FRBSF Economic Letter
2006-19; August 4, 2006
Performance Divergence of Large and Small Credit Unions
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By various measures, larger credit unions have recently had
stronger financial performance than smaller credit unions, indicating
that these institutions face large and pervasive economies of
scale (Wilcox 2005a). This Economic Letter uses data from the
1980-2004 period to show that this performance difference is
a long-running state of affairs. Moreover, these data reveal
increasing performance divergence over this period--that is,
a widening in the gap in financial performance between large
and small credit unions. Thus, it is not surprising that the
number of smaller institutions has been shrinking, while the
number of larger institutions has been rising. Specifically,
between 1980 and 2004, the number of small credit unions (less
than $100 million in assets in 2004 dollars) shrank from 17,132
to 7,859, while the number of large credit unions (over $1 billion)
grew from 2 to 98. If performance divergence continues, it is
likely to quicken the pace of consolidation in the credit union
industry; nonetheless, thousands of small credit unions may well
survive for decades.
Diverging costs
 One measure
of the relative cost efficiency of a bank or a credit union is
lower noninterest expense, which consists
of wages,
salaries and benefits, depreciation of equipment and buildings,
costs of supplies, marketing, office operations, and travel,
among others. As the string of negative readings in Figure
1 shows, noninterest expenses were consistently lower at
large
credit unions than they were at small credit unions. In particular,
at large credit unions, the ratio of noninterest expenses
to assets was more than 100 basis points (1 percentage point)
lower on average than that for small credit unions. To
put
the size
of this cost advantage in perspective, note that, on average,
noninterest expenses at small credit unions are about one
and a half times as large as those for large credit unions. Expressed
differently, if large credit unions had noninterest costs
in
2004 as high as those of small credit unions, all else equal,
the net income of large credit unions as a group would be
negative. Instead, large credit unions enjoyed a very profitable
year.
Figure 1 also shows that the long-running cost advantage
of large credit unions has increased from an average of
fewer than 100
basis points during the 1980s to more than 120 basis points
over the past dozen years. Diverging costs make it ever
more difficult
for small credit unions to offer financial services and
interest rates on loans and deposits that effectively compete
with
those
of larger credit unions.
This sizable increase in the already large cost advantage
of large credit unions might have several sources. One
might be
the faster growth of large credit unions relative to
smaller institutions, which would allow them to achieve relatively
more scale-related cost savings. In addition, recent
legislation
may
have imposed costs on banks and credit unions that weigh
more heavily on small institutions. To the extent that
the costs
of complying with the Bank Secrecy Act and anti-money
laundering and other regulations increased after our data end
in 2004,
the
cost disadvantages of smaller institutions may have worsened
even further. Such cost divergence can further stimulate
consolidation.
Diverging earnings
 Figure 2 plots the annual differences in the ratios of
net income (or return on assets, ROA) and of interest
expenses between large
and small credit unions (measured as a ratio to assets).
Credit unions are mutually owned by their members,
not by
stockholders.
Thus, all else equal, both higher ROA and higher
interest expenses (which are interest incomes to credit union
members) signal
that credit unions are providing greater benefits
to
their members.
On average, larger credit unions both earned more
net income and paid more interest to their members than
small credit
unions did. Because they have substantially lower
noninterest expenses
than small credit unions do, large credit unions
have the wherewithal both to pay higher interest rates and
to generate
higher earnings.
In addition, members of larger credit unions also
benefit from lower loan interest rates and a wider range of
financial services
(Wilcox 2005b, CUNA 2006).
Figure 2 shows that the persistent reductions in
noninterest expenses at large relative to small
credit unions tend
to be mirrored by persistent upticks in the earnings
of large
relative
to small credit unions. While large and small credit
unions had approximately equal average ROAs over
the 1980s, the
earnings of large and small credit unions steadily
diverged since then,
with the difference in their ROAs averaging over
40 basis points since 2000.
In contrast to noninterest expenses and earnings,
interest expenses at large and small credit unions
have shown
no clear tendency
to diverge. Large credit unions paid about 40
basis points more in interest to their members than small
credit unions,
both on
average since 1980, and in 2004.
W(h)ither small credit unions?
Since large credit unions have long been more
efficient, earned more, and paid higher interest
rates to
their members than
small credit unions, why have small credit
unions historically had
so many members and assets? Is the relative
shifting of members and assets toward large credit unions
likely to
continue
and, if so, at what pace and with what repercussions?
The history, the unwinding, and the recent
additions of financial regulation each
helps answer these
questions. Just as banks
faced stringent branching and ownership
restrictions before
the 1980s,
restrictions on fields of membership (FOMs)
usually confined individual credit unions
to serving
the employees of
a single government agency or company,
or even a single plant
of a
company. Thus, millions of people were
eligible to join only one, often-small,
credit union, or to join none at all. Thus,
as for banks, the large numbers of small
credit unions historically
were partly
an artifact of regulation.
Over the last 25 years, changes in regulation
have greatly expanded FOMs; for example,
sometimes individual
credit
unions can serve
all of the employees of a nationwide
company, all of the local or state government employees
within
a state,
or
all of the
residents and employees within a local
area (which might encompass several
counties or millions of residents). Larger
FOMs have both allowed individual credit
unions to
grow and
thereby reap
certain economies
of scale and created more overlapping
FOMs, which permit individuals to choose among
credit unions.
To the extent
that credit union
members migrate toward the (typically
larger) credit unions that pay higher deposit rates,
expanded
FOMs contributed to the decline
in the share of total credit union assets
in small credit unions from 69% in 1980
to 46%
in 1990,
to 29% in 2000,
and to 21%
in 2004.
While Figure 1 shows the average amounts
by which the costs of small credit
unions exceed
those
of large
ones, it does
not reveal
how much the cost disadvantages vary
between small credit unions. In 2004,
more than
4,000 small credit
unions,
which together
held most of the assets of all small
credit unions, had noninterest expenses
that exceeded
the average
for large
credit unions
by more than 100 basis points. For
a time, many of these relatively inefficient
credit
unions
will likely
survive,
if not thrive.
However, their earnings and interest
rates are likely to preclude growth
sufficient to reduce
their average
costs
significantly.
As a result, these credit unions likely
will constitute shrinking shares of
an otherwise
sizable and sound
industry. Further
liberalization
of FOMs or other changes that raise
the average sizes of credit unions would
likely
also
further stimulate
consolidation
among
credit unions.
Nonetheless, the credit union industry
is unlikely to be dominated by a
few nationwide institutions
any time
soon.
One reason
is that legislation and regulation
still restrict the expansion of the
FOM for
an individual
credit union
at most to the
employees of a profession or business
or to a local area. Another reason
is that costs at many small credit
unions are low enough to keep
them competitive. In 2004, for example,
more
than 1,500 small credit unions (accounting
for 15% of
assets in
all small
credit unions) had noninterest expense
ratios that were lower than
the average ratio for large credit
unions. While the total number
of credit unions has fallen from
a peak of 23,866 in 1969 to 9,483 in
2004, the
rate
of consolidation
has
slowed
recently. Indeed, if the 1995-2004
rate of consolidation continued,
for
example, the U.S. would still have
over 5,000 credit unions in 2025.
Similarly, for commercial banks,
the loosening of geographic and
other restrictions
contributed
greatly
to the consolidation
from a post-Great Depression peak
of 14,482 banks in 1984 to 7,630
in 2004.
Nonetheless,
in recent
years,
small banks
have
prospered, numerous new banks have
been chartered, and the pace of
consolidation has slowed.
(Perhaps further
testimony
to the
prospects for small credit unions
generally is the virtual absence
of any new credit
unions being formed
over the
past decade.)
Indeed, if the 1995-2004 rate of
bank consolidation continued, the
U.S. would
still have about
4,000
commercial banks
in 2025. Together, their current
healthy performance and condition
and
the pace of recent consolidation
suggest
that the U.S. may well have thousands
of small credit
unions
and
small commercial
banks
for decades to come.
Summing up
The credit union industry's responses
to the deregulation, technological
advances, and additional
regulations
of the recent past suggest
that it will be consolidating
for many years to come. The industry's
successes
suggest
that some
small
credit unions
(like some
small banks and some small
nonfinancial businesses) are sufficiently
cost-efficient and attuned
to the needs
and circumstances
of their local deposit and
loan customers that they will thrive.
Many other credit unions, however,
will not thrive or even survive.
Continuing performance
divergence
will
make it
increasingly difficult
for smaller credit unions
to serve their
members as effectively as
larger credit unions do and
to meet
standards for
safety and soundness. In
that event, less-efficient and less-profitable
credit unions will increasingly
feel pressures to liquidate,
merge,
or
convert to other
charters. The
size and shape
of the
credit union industry will
reflect which of these options
are favored
by credit
union members
and
managements and their regulators. James A. Wilcox
Visiting Scholar, FRBSF, and
Professor, Haas School of Business, UC Berkeley
References
[URLs accessed August 2006.]
CUNA (Credit Union National Association). 2006. Credit
Union Report Year-end 2005. Madison, WI.
Wilcox, James A. 2005a. "Economies
of Scale and the Continuing Consolidation of Credit Unions." FRBSF Economic
Letter 2005-29 (November 4).
Wilcox, James A. 2005b. Failures and Insurance Losses of
Federally-Insured Credit Unions: 1971-2004. Madison, WI:
Filene Research Institute.
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
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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