A new analysis by Sandler O'Neill underscores how critical the sheer size of financial institutions has become to their surviving and thriving. Yet top performing credit unions are being held back by a systemic lack of accountability.

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

In 2000, credit unions with less than $100 million in assets generated 90 basis points of ROA, and their net interest margin was 80 bps higher than their operating expenses. Today, the margin does not 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 $900 million higher in assets in 11 years. The sweet spot for banks is also around $1 billion, and their ROA has declined, but their margin covers expenses in all asset sizes, according to year-end 2011 FDIC Call Reports.

This is the continuation of a long-term trend not simply a function of low rates or high share insurance assessments. In fact, the margin no longer covered expenses for many credit unions in 2002. Small institutions have fewer resources and more difficulty keeping up with the expectations of members while meeting the greater demands of safety and soundness and consumer protection compliance.

These and other factors were expected to lead to an increase in credit union consolidation, but it has not materialized. The number of credit union mergers has actually declined every year since 2004, despite the fact that more than one-third of the industry generated a negative ROA last year and the combined number of CAMEL 3, 4 and 5 credit unions has increased.

Although the recent pace of bank mergers is slower than in previous years, meaningful consolidation had already begun. What's more, the recent pace does not threaten the well-being of top performing banks the way the lack of merger threatens top credit unions.

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

Over time, the impact on income and competitiveness will be felt as stronger banks merge meaningful assets and improve their efficiency ratios, while stronger credit unions cannot. Stronger banks of all sizes acquire weaker banks, sometimes with FDIC assistance, which has led to only 10% of the industry's assets residing in banks smaller than $1 billion. Further compounding the issue is the relative size of the merged institutions. Sandler O'Neill research derived from NCUA and FDIC data reveal the average credit union merged since 2004 has $19 million in assets, compared to $749 million for banks.

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

Thus, an unintended consequence of regulatory forbearance and insufficient merger and acquisition activity is reduced income for all and a growth tax on healthier credit unions. As marginal and weak credit unions shrink, the top credit unions pay higher assessments because their percentage of the industry's total shares increases. To illustrate, one credit union grew shares by 16.2% in 2009-2010. The credit union's total documented assessment was $19.3 million, of which $5.2 million is due to its growth combined with the shrinkage that occurred at many credit unions. Documented assessments are those identified by the NCUA as a result of funds owed to investors in medium-term notes issued by the NCUA and funds owed the U.S. Treasury from previous borrowings but do not include additional assessments that may occur from continued losses on the legacy assets of failed corporate credit unions or failure of natural person credit unions.

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

Peter F. Duffy is managing director with Sandler O'Neill & Partners LP.
Contact 212-466-7871 or pduffy@sandleroneill.com

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Guest Opinion: Top Credit Unions Are Held Back by Industry&rsquo;s Shortcomings

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Guest Opinion: Top Credit Unions Are Held Back by Industry’s Shortcomings