A new analysis by Sandler O'Neill underscores howcritical the sheer size of financial institutions  hasbecome to their surviving and thriving. Yet top performing creditunions are being held back by a systemic lack ofaccountability.

Consumers have aggressively shopped for the best rate on loansand deposits, triggering a 20-year decline in the net interestmargin of banks and credit unions. Further challengingprofitability is the need to continually invest in technology, bothto increase customer convenience and to protect against fraud.Added to that are the increased compliance costs and pressures onfee income arising from the Dodd-Frank Act.

In 2000, credit unions with less than $100 million in assetsgenerated 90 basis points of ROA, and their net interest margin was80 bps higher than their operating expenses. Today, the margin doesnot cover operating expenses for the group of credit unions below$1 billion in assets, according to year-end 2011 NCUA Call Reports.This means the sweet spot for economies of scale has moved $900million higher in assets in 11 years. The sweet spot for banks isalso around $1 billion, and their ROA has declined, but theirmargin covers expenses in all asset sizes, according to year-end2011 FDIC Call Reports.

This is the continuation of a long-term trend not simply afunction of low rates or high share insurance assessments. In fact,the margin no longer covered expenses for many credit unions in2002. Small institutions have fewer resources and more difficultykeeping up with the expectations of members while meeting thegreater demands of safety and soundness and consumer protectioncompliance.

These and other factors were expected to lead to an increase incredit union consolidation, but it has not materialized. The numberof credit union mergers has actually declined every year since2004, despite the fact that more than one-third of the industrygenerated a negative ROA last year and the combined number of CAMEL3, 4 and 5 credit unions has increased.

Although the recent pace of bank mergers is slower than inprevious years, meaningful consolidation had already begun. What'smore, the recent pace does not threaten the well-being of topperforming banks the way the lack of merger threatens top creditunions.

Banks can grow two ways, credit unions just one. Strong creditunions are at a competitive disadvantage to their bank counterpartsbecause they cannot equally grow through merger. This reality isbecoming more obvious to the large credit unions. Consider that 52%of the credit union industry assets reside in institutions withless than $1 billion in assets, while only 10% of banking industryassets are in banks smaller than $1 billion. Over the years,numerous players in the banking industry imposed moreaccountability on average and weak performers. These playersincluded customers, shareholders, directors and regulators of weakbanks as well as stronger competitors. Top performing credit unionsbelieve the CU system of accountability is not functioning asefficiently as evidenced by fewer mergers and subpar ROI on capitalspent on branches and marketing among other things.

Over time, the impact on income and competitiveness will be feltas stronger banks merge  meaningful assets and improvetheir efficiency ratios, while stronger credit unions cannot.Stronger banks of all sizes acquire weaker banks, sometimes withFDIC assistance, which has led to only 10% of the industry's assetsresiding in banks smaller than $1 billion. Further compounding theissue is the relative size of the merged institutions. SandlerO'Neill research derived from NCUA and FDIC data reveal the averagecredit union merged since 2004 has $19 million in assets, comparedto $749 million for banks.

Average and weak credit unions are not merging. To maintainmarket relevance, many are pricing their products and fees in amanner that not only produces a negative ROA, it erodes theircapital. In addition, such loss-leader pricing harms healthierinstitutions by creating customer expectations of similar pricingfrom them. When resolution of a weak credit union finally occurs,there is little left to attract suitors.

Thus, an unintended consequence of regulatory forbearance andinsufficient merger and acquisition activity is reduced income forall and a growth tax on healthier credit unions. As marginal andweak credit unions shrink, the top credit unions pay higherassessments because their percentage of the industry's totalshares  increases. To illustrate, one credit union grewshares by 16.2% in 2009-2010. The credit union's total documentedassessment was $19.3 million, of which $5.2 million is due to itsgrowth combined with the shrinkage that occurred at many creditunions. Documented assessments are those identified by the NCUA asa result of funds owed to investors in medium-term notes issued bythe NCUA and funds owed the U.S. Treasury from previous borrowingsbut do not include additional assessments that may occur fromcontinued losses on the legacy assets of failed corporate creditunions or failure of natural person credit unions.

In a previous article, I wrote about the possibility for a PlanB to deal with the outcome of the credit bubble. (See CUTimes, March 31, 2010, or CUTimes.com/BigBang.) Plan B calledfor the healthy banks, thrifts and credit unions to move under oneprudential regulator, as articulated in the Treasury's “Blueprintfor Regulatory Reform,” and team up with the FDIC in assistedtransactions. Perhaps it's time to revisit Plan B. 

Peter F. Duffy is managing director with Sandler O'Neill &Partners LP.
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