Gary C. Zimmerman

English

Research Papers in Economics

FRBSF WEEKLY LETTER
December 11, 1987
Growing Pains
In the last three years, credit unions have been
the fastest growing type of depository institution.
The growth of their assets and deposits has sig-
nificantly outpaced that of the much larger bank
and savings and loan industries. For example,
credit union assets rose by more than 25 percent
in both 1985 and 1986 when assets at all depos-
itory institutions grew an average of about 10
percent per year. In 1987, the credit union
industry continues to show strong deposit and
asset growth; assets recently passed the $175
billion level. However, while the volume of
business is rising for the nation's nearly 16,700
credit unions, there has been substantial consol-
idation within the industry, and the number of
credit unions in operation has fallen from nearly
22,000 in 1980.
These recent trends point to a number of chal-
lenges facing the industry. Deregulation in gen-
eral, and specifically, the removal of interest rate
ceilings on consumer loans and deposits, has
increased price competition. Moreover, tax
reform and increasing competition from other
depository institutions make it imperative for
credit unions to price their growing array of
deposit and loan products competitively.
The industry
The credit union industry is distinguished by the
"common bond" of each institutions' members.
That common bond typically takes the form of a
common employer, union, industry, organiza-
tion, or locality, and gives credit unions a strong
affiliation with their customers or "member-
ship". Membership now numbers about 55 mil-
lion persons nationally.
Credit unions also are nonprofit cooperative
.organizations, and thus are not subject to
income taxes. In many cases, credit unions also
benefit from volunteer labor and subsidies of
labor, office space, etc. from sponsoring groups.
More importantly, for many credit unions, the
close affiliation with their borrowers may give
them better information with which to evaluate
lending risks. These stylized facts are consistent
with the history of credit unions as low cost pro-
ducers of consumer banking services that have
enjoyed lower loan loss ratios than other retail
lenders.
Compared to other depository institutions, credit
unions typically are small, averaging only about
$10 million in assets. However, recent consol-
idation is resulting in a trend towards fewer,
albeit larger, credit unions. While most credit
unions remain small, the nation's largest, with
nearly $3 billion in assets, is larger than most
banks and thrifts.
Services and pricing
Most credit unions provide households with
retail banking deposit products such as share
draft checking accounts, savings deposits, and
savings certificates. Interest is paid to depositors
on "share" accounts or certificates in the form
of "dividends to members."
Historically, the funds deposited with credit
unions have been lent to credit union members
in the form of personal and automobile loans. In
recent years,the scope of lending operations has
been broadened to include real estate-related
lending and credit cards. Earnings from their
lending operations allowed credit unions to pay
the "dividends" on their deposit liabilities, cover
operating and overhead costs, as well as gener-
ate capital- through retained earnings.
The industry typically has paid deposit interest
rates higher than bank or thrift rates while offer-
ing loan rates that were lower. This pattern
appears to be changing, however. Credit unions
on average continue to pay higher interest rates
on deposits. However, National Credit Union
Association data indicate that, since 1985, the
average loan rate for credit unions has been
higher than the comparable loan rate for banks
(Chart 1). This reversal of the traditional pricing
relationship has been accompanied by slower
loan growth as compared to deposits after 1984
(Chart 2).
Cooperative objectives
To help understand the changes that have
occurred in the industry's pricing practices, we
need to examine credit unions' operating objec-FRBSF
tives. Since credit unions are nonprofit coopera-
tive organizations, their goals and objectives
may differ from those offor-profit banks or
thrifts.
The behavioral model normally assumed for
banks is that they price deposits and loans to
maximize stockholder wealth. Analysts and reg-
ulators have argued that credit unions would be
better off by lowering both deposit interest rates
and loan rates because they could then maintain
or improve interest rate spreads and earnings.
This argument assumes that the supply of
deposits is relatively inelastic and the demand
for loans is relatively elastic with respect to
interest rates. Lower deposit rates would reduce
costs while the combined effect of lower loan
rates 'and greater loan volume would increase
revenues. Together, the effects would increase
interest-rate spreads and, consequently,
earnings.
The fact that the industry has not embraced the
recommendations of the regulators and industry
groups suggests that credit unions may have
objectives that take precedence over aggregate
wealth-maximization. One alternative objective
is to let borrower members capture the benefits
of credit union operation through "below mar-
ket" loan rates. Although this was the case in the
past, since deregulation removed the 12 percent
usury ceiling on federal and some state-char-
tered credit union loan rates in the early 1980s,
credit unions have charged higher interest rates
on autos and unsecured personal loans than
banks. (Credit card loans, which are a much
smaller portion of total lending, though, are still
generally available with lower rates and smaller
fees at credit unionsthan at banks.)
Alternatively, the primary credit union objective
may be to maximize returns to savers/depositors.
If so, then we may expect to see credit unions
offering relatively high deposit interest rates (or
dividends) to reward "member" savers. Anecdo-
tal evidence supports the idea that credit unions
pass benefits to depositors - the "owners" of
the cooperative. The industry <::ontinues to offer
higher interest rates on its deposit products than
banks or savings and loans. Moreover, credit
unions offer a higher proportion of free or low
cost checking accounts (share drafts) than banks
or savings and loans.
Investment shift
Attractive rates and fees have resuIted ina rapid
net inflow of deposits that has sharply raised liq-
uidity in credit unions. "Surplus" funds (mea-
sured as the difference between assets and loans
to members in Chart 2) totaled nearly 40 percent
of assets at the end of 1986, up from only 31
percent in 1984.
Credit unions now face the decision of how to
invest those surplus funds. Most of the surplus
funds are now invested in a wide array of liquid
money market assets, including jumbo CDs,
repos, federal funds, and government securities,
or are lent to corporate central credit unions,
which invest them in the money markets. But
there is some question as to the long-term
viability of such a strategy.
The appropriate choice of investment strategies
will depend on the source of credit unions' pric-
ing advantage. On the one hand, if the source
were simple operating and tax cost savings, then
credit unions could in essence serve as low cost,
mutual-fund-like conduits between savers and
open securities markets. They would offer the
additional competitive advantage over mutual
funds of providing insured deposits that do not
decline in value.
On the other hand, if their pricing advantage
derives primarily from advantages in the credit
evaluation of borrowers, then the shift away
from lending activity would be self-limiting. As
they replace their loan portfolio with open mar-
ket securities, credit unions will find it difficult
to support their more generous deposit rate (divi-
dend) policy.
This difficulty may already be apparent in the
financial performance of credit unions. For
example, credit unions earned an average of
12.31 percent on their $97 billion loan portfolio
during the first quarter of 1987. By contrast, the
investment yield on their $60 billion in surplus
funds was only 6.75 percent, which is only
slightly above the 6.32 percent average cost of
total savings balances for the industry. Thus, the
growing surplus has reduced the industry's net
spread and placed pressure on some credit
unions to invest in higher return, but more risky
financial instruments.-1.0 +----,-----.,.-----.-----~
Chart 2
Credit Union Assets,
Loans, and Savings Deposits
85
70
".."
" ....'
"...... Loans ........... .,.
-,,'" .-,-'
40 --_.•.•.•,.-'
Billions
of Dollars
175
160
145
130
115
100
1982 1983 1984 1985 1986 1987 * 1987 1986 1985 1984
Savings Accounts
1.5
Chart 1
Credit Union Interest Rates Less
Bank Interest Rates 2.0
1
- _
1.0
0.5
Percentage
Points
Difference
\"\\Illllll ..••~_~,,..
. "".""""""".""."".".".
0.0 +'-""-'''-11
11
-'''-''-- ••-" ...... - ..........- ...........-" ........;>:----------
-0.5 """"".·"Auto Loans
• First six months. Source: Federal Reserve Bulletin
Tax reform
Pricing issues and credit unions' move away
from lending to members comes at a time when
the industry faces other major challenges. Tax
reform, for example, is likely to accelerate the
shift away from traditional credit union install-
ment loan products. (Today, over 20 percent of
loans to members already are real estate-
related.) The 1986 tax reforms will lead to the
gradual phase-out of the personal interest
deduction on consumer loans.
Since most credit union lending has been made
in the form of consumer installment loans, credit
unions already have begun to offer loan prod-
ucts that will provide borrowers with tax-deduct-
ible interest. The most typical form of these new
products is a home equity loan or line of credit
that allows homeowners to borrow, with some
limitations, against equity in their homes.
Indeed, a recent study indicates that nearly all
credit unions either offer or plan to offer mort-
gage-related loan products, despite the fact that
mortgage lending requires new expertise and
increases the complexity and cost of credit
union operations.
Competition and deregulation
Pricing has also been made more complex as
other lenders have become more active in con-
sumer lending. Substitute financing, especially
from the "captive" finance companies operated
by the major domestic automobile manufac-
turers, has played a major role in shifting house-
holds' automobile financing patterns. Finance
companies' automobile installment lending has
nearly doubled since 1984 as automobile man-
ufacturers actively offered discount financing to
promote sales. Commercial banks also have
increased automobile financing and consumer
lending dramatically to offset the prolonged
slowdown in corporate borrowing.
Finally, deregulation has allowed savings and
loans to offer consumers a wider array of con-
sumer loan products, from automobile financing
to credit cards, placing further pressure on the
credit union industry's ability to maintain its
consumer lending market share.
Conclusion
In an environment of declining interest rates and
increased competition, credit unions as an
industry appear "to have been slow to lower
(deposit) costs and re-price their loans in
response to changing market conditions," sug-
gested Roger Jepsen, Chairman of the National
Credit Union Administration. Hence, the credit
union "movement" has been faced with a grow-
ing surplus and narrowingspreads. This Letter
argues that this situation is consistent with the
cooperative nature of credit unions, which may
result in goals and objectives that are less mar-
ket-driven than those of profit-maximizing firms.
Gary C. Zimmerman
Opinions expressed in this newsletterdonotnecessarily reflect the viewsofthemanagement ofthe Federal Reserve Bank of San
Francisco, orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybe addressed totheeditor(GregoryTong) ortotheauthor.•••Free copiesofFederal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
large Commercial Banks
Amount
Outstanding
11/18/87
Change
from
11/11/87
Change from 11/19/86
Dollar Percent?
Loans, Leases and Investments1 2 208,611 - 447 2,239 1.0
Loans and Leases1 6 184,302 - 410 - 1,470 - 0.7
Commercial and Industrial 51,377 127 - 169 - 0.3
Real estate 72,309 46 5,260 7.8
Loans to Individuals 36,943 60 - 4,481 - 10.8
Leases 5,415 - 5 - 166 - 2.9
U.S. Treasury and Agency Securities2 16,966 - 123 4,190 32.7
Other Securities2 7,343 85 - 482 - 6.1
Total Deposits 206,591 - 1,137 - 951 - 0.4
Demand Deposits 51,470 - 688 - 2,070 - 3.8
Demand Deposits Adjusted3 47,310 - 865 - 1,669 - 3.4
OtherTransaction Balances4 20,030 - 301 1,791 9.8
Total Non-Transaction Balances6 135,091 - 148 - 672 - 0.4
Money Market Deposit
Accounts-Total 44,313 72 - 2,600 - 5.5
Time Deposits in Amounts of
$100,000 or more 31,660 - 210 - 1,725 - 5.1
Other Liabilities for Borrowed MoneyS 23,811 - 2,024 - 5,325 - 18.2
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
11/16/87
13
6
12
Period ended
11/2/37
36
4
31
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes u.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Growing pains

http://www.frbsf.org/publications/economics/letter/1987/el87-50.pdf

Growing pains

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Research Papers in Economics