Earnings Remain Elusive for Small Credit Unions
Based on NCUA's second-quarter credit union numbers released Sept. 2, it seemed as if Christmas had come early this year.
Sleigh bells almost jingled behind reports of the highest levels of credit union loan growth since 2006 and other economic milestones derived from NCUA 5300 Call Report data.
Granted, for the second consecutive quarter, credit unions posted positive returns thanks in large part to a recovering economy and other market variables.
But not all credit unions shared equally in the celebration. When it comes to earnings that drive growth and the ability to compete, in fact, some revelers faced a haze of uncertainty in a market that's getting increasingly more competitive, according to industry analysts.
“Looking at credit unions in general, I would be the first one to say that they are doing a good job, but that does set up their big challenge,” said Tom Bennett, senior managing director for Profit Insight, a bank and credit union consulting firm based in Mooresville, N.C. “Credit unions operate as a margin business and net interest is 70% of that margin, which means loan volume is the key to continuing the pace.”
At first glance, loan volumes are meeting, if not exceeding whatever goals the credit union industry may have set. The NCUA reported that during the second quarter, new auto loans increased 17% to $77.7 billion, while used auto loans increased 11.6% to $135.3 billion.
In addition, net member business balances rose 12% to $48.8 billion, private student loans increased 26% to $2.9 billion and short-term small loan originations totaled $106 million at an annualized rate in the first half of 2014, up 27.5% from the first half of 2013.
Drill down a level, however, and it's clear that not all credit unions are created equally when it comes to growth. While many credit unions with $500 million or more in assets are celebrating double-digit increases, smaller institutions are seeing what some may consider dramatic declines in loans and shares.
The dichotomy represents the growing earnings gap between large and small institutions, according to Brian Turner, former chief strategist for Catalyst Strategic Solutions, a subsidiary of Catalyst Corporate Federal Credit Union in Plano, Texas.
“I think for the most part, we can see the direct parallel between loan growth and earnings,” said Turner, who resigned from Catalyst Aug. 27 and opened the financial consulting firm Meridian Alliance LLC. “Obviously, larger credit unions feel less restricted in their lending than smaller credit unions, which have seen loan balances decline because of their resistance to pursue and retain real estate loans over the year.”
Peer-to-peer analysis based on NCUA's second-quarter numbers bore this out. Credit unions with more than $500 million in assets represent just 7% of industry institutions, but currently control 69% of all credit union assets. The larger asset group experienced 14% in loan growth, which suggested that 93% of the industry, collectively, suffered a 2.9% decline in loans, Turner said. In terms of share growth, large credit unions saw a 10.6% uptick, while the industry in aggregate experienced a 1.3% loss in shares.
Take the analysis down one more level and the differences became even more evident, the economist said. Credit unions with more than $100 million in assets – now 23% of the industry – saw loan growth of 10.6% and share growth of 10.3% during the second quarter. Credit unions with assets less than $100 million underwent a decline in loans of 7.6% and a decline in shares of 1.6% for the same period.
And, while NCUA touts the more than 98 million U.S. credit union members as of June 30, there are 125 fewer credit unions to serve them than there were at the start of the year, Turner said.
Read more: Small credit union struggles nothing new ...
Despite apparent growth trends to the contrary, the widening gap and the downturn in earnings is not a new credit union phenomenon, according to Pete Duffy, managing director at New York-based investment banking firm and broker-dealer Sandler O’Neill & Partners LP.
“The decline in credit union earnings is the continuation of a long-term trend,” Duffy said. “Community lending has gotten highly commoditized and the power is in the hands of the consumer. There's no new wheel and nothing unique that allows any one institution to price its products in a way that will generate greater incremental income.”
Since larger credit unions are faring much better in what Duffy described as a more commoditized and competitive environment, one alternative to shore up a declining return on assets might be increased merger activities through which smaller credit unions can gain greater advantage for their members by merging with larger institutions. However, that's not always viewed as a viable or popular solution, Duffy said.
“Credit unions and community banks are focused on organic growth and growth through mergers,” Duffy said. “Several keys elements around that dynamic make mergers uniquely difficult for credit unions.”
Community banks have access to more capital that better accommodates mergers and acquisitions, something that's mostly unavailable to credit unions. The lack of accommodations includes the reclassification for credit unions of goodwill, a traditional but intangible asset based on the perceived market value of a company acquired during a merger.
Under the NCUA's risk-based capital rule, goodwill is subtracted from capital, reducing the amount available for acquisition. Lack of that additional capital can hinder merger activity among credit unions that otherwise may view acquisitions as part of an overall strategic plan, Duffy said. But that's not the only thing stopping credit union merger growth.
“In most discussions with large credit unions, the boards and management are frustrated in their effort to accomplish mergers with average or weak credit unions that show no interest, even though their members would be better off being merged into stronger credit unions,” Duffy said. “These are credit unions whose member value proposition has long since evaporated.”
What makes this critical is the fact that the financial services industry overall is fast approaching an environment in which larger banks between $500 million and $50 billion in assets will gobble up smaller ones to gain competitive market advantage and cost efficiencies. Credit unions will become increasingly challenged to serve members, causing continued erosion in earnings, Duffy said.
“That's a situation unique to the industry that will lead to a competitive disadvantage for even the largest credit unions,” Duffy said. “And that is coming unless something is done.”
Despite such challenges, credit unions’ membership mantra can still work to their advantage in an increasingly commoditized marketplace, said Profit Insight's Bennett. Combine the financial cooperative industry's own version of ‘goodwill” with greater operating efficiencies and many credit unions will still have some fight left in them, he said.
“When I think about credit unions, they seem well-positioned in the marketplace for the most part,” Bennett said. “They need to build out their features and functionality and retain competitive pricing to be competitive from supply-side perspective. It would help, too, if the demand side had better information about credit unions.”
Credit unions also need to grow earnings in order to effectively compete, Bennett said. In an environment in which regulators are becoming increasingly fee-averse, this means increased lending, more competitive pricing and the ability to adjust to rapidly changing market conditions.
“If credit unions focus on driving member and revenue growth, in the long run they also will drive incremental returns,” Bennett said. “It's a good message, but also a somber one, that you need to balance revenue streams, think about noninterest income and make sure your organization is performing as effectively and efficiently as it should be.”