Summer 2019 – Staying Power

Cruise Control

Finding the right speed for sustainable growth

By Luis G. Dopico

Credit unions serve their members by providing them with a broad range of loan, savings and other financial products and services. To best serve their members, credit unions must balance short-term and long-term goals. Serving members in the short term involves providing services at attractive terms, fees and interest rates—for example: high loan approval rates, low interest rates on loans, high interest rates on saving products, and a broad range of other financial services at low fees. Serving members in the long term involves ensuring that credit unions continue to remain relevant in the financial lives of their current members and in the future marketplace.

Thus, credit unions must be able to continue to offer attractive terms, fees and interest rates—not only for the short term, but also for the long term. To remain relevant, credit unions’ assets must also at least grow in line with current members’ and, more generally, all Americans’ incomes. In other words, to best serve their members, credit unions must be financially sustainable.

What does financial sustainability mean for credit unions?

In my previous research with Ben Rogers,¹ we defined credit unions’ financial sustainability as being able to:

1. Offer attractive terms, fees and interest rates indefinitely for a broad range of financial products;
2. Remain relevant in the financial lives of their members and of Americans as a whole by maintaining constant, or growing, market shares and;
3. Maintain capital per assets ratios that are sufficiently high to withstand periodic shocks, such as economy-wide increases in loan losses.

To highlight the extent to which credit unions provide their members with more attractive interest rates on loans and deposits than commercial banks, Figure 1 presents our estimates of credit union member benefits on loans and deposits between 1985 and 2018.

We compute “benefits on loans” as the weighted average of the interest rates charged by banks minus those charged by credit unions across up to six key loan types (credit cards, other unsecured loans, new cars, used cars, first mortgages and other real estate loans)—i.e., how much lower interest rates on loans are at credit unions.

We compute “benefits on deposits” as the weighted average of the interest rates paid by credit unions minus those paid by banks across up to five key types of deposits (checking, savings, money market deposits, certificates of deposit and IRAs)—i.e., how much higher interest rates on deposits are at credit unions.

Despite some variation across the years, credit unions have consistently delivered more attractive interest rates across a wide variety of macroeconomic conditions, averaging interest rates on loans 0.62 percent lower than banks and interest rates on deposits 0.51 percent higher than banks between 1985 and 2018.

To highlight the relevance of credit unions in the financial lives of their members—and of Americans as a whole—Figure 2 presents credit unions’ assets per assets in all depositories (i.e., including banks and thrifts), and credit unions’ assets per GDP between 1910 and 2018. Credit unions have been growing more relevant in the U.S. economy, steadily gaining market share for more than a century. For instance, credit unions’ assets relative to total GDP passed 1 percent in 1960 and 5 percent in 2002, and stood at 7.1 percent in 2018.

To highlight credit unions’ ability to withstand periodic shocks, Figure 3 presents credit unions’ capital per assets between 1911 and 2018, showing 1.) stable levels over the long term, 2.) markedly higher levels since the early 1990s when regulatory interest on capital levels was heightened, and 3.) relatively fast recoveries following each decline, such as after the recent financial crisis.

A two-speed-limits framework for credit union financial sustainability

The previous three figures clearly highlight the financial sustainability of the credit union system over many decades. However, applying such analysis to individual credit unions (or to groups of them) would require practitioners to have access to a wealth of data (e.g., historical interest rates and volumes for a wide range of loans and deposit products at banks and credit unions) and would require complex, interpretive estimates across three figures.

Thus, we present a “two-speed-limits” framework for credit union financial sustainability. Its advantages are two-fold. First, the framework only uses data that individual credit unions can readily access about themselves: their own net income, net worth and assets over time, plus nominal GDP. Second, the framework is intuitive, comparing in a single figure the asset growth for a credit union (or group thereof) and two “speed limits” (a maximum and a minimum one) between which to steer to ensure financial sustainability.

Under this framework, to be financially sustainable credit unions’ nominal (i.e., not inflation adjusted) asset growth rates must:

• Grow faster than the “5-year moving average” of the growth rate of nominal GDP growth. Growing faster than this minimum speed limit ensures that credit unions maintain their market share and relevance.
• Not grow faster than “Return on Equity (ROE)-adjusted,” which we calculate as the 5-year moving average of Return on Assets (ROA) divided by the minimum of the capital per assets ratio or 10 percent.² Growing slower than this maximum speed limit buttresses credit union capital ratios.

Figure 4 presents the two-speed-limits framework using data for all credit unions between 1940 and 2018. The figure highlights that maximum speed limits have almost always been higher than minimum speed limits.³ The historically broad gap between maximum and minimum speed limits meant that even if credit unions’ asset growth rates ranged quite widely, they would fall within the range between the two speed limits, and thus meet both conditions for financial sustainability.

However, the gap between maximum and minimum speed limits has shrunk steadily, falling from 11.6 percent (= 18.0 percent – 6.4 percent) during the 1960s to 2.3 percent (= 6.1 percent – 3.8 percent) during the past ten years (2009-2018). As this gap has dwindled, credit unions are unavoidably operating closer to their speed limits. The gap has dwindled, largely, as maximum speed limits have fallen. In turn, maximum speed limits have fallen as 1.) capital ratios have risen from 7.06 percent during the 1960s to 10.65 percent between 2009 and 2018, and 2.) ROAs have fallen from 1.27 percent to 0.69 percent during those same time periods. Capital ratios have risen responding to an increased regulatory focus on capital. ROAs have fallen as credit unions face growing margin pressures, rising demands for more sophisticated products and services from their members, rising regulatory costs and, complexly, as credit unions accept lower growth rates and thus do not need to target ROAs that are as high.

The shrinking gap between maximum and minimum speed limits may have ominous implications for credit unions. Should the gap continue to shrink and if, eventually, the two speed limits “crossed,” then the maximum speed limit would be lower than the minimum speed limit. At that point, credit unions would be in breach of at least one of the two speed limits.

Credit unions whose asset growth exceeded the maximum speed limit would see their capital ratios fall and, shortly thereafter, would have to accept slower asset growth. Credit unions whose speed limit fell short of the minimum speed limit would grow so slowly as to continuously lose market share and relevance.

Applying the framework to smaller credit unions

The narrowing gap between the maximum and minimum speed limits means that, even if they have yet to cross for the credit union system as a whole, those limits are likely to have crossed for many subsets of credit unions and for many individual institutions—i.e., many credit unions are in breach of at least one of the conditions for financial sustainability.

While the credit union system as a whole is financially sustainable, the number of smaller credit unions has been dwindling for decades. Thus, next we present our framework focusing on credit unions with between $1 million and $10 million in assets (later referred to as “very small credit unions”).

Larger credit unions have long had, on average, substantially lower noninterest expenses and loan delinquency rates than smaller credit unions.⁴ Having lower costs and delinquency rates, larger credit unions have been able to simultaneously 1.) pass part of these advantages on to their members as lower interest rates on loans and higher interest rates on deposits, and 2.) have higher ROAs. More attractive interest rates and higher ROAs combine to deliver higher asset loan rates for larger credit unions, but also for larger credit unions having enough earnings to ensure that their capital keeps up with asset growth. Thus, on average, larger credit unions are far more likely than smaller credit unions to meet the conditions for financial sustainability.

Many factors contribute to the long-term challenges faced by smaller credit unions. Among them are financial consumers’ increasing demand for more sophisticated financial products (credit cards and home equity lines of credit instead of traditional unsecured short-term loans) and more sophisticated means of delivery (debit cards and online and mobile banking instead of cash and checks).⁵ These more sophisticated products and services impose fixed costs that are difficult for smaller credit unions to defray across their small memberships. In addition, increasing regulatory costs further burden smaller credit unions.⁶

Figure 5 presents the two-speed-limits framework for very small credit unions, showing that they have long not met the conditions for financial sustainability. Very small credit unions have, for the most part, grown more slowly than GDP since the mid-1990s, and are thus losing market share and relevance. Moreover, since 2005, the maximum and minimum speed limits have crossed. Since the maximum speed limit is lower than the minimum one, these credit unions must fail to abide by at least one of the two speed limits. Thus, in recent years, very small credit unions have often grown not only so slowly that they lose market share, but also so quickly that their capital ratios fell.

While this situation is mathematically not sustainable over the long term, conditions for very small credit unions might be somewhat less ominous in the short term than they appear at first glance. Very small credit unions’ maximum speed limit is currently so low, in part, because their capital ratios are so high and, in part, because their ROAs were depressed by the financial crisis and its aftermath, perhaps temporarily. If, averaging 15.93 percent, capital ratios are excessively high for many individual very small credit unions, then they could temporarily tolerate low maximum speed limits (or even negative ones).

Low maximum speed limits would be consistent with a transitional period toward a more optimal level of lower capital ratios. Once very small credit unions attained some lower target level for their capital ratio, they could discontinue temporary policies to attain low ROAs.

However, even after very small credit unions reduce their capital ratios to some lower target level, they are likely to continue to face challenges. On average, smaller credit unions bear far higher noninterest expenses. Absent particularly successful cost control efforts, most very small credit unions will continue to struggle with 1.) offering interest rates that are as attractive as their (larger) peers,’ 2.) attracting the asset growth needed to maintain market share and relevance, and 3.) achieving the ROAs required to maintain even lower capital ratios.

Credit union market share and relevance in the U.S. economy

Despite many macroeconomic and regulatory challenges, the credit union system as a whole has remained financially sustainable. Applying our two-speed-limits framework, during the last ten years (2009-2018) credit unions’ asset growth (5.9 percent) exceeded their minimum speed limit (GDP growth, 3.7 percent), helping credit unions increase their market share and relevance in the U.S. economy. Credit unions’ asset growth has also been roughly at par with their maximum speed limit (ROEadjusted, 6.1 percent), ensuring somewhat stable capital ratios.

However, in recent decades credit union performance has begun to diverge markedly across asset size ranges. Very small credit unions bear far higher noninterest expenses per assets than their larger peers and, thus, struggle to offer comparable interest rates and to maintain similar asset growth rates. While larger credit unions are financially sustainable, many smaller ones continue to struggle.

Luis G. Dopico is an economist at the Filene Research Institute. His areas of expertise include credit unions, their historical and current call report data, and analyzing their performance statistically. Over the years, he has researched crucial credit union topics including deposit insurance, capital requirements, financial sustainability and structuring credit unions for innovation.