Evolving Credit Unions Demand What Congress Intended: Option to Change Charters
Consider the irony that charter choice has become all but extinct in the credit union movement, and then along comes the Treasury’s proposed Blueprint to consolidate banks and CUs with its requirement of a common federal charter for national banks and federally chartered thrifts and CUs.
Evolving CUs (community and select employee group charters) now realize how difficult adding members and generating earnings can be without regulatory relief. A recent survey speaks to this realization.
According to the Aite Group, 33 of 101 CEOs of CUs with $100 million-plus in assets indicated their CU credit union would consider a conversion twas planning to convert to a mutual savings bank (MSB) charter. Such a charter change would bring the regulatory relief found in the stalled Credit Union Regulatory Improvements Act (CURIA).
For perspective, according to Sandler O’Neill research, the statutes and regulations for banks allow them to generate after-tax earnings significantly greater than CUs. The average bank ROE is 440 basis points greater than the average CU on similar capital levels (NCUA/FDIC call report data for banks and CUs $100 million to $33 billion in assets).
While the legal right to choose charter exists, in practice it has become a perilous proposition. CUs are saying that rulemaking and organized disruption drive up the cost of charter conversion dramatically while lowering the probability of winning the necessary votes to unacceptable levels.
For example, credit unions that recently concluded the conversion process were required to send a letter to all members that contained, among other things, a link to a site containing anti-conversion rhetoric and arguably misleading and defamatory information.
Another example is the rule that requires a “Boxed Disclosure” to be prominently displayed in the disclosure material sent to members. Among other things, the “Boxed Disclosure” alerts members to the possibility of a mutual-to-stock conversion subsequent to charter conversions, implying a likelihood of such an event. Here’s how it reads:
“POTENTIAL PROFITS BY OFFICERS AND DIRECTORS. Conversion to a mutual savings bank is often the first step in a two-step process to convert to a stock-issuing bank or holding company structure. In such a scenario, the officers and directors of the institution often profit by obtaining stock in excess of that available to other members.”
A possible mutual to stock conversion becomes a major focal point of the organized obstruction because the required disclosure allows the opposed to the conversion to imply that a conflict of interest exists for the board and senior management in the event of a stock offering.
Frustrating Congressional Intent
Interestingly, such mutual to stock conversions have occurred in less than half of the former CUs. What’s more, a mutual to stock conversion requires membership approval through a separate vote, as well as other member safeguards provided for under OTS rules. Perhaps most important is that many FIs are taking advantage of the option to raise capital in an effort to continue growth initiatives and/or repair their balance sheet and stock is only one way of raising capital.
This situation clearly frustrates Congressional intent in the Credit Union Membership Access Act that NCUA rules be “no more or less restrictive” than other agencies’ rules for charter conversions. Such a free-market approach to charter choice would allow credit unions–like all other depository institutions – to choose the charter that best suits their individual business model. The current rules do not seem to fit this description. The Treasury’s proposal would address the problem if implemented, although the timing and final provisions of such implementation are uncertain.
Your regulator sought comment on ideas for even more rules regarding conversion (as well as merger and acquisition). If any or all of the proposed rules in the ANPR for 12 CFR Parts 708a and 708b become reality, the closed door to charter conversion will be bolted shut. Please visit www.ncua.gov and click on “Rules, Legal Opinions and Laws” and then click on “Proposed Regulations” and then view the comments by the various leagues, trade associations and, most important your fellow CEOs.
In the face of a slowing economy, some of the most consumer and small-business friendly lenders, Evolving CUs, are becoming less able to contribute to a turnaround. Evolving CUs are not generating competitive earnings, largely due to a lack of parity in regulations (and despite the tax advantage). Without earnings on a par with their competition, Evolving CUs can’t branch and market competitively, limiting their reach.
Recent NCUA and FDIC call report statistics bear this out. Banks between $100 million and $33 billion in assets enjoy a 108-basis point advantage in net interest income versus CUs the same size. Think of this earnings differential in the context of an industry that can muster an ROA of only 65-80 basis points. The average bank is generating much more income that it’s putting to work to acquire customers. For example, banks have added seven times more branches than CUs in the last few years, and in the past five years the average growth rate for banks is 50% greater than for CUs. What’s more, CU growth in large measure is a result of indirect lending and therefore represents both “temporary” members and non-recurring assets.
Lacking competitive growth and earnings, many CUs turned to alternative lending sources and bulked up on indirect and sub prime loans with non-members. According to NCUA call report data in 2006, of the 150 fastest growing CUs greater than $100 million in assets, 61 had indirect loans equal to or greater than 20% of loans.
Many CUs have shared with me that they weren’t thrilled with the indirect and sub prime alternative but, as one CU exec explained: “Growth is difficult because competition is fierce and many people don’t even know what a CU is. Maintaining a 1.0% ROA became impossible as our margins eroded and we peaked on fees. Plus, we’re boxed in by remaining FOM restrictions.”
As a result, stories of CUs losing money in the loan portfolio (involving all collateral types) headline CU trade publications. NCUA and FDIC call report data reveal that years of earnings below competition borne of regulatory impediments have made CUs more reliant on fee income than banks. Specifically, fees account for 13.7% of gross income for CUs versus 5.3% of gross income for banks ($100M-$33B assets). This situation began 10 years ago and is worsening.
About 1,000 credit unions with assets more than $100 million have opted for a community or SEG charter to address the concentration risk inherent in the single-sponsor charter. As these Evolving CUs have begun branching and marketing to the public in competition with community banks, they are discovering how restrictive CU regulations are. Differences in the risk weighting of assets between banks and CUs, caps on business lending, capital treatment, the inability to raise capital, and field of membership restrictions all contribute to the income disadvantage and slow growth of Evolving CUs. As a result, they are at serious risk of becoming less relevant and helpful in their local economies.
By contrast, the more traditional, single-sponsor CUs that remain continue to thrive. Single-sponsor CUs typically enjoy a 175 to 225 basis-point cost advantage versus evolving CUs because they are less dependent on branching and marketing to get new members since the sponsor is often large and/or growing. However, the roster of such traditional CUs with assets greater than $100 million has shrunk to fewer than 70 nationally.
Four Alternative Courses
Evolving CUs have four alternatives to staying the course:
- Lobby hard(er) for CURIA.
- Merge with another CU.
- Convert to an MSB charter.
- Hope the Treasury proposal doesn’t get bogged down.
Lawmakers could consider passing CURIA as an economic stimulus measure. It makes no sense to allow the business model of some of the country’s most consumer and small business-friendly lenders deteriorate further. Although banks may not appreciate giving CUs the ability to raise capital, equal access to all consumers, equal capacity to originate small businesses loans, and the same risk weighting for assets, clearly something needs to give.Of course, the banks will argue that equal operational freedom should mean equal tax treatment, and therein lies the challenge.
To the north, Canadian CUs have paid taxes for years and wouldn’t go back. Many American CU management teams have met Canadian CU managements at conferences, and so already know this. Canadian CUs are uniformly puzzled that U.S. CUs cling so hard to tax exemption when the offset of more market friendly bank regulations is available.
Perhaps the easiest and best idea is for lawmakers to mandate that the conversion rules give effect to statutory intent. Instead of dealing with the never-ending political hot potato of taxing CUs in order to provide regulations equal to banks, just let the market decide. With charter conversion rules “no more or less restrictive” than those of the other agencies, CUs that want to convert will be free to make the decision and move on to an MSB charter if that is what their business model requires. This could be done immediately to allow Evolving CUs to convert on timing that suits their business model as the proposed Treasury Blueprint evolves.
Some CUs have already begun to anticipate a “taxed” world. Since the Treasury’s Blueprint was announced, I have received many calls from CEOs seeking to understand the tax impact to their CU’s earnings coupled with the benefits of the more “market friendly” regulations related to growth and earnings (which the movement had hoped to address through CURIA).
One thing is clear: the market is not being allowed to decide because in practice (for the reasons stated above) CUs have little charter choice. Meanwhile, the inability to achieve regulatory parity is severely impacting the competitiveness of some of the nation’s best community lenders.
With true charter choice, the biggest beneficiary will be the consumer and the small business owner, who will get more access to some of the best lenders in the country. The converted CUs will remain active lenders and deposit gatherers, but with regulations that promote competition without putting so much income and capital at risk.
Lawmakers would get CUs that become tax paying, CRA complying, competitive consumer and small-business lenders that are hungry to grow their franchise with the added ability to raise capital if necessary, to the benefit of their local communities.
If keeping all options available is important, Evolving CUs must demand and get the charter choice Congress intended.