FRBSF Economic Letter
2005-29; November 4, 2005
Economies of Scale and Continuing Consolidation of Credit Unions
Whether depository institutions can achieve economies
of scale, that is, lower their average costs by increasing
their sizes, has been a subject of great interest and importance
to economists, regulators, and depository institutions
themselves. Deregulation has allowed banks, thrifts, and
credit unions to increase their size—and, thereby, to
reap whatever economies of scale have long been available
to larger depositories—by easing restrictions on their
abilities to acquire other financial institutions and to
operate over broader geographic areas. In addition, technological
advances in information processing and in financial practices
may have further added to depositories' economies of scale.
The resulting gains in efficiency can benefit the owners
and customers of depositories specifically and the economy
generally.
Economies of scale also provide powerful incentives for
industry consolidation, as firms grow and merge in order
to lower their costs and as smaller firms find it more
difficult to continue competing with their growing, increasingly
efficient competitors. Indeed, as technologies advanced
and deregulation proceeded, the total number of depositories
fell from about 40,000 in 1980 to less than 20,000 in
2004. And, over the same period, the average asset size
(in 2004
dollars) of banks quadrupled, while that of credit unions
grew tenfold.
However, the overall evidence in favor of the practical
importance of economies of scale in banking has, at
best, been mixed. As Kwan and Wilcox (2002) noted, academic
studies rarely find evidence that bank mergers reduced
banks' costs.
(They also suggested why some genuine, postmerger,
cost-cutting
was likely "hidden" by accounting conventions.)
And, in 2004, the noninterest expenses and net incomes
(relative to bank assets) of small banks differed little
from those of large banks.
The evidence for credit unions is different. This Economic
Letter shows that, in contrast to banks, larger credit
unions, on average, have decidedly lower average
costs and higher net incomes, as we might expect in the
presence
of important economies of scale. It further notes
that these economies of scale put pressure on the credit
union industry to continue consolidating into fewer,
larger
credit unions. It also describes how some recent
legislation
may
have further added to the pressures on both the banking
and credit union industries to consolidate.
Lower noninterest expenses at larger credit unions
 One conventional measure of the cost efficiency of a
depository is noninterest expense: Other things equal,
lower expenses
signal greater efficiency. Figure 1 depicts the noninterest
expenses (as a percent of assets) in 2004 for federally
insured credit unions in each of five asset-size categories.
(The first four categories include all credit unions
that had up to 10% more or fewer assets than the specified
number; the number of credit unions in each category
is: 147 in $1M; 423 in $10M; 171 in $100M; 34 in $1B.
The largest size category includes the two credit unions
that had at least $9B in assets.) These data show that
costs for larger credit unions are substantially lower,
suggesting very considerable economies of scale in
credit unions' noninterest expenses.
A noninterest cost disadvantage of 100 basis points
(1 percentage point), and often much more than that,
for smaller
credit unions puts severe pressure on the interest
rates that they charge borrowers and the interest rates
that
they offer to savers. Further, small credit unions
may typically offer fewer products and services as a way
to contain their costs. Because these data include
any extra
expenses for offering more products and services—such
as more hours at more branches, more ATMs, more e-banking,
and so on—Figure 1 may understate the cost advantages
of larger credit unions. Higher net income and interest
paid at larger credit unions
 Figure 2 depicts interest expense and ROA (return on assets,
which is net income as a percent of assets) for the sample
of credit unions. One repercussion of higher noninterest
costs at smaller credit unions is that they cannot afford
to pay the same high interest rates on deposits that larger
credit unions can. Figure 2 shows that interest expense
at the credit unions in the two largest size categories
exceeded that paid by those in the two smallest size categories
by about 50 basis points (one-half percentage point).
Credit unions are mutually owned by their members rather
than by outside shareholders, making their depositors
also their owners. Therefore, unless the differences in
interest
expense are due to differences in the composition of
deposits and their interest rates, the extra interest expense
incurred
by larger credit unions provides a larger benefit to
the depositor-owners of larger credit unions than is afforded
by smaller credit unions.
Figure 2 also shows that ROA rises steadily with the
size of credit unions, with the average ROA at very
large credit
unions about twice as large as that for medium-sized
credit unions and nearly one full percentage point
larger than
that for very small credit unions. In fact, on average,
very small credit unions earned virtually no income
in 2004. Thus, larger credit unions tend to have lower
noninterest
expenses, which enable them both to pay their members
higher interest rates on their deposits and to earn
higher net
income for their member-owners. One might expect this
pattern of performance when economies of scale in the
industry
are both large on average and pervasive, in that they
are available to numerous credit unions over a wide
range of
sizes.
ROA is important to credit unions in particular because,
in effect, those retained earnings are the only source
of the additional capital that regulators require
in order for a credit union to grow and thereby benefit
from economies
of scale. By contrast, regulators allow banks to
treat
as additional capital those funds that banks raise
by issuing various kinds of stocks and bonds to outside
investors.
Another, typically overlooked, aspect of the greater
cost efficiency of larger credit unions is that
they tend to
operate with lower capital ratios than smaller
credit unions. Larger credit unions are likely to be more
diversified because they have larger numbers of
borrowers
and savers.
They may also be more diversified by offering more
products and services. More diversification would
then allow larger
credit unions to have both lower capital ratios
and lower risks of failure. Wilcox (2005) documented
that larger
credit unions have indeed had lower failure rates.
One reason that the cost of capital may often be
overlooked is that credit unions do not distribute
any of their
net income—it all accumulates within the credit
union as capital.
A more complete assessment of costs would impute
the opportunity costs to members of the capital
that their
credit unions
have accumulated. Since capital is generally
regarded as the most expensive source of funding for any
depository, that larger credit unions generally
use less capital
is,
in practice, another source of economies of scale.
Somewhat offsetting these indications of economies
of scale are the larger noninterest fees that
larger credit
unions
tend to charge their members. This extra noninterest
income that larger credit unions earn can be
used to fund the
higher deposit rates and the extra services,
if any, that larger credit unions offer. Without
so
much
fee income,
larger credit unions would likely pay lower
rates on their members' deposits and charge higher
rates on
their members'
loans.
Economies of scale and
industry consolidation
Perhaps not surprisingly, given larger credit unions'
lower noninterest expenses, higher interest rates that
they offer to savers, and lower interest rates that they
charge their borrowers, the numbers of larger credit unions
and the share of total credit union industry assets in
larger credit unions have grown from 1980 through 2004.
For example, the number of credit unions that had over
$1 billion in assets grew from 2 to nearly 100, and the
share of total credit union assets in those credit unions
grew from 2% to 33%. Despite the overall growth of the
credit union industry, the number of credit unions that
had less than $100 million in assets shrank by one half,
from about 17,000 to fewer than 8,000, while their share
of assets of the credit union industry plummeted from about
70% to about 20%. (NB: These data are expressed in 2004
dollars.) Given the apparently quite large and pervasive
economies of scale, it is perhaps not surprising that smaller
credit unions have had higher failure rates than larger
credit unions.
Conclusion
Past and ongoing deregulation and recent legislation have
increased the means and the motives for credit unions to
consolidate and grow. The combination of the relaxation
of regulatory restraints on their products and services
and on their ability to reach more members, of substantial
cost advantages for larger credit unions, and of vigorous
competition among depositories of all kinds provides powerful
incentives for the credit union industry to consolidate
into fewer, larger and, therefore, more efficient, operations.
Smaller credit unions likely will face continuing pressures
to be acquired or otherwise exit the industry. Indeed,
credit unions of all sizes likely will face growing pressures
to improve efficiency by increasing the scale of their
operations, either by internal growth or by acquiring other
credit unions.
Government policies may also increase the economies of
scale that depositories face. Recent legislation, such
as the Gramm-Leach-Bliley Act, the USA Patriot Act, and
the Bank Secrecy Act, may well provide some important
benefits to the nation. But, quite apart from such benefits,
these
recent laws may also impose unavoidable and unintended
costs on depositories and consequences for the structure
of the banking and credit union industries. For example,
these laws may have the effect of imposing various sizable
costs that are borne disproportionately by the smaller
depositories. If they do, they strengthen the incentives
for depositories to grow and thereby spread the quasi-fixed
components of those costs over larger-sized operations.
Such disproportionate, law-induced costs would increase
the returns to scale in the banking and credit union
industries and thereby strengthen the motives for consolidation. James A. Wilcox
Visiting Scholar, FRBSF, and
Professor, Haas School of Business, UC Berkeley
References
Kwan, Simon H., and James A. Wilcox. 2002. "Hidden
Cost Reductions in Bank Mergers: Accounting for More
Productive Banks." In Research in Finance 19,
ed. Andrew H. Chen, Elsevier Press, pp. 109-124.
Wilcox, James A. 2005. "Credit Union Failures and
Insurance Fund Losses: 1971-2004." FRBSF
Economic Letter 2005-20 (August 19).
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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