With adversity comes opportunity, for some.

Healthy credit unions and community banks have the opportunity to increase market share significantly through both organic growth and merger. Will they need to convert their charters to fully participate?

Increasingly, large credit unions believe the charter's regulations inhibit their ability to weather the storm and seize the growth opportunity. Some credit unions also believe the restrictive nature of their regulations actually led to excessive risk taking in loan portfolios and corporate credit union investments.

The cost of the bailout appears too large to endure and threatens to sideline healthy credit unions.

Since 2000 we have discussed the credit union business model in over 3,000 senior management and board meetings. These discussions and our research provide the basis for the observations that follow.

Credit unions with assets exceeding $100 million represent 86% of industry assets but are subject to rules that in many cases don't work for the way they've evolved. Credit union regulations are still based on the traditional, single-sponsor model despite the fact that so few — fewer than 75 of the 1,365 — meet this criterion.

As a result, credit unions have experienced worse erosion in their return on assets than have banks.

Since 2000, community banks with assets of between $100 million and $40 billion have had average return on assets 20 basis points higher than that of credit unions in the same assets range, according to data from the National Credit Union Administration and the Federal Deposit Insurance Corp. This the continuation of a trend that goes back to at least 1995.

As a result, fee income represents 14.7% of gross income for credit unions, versus just 7.7% for banks. With significant sources of fee income in jeopardy from enacted and proposed legislation, the outlook for future credit union earnings could be dire.

For example, some credit unions have calculated that the potential impact of the new overdraft regulation will be to reduce return on assets by 10 basis points. That was roughly 25% of the return on assets for all credit unions in the quarter ending September 2008 (before special assessments to bail out the corporate credit union system began).

In fact, without fees, the industry would have lost more than 30 basis points last year. Net loss before fees has been an industry reality since 2006, according to NCUA data.

Meanwhile, credit unions' share of U.S. deposits has not changed over the last decade and annual average membership growth has been less than 2.5%, despite passage of the Credit Union Membership Access Act in 1998, which enhanced the ability of credit unions to add members.

Other elements of regulation affecting growth and earnings include:

  • Remaining field of membership restrictions.
  • Asset risk weighting is less "income friendly" than that of banks.
  • Minimum capital ratio of 7% is 40% higher than that of banks.
  • No access to supplemental/secondary capital.
  • Inability to use leverage in a way that produces meaningful income due to the "matched book" rule.
  • A cap on small-business lending.

The regulatory system for credit unions discourages holding assets with longer durations, which is different from the credit risk focus of the bank system. Holding longer duration assets allows banks to generate better earnings while managing interest rate risk. The capital limitations on credit unions meanwhile, limit growth and create a double-barreled regulatory tax.
Because of the capital rules and the lack of secondary capital, some of the fastest-growing credit unions have had to stop or slow their growth according to our research.

How can healthy credit unions grow and contribute to the economy without access to secondary capital?

Without a legislative remedy, the only escape valve for a growing credit union is to change its charter to a mutual savings bank. It will otherwise be unnecessarily constrained while strong banks raise capital and widen their footprint by acquiring competitors at bottom-of-the-market pricing.

Additionally, credit union regulation is an inadvertent, yet significant contributor to the risk now facing credit unions.

Many credit unions, boxed in by the regulatory constraints discussed above, stretched for growth by originating more risky loans. As a result, credit unions with Camels ratings of 4 or 5 represented 5.5% of the movement's assets as of December.

This figure does not include $106 billion of corporate credit union assets with total negative equity of $18 billion. By comparison, banks with Camels 4 and 5 ratings represented just 3% of their industry's assets.

Credit unions also looked to their investment portfolio as a way to stabilize income. This changed the way corporate credit unions, which are wholesale providers of liquidity and investments, interacted with them.

Corporate credit unions sought to increase yield by holding higher-risk securities in their own portfolios so that they could compete with investment yield on securities offered by the broker-dealer community. The consequences were disastrous, leading to the conservatorship of the two largest corporate credit unions in March of last year.

Sixteen of the 27 corporate credit unions have negative equity, with a combined $14 billion in unrealized losses in investments.

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