We have all read about the recent successes and failures of credit union attempts to convert to thrift or mutual bank charter. All the attention and the type of attention these events generated worked against the effort to convert.
So much press was given to the sensational aspect of conversions, notably the financial windfalls to management, that we continue to miss one of the most fundamental-and far more benign-elements of why there have been and will continue to be conversions.
At the very foundation of business, an enterprise seeks to focus all the capital, resources, time and effort in building marketshare. Under current regulation, credit unions that have fine-tuned their approach and are successfully building their business will be told to throttle back on the two things they need to do the most: grow and grow earnings.
Why Size Matters
The realities of this business are that size matters; size is HUGE in the lending business and that is why there have been so many mergers in banks and CUs. The Top 10 credit card issuers now control 85% of the credit card business in our country. The Top 100 Mortgage originators now account for 83% of the mortgage business, while old-line industrial companies such as GM and GE now generate more than 50% of their earnings from making loans on cars, homes, businesses, etc. This means that almost all credit unions and community banks are slugging it out for the remaining 15% of the credit card and mortgage loan business, while the dealers run 0% financing. So, what is a CU supposed to do, give up?
No, of course not. With the winning culture that puts the member first and the passion that exists in most credit union franchises, you take your strength and build the business and find more ways to protect or enhance earnings. In other words, since CUs can't do anything about the over supply of lenders in America today that forces margins tighter, CU managers need to do MORE loans and perform better in the investment portfolio (where banks are routinely making 100 basis points more yield than CUs, unnecessarily).
At the same time, credit unions are caught in a bind. On the one hand, the regulations can hinder, even undermine, the CUs' ability to deal with the market realities just mentioned, in addition to others. On the other hand, CUs' consumer/members have been trained to get the best deal, and if their credit union doesn't give it to them, the other guy will, gladly.
These two realities have forced pricing power out of the loan and share business and driven margins to all-time record lows. In June of 2004, the spread between net interest margin and operating expenses reached an all time low of 13 basis points (down steadily from 69 basis points in 1995, according to NCUA call report data). I was just checking September call report data for about 30 CUs ranging in asset size from $70 million to $2 billion and almost all of them and all their peers were below the 20 basis point spread.
Regulations Put CUs At Disadvantage
Yet, the regulations that risk-weight duration (and thus discourage mortgages and diverse investments, no matter how fundamentally sound or consistent with building a stable, high-performing asset base) put the CUs at a competitive disadvantage in the marketplace. In some cases, regulations force the CUs to slow or stop growth.
The competitive disadvantage is stunning. CUs are regulated for safety and soundness based on interest rate risk, while the banks are regulated based on credit quality. Therefore, banks have been able to define the relationship between appropriate duration (which, if correctly managed, means more income) and sound interest rate risk, while being held responsible for maintaining proper credit standards. The issue here isn't that credit unions are writing bad loans (although it is a good bet that more money has been lost in the past on bad indirect car loans than ANY interest rate risk scenario). The issue is the lack of income in the investment portfolio and the impractical, and severe, restriction on mortgage lending.
For an indication of the millions missed (lost) due to a regulatory approach that emphasizes duration risk rather than credit risk, take a look at the graph on CU and bank net interest margin as rates change since 1993. Regulations (and the way many CUs interpret them) have led credit unions to become so asset-sensitive that in flat rate and declining rate scenarios, the CUs' margins suffer unnecessarily. Note how in flat and declining rate scenarios, bank margins go down but not as far and then recover much more quickly.
And this, in a business where margins are already pressured due to competition!
Interestingly, the credit unions I know that have been willing to do what is necessary with investments and ALM by generating competitive yield income and putting less income at risk as rates stay the same or go down, are navigating these times more easily and finding the funds to provide for member convenience. Thus, they have been able to resist the temptation to "fee" the member as a way to offset income loss from underperforming assets. There are plenty of successful credit unions that have ignored the doom and gloom of some ALM vendors and instead, are like the banks intelligently defining the relationship of duration, income, and proper interest rate and liquidity risk management.
There are, however, plenty of CUs of all sizes looking at the capital requirements (both the formal 7% minimum and the "whisper" number of 8%) and saying to themselves, "I spend all my time figuring how to satisfy the member, pay my staff competitively, and grow to meaningful size-only to be told I may need to slow or stop growing because my capital level is not high enough-while my competitor is being held to lower levels of capital and have other ways of raising capital besides undivided earnings."
My View
Here's where I come out: I will accept the proposition that CU conversions are solely, or even primarily, motivated by greed ONLY when CUs looking at the conversion option are doing so from a level playing field on capital and risk management.
Until then, we have our eye off the ball, because in a free market society where the consumer has a choice of where to deposit money and get a loan, the benefits of tax-free status of the CU are more than offset by both the restrictive nature of regulation and the way we traditionally interpret regulation. The margin advantage that we see in the accompanying graph is A LOT MORE than the tax we are not paying.
In other words, until we take away the valid reasons to convert, conversions will continue.
Peter Duffy is Associate Director with Sandler O'Neill & Partners, New York. Mr. Duffy can be reached at pduffy
