitability, take more risks, and manage that risk. Credit unions need to track profitability for all areas of the operation, he said, including branches, products, delivery systems, ATMs, households, and individual members.

Once the profitability of all areas of the operation is calculated, then the credit union can determine how to make unprofitable areas profitable. Those interviewed told The Credit Union Journal that unprofitable members can become profitable by analyzing:

* How does the member use products and services?

* What is the product mix?

* What are the balances?

* What delivery system does the member use?

"Profitability is not a primary focus, but it should be," said Glatt. "Profitability and member service are not at odds. The more profitable you are the better service you can give to members."

Glatt contends that there are many "one-thing" members who use the credit union for one service only. They are single service-users and unprofitable. But the goal is not to increase product usage by itself; the goal should be to increase profitable members.

Dave Colby agrees that an improved profitability model that takes a chance on young members using risk-based pricing makes sense. These young members may have credit scars and artificially low credit scores.

"If you apply for a credit card at a sporting event, you receive a free t-shirt," said Colby. "That aggregator may sell that application to 10 or 20 banks. Every time that application is used, the young person's credit score goes down. If it is used by a finance company like Household Finance, it goes down faster."

Colby said that in an era when every basis point counts even more, placing more assets in loans than investments would increase profitability as well. "Member loans on average earn some 294 basis points over average investment yields, according to NCUA 5300 data."

Know Your Profitable Members

Executives are mining their databases to get a better understanding of profitable members. Mark Sievewright, who was well-known in a previous position with TowerGroup and who is now SVP for corporate market development for Fiserv, gave the following real world case study of a credit union and its household segments and profitability spread in Figure B (see upper right).

The meaning of this case study, according to Sievewright: you can't assume that members in each of the categories have the same characteristics, financial profiles, product needs or wants. Within each segment there are likely to be significant differences between members.

Calculating the cost of serving members within each of the segments is critical. For example, members who use the branches heavily will have a different cost than those who prefer online services. A credit union manager needs to understand the cost of each service and make a judgment call: does the credit union want to price all members the same?

According to Sievewright, credit unions should:

* Identify the "A" households. They are the source of earnings.

* Develop and maintain a migration strategy to move C, D, and E members to higher levels.

* Recognize that "D" members can become "A" members with one loan.

* Recognize that "C" members through "E" members are not necessarily less affluent; they could belong to this category because of a pricing mistake that the credit union made.

* Members move and change through these categories, this case study is a snapshot in time similar to a balance sheet.

One of the lessons of this case study: avoid treating all of your members alike. If a credit union starts drilling down and finding out information about financial preferences and needs, life choices and events, it will note quite a bit of difference, said Sievewright.

There are problems measuring profitability, of course. It's an imprecise science to determine how staff costs should be allocated to each product and service. Credit unions need an understanding of the cost structure. An MCIF system can help accomplish this by providing the services, products and balances used by each member, said Brian McVeigh.

"In the future, we'll be able to customize prices for each member," said McVeigh. "Today we are at the early stages; we can fit members into general segments. For example, we can segment affluent, middle- and low-income members."

CUNA's Bill Hampel is sympathetic to the attempts of credit unions to measure the net income of members and all areas of the credit union. "But, I'm not sure we have the proper metrics to do this; we have a fragile measuring system, highly sensitive to assumptions made in analysis. The information is valuable but let's not be a slave to it."

Attracting Deposits, Building Branches

Attracting deposits is an increasing challenge for all financial institutions. Part of the reason is the changing American culture that no longer values saving as it once did. In 2005, the savings rate fell to a negative number-a minus 0.5%-according to the U.S. Department of Commerce. The savings rate has been negative only twice before, in 1932 and 1933. Consumers are relying on credit-home equity loans and credit cards-to pay for goods and services. In a real sense, the home has become the savings account.

Credit unions have had more problems than banks in gaining deposits. For a 12-month period ending March 31, 2006, banks had twice the deposit growth of credit unions as figure C indicates. It should be noted that commercial deposits are much more of a factor for banks and thrifts than credit unions, so the numbers are skewed somewhat. The source for this slowing of deposit growth is due to shrinking margins, said Peter Duffy. "Credit unions would like to offer more on share rates, but they can't because their margins are squeezed. The credit union franchise is in trouble under current regulatory restrictions."

Share growth, though, is picking up. At the end of the first quarter of 2006, it increased $17.9 billion, which is the fastest growth rate since 2003, according to Callahan & Associates (see chart, above). And dividend expense rose 42% for the same time period compared to first quarter 2005.

Credit unions historically have had a 50-basis point advantage over banks on one-year CDs, according to Hampel. During the past two years that spread has narrowed. In addition, from 2000 to 2004, credit unions were paying more on CDs than Treasury bills, but in the past two years credit unions were paying less than T-bills, said Hampel. "Market rates have risen, but credit unions haven't increased rates; financially savvy members who have a substantial amount of money in credit union share accounts will go somewhere else," said Hampel.

Even though branches were forecast to decline with the advent of the Internet, the opposite has happened. Consumers want to perform certain financial transactions in person-such as making savings deposits. As the Filene study of the buying behavior of young adults indicates, consumers are reluctant to make home and car purchases online. Other research shows that consumers in general are not buying big-ticket items online. There is also increasing evidence that branches are required to attract deposits. Banks realize this and have been building branches at a frenzied pace with no end in sight.

Even though the number of commercial banks declined by 29% from 1994 to 2003, the number of bank branches increased by 15% over the same time period to 67,000 according to the FDIC's 2004 Future of Banking study. A 2004 study by Callahan & Associates of 154 credit unions ranging in assets of about $200 million showed that credit unions with five or more branches had an annual share growth rate of 7.02%, while those with four or fewer branches had a growth rate of 5.22%.

While they are needed to attract deposits, branches are used differently by various age groups, according to CUNA Mutual's Colby. He contrasts branch usage with the three generations in his family.

"Most credit unions can't get deposits without branches," said Colby. "My dad is a lobby lizard; he likes to hang out in a branch. I spend some time in a branch. My 26-year-old daughter has never been to her credit union branch."

Branches also offer the opportunity to attract new members. More than 90% of new accounts and most checking accounts are opened at branches, according to "A Brave New Brick and Mortar World," a 2005 branching study by Callahan & Associates.

Fees: Friend or Foe?

The question of increasing fees is a passionate topic. Traditionally, fees were one of the differences between banks and credit unions, with banks charging a great deal more for fees than credit unions did. That gap is narrowing as credit unions are depending more on fee income. In 1997, 0.57% of total assets accounted for fee income; that number increased to 0.83% of total assets in 2005, according to Jeff Taylor, senior economist for NAFCU.

"Fees are like a regressive tax," said NAFCU CEO Fred Becker. "They affect lower income folks more than the wealthy.

That may be true, but as the chart on page 13 indicates, credit union fee income continues to increase. Courtesy pay on checking accounts is an example of how credit unions have come to rely on fee income; courtesy pay is becoming the most profitable financial service offered. NuUnion Credit Union in Lansing Mich., for instance, earns 60% to 80% of its net income from courtesy pay. In 2005, the credit union earned $3.5 million in courtesy pay out of a total $4.7 million net income.

"It seems like an easy thing to balance your checkbook and keep your accounts straight," said Brian McVeigh, SVP at NuUnion. "But for a lot of members, they don't mind paying $50 a month to not have to balance their checkbook. With time so precious, it appears some members would prefer saving the time and paying the monthly fee."

Members do appreciate courtesy pay when one considers that alternative-the embarrassment of a bounced check. Sometimes that event can be the equivalent of walking down main street without clothes. A mini-billboard outside of a gas station in Fond du Lac, Wis. recently posted the name of a hapless customer who bounced a check for all of her fellow citizens to see. One suspects that the young woman would have been an advocate for courtesy pay.

"Courtesy pay is one fee where members will actually call the credit union and thank you for the service," said Tom Glatt.

Members are not averse to fees as long as they get something of value, the analysts suggested. Customers at the Bank of America and other mega banks continue to pay fees because they get convenience, access and speed at their branches and ATMs. In most cases, fees at a credit union remain a better deal than fees at a bank. Fees in a credit union are used for better services and better rates. At a bank the shareholders get the revenue - at least that's the theory, if not always the practice.

"If it weren't for fee income, credit unions would be a losing proposition because of operating expenses," observed Glatt. "The rationale for fees is two-fold; first is behavior modification. Secondly, fees are a method of cost recovery. If you want to thrive as a credit union, you'll need to look at fee income. No matter what your fee structure is you are still a better deal than the banks."

Interchange charges on debit and credit cards are fees that are virtually invisible to members, said Jay Johnson, EVP of Callahan & Associates.

"We are seeing a change in the credit union business model with declining net interest margins. Credit unions can no longer rely on interest margin and need additional sources of revenue," he observed. Interchange income from debit and credit cards is the largest source of non-interest income today, added Johnson.

Ready To Take On Risk

Even though credit unions tend to be risk-averse, they are in a solid position to take more risk given their relatively low delinquency and high net worth ratios. Risk-based pricing of loans is one means of reaching out to new members and markets while increasing profitability. When comparing credit unions to banks and thrifts, one of the few areas where credit unions shine is in controlling delinquency.

As noted previously, slimmer margins for credit unions are not necessarily a bad thing; credit unions give back more to their members in service and, at least in the past, provided better rates on loans and savings.

In the figures below, credit unions have an average of 0.73% in delinquent loans to total loans, which is slightly better than all FDIC-insured institutions at 0.74% and significantly better at financial institutions under $100 million in assets.

Increasing the loan portfolio is more art than science. Every credit union has a comfort level and goes through certain cycles, according to Keith Peterson, CFO at the $367-million Great Wisconsin Credit Union in Madison, Wis.

"We adjusted underwriting to increase loan approvals, but it isn't a precise science," said Peterson. "If you take a little more risk, you might see a big increase in delinquency or charge-offs unless you have an extremely detailed and rigid loan policy and approvals."

Peterson said that word-of-mouth comes into play once underwriting is changed. The credit union can bring in more members or lose members because of word of mouth. "We made a small adjustment in underwriting; we received much more business, because of word of mouth," said Peterson. "Some were good loans, but for quite a few loans we had no contact with the members after they cashed their checks."

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