RALEIGH, N.C. -
From those modest beginnings State Employees' Credit Union has grown to be the second-largest credit union in the United States at $14.6 billion in assets and 1.3-million members.
Today the small credit union founded in a basement or in Alphonse Desjardins' kitchen in Levis, Quebec has a vaunted place both in the credit union community's sentiments and cooperative history.
Small credit unions dominated the movement at one time, but no longer.
Nevertheless, the small credit union continues to hold a mythological status with exceptional abilities to serve their members.
The reality, though, is at odds with the myth. Large credit unions-those more than $1 billion in assets-have significant economies of scale that result in better rates for savings and loans and return more benefits for its members. While this is not a new phenomenon, the cost differential gap between small and large credit unions has grown significantly in recent years.
This is not to say that small credit unions are unable to serve their members effectively. Many small and medium-size credit unions do an excellent job as the profiles at the end of this report attest. But it is has become increasingly difficult to do so. Add to this mix the increasing costs of compliance and technology, and the cost-differential gap has profound implications for the industry.
As the number of credit unions continues to shrink, will the small, and to a lesser extent, medium-size credit unions, share the fate of the corner grocery store? There is no definitive answer to the question.
The research and profiles cited in this report, though, provide the success factors, trends and staying power of the credit unions that will likely greet the new year of 2017.
This report looks at research from UCLA Professor Jim Wilcox on the cost differential as well as soon-to-be published research by Filene Research Institute on the characteristics of "star" small credit unions versus "laggards" of the same category. Credit Union Journal will also examine strategies that small and medium-size-credit unions are using to compete with their billionaire counterparts.
Wringing Out Inefficiencies
"There is really long-running and pervasive economies of scale in credit unions," said Jim Wilcox earlier this year during the California and Nevada Credit Union Leagues' Big Valley Conference. "On average, the larger credit unions get, the better they are able to wring out the inefficiencies."
By most financial indicators, credit unions with $1 billion or more in assets outperformed their smaller counterparts, and the difference is getting greater. Medium credit unions are defined, for this report, as $100 million in assets to $1 billion; small are those under $100 million in assets.
Non-interest expenses were 138 basis points lower at large credit unions, said Wilcox, whose research is based on statistics from NCUA call reports. Net interest income is about 108 basis points lower at larger credit unions because they are paying 60 basis points more on average on savings and charging 48 basis points less on loans, according to Wilcox.
"And at the same time, the larger credit unions are still earning about 30 basis points more than smaller credit unions," Wilcox said.
Costs, on average, fall dramatically as the credit union rises in assets. Cost declines are fairly modest between credit unions under $100 million in assets. Significant reductions in costs occur when the credit union crosses the $100 million asset line. Where do the cost savings go?
"To a very large extent, to the benefit of members with lower net interest income," Wilcox said. "The cost savings do tend to get passed on to members."
Non-interest income at larger credit unions offsets much of the non-interest expenses as shown in the chart below. NSF and interchange income are examples of non-interest income. As previously mentioned, the cost differential between large and small credit union isn't new. Ten or 15 years ago, it was an advantage of 90 basis points.
"What's new is the differential has gotten much bigger," said Wilcox. "Now it's about 140 basis points."
Unpleasant Arithmetic
The larger, non-interest costs at small credit unions have meant some "unpleasant arithmetic," Wilcox said. And the larger credit unions are offering more benefits to members, which is why there is a member migration from smaller to the larger credit unions. This is among the prime factors for consolidation in credit unions, which has been occurring for the past 25 years.
There are wide differences in performance among small credit unions. According to Wilcox, approximately 1,300 out of 4,332 are efficient. "Sometimes it's good management, sometimes it's sponsor subsidies."
Small credit unions will continue to shrink in numbers and market share, medium credit unions will lose more market share, and larger credit unions will add more members, size and market share, said Wilcox.
The large credit unions are also gaining more of the industry's assets. In 1990, the 500 largest credit unions had 52% of all assets; by 2006 that number increased to about 63%.
The 1,000 largest credit unions had 66% of all assets in 1990; by 2006 that number jumped to 77%, according to Professor Jim Likens of Pomona College, and chairman of the board of First City Credit Union in Los Angeles.
These trends have been steadily developing since the 1970s. Rapid consolidation is also underway in banking.
"Financial services consolidation is being driven mainly by technology, which provides economies of scale and scope for large providers," Likens said . "The flat yield curve of the past few years adds to the pressure and favors credit unions that can earn fee income."
While consolidation of credit unions can be expected to continue, Likens said that there will continue to be many successful credit unions of all asset sizes. He said that effective management and boards as well as a strong field of membership seem to be the most critical factors for success.
Technology as Great Leveler
Technology was predicted to be the great leveler for smaller and medium-size credit unions. The reasoning was that technology would allow this group to compete with electronic delivery channels even while lacking the resources and branches of larger financial institutions.
"I think a lot of us thought that technology would work to the advantage of the smaller credit union," said Wilcox. "But what we've found is that it's really expensive and it's relatively more expensive for the smaller institution. Technology seems to have accentuated the costs for smaller credit unions."
Sam Tuohey, VP and CT at Stanford Federal Credit Union in Palo Alto, Calif., views technology as an addition, not a replacement for other processes.
SFCU was the first financial institution in the United States to offer online banking in 1993. Tuohey cites the example of buying an optical system to convert files to PDFs.
"It is a new and ongoing expense and the software to operate it is very expensive and you need additional staff," he said. "If you write your own program, you need a programmer to do it. You have to comply with regulations; it will speed up the retrieval time of documents and improve service, but it adds another layer of costs."
Not everybody agrees. Technology can be a competitive advantage for small credit unions by keeping acquisition costs low, according to Doug True, SVP lending and technology at the $996-million FORUM Credit Union in Indianapolis. One way to accomplish this is to develop software in-house. FORUM has been successful by developing software for indirect lending and forming a CUSO.
"Technology doesn't have to be expensive," said True. "Small credit unions can build innovation by hiring one software developer or by joining a CUSO."
There are some areas a small credit union can control, such as automating operations, but "you don't have to buy a $1-million CRM system," True added.
Compliance: The Malady That Lingers On
"You can hire a programmer on staff, but once you write the software you have to maintain it," said Steve Punch, CEO of the $344-million First City Credit Union in Los Angeles. "Credit unions find that original software programs are too costly to maintain and they end up spending a lot of time programming in regulatory changes, and adapting the product to new releases from their existing providers."
Compliance "seems easier to live with" for a larger credit union as there are large, fixed costs with compliance, whether it's PATRIOT Act or BSA, said Jim Wilcox.
At a recent National Association of Federal Credit Unions (NAFCU) meeting, one of the participants remarked to NCUA Board Member Gigi Hyland that the regulator keeps adding regulations, but "you don't take any away."
In a recent interview, Hyland was asked if this was a fair assessment.
"Yes, more regulations are added and none are taken away," Hyland said. "A lot of regulations are causing difficulties for credit unions and increasing the cost of compliance, but NCUA doesn't have the flexibility to give relief. NCUA is charged to enforce, it has no control to issue regulations."
NCUA helps small credit unions with the costs of compliance in three areas, according to Hyland:
* Economic development specialists. They work with small credit unions to help resolve problems.
* Office of Small Credit Union Initiatives. Some 20 to 25 workshops a year are planned that offer accounting, compliance and strategic planning.
* Outreach task force. Formed to document what credit unions and NCUA are doing to serve low-income and modest means members.
The task force is a response to the November 2005 House Ways and Means Committee Review of the Tax Exemption.
Then Chairman Bill Thomas (R-CA) scolded NCUA and the industry for lack of transparency and data that supports the credit union claims of serving those of modest means. While credit unions that serve low-income members aren't necessarily small, many are.
A Capital Question
The role of capital-especially for small credit unions-has been evolving. Before the 1970s, credit unions limited the amount of capital retained; excess funds from net income were returned to members as part of the cooperative ethos. After the National Credit Union Capital Commission was formed in the 1980s, the industry's view of capital evolved. Credit unions realized it made sense to build net worth.
The industry has moved to the other side of the spectrum by building up capital at the expense of member benefits and growth. The average net worth ratio hovers around 11%, which is 400 basis points higher than what NCUA considers "well capitalized." Jay Johnson, EVP of Callahan & Associates in Washington, said there was an excess of $33 billion of capital at the end of 2006, an increase of 3% from $32 billion in 2005.
One of the nine traits of successful small credit unions, according to research by Filene Research Institute's upcoming study of "Thriving Mid-Size and Small Credit Unions" is maintaining net worth levels while investing in membership growth and product and services.
By building high or-or excessive capital-small credit unions become less efficient. That excess capital could be used for growth and better rates on loans and savings, according to Filene. The credit unions identified as performing poorly or laggards, built up net worth and are overcapitalized, the analysis concludes.
But many executives and CEOs say that regulators push for more and more capital. "There will always be a push by a regulator to have more capital," said Hyland. "There will always be some tension between regulators and the credit union."
How does a credit union determine an adequate level of capital?
"I think that in addition to current statutory capital requirements, a credit union needs to look at its strategic direction and the services it provides to members to determine the appropriate level of capital," Hyland said. "Earnings must be evaluated in the larger context of balancing risk with service to members."
Cooperation as Competitive Advantage
If small-or any size-credit unions successfully follow the nine factors they would be on their way to becoming stars. Easier said than performed, of course, as the nine factors are the result of years of efficient management coupled by effective board governance.
Cooperation-at least in theory-presents a competitive advantage for small and medium-size credit unions. It could be considered the tenth factor for success.
Whether the practice of cooperation matches the premise is a matter of debate. But, the full potential of credit unions joining other credit unions for collaborative ventures has not been reached.
While many smaller credit unions would benefit greatly from cooperating with each other to provide front and back office services, few do, observed Steve Punch.
Multi-owned Credit Union Service Organizations (CUSOs), to name one cooperative venture, are vehicles to offer products and services a small or medium-size organization couldn't afford on their own. Yet of the nation's 8,400 credit unions, only 2,000 are members of a CUSO.
There are a number of reasons for this reticence. "The cooperative model is gaining some steam, but it is not the dominant theme in the credit union industry," said Tom Davis, president and CEO of NACUSO, who is also an industrial psychologist. Another reason is emotional, based on the fear of merger.
Power & Control
"If you take my credit union and members away through a merger, I will lose my power and control," Davis said. "If part of my self-identity is grounded in that power and control, I might lose some of my self-identity related to being a director or member of a management team. This is very difficult to deal with from a psychological perspective."
The competitive pressure has also changed the cooperative dynamic, according to Tun Wai, NAFCU's chief economist. "Credit unions are feeling the competitive pressure because of overlapping fields of membership," he said. "It is becoming more difficult to be cooperative if they are in the same community-that has changed the landscape and the way credit unions do business."
"In the early days there was a lot of cooperation, for example, offering share drafts and clearing checks," continued Wai. "We are not forming that kind of alliance today. There is a lack of recognition that services are profitable."
The mode of thinking has changed as well, as there is more emphasis on "my piece of turf," as opposed to thinking of offering better value to members, Wai said.
"Now with community charters, the choices are vast and the competition is greater," Wai observed.
Send your comments on this report to Lisa Freeman at lfreeman
