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What Regulatory Leadership Looks Like: Promoting Innovation and Cooperation

One of the critical qualities of leadership is the ability to rally support for vital issues through cooperation and example. When this leader is a regulator with the ultimate power of coercion, to see an approach based persuasion, logic and we’re-in-this-together is enlightening.

The FDIC Chair Jelena Williams outlined a new approach to innovation, not via a rule or policy statement, but rather in a public op-ed in the American Banker. I thought the following comments were powerful:

…if our regulatory framework is unable to evolve with technological advances, the United States may cease to be a place where ideas and concepts become the products and services that improve people’s lives.

At the FDIC, we want to foster innovation…By promoting and encouraging our supervised institutions toward a more advanced technological footing, the FDIC can help lead a transformation in the financial sector — one that results in easier access to banking products and services, brings more consumers into the banking fold, and makes the banking system safer and more stable…

We are looking for techies to join our ranks…

Should I Be Jealous of Bankers Over Their Regulator’s Appeal?

In this recent commentary, Randy Karnes outlined the leadership vacuum facing credit unions in the regulatory arena. He stated in part:

Does the credit union industry even have a process that is capable of placing a real leader of people, communities, and our CU stakeholders on the NCUA board today? Or are we doomed to a continuing future of cardboard, keep your head down, tactical players who only confirm the bureaucratic functions versus board members that could balance the need for a strong regulator with the passion for a strong credit union industry, and sell it?

Leaders Who Can be Assets, not Liabilities

In a dynamic, technology driven and competitive financial services market place, the soundness of the system is more than an aggregation of individual balance sheets and operating statements. For the cooperative system is interdependent in ways the banking industry is not. That means weakness in any leadership role can jeopardize the future of the industry. Jelena Williams shows how a proactive, positive focus can be an incalculable asset, not a liability or burden, in the ongoing arena of financial competition. Isn’t it time for credit unions to expect nothing less?

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Should a Credit Union Be Bailing Out a Bank’s Stockholders?

The July 16 headline in CUToday said it all: In First-of-its Kind Deal, Corporate America Family CU Buying Bank.

Just another in the 20+ bank purchases by credit unions over the past two years? Hardly.

The article mentions that this is the first time a federal mutual holding company that converted to stock, will have its assets and liabilities sold to a credit union.

The Ben Franklin Bank of Illinois converted to a stock holding company in 2015. Ben Franklin Bank was founded in 1893 as a mutual savings and loans. Thus, one uncertainty in the transaction is the obligation to the “liquidation accounts” created for depositors in the mutual at the time of conversion. But this is not the core issue.

The Real Issue

In a joint press release by both firms’ CEOs, the “transaction has been unanimously approved by the board of directors of each party and is expected to close in early 2020.”

Steven Sjogren, President and CEO of Ben Franklin commented in the release “we have spent a long time seeking to maximize stockholder value and believe that we have negotiated an outstanding transaction for our stockholders.”

Reviewing the past ten years of Ben Franklin’s results and its stock price prior to the announcement, that would certainly appear to be a reasonable description. The question the members of Corporate America Family CU and its board should be asking is whether it’s a reasonable deal for them.

Ten Consecutive Years of Losses at Ben Franklin

Reviewing the annual reports and 10K filings on the Ben Franklin website, the following facts stand out:

  • June 30, 2019 data shows: $97.8 million in assets, $77.6 million in deposits; $11 million in equity; a $7.0 million FHLB loan; and loans of $73.7 million.
  • The bank has had negative income every year since 2008.
  • The efficiency ratio for 2018 was 111.08% and for 2017, 129.0%. At June 2019, 127.8%.This means operating expenses exceeded net interest income plus all other revenue.
  • The bank raised $4.5 million by issuing 600,000 new shares for a price of $7.50 per share in January 2018. The cost of the offering was $366,000 or 8.1% of the gross proceeds
  • Two consent orders have been issued by the Office of the Comptroller of the Currency. The one on Dec 19, 2012 was followed by a second on November 2015 designated the bank a “troubled institution”. This order was ended in February 2019.
  • The stock price before the purchase announcement was $6.80 jumping to $9.56 the day after the announcement. The credit union announced a purchase price per share of 10.33-$10.70 subject to various costs and other factors to be determined.
  • In the 2018 annual report, the following outlook is given: We do not anticipate net income until we experience significant growth in our earning. At mid-year 2019, the credit union’s operating loss was $262,000.
  • At a price of $10.50 per share, the purchase would be at approximately $2.4 million higher than the June 2019 equity, that is 122% of the current book value.
  • The bank’s 2018 annual report states its share of bank deposits in its core markets are 1.69% Arlington Heights, 2.83% Rolling Meadows, and .03% in Cook County.

None of this operating history was discussed in the press release or how the credit union expected this decade long losing operation to be turned around.

As of June 2019, Corporate American Family reports $605 million in assets and 20 branches in ten states including AZ, CT, GA, CA(2), OH, PA VA TX and IL. Its year over year share growth was -0.81% and loan growth 4.68%. ROA was 0.61% and net worth 17.17%

Questions the Board Should Be Asking on Behalf of Members

Why is this purchase in the members’ best interest? How would Corporate American Family be able to turnaround an operation that has lost money every year for over a decade? What are the all-up transaction costs in addition to the stock purchase price?

How was the offer price determined given the stock price at the time of the announcement ($6.59) and the recently completed 600,000 new shares at a price of $7.50, less transaction costs?

The CEO of Ben Franklin is correct: This is an “outstanding transaction for our shareholders,” (especially for those that bought in at $7.50 per share 18 months earlier). It would not seem to be the same value for the member-owners of the credit union.

Is this first-of-its-kind deal why NCUA recently announced its intent to consider requiring more transparency around credit union’s purchase of banks?

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Doing What’s Right for Our Members

An earlier blog I wrote (August 1) discussed the harm done to local communities and members when sound, well run credit unions are merged into firms outside the traditional community or market areas being served.

The poster child for this concern was the announced merger between two credit unions over 1,200 mile apart:  Infinity in Westbrook, Maine, and Vibrant in Moline, Illinois.

On September 24, the merging credit union Infinity FCU reported that the deal was off, stating in part:

“The merger process brought some important differences to light and it became evident that the integration was simply not a good fit. The talks ended amicably, with both sides agreeing to work as collaborators rather than partners going forward. Infinity FCU continues to be a strong and financially sound organization and we are committed to achieving our vision for the future of doing what’s right for our members, our communities, and our employees.”

Congratulations to the CEO Elizabeth Hayes and the Infinity Board for this change of direction. It is hard to reverse course when an initiative is publicly announced. As noted above “doing what’s right for our members” is always a fail safe policy touchstone.

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When a President Promoted Credit Unions

The White House
Washington D.C.
July 2, 1936

MEMORANDUM FOR
THE SECRETARY OF THE TREASURY

What do you think of some
publicity on Federal Credit Unions?
I understand 1,479 of them have already
been organized, with an estimated
membership of 205,000. We might do
something to push this. They are
popular.

–F.D.R.

My only question is, who brought this opportunity to FDR’s attention? That is the kind of “Washington presence” credit unions should have today!

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How Shadow Banks and Fintechs Keep Increasing Their Role As Financial Intermediaries

Amit Seru, a Stanford University Professor, presented his most recent data updates on the role of shadow banks and FinTechs at the FDIC’s 19th Annual Research Conference last week.

The slides he used can be found here.

The trends show that more and more lending is originated by non-depository institutions in both the mortgage and consumer lending arenas.

Two of his slides (#10 & 11) illustrate this growing market penetration geographically by county between 2008 and 2015.

These alternative financial firms enter markets as depository firms withdraw primarily due to their lack of profitability.

FinTechs’ role

Seru was especially interested in the role of FinTechs firms, which he defines as firms relying on virtual channel operations that can be completed from beginning to end without human intervention.

The FinTech advantages of faster processing, use of broader data sets for marketing and decisioning, and a superior quality online experience, are well known.

But he also suggests their success is not because of a price advantage over banks. In some cases consumers pay more for online convenience and speed.

Why the loss of market share?

Seru concludes that the Fintech technical advantages account for only 30-40% of the shift in market share. He asserts the most important factor (60-70%) in this ten-year market share change is the impact of regulation on banks’ ability or willingness to continue serving specific markets. This regulatory burden has increased substantially since the 2008 financial crisis primarily as a result of regulations from the Dodd-Frank legislation.

Even with a lesser regulatory burden, FinTechs are not all-powerful. He points out they are mostly dependent on the secondary market for final loan funding. Importantly, the balance sheets of depository institutions gives them more flexibility in certain products such as jumbo loans. Should the secondary markets become more selective or volatile, then the banks traditional funding advantages may reassert themselves.

Credit union takeaways

For both traditional and new entrants in the consumer and small business lending markets, the key factor to long term growth and resilience is access to liquidity. Generally depositor relationships are more stable and often less expensive than wholesale and secondary market reliance. Convenience, not price, seems to be the primary reason FinTechs disrupt traditional service models. However this advantage in the digital channel is rarely permanent. An all-channel strategy is especially valuable for community institutions.

Credit union relationships based on loyalty and trust are a significant advantage versus competitors focused on transaction capture. For 110 years the cooperative model has followed a second-to-market innovation strategy that has resulted in growth and evolving business models. Cooperative design, aligning with members’ needs, would seem to be a continuing advantage regardless of where disruption may occur.

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The Job Outlook for US Manufacturing – the GM Strike

In no other sector of the “post-war” economy, has the impact of automation, robotics and AI been more important than manufacturing. This is one of the factors underlying the current GM strike. Not only are jobs being lost to automation and outsourcing, the demand for more simply-assembled electronic vehicles may further reduce the need for skilled auto workers.

Real manufacturing output has grown consistently through greater productivity while total employment in this sector peaked in the late 1970s. This long term trend (1947-2014) is shown in this graph by economics professor Alan Gin:

More Jobs Being Created

Employment keeps expanding, but the allocation of jobs between sectors is changing. The bureau of labor statistics publishes an annual ten-year forecast of job growth by sector. Its latest projection https://www.bls.gov/emp/ is as follows:

Implications

The implications for credit unions serving communities or SEGs are many. The fastest growing job segments tend to be lower paying as indicated by May 2018 salaries.

Two of the fastest growing sectors are driven by the response to climate change and energy production. Higher paying jobs would appear to require more college than lower paying ones. Both wholesale and retail trades show shrinking levels of employment.

The manufacturing sector is the one industry with the highest rate of projected job decline.

Credit unions have traditionally done a good job of knowing much about their members. However, as more credit unions seek ways to have a positive impact and influence the economic direction of the communities they serve, monitoring local job trends will be increasingly critical when making loans and future infrastructure investments.

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How Tight is Today’s Labor Market?

In CUInsight’s Sunday jobs report, there are credit unions listing 10 to as many as 40 job openings in this weekly post. In addition to individual senior management positions, the most recent numbers ranged from a high of 23 to a low of 7 openings per credit union.

Finding and keeping employees is getting tougher. In a recent presentation by Economics Professor Alan Gin from the University of San Diego, some of the macro trends show why today’s labor market is so competitive.

All traditional measures of under or unemployment segments are the lowest levels in the past 15 years.

Secondly, the labor force participation rate is at its lowest since the 1980s. He cites four factors contributing to this structural decline:

  1. Baby boomer retirements;
  2. Fewer students working;
  3. Disability leavings;
  4. Affordable Care Act enabling persons to be insured when leaving a company plan

The Human Factor Challenge

Tactics for responding to this tight labor market are vital. Retaining and growing current staff becomes more urgent.

Other efforts include automation (how many credit unions answer the phone with a live person), moving jobs to different areas with less tight labor markets, process and productivity improvements, and outsourcing.

Whether the situation is short lived or a more permanent feature of the evolving economy, the need for new ways to find and retain the right staff will be a critical factor in many credit union’s ability to grow and to serve members well.

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Why Risk Based Capital Requirements Fail in Practice

We’ve already seen that the risk based approach does not work. It’s obvious that neither man nor model can adequately assess a given asset’s risk under all circumstances before the fact. It doesn’t make sense to spend a lot of time trying. It does make sense to have a minimum leverage ratio but it should be the same for banks of all sizes.”

(Thomas Brown, A Loss of liquidity, not inadequate capital, is what often dooms banks. Bankstocks.com, April 22, 2014)

The leverage, net worth ratio, is the current credit union capital model. Risk based capital formulae should be tools, not a rule.

The immediate vulnerability for the credit union system at this time is the absence of the CLF-Corporate liquidity safety net.  Liquidity allows fluctuations in asset values to recover rather than selling during market disruptions and taking losses that reduce capital.

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The End of Risk Based Capital for America’s Community Banks

On September 17, the FDIC board eliminated risk based capital (RBC) requirements for community banks with assets of less than $10 billion.

It replaced the international banking BASEL-inspired approach with a simple leverage ratio. A community bank will be considered well-capitalized under required prompt corrective action (PCA) regulations if the tier 1 leverage ratio is 9%.

Banks will not be required to report or to calculate a risk-based capital according to the FDIC’s press release.

The FDIC Chairman Jelena Williams said the new rule ensures that the regulatory framework is commensurate with the operational reality of these institutions.

“The final rule. . .supports the goals of reducing regulatory burden for as many community banks as possible. . .and will allow community banks to significantly reduce the regulatory reporting associated with capital adequacy on the call report.”

The rule was also supported by all the other banking regulators,  the comptroller of the currency and the Federal Reserve.

An Example for the NCUA Board

The final RBC rule passed by the NCUA board was over 400 pages and requires all of the regulatory and reporting burdens cited by the FDIC as the reason for eliminating this requirement.

Surely the NCUA can learn from this experience! There is no better time or precedent to cancel this ineffectual, burdensome and deeply flawed approach to capital measurement. For if such a rule had been effective, it would have stayed. The FDIC’s experience shows RBC doesn’t work in practice.

The simple to understand leverage ratio, now in effect, has served credit unions well since deregulation and the imposition of PCA in 2008.

Don’t be misled by the 9% well-capitalized FDIC level versus the credit union’s 7% well-capitalized PCA standards into thinking cooperatives need to raise their capital. All of the capital reserves in credit unions are “free.” More than half of bank capital is in equity shares, whose owners are expecting a return on their investment.  Free cooperative reserves do not have this performance expectation and cost.

There is no better time for NCUA board to withdraw this misguided rule. Will the board show the leadership demonstrated by the FDIC?

All credit unions would give a great sigh of relief to have this burden removed from the horizon.

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Why Cooperatives Exist in a Market Economy

While it is true that cooperatives create “common wealth” to be paid forward for use by future generations of cooperative members, the context of why this option is critical in a market economy is often overlooked.

The following statement by Mark Carney, Governor of the Bank of England, in a May 29, 2014 speech, outlines the importance of the contribution from cooperative design:

Just as any revolution eats its children, unchecked market fundamentalism can devour the social capital essential for the long term dynamism of capitalism itself. . .Prosperity requires not just investment in economic capital, but investment in social capital; that is the links, shared values, and beliefs in a society which encourages individuals not only to take responsibility for themselves and their families, but also to trust each other and work collaboratively to support each other.”