November 2006

Credit Unions in the Broader Financial System

Congress created the credit union charter in 1934 to establish small, local, mutual associations of “people of small means seeking to protect themselves from high rate money lenders.” A lot has changed in the intervening seventy years, including the transformation of many formerly mutual organizations into stock-issuing corporations, and the growth of some credit unions into large institutions with billions of dollars in assets. In this environment, the credit union charter--unlike those of other American financial institutions--still requires that the 8,700 U.S. credit unions operate as mutual associations, reflecting a long-standing belief in the virtues of cooperatives. At a November 29 AEI conference, panelists discussed the key challenges and trends in this important financial sector, how credit unions relate to the broader financial system, the meaning of "ownership of a mutual by the members," and whether conversion from a credit union to a savings bank charter should be made easier or harder.

Alex J. Pollock
AEI

A regulated financial system can be thought of as a system of charters. The system that exists within the United States, for example, contains both state and federal charters, as well as corporate and cooperative ones. The federal credit union charter is cooperative in nature, and was created by Congress in 1934 in order to enable “people of small means to protect themselves from high-rate money lenders.” The primary goals of this conference are to understand the place of credit unions within the broader financial system, to consider the idea of “ownership” of the equity of a mutual association by its members, and to examine the issue of credit unions’ converting from cooperative charters to corporate form.

Rodney E. Hood
National Credit Union Administration (NCUA)

Credit unions are structured on a democratic-cooperative basis and are meant to promote thrift and serve as a source of credit for their members. The NCUA is charged with overseeing the safety and soundness of federally chartered credit unions, as well as federally insured, state-chartered credit unions. NCUA embraces the dual charter system. Like the Federal Deposit Insurance Corporation, NCUA insures credit-union deposits up to $100,000, and its insurance fund--worth $6.8 billion--is funded entirely by the credit unions themselves. Currently, there are approximately 8,460 federally insured credit unions serving 88 million Americans. These credit unions hold over $700 billion in assets--6 percent of U.S. financial assets. The median credit union holding is $11 million, the average is $73 million, and 80 percent of credit unions have holdings smaller than $50 million. NCUA has a two-pronged regulatory philosophy. First, regulation needs to be effective and not excessive; credit unions should have the flexibility to get good results. Second, NCUA must help credit unions manage risk, not avoid it.

Peter F. Duffy
Sandler O’Neill & Partners, LP

For many credit unions, recent regulatory issues have been an obstacle to effective competition within the financial-services marketplace. Over the past twenty years, there has been considerable consolidation in both the credit-union and banking industries. The number of credit unions has fallen from 18,000 in 1985 to 8,640 in 2006, and the number of banks has fallen from 14,000 to 9,000. In addition, the vast majority of credit unions and banks are competing for a very small portion of the market, as the top 100 mortgage originators have an 83 percent market share, the top 100 credit-card issuers have an 89 percent market share, and the top 50 bank holding companies have 75 percent of the deposit-market share. In addition, banks have expanded their customer base by increasing the number of branches by 11 percent, cutting fees, offering cash bonuses for deposits, and undertaking intensive marketing campaigns. Conditions have changed drastically since 1934, so that today “no borrower is left behind.”

In order for credit unions to survive, all options must be open. In recent years, credit unions have experienced slow growth in assets and new customers compared to banks. Because the profit margin on various services has narrowed, financial institutions need volume in order to make a profit. However, regulation limits the earnings, capital utilization, business lending, and growth of credit unions. To expand their business, some credit unions believe the more robust and flexible mutual-savings-bank charter is more important than the federal tax subsidy garnered by their cooperative status. Yet when credit unions have wanted to convert, they have faced unusual interference, infiltration, and risk. 

Alan D. Theriault
CU Financial Services

In order to retain or increase their competitiveness, certain credit unions have converted their corporate charters from credit-union charters to mutual-savings-institution charters. The first conversion took place in 1995. In reaction, the NCUA passed rules which many believed were designed to impede future conversions. For example, it required federally insured credit unions, among other demands, to collect a ballot in favor of conversion from 51 percent of members eligible to vote within a short thirty-day balloting period. Voter turnout at credit union elections is usually less than 5 percent. The NCUA also wrote controversial "box language" (similar in content to what NCUA has recently required) for distribution with ballots.
 
In 1998, recognizing the difficulties of compliance with NCUA's conversion rules, Congress made the conversion process more feasible by stripping NCUA of its conversion-approval authority and requiring only a simple majority of those voting (over a ninety-day period) to approve the transaction. Congress did so because that same year it had imposed capital requirements on credit unions and set limits on business lending; therefore, Congress wanted to provide an option for credit unions, which found the new limits too restrictive.
 
Credit-union conversions continued problem-free for about a five-year period until larger credit unions started to announce conversion plans. Since 2003, NCUA has revised conversion regulation three times after large credit unions filed, in each instance making the process more difficult, and reverting to many punitive elements eliminated by Congress in 1998. Because the mutual-savings-institution option is important for credit unions that want to expand, create new branches, and better serve members and the community, NCUA’s actions have been an unfortunate development.

J. Kirk Cuevas
Dollar Associates, LLC

The credit-union charter is still viable and plays a valuable role in America’s financial system, particularly in the way it serves millions of people in underserved areas of the country. The credit-union members determine the value of the institution, which is often tied to intangible factors immeasurable by price. Credit unions have taken an active role in financial education, and their products have evolved to meet the needs of consumers. While credit unions are safer and sounder than ever before, there are still challenges, particularly the costs of regulatory compliance--the greatest concern of most CEOs. There is nothing wrong with credit unions having the option to convert, so long as it is done with full disclosure and in a way that the members understand.

John D. Hawke
Arnold & Porter, LLP

The ability of a bank to change its charter without approval from the regulator whose jurisdiction it is leaving is central to current banking regulation. This capacity for free exit helps ensure that institutions are not held hostage to inefficient structures and minimizes the potential for turf-building. While free exit was provided for in the underlying credit-union legislation, on the model of banking regulation, NCUA has given lip service to the principle. In particular, the rules promulgated by NCUA on voting procedures are a considerable stumbling block to free exit.

The concept of ownership has also raised numerous problems and questions. Making the members as of some arbitrary date those solely entitled to receive rights in the conversion not only ignores the fact that past members helped build up the credit union's net worth, but fails to take account of the fact that among members of record (as of the record date), new members are given the same rights as members who have been on board for many years. These difficulties emanate from the assumption that the members are the "owners" of the net worth. One might just as readily argue that the insuring agency should be treated as the "owner," since the availability of deposit or share insurance is a major contributor to the generation of net worth.

AEI research assistant Daniel Geary prepared this summary.