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The Nose of the Camel?

At FDIC’s December meeting, the Board approved an updated regulation relating to interest rate limits on banks that are less than well capitalized.

The changes are intended to provide flexibility for institutions subject to the interest rate restrictions and ensures that those institutions will be able to compete for deposits regardless of the interest rate environment.

One way this flexibility is enhanced according the explanatory Fact Sheet is:

MORE COMPREHENSIVE NATIONAL RATE – The final rule defines the National Rate to include credit union rates for the first time.

  • “National Rate” is defined as the weighted average of rates paid by all IDIs and credit unions on a given deposit product, for which data are available, where the weights are each institution’s market share of domestic deposits.

The Level Playing Field

Is this what bankers mean by “a level playing field?” To implement this rule, the FDIC camel must poke its nose into co-ops’ tent to track credit union rates on “given deposit products.” Be alert for more “leveling” activities in the future.

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Underwriting Cooperative Designs

The list of the top 100 US cooperatives by total revenue lists only five credit unions.

Do you know the co-ops operating in your communities? How are credit unions supporting cooperative solutions especially with needed, local  startups?

A proposal  from Finland where 90% of the population belongs to a co-op

It would be fair to say that the American credit union movement was born from a unique way that Edward Filene did charity. He helped reduce obstacles people face when they try to help themselves by setting up cooperatives. As it became harder and more expensive to start new credit unions, this tradition started to fade away. It could be more complex for credit unions to help people set up cooperatives, other than credit unions, because it requires different expertise. But I hope credit unions would ask themselves – if we are not carrying on Filenes distinctive civic tradition of helping start new coops, who is? 

It’s common for credit unions to donate to food banks and other local charitable efforts.  

What if some of those donations would be used to give food cooperative coupons/vouchers to credit union members who are struggling economically? Ideally the food cooperative would also provide opportunities to get further discounts by volunteering to help run the business, as is common in grocery coops. 

I think many would find this sort of mutual self-help more dignifying than being given food from a food bank – not that there should be a stigma in doing so. Perhaps especially men who are reluctant to get assistance would find this psychologically more helpful. Abstract models of comparing the logistical cost-effectiveness of providing food through food banks or food cooperatives can’t capture this difference. But can credit unions? 

It could be used to demonstrate the cooperative difference of credit unions in a way no advertising campaign could. The Open Your Eyes campaign remaining budget was $50 million. What if there was an equally large campaign, where 5 million credit union members would use a $10 coupon in a new cooperative business?


It doesn’t have to be limited to food cooperatives either. Maybe a couple who open up a joint-account could be given a pair of movie tickets that could be used in a local cooperative cinema. The possibilities are endless.  

Leo Sammallahti

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AN EYE-OPENER: New Study on Size and Cost Efficiency

This month the FDIC released a 27-page study entitled “Economies of Scale in Community Banks.”

The authors analyze all community banks less than $10 billion in assets from 2000 to 2019 to measure their actual trends in economies of scale and productivity by asset size.

The major findings are below. Over two thirds of the paper present the analytical method and data used to develop their conclusions. The most significant conclusion in my view is:

“. . .our results suggest efficiency gains accrue early as a bank grows from $10 million in loans to $3.3 billion, with 90 percent of the potential efficiency gains occurring by $300 million”

The Relevance for Credit Unions

The average credit union size on September 30, was $345 million. That is the sweet spot for peak operating gains in the study. While credit unions would not mirror the balance sheet and business model of a typical community bank, the overall conclusions seem applicable.

Moreover, it is probable that the greatest gains in efficiency occur at an ever lower average asset range in coops for three reasons. Credit unions have a consumer-focused lending specialty, which the authors cite as a factor in greater efficiency. They do not have to manage the complexity of paying federal or state income tax. Finally, credit unions achieve economies of scale and efficiencies by cooperating in local and national CUSOs that bring members convenience no single bank or firm could duplicate with its own resources.

Credit unions are undergoing some of the same consolidation pressures described for banking. The study provides needed insight for two much talked about issues in the credit union system. One is what is the ideal size for operational competitiveness. The finding that a range of $300-600 million in assets achieves 95% of efficiency gains, is easily within reach for many credit unions’ business models. Secondly, larger size does not create major gains in efficiency.

In fact, there may even be a cap on size ($3.3 billion) after which diseconomies of scale occur, that is increasing expense ratios. An example of this would be the dramatic performance decline in PenFed, the industry’s third largest institution, as it grew by $7.5 billion over the past five years. This is documented in the analysis “PenFed’s Spurious Strategy.”

The Problem We All Share Part I: PenFed’s Spurious Merger Strategy

In the extracts below, emphasized (bolded) text focuses on the most important conclusions presented by the FDIC authors.

Abstract Summary

Using financial and supervisory data from the past 20 years, we show that scale economies in community banks with less than $10 billion in assets emerged during the run-up to the 2008 financial crisis due to declines in interest expenses and provisions for losses on loans and leases at larger banks. The financial crisis temporarily interrupted this trend and costs increased industry-wide, but a generally more cost-efficient industry re-emerged, returning in recent years to pre-crisis trends. We estimate that from 2000 to 2019, the cost-minimizing size of a bank’s loan portfolio rose from approximately $350 million to $3.3 billion. Though descriptive, our results suggest efficiency gains accrue early as a bank grows from $10 million in loans to $3.3 billion, with 90 percent of the potential efficiency gains occurring by $300 million.

Introduction

Economies of scale occur when the per-unit cost of production falls as the number of units produced increases. In the context of banking, scale economies exist when the cost per dollar of loans (or assets) declines as the number of loans (or assets) increases. An efficient bank is operating at the lowest cost per dollar of assets or loans, , , ,

Our estimates are not causal and do not predict how a bank’s costs would change were it to change in size. We find evidence, however, that the overwhelming majority of any gains from increasing a bank’s loan production from $10 million to the cost-minimizing loan portfolio size of $3.3 billion accrue early in the growth process. Our nonparametric results suggest that once a loan portfolio reaches approximately $300 million, a bank has achieved about 90 percent of the potential efficiencies from increased scale; by $600 million, a bank has achieved about 95 percent of potential efficiencies. . . .

Our analysis focuses on community banks—banks with less than $10 billion in assets—as these banks comprise the vast majority of banking organizations. Approximately 97 percent of all banks in the United States have less than $10 billion in assets, and roughly 90 percent of those have less than $1 billion in assets. The consolidation trend in the industry has differentially affected community banks. The number of small institutions—those with less than $100 million in assets—has declined by 92 percent since 1985. Much of the debate about bank consolidation centers on the largest financial institutions, primarily those some argue are “too big to fail.” But as consolidation in the industry has persisted in recent years, some have begun to turn the “too big to fail” designation on its head and question whether small community banks are “too small to succeed.”

Conceptual arguments that support this notion are often based upon the economics of scale. Some have suggested that increased regulatory burden affects small banks in particular because regulatory compliance cost is a relatively larger item in a small bank’s finances. Likewise, banks that operate in limited geographical areas may find expansion into new product lines less profitable. Another possibility is that technological investments, for example in credit scoring and model-based lending, may not offer enough upside to justify the investment cost for small banks to transition from slower, more cost-intensive business practices (i.e., relationship lending).

Consolidation that shifts assets from small to large banks is more than just a rearrangement of resources. Small and large banks are not interchangeable; a single $1 trillion bank is not the same as one thousand $1 billion banks. Small banks are often built around a relationship-lending business model. Bankers acquire costly but valuable private information about their customers and make lending decisions using this expertise. In contrast, large, remote banks often lack personal relationships with customers and knowledge about the local community, instead relying on a standardized approach to lending. Customers that are good credit risks to a small bank may be unable to obtain credit from a large bank that lacks local knowledge.

As the number of small banks has declined, concern about the future of small banks has extended to the future of small businesses. Small businesses generally obtain loans from small banks, especially when the businesses are in their infancy. The report of findings from the FDIC’s Small Business Lending Survey states that large banks are more than five times more likely than small banks to require minimum loan amounts for the primary loan products provided to small businesses and eight times more likely to use standardized small business loan products. Small banks are also roughly five times more likely than large banks to underwrite loans to start-up small businesses differently These businesses are sometimes described as the engine of economic growth in the United States, so a decline in credit availability to such businesses could affect the real economy.

The fate of small banks also portends that of the communities in which they operate: Kandrac (2014, p. 23) finds meaningful feedback from the failure of a bank and local economic performance, stating, “The disruption of banking and credit relationships is an important channel through which bank failures affect economic performance.” Scale economies in banking thus transcend the domain of business policy into that of public policy. . . .

Conclusion

Consolidation and growth have been hallmarks of the banking industry since the 1980s. The number of institutions has decreased by more than two-thirds while the size of the remaining institutions has increased. Although the problem of “too big to fail” has been frequently discussed within the corridors of government, academia, and the media, community bankers have begun to question if a “too small to succeed” problem also exists. Such concerns are commonly motivated by notions of economies of scale, whether due to cost efficiencies, expanded business opportunities, or the allocation of regulatory costs across a wider asset base.

Using financial and supervisory data on banks and thrifts with less than $10 billion in assets, we study economies of scale within the banking industry using nonparametric kernel regression and translog cost estimation. Our estimation period spans both sides of the financial crisis, enabling us to distinguish pre-crisis trends from post-crisis trends. We find that total costs have generally been declining over time. The crisis temporarily halted this trend, at least for some institutions, but the trend resumed in force post-crisis. With economies of scale, lending specializations matter: agriculture banks show less evidence of scale economies than commercial banks, while mortgage banks display the strongest signs of economies of scale.

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A Historical Perspective for NCUA’s 2021 Budget Discussion

If the NCUA board approves a reduction in NCUA’s budget for 2021, it will be the first time in 35 years the budget has been reduced, not increased. In fact, the Agency was able to cut its budget for three years in a row, 1982-1985. Here is how NCUA did it as documented in Agency records.

The Credit Union System 1984 and 2020: 10,229 Fewer Charters

To comprehend the unprecedented nature of NCUA’s prior management achievement, it is helpful to compare the scale of the Agency’s operations in 1985 versus today. At September 30, the end of fiscal 1984, NCUA with six regional offices examined annually 10,640 federal charters, and insured 4,722 state charters, a total of 15,362 active credit unions.

Thirty-six years later, September 30, 2020, NCUA oversees 3,213 federal charters and insures

1,920 state charters for a total of 5,133 or a reduction of 10,229 federally insured credit unions. There are three regional offices.

The following two NCUA press releases from 1984 provide budget details and the benefits the savings brought to federal credit unions enabling a 64% reduction in the FCU operating fee scale over these three years.

From an NCUA Press Release, July 25, 1984:

NCUA 1985 Budget Down 4.9%

The National Credit Union Administration board approved a fiscal year 1985 budget that is 4.9% below the Agency’s 1984 budget. This is the third consecutive year in which the budget has been cut. It is he largest reduction to date.

. . . the fiscal year 1985 budget , totaling $32 million, is down $1.7 million or 4.9% from the 1984 budget of $34.7 million

“We won’t forget that credit unions provide the primary source of funding the Agency,” said Board Chairman Edgar Callahan. “Deregulation and decentralization have enabled us to provide better and faster service to credit unions at less cost and to concentrate our efforts on our primary mission—safety and soundness. “

Despite the trimmed down budget, money for training and education has been increased because the Agency believes a better trained examiner force is essential in a deregulated environment. . . The bulk of the increase will go to a training session for new examiners and for the NCUA’s National Examiners’ Meeting in December. This week-long educational session will bring together federal and state credit union examiners. It is the first meeting of its kind. . .

From a September 15, 1984, NCUA press release announcing the reduction in its annual operating fee.

FCU Operating Fee Slashed 24%; Scale Cut 64% Over Three Years

The National Credit Union Administration Board today slashed by 24% the operating fee scale for federal credit unions in 1985, bringing to 64% the total fee scale cuts over the past three years.

The dramatic 24% cut will save federal credit unions more than $4.3 million in 1985 and has saved them more than $15 million since 1983, the first year in the NCUA’s history that the fee scale was cut. . . .

Previously the operating fee scale had risen by 9% in 1980, 8% in 1981, and 7.5% in 1982

“For the third straight year the efficient operations of the Agency have allowed us to put money back into the pockets of federal credit unions,” said NCUA Chairman Callahan. “This is an impressive track record, one that the agency and the entire credit union system can be proud of.. ..”

The NCUA board attributed the Agency’s success in keeping costs down to high productivity by NCUA staff, personnel reductions and a shifting of resources from the central office to the field where they are needed most.

For example, NCUA for the second year in a row has completed an annual examination of each federal credit union, an achievement not seen since the mid-1970’s. Although total agency employment has been reduced by 15%, the number of examiners has increased to an all-time high (369). Getting back to a once-a-year exam cycle exemplifies the Board’s desire to promote safety and soundness while leaving management decisions in the hands of credit unions. . .

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The Problem We All Share Part III: Addressing the Problem

A Solution: Open Up Market Participation and Transparency

I believe more open competitive forces must be added to a Board’s decision to give up their charter. All merger intentions should be announced in a public notice so that any interested party is able to participate when a board decides to end its independence.

For example, why should Post Office in Madison or Sperry Employees in Long Island negotiate their members’ future in secrecy and then announce their decision without other area credit unions able to “bid” for these long-standing, local, well-capitalized ”franchises?”

Why not give members a real choice of a convenient and familiar credit union as well as one that is remote, digital only, and with no connections to the community?

Bringing more market forces could add better options for members. If two large billion-dollar credit unions want to merge locally, why shouldn’t a large credit union from outside the market be able to participate and preserve a real choice for members?

If the members are informed by an open process, they are more likely to support the board’s recommendation. Now they are forced into a combination they know nothing about and where the results are approved by only a very tiny minority of members returning the requested mail ballot.

Mergers that Enhance Safety and Soundness

Opening up the merger process would make the credit union system more transparent, responsive and relevant for members and their communities. Facts and plans would have to be laid out, not merely bland marketing assurances of “ a better future.”

Credit union safety and soundness would be enhanced because members can make an informed choice. Interested credit unions must take their time to present a relevant option. Token payouts of members’ equity to achieve a positive vote could be replaced by considered bids for the credit union’s real value, including good well.

As presented in Part I, PenFed’s five-year performance has not been enhanced by its merger-growth efforts. Its asset growth rate is half that of its peers; expenses are rising and there are no obvious economies of scale. Asset quality challenges have heightened. There is no evidence members see better value. Member relationships are declining. PenFed’s ROA and asset growth increasingly depends on acquiring other credit union’s net worth. Mergers are disguising its underperformance and slowing internal growth.

Even more pernicious is that PenFed’s mergers have eliminated 20 credit union boards of directors, CEOs and senior management teams. Twenty seeds of future innovation are gone. Multiple long-term relationships with local communities are broken. Members’ loyalty is discarded. None of these outcomes enhances the cooperative system’s financial diversity or soundness.

Transferring the financial equity from generations of members to a board and senior management with no connections to the community’s surplus further removes members from their cooperative creation.

Directors’ view of their responsibility changes in mergers. Instead of acting as stewards of a legacy they inherited, they become deal makers. They routinely ratify payoffs to other credit union’s directors and employees as just the “the art of the deal.” Values be damned.

In the end, the current secret negotiations corrupt both credit union buyers and sellers. And in so doing, the cooperative model.

The Problem We All Have

The current merger practice promotes the privatizing of members’ common wealth and the degrading of credit unions’ role in their communities. Because participation in voting is so minimal, members are left with the feeling they were not informed, or maybe even tricked. The experience is no different than when a bank is sold. Instead of being the alternative to for-profit capitalism, the industry is becoming that which it was supposed to replace.

There are two traditional approaches to system problems. The first is, let the “free” market work it all out. Give the forces of competition loose rein so the magic of the invisible hand can create the best outcome. In the end, all will be right. Winners take all.

The second is that government must step up to regulate abuses, enact better rules and enhance its supervision of the current practice of routine signoff.

But I recommend a third solution built on cooperative principles. Let the members decide. One person, one vote. Put their interests truly front and center.

There are multiple current merger practices that would give member owners the information to have a real choice about the future of their credit union. Working with the industry, regulators should design a truly “cooperative” process that enhances members’ involvement and in so doing, their commitment to the outcome.

The revitalized process would seek traditional financial and operational proposals combined with the important qualitative values credit unions promote: community connections, local focus, giving back to members, and demonstrated track records.

For many Americans, the lack of trust of those in authority is based on their perception that leaders place their interests above their own and the community’s broader shared values. PenFed is a prime example of an outside organization hollowing out local communities by cashing out its leaders.

The social trust on which the cooperative model exists is enhanced by a more visible and transparent process. The public support for the industry’s tax exemption is upheld. The movement will be guided by the shared set of norms and values that created it.

Going from Spectators to Engaged Co-op Citizens

With over 99% of credit unions in NCUA’s lowest risk CAMEL ratings, it is easy to lose sight of the interdependence and cooperation on which the cooperative movement is established. The common good slowly recedes to second place versus individual institutional success.

Market forces are not motivated by the common good or subject to moral limits. Credit unions were to be a counterexample to Mark Twain’s assessment of human motivation:

“Some men worship rank, some worship heroes, some worship power, some worship God and over these ideals they dispute and cannot unite–but they all worship money.”

Current merger excesses are destroying the moral capital created by movement’s founders. Instead of active citizens we become spectators or voyeurs hoping the abuses will go away or maintaining that this is not my problem.

A Renewed Movement

However, movements are not simply a one-time past occurrence, but rather something we can all participate in our own time.

Individual economic isolation and the power of large monopolies which gave rise to the progressive movement at the turn of the 20th century is as pervasive today as 100 years ago.

Some label credit unions as an industry. They are no longer disrupters of the status quo, but a mature segment of financial services with resources, opportunities and influence to play like the big boys. Movements are a moment of history, not the current reality they argue.

Both views can be true, but when movement is left out, credit unions become identified with the status quo and its problems, versus innovators of trusted value to members.

In its finest expression, cooperative design is an ongoing experiment to address the shortcomings of unfettered capitalism. It takes only a few leaders to stand up for change to convert perverse merger activity to a more productive outcome for members. Who will have the foresight and courage to push this to the top of the movement’s agenda?

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The Problem We All Share Part II: Mergers’ Impact on the Cooperative System

Part I documents the flailing financial performance of PenFed’s merger growth strategy. It increasingly depends on acquisitions of sound, well-capitalized credit unions to prop up its below average financial performance.

Why should this be a concern of other credit unions? Or industry leaders? Or regulators? Aren’t mergers independent decisions by CEOs and boards claiming to do the right thing for their members? Why should others get involved in these “consenting combinations” of two distinct firms? And if there is something untoward going on, isn’t that the responsibility of the regulators to address, not other credit unions?

So far, PenFed has acquired 20 credit unions, the vast majority of whom were exemplary models of how credit unions can make a difference for their members and local communities. This value established over decades is ended by PenFed mergers and replaced by a distant, virtual model devoid of local connection and relationships.

PenFed’s actions are not only a sham strategy, they also debase and weaken the cooperative system.

Induced Consent

The process by which this is done is to pay CEO and senior staff severance bonuses and other salary and benefit increases, provide one-time staff bonuses as much as 10%, and often offer a special bonus dividend of several hundred dollars to members—all contingent upon member approval of the merger.

These incentives ensure the required member vote is a mere administrative formality. It presumes the decades of member trust and loyalty can be relied upon so they will follow the recommended action of the board and familiar management team. The member vote is largely by mail and the required in-person meeting is always on the final day of voting. That timing eliminates the opportunity for discussion of alternatives by members.

This managed process virtually guarantees approval. The percentage of members who vote in favor are always in single digits, but none the less sufficient to meet the only legal requirement– that a majority of those voting must approve the merger.

The process is both dishonest and corrupting. Member voting is charade. NCUA’s merger regulation gives legal cover to the payment of personal incentives that by any objective criteria bear all the earmarks of payoffs.

The Falsehoods of the Participants

This duplicity is confirmed by other documents. There are written statements by the leaders which contradict the merger action recommended. For example, Sperry Associates FCU’s CEO, two weeks before the mailing of the Member Notice, published an op-ed in Credit Union Times, extolling the superior strategy and performance of his ”right-sized” credit union versus larger or smaller ones in the pandemic:

A larger firm would have had to schedule meetings, create committees and navigate the rough waters of corporate politics, while a smaller firm would be working to enter the market. For us in the middle, we were the right size to react appropriately, all while using our internal talents to ensure that due diligence was conducted, and our solutions were beneficial to those we serve.

Is This Who We Are? Part I: The Proposed Merger of PenFed and Sperry Associates FCU

PenFed’s merger eliminated this credit union’s single office and ended virtually all of the local activities and relationships. The 16,303 members are now required to transact all contacts virtually.

Sperry’s Chair had been honored as volunteer of the Year by the New York Credit Union League in June 2020. He readily accepted knowing that in January he had agreed to the PenFed merger, an action not disclosed until July, after the award.

The Proposed Post Office Merger in Madison WI

Corruption is a form of dishonesty or criminal offense undertaken by a person or organization entrusted with a position of authority, to acquire illicit benefit or abuse power for one’s private gain. Wikipedia

PenFed’s acquisition of the $35 million Post Office CU follows the same game plan as the Sperry Associates FCU merger. The Wisconsin credit union, chartered in 1934, has a net worth ratio of 22%, seven employees, one branch and serves all of Dane County. It is sound, well-run and long serving. https://www.pocu.com/our-story

In the October 15, 2020 Special Meeting Notice, the required disclosures show that the CEO will receive a five-year employment contract with an increase in annual salary to $125,000; the Vice president has a comparable gain. “Select” employees will get a 10% retention bonus and all, a three-year employment offer. If either the CEO or Vice President terminates employment, they are eligible for one-time payments of up to $614,900.

Each eligible member will get a one-time $200 capital distribution “if the merger is approved and consummated.” This would be from the credit union’s 22% net worth of $7.6 million and is estimated at only 8% ($640,000) of this total. The remaining $7.0 million reserves transfers to PenFed as other operating income, that is free money.

The payments are in plain sight, all contingent on a merger. The member notice provides not a single rate, fee or factual service benefit from this action. In Sperry, the single office is being closed. In Post office the wording is vague: “PenFed intends to maintain the current POCU branch at. . .” This is not a commitment.

While the objective evidence of financial inducements is clear, how can one know this is not a considered, well intentioned decision to enhance members’ future? After all, the Post Office board of directors affirmed in their Notice that the merger is desirable for the following reasons:

  • Our board evaluated strategic possibilities to ensure that you our member, will continue to receive the full range of products and service you deserve.
  • We have been diligently seeking to find alternatives.
  • Only one option meets the full range of our objectives: growth of membership, expansion of product offerings, infusion of investment in IT cybersecurity, improved training and enhanced community service. . .PenFed is in the best interests of our members.

The director’s closing assurance of its considered judgment is given in these words:

“It is the recommendation of your Board that you vote “yes” to approve the merger. Please be assured that you are our valued member, and we have every confidence that you will be pleased by the level of commitment service, and value that you will receive from PenFed etc. . . “

If the financial facts were not sufficiently self-incriminating, the words above expose the dishonesty of the Board’s actions. There was no due diligence of PenFed that caused them to choose this from “ a range of options.” How do we know? Because these are exactly the same representations word for word sent to the members by Sperry Associates and Magnify, PenFed’s two most recent mergers. And the explicit “assurance” contained in the Notice, “we have every confidence that you will be pleased,” is exactly the same as in these two prior mergers.

PenFed assisted in the drafting of these notices. Since NCUA approved these wordings in the past, it will do so in the future, regardless of their veracity. NCUA endorsed Post Office Board’s assurance of due diligence even though there are no facts in the notice that would confirm this assertion. NCUA’s dereliction in ratifying these exact duplicates of alleged diligent representations of member interests, raises the question whether the agency has any clue about events.

As in PenFed’s other mergers, the leaders of Post Office have compromised their responsibility to their members. The member-owners will now be shorn of their credit union through their directors’ and CEO’s indifference to their legal and fiduciary duties.

NCUA Greenlights PenFed’s Conduct

The ONES office at NCUA oversees the examination of PenFed and approves all its mergers. It has seen the member notices that repeat word for word the misleading claims of due diligence and member assurance. It examines and tracks PenFed’s subpar financial performance.

NCUA has all the facts and fictions presented in Part I above. But the agency has no interest in members’ best interests, the phrase used to describe its merger oversight role.

NCUA issued its proposed merger rule in 2017 with following preamble:

In granting or withholding approval for a merger, the board is required to consider the following statutory factors: . . . the general character and fitness of the FICU’s management, the convenience and needs of the members to be served by the FICU. . . and in the case of competing proposals, “management must appropriately evaluate which. . .would be in their members’ best interests in terms of member philosophy and continued or expanded products and services.”

General character obviously is irrelevant so long as management discloses their personal gains and words of assurance—words which carry no accountability. NCUA has been aware at the highest levels of PenFed’s activity since the Ft. Belvoir merger in 2016. The Agency greenlights this avarice as long as the financial incentives promised management are divulged.

The words, character and fitness, mean nothing. NCUA’s actions are complicit and derelict in this perversion of “members’ best interests.”

Why This Is a Problem We All Share

The related and irreversible outcomes exemplified by PenFed’s mergers is that it is shutting down strong, well-run, long-serving, locally focused credit unions. These actions undermine member trust in the cooperative model. They erode confidence in the unique member-owned financial system.

As the CEO of Atlanta Postal Credit Union recently stated: “Likewise, although members of national postal organizations from other states were eligible to join APCU, doing business with a financial institution that was not in their home state probably did not come across as very practical.” Apparently Wisconsin postal workers don’t care about this practicality.

https://www.cutimes.com/2020/11/25/atlanta-postal-cu-launches-consumer-facing-credit-union-for-growth-opportunities/

PenFed’s goal for Post Office is not scooping up isolated $35 million credit unions in states where it has no presence or even legacy connection. Rather, it wants to demonstrate to a new market and another set of credit union leaders that these self-serving merger arrangements are an option for their future as well.

By putting small minnows on the hook, PenFed hopes to bring in much larger combinations. As documented above, PenFed’s organic growth has dwindled to almost nothing, 3.1%. But if this merger option is validated far and wide, along with its misleading claims about size, then as PT Barnum said, there is one born every minute.

Peeing in the Cooperative Swimming Pool

The temptations for apparent “easy growth” fueled by self-interested gains are not limited to PenFed. Other credit unions look for options to emulate this superficial outcome. Consultants line up to create “change of control” clauses in management contracts. Accelerated payments are structured upon the termination of benefit plans in mergers.

When one credit union repeatedly pollutes the water by peeing in the cooperative swimming pool, it will become unfit for all, not just where the offender swims. Ultimately the pool will be closed for good.

Orwellian Merger Logic Spreads

Not all mergers disdain member interests. But the reverse logic does not apply–that all mergers are good for members and the cooperative system.

Increasingly, merger explanations offer contrived reasoning void of fact. Others are outright sales manipulated for personal benefit. NCUA is partly responsible due to its routine endorsements. NCUA is validating flat out falsehoods and conflicts of interests. It has “legalized” the personal payoffs previously done behind closed doors.

Common sense suggests dubious combinations completed or announced have little to do with “members best interests.” Recent examples of these contrived explanations are the following:

  • Why would members of a successful $350 million community federal credit union in Maine have any interest in merging with a John Deere focused credit union headquartered in Moline, IL, more than 1,230 miles away? Moreover, the surviving state credit union would eliminate the one member one vote FCU governance model. It would be replaced by proxy voting in all situations and in which all votes are weighted by the amount of member shares. The Maine CEO’s assertion that this merger would “retain local control” when DECU’s board, not the members, make all the decisions is nonsensical. https://www.cutimes.com/2020/10/20/maine-credit-union-seeks-merger-with-an-illinois-based-cu-again/
  • Why should the members and employees of NorthStar Credit Union be forced to follow their CEO by merging with the credit union their CEO joined for a significant pay increase? Due to proxy voting, the members had no say in this transaction as the NorthStar board controlled the votes via proxies. https://www.cutimes.com/2020/08/18/seven-credit-unions-in-six-states-announce-new-mergers/
  • How do members, employees or the community benefit when two strong, long-serving independent billion-dollar credit unions merge in Minneapolis? Why should they give up the freedom of choice and the cooperative system lose the diversity and contributions of two independent leadership teams? https://www.cutimes.com/2020/05/05/billion-dollar-minnesota-credit-unions-plan-2021-merger/

Mergers become an addiction, not a strategy. The fix needs to keep happening or the whole enterprise starts to decline. Unable to innovate for organic growth, merging creates only greater size and a temporary illusion of success.

Mergers based on rhetorical flourishes are not plans, but chimeras. They turn the credit union model upside down. Instead of pursuing common benefit, personal ambition and gain become paramount.

As administered by regulators today, the merger process has become a blueprint for larceny. Better rules might provide an improved process. However, laws preventing wrongdoing do not prevent robbery.

Part III will outline a solution to this growing merger exploitation.

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The Problem We All Share Part I: PenFed’s Spurious Merger Strategy

The traditional reasons for mergers of sound, well-run credit unions are the following: the credit union must get bigger quickly, to achieve scale necessary for greater efficiency, and to acquire more resources and internal capacity to improve member value.

On the surface the logic seems plausible. The challenge is that it is not self-fulfilling in practice.

Pentagon FCU (PenFed) has been the preeminent practitioner of this business approach. But a review of its results demonstrates how shallow and dubious the logic of a merger “growth strategy” can be.

PenFed’s Five-Year Merger Efforts

From September 2015 through the third quarter 2020, PenFed has implemented a very public, nation-wide effort and acquired 18 other credit unions via merger. The largest was the $420 million McGraw Hill FCU in May 2019. This followed the emergency January 2020 merger of the $320 million Progressive CU–with its open NY state charter–which enabled PenFed to serve anyone anywhere in the US.

The final stand-alone call reports from these 18 credit unions showed total assets of $2.4 billion. This total does not include the addition of the $265 million Sperry Associates FCU finalized in October, nor the proposed December merger of the $34 million Post Office CU in Madison, WI.

The Results of PenFed’s Merger Strategy-Faster Growth?

Since September 2015 the compound annual growth (CAGR) in Pen Fed’s total assets is 6.4%. Without the added mergers and $1.2 billion in additional borrowings, its organic growth rate is only 3.1%. In the five years prior with no mergers, PenFed’s annual internal growth was 5.3%.

The five-year peer growth rate for the 14 credit unions over $10 billion at September 2020 is 11.22%. None has a merger strategy similar to PenFed’s. PenFed’s 6.4% growth is only 57% of the peer’s pace and places them 13th or at the bottom of the peer table.

Five Year Annual Asset Growth for Credit Unions over $10 Billion in assets

( data: September 2015 & September 2020 assets)

Asset Rank State Name 2015 assets 2020 assets 5 Year CAGR
7 TX Security Service $9,052,442,285 $10,081,370,509 2.18%
3 VA Pentagon $19,223,138,716 $26,257,438,559 6.44%
2 NC State Employees’ $31,162,020,508 $45,851,733,095 8.03%
8 IL Alliant $8,463,784,328 $13,027,161,832 9.01%
13 MA Digital $6,519,513,295 $10,469,689,635 9.94%
6 CA Golden 1 $9,508,199,852 $15,567,120,747 10.36%
9 CA First Tech $8,335,581,297 $14,404,660,260 11.56%
12 FL Suncoast $6,627,125,361 $12,026,016,187 12.66%
1 VA Navy $71,967,667,797 $131,620,239,595 12.83%
4 WA BECU $13,878,323,252 $25,637,148,406 13.06%
11 TX Randolph-Brooks $6,665,438,060 $12,550,850,662 13.49%
10 UT America First $7,002,583,992 $13,795,623,334 14.52%
5 CA SchoolsFirst $11,438,769,717 $22,597,939,638 14.59%
14 UT Mountain America $4,823,680,120 $11,404,026,075 18.78%
PG Credit Unions Over $10B $15,333,447,756 $26,092,215,610 11.22%

If the comparison is expanded to all 49 credit unions over $5 billion, PenFed’s growth is still much slower than this peer group’s 10.8%.

But what if a new strategy takes time? The September 2020 annual numbers show an even greater fall off from the peers’ results compared to the five-year trends:

September 2020

Annual Growth PenFed Peers
Share growth 5.9% 21.9%
Loans 5.3% 7.6%
Assets 6.0% 17.4%
Capital 6.0% 13.0%
Members 13.2% 8.2%
Operating Expense 18.9% 12.6%

Greater Efficiency?

The second reason for a merger strategy is that growth brings greater efficiency. PenFed is already the third largest credit union in America. So it should be at a high level of efficiency already. However, when comparing different measures of operational efficiency before and after these eighteen acquisitions, the operating results show a dramatic decrease in efficiency even as Pentagon has increased assets over $7 billion.

PenFed Efficiency Trends as of Sept 2015 and 2020

Ratio September 2015 September 2020
Efficiency Ratio 62.6% 80.8%
Op Exp/Avg Assets 1.35% 2.33%
Assets/FTE $12.5 mn $9.9 mn
Avg Acct Relationship $23,734 k $19,094 k
Loan/Share 118.6% 108.5%
Net Worth 10.06% 10.7%
Delinquency 0.26% 1.07%

The ratios show a dramatic deterioration in efficiency and productivity. With the same balance sheet structure and net worth as five years earlier, PenFed has higher costs, members have smaller average relationships, and the expense ratio increased 73%. Delinquency is four times higher.

Greater Member Value?

PenFed’s product driven focus may provide competitive choices for members in specific circumstances. Their credit card and first mortgages can be excellent value in some markets. Building member relationships is not the focus of its strategy, however.

Several numbers illustrate this product versus member-centric focus. The share draft penetration, ( a primary financial institution indicator) is 14.1% versus the peers’ 67.4%. The average member relationship has declined from $23.7K to $19.1K over the five years. The number of share accounts per member at 1.41 trails the peer’s of 2.03.

Rather than building member relationships, the credit union’s approach is akin to commercial financial firms that move in and out of markets pursuing different product priorities as suggested by circumstances.

Investments to Enhance Competitive Capabilities?

A final rationale for mergers is that more assets provide more capacity to underwrite greater investments in technology, staff and other fixed assets to maintain or enhance competitive position. The single largest investment by PenFed was in 2016 when it purchased a new head office in McLean VA. (https://patch.com/virginia/mclean/penfed-purchases-new-corporate-hq-tysons-0

PenFed CEO James Schenck explained the reasons for the purchase, which has resulted in a 580% increase in building and fixed assets in just four years:

“In order to attract the best and brightest employees, a firm needs to not only pay a competitive salary with benefits, but needs to offer a best-in-class work environment with a meaningful mission.

“PenFed has an insatiable appetite for talented, educated professionals to provide perfect service to our members. Locating our corporate headquarters in Tysons will continue to enhance our operational efficiency and it will be conducive to sustaining growth of the intellectual capital required to keep pace with our members’ needs and deliver exceptional value and superior service.”

Before the merger strategy, PenFed reported total building and fixed assets investments of $91 million (4.8% of net worth). Five years later the $530.5 million total equals 19.4% of net worth. In this same period, the number of fulltime equivalent employees has increased just 73% from 1,539 to 2,662.

The average salary and benefits per employee of the current staff is $101,969, a 5.1% annual growth from the $79,616 five years earlier.

In addition to this growth in average salary, the credit union has increased its balance sheet assets funding employee benefit and deferred compensation plans with investments not authorized under Part 703 of NCUA Rules. This five-fold increase over five years, from $126 million to $732.2 million, includes $130.1 million in Charitable Donation Accounts.

The Strategic Mirage

PenFed’s “growth via mergers” has resulted in slowing rates of both internal and total asset growth, increased expenses, reduced average member relationships and a dramatic increase in fixed investments with uncertain return. Instead of an example of improved performance from growth, the results are at the bottom of its peer group.

PenFed’s floundering performance is being propped up by taking in as other operating income (negative good will) the equity from other strong, long-serving credit unions. As described in the analysis of the Sperry Associates FCU merger:

For over five years “$0 cost acquisitions” have been a critical contributor to PenFed’s bottom line and balance sheet size. In 2019, it booked a total equity increase of $92.4 from mergers. “Bargain gains from mergers” (negative good will) totaled $74.2 million and $18.2 million was added equity value. Of the credit union’s $151 million 2019 net income, over half is from transferring the accumulated surplus from other well-capitalized, merged credit unions which PenFed recognized as “other operating income.”

This 2019 one-time income boost came from three mergers. . . PenFed’s reported asset growth was only $300 million. But without these three mergers it would show a balance sheet decline of $500 million.

Credit unions’ advantage is their relationship with members. PenFed’s mergers help disguise the pitfalls of its open field of membership. For it has no market focus, no niche, and nowhere to effectively mine for organic growth. Its minimal performance outcomes are a veneer. They can be sustained only by finding more sound, established and well-capitalized credit unions willing to become further victims of this Ponzi-like business model.

And that raises the second, and more consequential issue. That is the irreversible shutdowns of strong, well-run, long-serving, locally focused credit unions built on generations of member loyalty.

I will address this challenge in Part II: Mergers’ Impact on the Cooperative System

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One CEO’s Vision for the Coming Decade

“I hope that it will look like a “back-to-the-future” revolution. Back to the most basic of cooperative design principles, alive and well. Those concepts move front and center in the organizations driving our futures.

And they are actively promoted by regulators, examiners and auditors of our operation.

I would hope that organizations, both small and huge, will capture the attention of cooperative owners in a way that truly radiates a win-win with the consumer side. “Do no harm” will be our thinking. A respect for our community will drive our entrepreneurial spirit to leverage our financial power more broadly.

We will cast aside our centralized thinking about what is relevant and put upon so many today. Instead we embrace the spirit that every charter is relevant for the simple fact that they willed their CU and its future into the mix.

Bottom line: It will be an industry with a resurgence of purpose over the balance sheet score cards of today.”

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The Municipal Credit Union Saga Stays Dark

In three prior commentaries I have described NCUA’s conservatorship of Municipal Credit Union.

Because of this credit union’s 104-year history and its vital role in the city, I contacted the credit union to update its recovery following the release of the September call report.

NCUA’s director of external affairs sent the following to my request:

November 30, 2020 at 10:49 AM

Hello, Chip. We received the inquiry that you sent to Municipal Credit Union requesting to speak to someone on the credit union’s progress. Please note that notwithstanding key personnel announcements, we do not comment on our efforts or conditions related to conserved credit unions.

Regards,
Joseph B. Adamoli
Office of External Affairs and Communications

My reply:

December 1, 2020

I understand your email responds to the inquiry I sent MCU to update their progress in conservatorship.

I am surprised your office would miss an opportunity to demonstrate NCUA’s leadership by ducking simple questions about running such a large and important $3.7 billion credit union serving New York and its 600, 000 members.

For example, the members and credit union system would be interested in:

        • Why has the Agency chosen four different chief executives in the last two years, Kyle Markland being the most recent? Who makes these decisions? What marching orders are they given?
        • Under agency control, why has the credit union reported such wildly fluctuating results, for example a loss of over $120 million in one quarter and an extraordinary ROA in the following two quarters? (https://chipfilson.com/2020/02/municipal-credit-union-nyc-reports-30-million-net-income-gain-in-4th-quarter/)
        • Why have the financial concerns of the 600,000 members not merited a statement about the forward conditions they will have to deal with or better yet, some announcement of confidence about the future?

The credit union’s quarterly call reports are public. Its financial performance is open for anyone to review and comment on. Are the numbers a good sign for members or not?

Given NCUA’s track record for conservatorships, does the turnover of executive leadership signal a lack of momentum for the institution, staff, and its financial plan?

Your policy seems positioned to give the NCUA a blackout period to simply keep the institution out of the members’ sightlines in hope the NCUA can package the credit union in a back-room handoff to a convenient suitor versus working to hand the credit union back to its community.

I urge you to manage this differently. Transparency creates trust. Silence undermines member and public confidence just when regulatory leadership is most needed.

Chip Filson

Why MCU’s Situation Matters

MCU’s September 30, 2020 call report numbers are in many respects very positive.

The credit union grew shares by 27% to $3.5 billion in the past year while adding 27,000 members to total 600,000. Its ROA is 1.18% and a net worth of 4.66%. Delinquency remains very stable with the allowance account funded over 200% of total delinquencies. Its balance sheet holds over $1.7 billion in investments including $800 million in cash.

Chartered in 1916, the cooperative has served five generations of New Yorkers through thick and thin. It is a vital part of the city and state’s credit union system.

Importantly, it is a highly visible example of the broader narrative of the cooperative role for members in times of crisis. Local response to circumstances is the hallmark of a credit union relationship.

NCUA Puts Itself In Charge

When NCUA manages a credit union via conservatorship, it has a heightened responsibility to all the member-owners. To keep the confidence of the credit union system, open communication is necessary.

All NCUA employees are public servants. They are paid entirely from credit union funds. Board members and their politically appointed advisors have a singular responsibility for the wise use of authority and industry resources.

This is especially true in difficult times. For if government is not effective when its role is primary, then the entire industry suffers.

Transparency Essential for Trust

Public dialogue is how trust is created in NCUA oversight. Kyle Markland’s appointment will be the MCU’s fourth chief executive in the past two years, all selected by regulators. In previous commentaries, I described the importance of this selection as follows:

The key success factor (in a conservatorship) is finding and supporting the right turnaround leader. The challenge is simple: Any jackass can kick down a barn, but it takes a carpenter to build one.

Will NCUA appoint a jackass or a carpenter? Someone to play caretaker until the agency elects a merger partner to resolve a leadership transition? Certainly, there will be vultures a plenty looking to take the “problem” off NCUA’s hands.

The financial numbers reported in conservatorship have fluctuated widely. A loss in one quarter of over $120 million to an extraordinary ROA two quarters later. Members have been kept in the dark about the credit union’s plans.

Decisions with long term consequences are being done in a vacuum. It is not clear who is calling the shots and who is willing to take responsibility.

Where is the Problem?

The Agency’s professional competence is on the line in its takeover of MCU. Many ask how this situation could have occurred if NCUA and state regulators had conducted adequate oversight to begin with.

Is the real problem the credit union or a multi-year failure of examination and supervision?

NCUA’s record in large conservatorships is not encouraging. In the takeover and liquidation of five corporate credit unions in 2010, the Agency’s forecasted costs to credit unions were in error by over $20 billion. In these forced liquidations there is a $6 billion surplus even after NCUA spent almost $4 billion additional expenses overseeing the closures.

Moreover, without timely information, it is hard for the credit union system, vendor partners and employer sponsors to provide support to MCU.

The Need for Leadership

Who at NCUA is willing to take responsibility for informing the credit union community about this critically important situation? It is a time for leadership. One leader stepping up could inspire others to contribute to MCU’s return to its member-owners.