CUs Must Rethink How They Manage Their Capital To Survive

Discussions with many credit union people confirm that two industry trends of great concern are lagging membership growth and deteriorating earnings. CU membership growth since 1996 has been a lackluster 2.5%, and only 1.5% since 2002. Factoring out temporary members from indirect lending, net growth has likely been flat, if not negative.

Meanwhile CU earnings continue to erode both in absolute terms and versus competition. The average CU with more than $100 million in assets loses 28 basis points before fees, leading to increased reliance on fee income. As of December 2005, CUs derived 14% of gross income from fees, up from 7.6% in 1998. Compare this to the bank trend which shows, in the same time frame, fee income as a percent of gross income was unchanged (8.0% to 8.1%).

Importantly, both of these trends are over eight years old. In this, the first of a two-part series, we will examine in greater depth the extraordinary importance of managing capital, and where banks true advantage lies.

Competitive Earnings, Competitive Value

Perhaps most disturbing is the lack of willingness to understand and address these issues, with some in the industry looking at the bad news through rose-colored glasses. You've no doubt read the NCUA letter (August 2006) and/or heard other industry leaders tell you it is "OK" to produce less profit because, "your capital can handle it." But banks with $100 million to $26 billion in assets are generating 84 basis points of income before fees. Much of this income is, either directly or indirectly, attributable to regulatory factors, including business lending caps, capital treatment, risk weighting, duration constraints and the ability to market to everyone with no field-of-membership restrictions.

As you can see from the graph, the income gap (before fees) between banks and CUs is expanding and part of a long-term trend.

With a 112-basis-point income advantage (before fees), banks have become less reliant on fees than CUs (as a percent of gross income), while many large banks such as WAMU, PNC, TD Bank North (among others) are reducing or eliminating fees while investing in services and adding more branches.

Incremental income generated today and spent tomorrow to increase the overall value experience for the consumer is a competitive threat to the service advantage CUs have enjoyed. For example, online banking by cell phone or PDA is now available at Bank of America, Wachovia and Citibank, according to the Wall Street Journal, Feb. 21, 2007.

Many credit union people know that, despite rhetoric, banks generate greater earnings by leveraging their regulations and not by "price gouging" the customer on loans, deposits and fees. More on this later.

Flat membership growth accompanied by earnings significantly below competition is not the proper use of excess capital, nor is it the recipe for growing a healthy franchise. CUs continue to be advised as if the majority are still operating in the closed environment of the factory floor. The world has changed, however. Of the 1,200 CUs with more than $100 million in assets in the U.S., only 66-roughly 5%-remain chartered as single field of membership (FOM). Marketing in the open community requires a different mindset about many things, not the least of which is capital utilization, profit and marketing. As capital is largely "undivided earnings," meaning the earnings have not been divided back into member value; why not fulfill the mission and use the capital? To date, regulatory pressure to maintain unnecessarily high levels of capital has "won out" over the mission. Underutilized capital has conspired with "not for profit" to render CUs vulnerable to competitors who are generating more profit while using capital in an eager effort to add more households. Lately, the debate has raged as to whether or not the inefficient capital position makes credit unions vulnerable to acquisition, too. Clearly, the market is "catching up" with this CU dynamic.

All of this is not to say that there are no success stories, because there are. As I have conducted frequent Competitive Analyses with credit union senior management and boards of directors, we discuss the "movement's" top 15 performers in both growth and ROE. The lists include some noteworthy success stories, which we discuss and look for ways to emulate. The list is somewhat thin, however: a relatively small number of the top performers are unique in a way that translates to continued performance in the coming years. (Roughly one-third are in high-growth areas of the country where their growth is better than most CUs in the country but not significantly better than neighboring CUs and lag the banks in the same market).

Capital Utilization Affect Member Growth

How does the consumer perceive "not for profit?" Does the consumer interpret "not for profit" as good rates WITH the willingness to invest in branches and services on the same basis as the rest of the market? Does the consumer/member with a "large" sum of money look at "not for profit" as an attractive reason to deposit?

Call report data for banks and credit unions indicate that banks are more successful in attracting higher deposit balances. Research conducted by Sandler O'Neill + Partners, L.P., shows 388 members per full-time employee (FTE) at CUs, while the customer average per FTE at banks is 43. With banks' U.S. deposit market share at 78% and CUs' at 6%, it is clear banks are more efficient in deposit gathering as a whole as well as on a per-customer basis. The data also suggest that the typical CU member has a "one-off" relationship to the CU and is not seriously or broadly "banking" with it.

The narrow range of services utilized by the typical credit union member relative to a typical bank customer is a big reason the efficiency ratio range for banks is 55-65%, while the CU range is 69-76%. The efficiency ratio is an important metric because it describes the cost to produce revenue. Specifically, the (approximately) 15 percentage points of difference between banks and CUs means that CUs have to spend 15 cents more to produce one dollar of revenue. This is a crippling drawback when one considers the regulatory "head start" the average bank has on the average CU.

With a 500 basis-point advantage in return on equity (ROE), the average bank generates significant incremental income and is already outspending the average CU in marketing and branching. This speaks to many issues, not the least of which is our consistent theme about marketing, branding and cross-selling. CUs have to educate the unsold household on both what a CU is and what the "requirements" are for "membership" BEFORE they can begin the sales process. Banks don't have to educate. Banks spend millions on advertising while reducing/eliminating fees and adding branches at close to double the rate of CUs (6% versus 3.5% in the last few years).

Managing capital as a tool for growth while generating competitive earnings is important because earnings enable the R&D and marketing necessary to produce new members.

Many credit union people tell me they have begun to tune out advice that has not evolved with the consumer, and therefore lacks solutions for dealing with both the stagnant member (share) growth and the relentless slide in earnings. Advice and regulations that have not evolved remain meaningful ONLY to those CUs that still serve a single field of membership with a common bond. It's worth repeating: Once a CU evolves from the original FOM to the open community, the needs of the business model change in many ways, including regulation, marketing, convenience, profit and capital utilization. When the institution is more competitive in these areas, it is better able to leverage its culture for success.

Pete Duffy is with Sandler, O'Neill, New York. He can be reached at Pduffy<at>sandleroneill.com.