Imagining a world in which credit unions pay income taxes

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The question of how the U.S. financial industry would be reshaped by the end of credit unions’ tax exemption usually gets lost in the well-rehearsed back-and-forth between banks and credit unions over the fairness of the existing system.

There’s little question that if credit unions had to pay federal and state taxes, many would no longer see any reason to maintain not-for-profit status. Carrie Hunt, a lobbyist for the National Association of Federally-Insured Credit Unions, said as much in a 2017 letter to congressional leaders.

“Simply put, the tax exemption is an issue of survival for credit unions,” she wrote. “If the tax exemption was removed, many would convert to banks or just go away.”

Credit unions vs. banks

It’s a pithy talking point that is likely to resonate with members of Congress, who typically see credit unions as sympathetic underdogs, but it also glosses over a lot of nuance.

Under a scenario where credit unions start paying federal income taxes, consolidation within the financial industry would likely accelerate, since smaller, less profitable credit unions would be made more vulnerable.

It seems certain, too, that many credit unions would seek to switch to bank charters, though if history is any guide, they would likely face resistance from their regulator, the National Credit Union Administration. If their efforts proved successful, the ensuing wave of conversions would weaken the political power of the credit union industry.

The scale of these effects is difficult to predict, and credit union and bank representatives both have incentives to exaggerate the impact of the exemption.

But at least one prominent former credit union CEO says that if Congress eventually eliminates the tax break, credit unions would likely still find ways to minimize their tax bills or avoid paying taxes altogether.

Importantly, credit unions would almost certainly be able to wrangle their own policy concessions from Congress, which could erode some the advantages that banks currently hold, such as their ability to easily raise capital and expand their membership.

What follows is an analysis of the dominoes that are likely to fall if Congress were to strip credit unions of their century-old tax exemption.

The growth of credit unions would be curtailed

Over the last six years, assets at U.S. credit unions rose by 43%, compared with 34% growth at banks.

The growth curve was even steeper at some big credit unions. The nation’s largest credit union, Navy Federal in Vienna, Va., built its assets by 93% between 2012 and 2017.

Banking groups point to the fast growth as evidence that credit unions have strayed from their original mission of serving narrowly defined groups of consumers with common bonds, such as employees of the same company. Their relaxed membership criteria were among the reasons why Sen. Orrin Hatch, a Utah Republican, recently questioned whether large credit unions deserve to remain tax exempt.

But credit union representatives argue that the industry’s growth is something to be celebrated, not decried.

“It was never intended that credit unions weren’t supposed to grow. Financial institutions have to grow in order to survive,” said Hunt, the general counsel at NAFCU.

Whether fast growth should be cheered or jeered is a matter of opinion. But it seems likely that, taken in isolation, ending the federal corporate tax exemption for credit unions would result in a slowdown.

That consequence is an outgrowth of rules that bar most credit unions from raising outside capital. Because they can only build their net worth by retaining earnings, and taxes would cut into their earnings, many institutions would be forced to grow more slowly.

“It’s mathematical,” said Alan Theriault, a consultant who advises credit unions on the feasibility of charter changes.

More consolidation would take place

Credit unions are already disappearing at a rapid pace, as larger institutions swallow up smaller, less-financially viable peers. At the end of last year, the U.S. was home to 5,684 credit unions, which represented a 53% drop from 12 years earlier, according to the NCUA. (Banks and thrifts have seen their ranks dwindle as well, falling 36% to 5,670 during the same period.)

That trend would likely accelerate if the tax exemption were eliminated, since many smaller credit unions are less well equipped to absorb the imposition of taxes than their larger peers.

“If the credit union tax exemption goes away, I think you would see consolidation,” said Keith Leggett, an economist who is retired from the American Bankers Association and is a frequent critic of the credit union industry.

Credit unions with less than $100 million of assets are not only adding loans and deposits at a far slower rate than those with over $1 billion in assets, they are also less likely to be profitable.

Among the smallest credit unions, those that have $20 million in assets or less, 30% do not have a positive return on assets, according to data from the Credit Union National Association. Some of these small institutions get financial assistance from companies that sponsor them, but many others do not.

Researchers at the Federal Reserve Bank of Richmond concluded last year that the federal tax subsidy could explain why lots of small credit unions are continuing to operate independently in an industry that has high fixed costs. Indeed, 59% of the nation’s credit unions have $50 million of assets or less.

“If the subsidy allows for the availability of credit where it would have otherwise been absent, even if the credit union is not offering higher deposit rates or lower loan rates than an average bank, it could provide the financing for, say, a low-income individual to buy a car to get to work or establish a source of credit in a rural area where a bank might not find it profitable to operate,” the Richmond Fed researchers wrote.

Bankers are quick to note that their beef is not with small credit unions that have relatively narrow membership criteria, but rather with the larger institutions that have opened their doors much more broadly.

As a result, banking groups appear to be open to legislation that limits the credit union tax exemption to firms below a certain asset threshold, even though they are typically skeptical of such cut-offs in banking regulation.

“It does strike me that policymakers are more focused on the larger credit unions,” said Ken Clayton, chief counsel at the American Bankers Association.

There would be a big wave of conversions, assuming regulators allowed it

Banking groups frequently argue that other than the tax exemption, there is little difference between their own industry and the large credit unions.

And it is true that some big credit unions have come to more closely resemble banks. In recent years, their membership rules have been loosened, and restrictions on business lending have been relaxed.

Still, there remain numerous disadvantages to the credit union charter, including the restrictions on raising capital, a cap on business loans and limitations on membership. Meanwhile, the charter’s main advantage is the tax exemption. If that benefit were to disappear, many credit unions would likely see more merit in switching to a mutual savings bank charter.

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For credit unions that convert, becoming a member-owned mutual bank is often only an interim step on the path toward becoming a stock-issuing institution. An eventual initial public offering would create wealth for not only the institution’s executives, but potentially also its employees and members.

The pressure to convert figures to be more acute for credit unions located in urban and suburban areas, where the competition for customers is intense.

Sound Community Bank in Seattle used to be called Credit Union of the Pacific. It converted to a bank charter in 2003, in large part because the rules against outside capital infusions were impeding its ability to grow. In the 15 years since the conversion — the bank eventually went public — Sound Community Bank’s assets have more than quadrupled, to $644 million.

“For us, the price of taxation really was just a part of the business case that we evaluated,” said Laurie Stewart, the bank’s CEO.

In the years since Sound became a bank, less than one credit union per year has converted. Stewart and others in the banking industry attribute the slow pace of conversions to roadblocks erected by the NCUA, in an effort to protect its own regulatory turf.

In one infamous case from 2005, the NCUA said that it would invalidate the vote to convert by members of a Plano, Texas, credit union because of how a double-sided disclosure document was folded.

The credit union did manage to become a bank the following year and has since merged with another bank, but Stewart argues that the NCUA has made the conversion process too burdensome. “They have made the ability to be successful so unlikely that nobody wants to take it on,” she said.

A spokesman for the NCUA said that the steps a credit union needs to take to convert are laid out in regulations. Still, if the tax exemption were to be abolished, credit unions interested in converting would likely exert more pressure on the agency to make the process less onerous.

Eliminating the tax break could also lead to more mergers between banks and credit unions. More than a dozen such mergers have closed or been announced over the last two years and it is easy to imagine the pace accelerating if credit unions’ tax break goes away and smaller institutions look to join forces to better compete against larger rivals.

There would also be follow-on effects

Credit unions argue that most of their tax savings gets passed along to their members in the form of higher deposit rates and lower interest rates on loans. The implication is that the elimination of the tax subsidy would cost U.S. consumers.

“The result would be exactly what the banks want — the removal of a lower-cost competitor and the increased profits that come from the ability to charge consumers higher interest and fees due to reduced competition,” Dennis Dollar, a former National Credit Union Association chairman who is now a consultant to the industry, said in an email.

That argument found partial support in a 2016 working paper co-authored by a business school professor, Robert DeYoung, at the University of Kansas.

The paper concluded that the bulk of the tax subsidy gets passed along to credit union members, mainly in the form of above-market rates on deposits. But the research also found that credit unions divert a substantial amount of the subsidy, in part by hiring more employees than they need.

“I promise you I can run a zero-balance every year."

There also figure to be political effects from the elimination of the tax exemption. Because credit union growth would slow, and the number of institutions would shrink, the industry’s clout in Washington would likely be diminished. The result could be a situation where banks hold more sway on Capitol Hill and are eventually able to extract more policy concessions.

But other factors would likely blunt the impact of a change in the tax treatment of credit unions.

The new tax law signed by President Trump in December lowers the U.S. corporate income tax rate from 35% to 21%. As a result, credit unions would not take as large a financial hit from the elimination of their tax-exempt status in 2018 as they would have if the change had been implemented in the past.

“The tax bill will have the impact of diminishing the value of the tax exemption,” said Theriault, the consultant who advises credit unions on the feasibility of charter changes.

In a scenario where taxes do get imposed, credit union executives might also behave differently in an effort to minimize what they owe to Uncle Sam.

Credit unions would not have much trouble managing their bottom lines to a zero-profit result, since they already pass on most of the savings from the tax exemption to members, argued Jim Blaine, who served for 37 years as CEO of the $37.3 billion-asset State Employees Credit Union in Raleigh, N.C.

“I promise you I can run a zero-balance every year,” Blaine said. “The only money that was ever retained by the credit union I worked for was the money required by NCUA to maintain reserves. Every other dollar was paid back to our members.”

All of the above assumes that no other rules would change, which is probably not a safe guess

It has been two decades since Congress passed the last major overhaul of credit union regulations.

That 1998 law, which came in response to a Supreme Court decision that placed stricter limits on the industry’s membership rules, was an effort to appease both credit unions and banks.

The law reinstated credit unions’ ability, which had been overturned by the Supreme Court, to accept members from multiple unrelated employer groups. That was a big win for the industry.

“The level playing field would involve credit unions having more powers.”

But to assuage bankers, the law placed a cap on credit unions’ power to make business loans. It also subjected the nonprofit institutions to capital requirements for the first time.

Similarly, the repeal of the credit union tax exemption seems unlikely to happen in isolation. Credit unions have a lot of sway on Capitol Hill, and they would undoubtedly demand significant concessions if their tax exemption were about to be eliminated.

The various restrictions under which credit unions operate, and banks do not, would suddenly be up for debate.

Credit unions would likely demand that the business-lending cap be lifted. They might seek to repeal a rule that prevents them from writing mortgages of more than 15 years on second homes. They would almost certainly demand more flexibility in terms of raising capital. And they may seek to expand their fields of membership or maybe even eliminate that restriction altogether.

Under any legislative deal that aimed to balance the interests of banks and credit unions, the result would be the continuation of a long-term convergence between the two industries.

Back in 2001, the U.S. Treasury Department concluded that most of the major regulatory differences between banks and credit unions were already gone. “Significant differences have existed in the past, but have been gradually disappearing,” Treasury stated in a report.

The demise of the credit union tax exemption would likely mean a further narrowing of the differences.

Bankers frequently argue that eliminating the tax break would level the playing field between the two industries. But Steve Swofford, the president of Alabama Credit Union, offered a rejoinder. “The level playing field would involve credit unions having more powers,” he said.

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