The earnings improvement by credit unions in 2012 may be short-lived as the industry increasingly relies on the larger, healthy credit unions to carry the burden for the entire industry. That is a burden that threatens to weaken the best CUs and the industry as a whole.
In order to appreciate the responsibility placed on large CUs, it is worthwhile to explore some of the headwinds related to profitability, achieving sufficient scale and efficient mergers.
If not for fee income, 70% of credit unions would experience a negative Return On Assets. This is the highest percentage on record and continues a trend started in 2000. What's more, the hurdle for achieving economies of scale has moved higher, to $3-billion in assets. This means that net interest margin does not cover expenses in the aggregate group of credit unions with assets less than $3B.
Within that group there are plenty of exceptions, but it's clear that the commoditization of the business has made earnings difficult. In fact, fee income now represents 16.3% of gross income for credit unions (5.5% for banks), making such income at CUs more vulnerable to potential legislation, such as capping both mortgage origination fees and overdraft protection. The sweet spot for banks also appears to be $3B, although there is a slight (20-30 BPs) profit without fees in banks between $100-million and $3-billion in assets.
Where The Growth Is
Without a doubt, 2013 will be a challenge. Assets continue to reprice into lower yields while cost of shares has likely bottomed. In 2012, bank cost of deposits was 2 BPs higher than CU cost of shares. (If non-interest bearing deposits are removed from bank deposit costs, banks out-pay credit unions by 15 BPs). This is noteworthy, because most DDA funds are from small business borrowers rather than consumer deposits, where banks may have more room than CUs to lower rates further.
Meaningful growth is also concentrated in the larger credit unions. Only 7% of CUs with assets less than $100M in 1995 are larger than $100M today, meaning nearly all of the asset (and membership) growth is being generated by the larger, healthy credit unions. This is noteworthy when considered alongside the recent announcement that the joint WalMart/American Express Bluebird debit card will carry FDIC insurance and allow direct deposit for anyone receiving a government check. Some 10,700 WalMart stores are in line to serve the underserved.
Despite the trends, CU mergers remain elusive and have declined every year since the credit bubble popped in 2007. For perspective, after a one-year hiatus, bank mergers have increased every year since the bubble (although not yet at pre-bubble numbers) and the average asset size is meaningful, ranging from $145M to $700M compared to $19M-$30M for CUs.
Questionable Benefit of Mergers
In a previous column we discussed the lack of accountability in CU boards that limits mergers, even in cases when the target's members would clearly benefit. A new study completed in conjunction with RP Financial now demonstrates that even when the merger occurs, in most cases the acquirer does not benefit in increased efficiency, which probably contributes to the lack of activity because the merger isn't worth the effort!
There have only been about 30 credit unions with $300M+ in assets merged since 2007. We looked closely at 23, highlighted in the table shown on this page.
In order to "get the deal done" many acquirers had to accept conditions that provide only a marginal improvement in efficiencies. Many CEOs tell us that the target board insists on retention of staff, branches and board members that are unnecessary. The numbers in the table certainly support their point. Improvements in assets per full-time employee and assets per branch are weak, and the ratios are significantly below the industry average, EVEN AFTER MERGER. These results leave many managers, who otherwise would be very interested in acquisitions, reluctant to bother.
Unfortunately, many CUs that are not growing are also not profitable, which means they're chewing up precious capital others could put to better use. Without better merger results, the credit union industry will experience a further cleavage between the small and large that threatens to weaken the larger CUs and the industry as a whole. Larger CUs will see their assessment burden increase as they grow and others shrink (the growth tax), while they fall behind their bank competitors who are merging up meaningful assets and generating improved efficiencies.
A 'Tax' On Some CUs
The cost-of-carry burden for the larger CUs continues to grow. Carrying the industry on assessments and trade dues-when combined with charter restrictions on small business lending, supplemental capital, asset risk weighting, and field of membership-have become important strategic considerations in board sessions. The burden is seen as a charter tax rivaling the federal tax of a community bank.
Lacking systemic accountability, capital will erode in the small CUs, while large CUs may increasingly decide against paying parts or all of a charter tax with no return.
In the meantime, improving balance sheet efficiencies, particularly investments, is a key opportunity for most CUs. In eight of the last 10 years, banks have generated at least 138 BPs more yield than CUs in the investment portfolio ($1.38M incremental income on $100M investments).
With investments representing over 30% of total assets, some credit unions are performing rigorous analysis to determine how to improve performance, including discussions with a different advisor, where a fresh perspective may be found.
Peter Duffy is managing director with Sandler O'Neill + Partners, New York.