Annuls of Public and Coopemtiw Economics 6Tl 1996 pp. 131-141 OPTIMAL CREDIT UNION REGULATION by Charles HICKSON and Dona1 McKILLOP Department of Accounting and Finance, Queen ’s University, Belfast First version received January 1995; final revision accepted January 1996 1 Introduction Credit unions are a relatively recent form of depository institution in the UK. While the first credit union was established in 1964, it was not until after the passing of the 1979 Credit Unions Act that the institution spread rapidly from its base in the Irish Republic, where it first emerged during the 19508, to Ulster and Scotland and then to the north of England. Today, credit unions are located in all regions of the UK. Over 1986-94 the number of registered credit unions in the UK increased from below 150 to 597. Much of the rapid growth in credit unions during the 1980s and early 1990s can be attributed to the fact that credit unions are better suited to serve the banking needs of people on lower than average income. The credit union movement was clearly helped in providing this function because the 1979 Act made them more attractive to customers, first by requiring that all credit unions be regulated by the Registrar of Friendly Societies. The Registrar inspects the quarterly and annual returns of the credit union, and has the power to suspend any credit union’s operations and, in more extreme cases, suspend any credit union’s registration. Secondly; the 1979 Act also lowered investor uncertainty by more clearly defining the legal status of credit unions as mutuals to be organized and politically controlled by their members. While in the early period credit unions were typically based in lower-income neighbourhoods, credit union’s bonds are increasingly following the North American pattern by becoming more based in the workplace and in professional groups. One implication of this is that many new credit unions have recruited members who are more affluent than previously As one would expect of an industry undergoing rapid growth in demand for its services, there is enormous pressure for institutional change. However, the industry’s ability to respond to QCIRIEC 1996. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 lJF, UK and 238 Main Street, Cambridge, MA 02142, USA.
Transcript
Annuls of Public and Coopemtiw Economics 6Tl 1996 pp. 131-141
OPTIMAL CREDIT UNION REGULATION
by Charles HICKSON and Dona1 McKILLOP
Department of Accounting and Finance, Queen ’s University, Belfast
First version received January 1995; final revision accepted January 1996
1 Introduction
Credit unions are a relatively recent form of depository institution in the UK. While the first credit union was established in 1964, it was not until after the passing of the 1979 Credit Unions Act that the institution spread rapidly from its base in the Irish Republic, where it first emerged during the 19508, to Ulster and Scotland and then to the north of England. Today, credit unions are located in all regions of the UK. Over 1986-94 the number of registered credit unions in the UK increased from below 150 to 597. Much of the rapid growth in credit unions during the 1980s and early 1990s can be attributed to the fact that credit unions are better suited to serve the banking needs of people on lower than average income. The credit union movement was clearly helped in providing this function because the 1979 Act made them more attractive to customers, first by requiring that all credit unions be regulated by the Registrar of Friendly Societies. The Registrar inspects the quarterly and annual returns of the credit union, and has the power to suspend any credit union’s operations and, in more extreme cases, suspend any credit union’s registration. Secondly; the 1979 Act also lowered investor uncertainty by more clearly defining the legal status of credit unions as mutuals to be organized and politically controlled by their members. While in the early period credit unions were typically based in lower-income neighbourhoods, credit union’s bonds are increasingly following the North American pattern by becoming more based in the workplace and in professional groups. One implication of this is that many new credit unions have recruited members who are more affluent than previously As one would expect of an industry undergoing rapid growth in demand for its services, there is enormous pressure for institutional change. However, the industry’s ability to respond to QCIRIEC 1996. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 lJF, UK and 238 Main Street, Cambridge, MA 02142, USA.
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changing demand conditions is legally constrained by the 1979 Act, which limits the size of a credit union in terms of both membership size and asset size. The Act also limits credit unions’ investments to essentially member loans. Understandably, many credit unions are calling for the removal, or at least the liberalization, of many of the Act’s restrictions. For example, the Association of British Credit Unions (ABCUL), to which typically the larger credit unions belong (298 credit unions in 1994 were affiliated to ABCUL), has called for the Act to be changed to allow for growth. The Association also supports the Registrar’s call for the establishment of an industry deposit insurance scheme. If all the above reforms are implemented, the Association hopes that the credit union industry will be more able to compete with other depository institutions. The object of this paper is to analyse, with use of standard contract theory, the impact such changes would bring, with the aim of offering a policy direction.
2 The legal constraint on a credit union’s size
The 1979 Act not only specifies that a credit union is restricted to recruiting members in accordance to its bond, but also that a credit union cannot exceed 10,000 members. In addition, the Act places an upper limit on the value of any member’s shares to $5,000. Thus, taken together, both provisions effectively place an upper limit on the deposit size that a credit union can attain. Moreover, since credit union borrowings are limited to an amount of $5,000 above a member’s deposit amount, and since loans are the only form of investment credit unions are permitted to make, a credit union is also limited in size in terms of its loan portfolio.Yet, a t the other extreme, a credit union can have as few as 21 members and, since there is no regulatory minimum deposit amount per member, credit unions can be of minimal size. In addition to the increase in the number of credit unions, many credit unions have grown in terms of both membership and asset size. As can be seen fiomlhble 1, many credit unions are now pushing against their legal size constraint. At the end of 1994,59 credit unions had assets of over El million and a further 49 credit unions had assets of over 2500,000 but less than $1 million. Table 1 also shows the wide variance in asset size between the largest and the smallest credit unions. For example, while credit unions with assets of over $1 million account for over 71.5 per cent of total assets, and credit unions with assets of between 2500,000 and $1 million account for over 14.7 per cent, approximately 57 per cent of credit unions have an asset base of only $613 to 249,999.Yet, despite accounting for such a large fraction of the
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'Table 1-Assets and membership of UK credh unfons, 1994
Assets Assets of group as YO of total Number of credit unions Number of members
over f 1,000,000 71.51 €500.000 to €999,999 14.72 €250,000 to €499,999 6.06 f100,OOO to €249,999 3.9 €50,000 to €99,999 1.44 f613 to f49,999 2.37 Total 100
'The total does not include those credit unions. 14 in total, which while registered have not as yet completed an annual return for the Reglstry of Friendly Societies
total number of credit unions, the lowest category accounts for less than 2.4 per cent of the total assets of the industry. The difference between the largest credit unions and the smallest in terms of membership size is also dramatic. From Table 1 we can see that credit unions with over 21 million in assets also account for almost 55 per cent of total credit union membership, and credit unions with over 2500,000 and less than 21 million account for just over 16 per cent of the membership total. In contrast, credit unions with assets of 249,999 or less account for just over 10.6 per cent of total credit union membership. Moreover, whereas the average membership size of credit unions with over fl million in assets is around 3231, the average membership of credit unions with less than 250,000 is approximately 109. Thus the largest credit unions in assets size are also the largest in terms of membership, while the smallest credit unions in terms of assets size are also the smallest in terms of membership numbers. Indeed, many of the smaller credit unions are not economically viable and are able to keep afloat only through voluntary labour donations and financial help from, for example, sympathetic city councils. The widening gap in terms of size characteristics across credit unions has, in turn, generated policy differences between the two main UK credit union associations - the ABCUL and the National Federation of Credit Unions (161 credit unions are affiliated to NFCU). Typically smaller, community-based, credit unions belong to the NFCU, whereas larger credit unions belong to the ABCUL. A third trade organization also operates in the UK, the Irish League of Credit Unions (ILCU). Although predominately based in the Irish Republic, it has affiliated credit unions in Northern Ireland (104 as of 1994). The ILCU has the same philosophy towards growth and deregulation a s ABCUL, although typically its member organizations are older than their
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counterparts in ABCUL and the NFCU. Given their longer history it is of no surprise to learn that ILCUcredit unions are much larger in terms of asset size and membership than credit unions affiliated to the other trade organizations. Both ABCUL and the ILCU (the latter in the Republic of Ireland) are currently a t the forefront in calling for changes to the regulatory environment under which credit unions operate. In the context of the UK, proposals are presently to the fore that are likely to lead to the elimination of membership restrictions by: allowing credit unions to recruit employees or residents who meet their bond requirements; and to allow credit unions to relax the upper limit on members’ shareholdings and loans. Below, evidence is presented that gives some support to the view that these proposals will increase the cost-effectiveness of credit unions. However, before entering this debate, we will first develop an economic view of credit unions in terms of agency theory.
3 A contractual view of a credit union
3.1 An overall view of the moral hazard problem in regard to the banking firm
Traditionally, the banking industry, unlike other types of industry, has been heavily regulated.Yet like other types of industry, the banking firm can be thought of as a set of complex contractual relationships that reconcile the interests of equity holders, bondholders and management. The incentive of equity holders is to undertake risky investments up to the point where, for the firm, the marginal expected loss from the investment gamble equals the marginal expected gain. In contrast, bondholders, who have only a fked claim on a firm’s future stream of earnings, must be compensated ex ante for risk of default. Therefore, given their contracted risk-adjusted rate of return, bondholders want to minimize as much as possible the riskiness of a firm’s investments. When there are no informational problems stemming from moral hazard, equity holders should be able to contract successfully with bondholders for a n appropriate risk-adjusted rate of return. A problem occurs only when equity holders have superior information in regard to the riskiness of the investment project. This can occur when equity holders, as in the modern corporation, control the firm. In the corporative form of ownership, not only do equity holders enjoy limited liability but they also control the firm’s policy and determine its management strategy. As argued by Williamson (1988) and Achian and Woodward (1988), the ability of a firm’s owners to engage in ex post
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opportunistic behaviour primarily depends on the degree of fungibility or plasticity of its assets. The authors refer by these terms to how easily the firm’s assets can be opportunistically redirected to other uses after a contract is signed. In the case of bondholders, this would include the case where equity holders redirect a firm’s investments into more risky ventures than was originally expected or agreed. Though bondholders can protect themselves against the risk of default by placing covenants on their bond contracts that limit the riskiness of a firm’s future investments, such covenants are typically unable to cover all contingencies because it is generally difficult to disprove management’s claim that a bad investment is the result of bad luck rather than the consequence of being too risky. A banking firm’s assets, which consist overwhelmingly of its loan portfolio, can be viewed as very fungible or plastic. The reason is that borrowers highly value a bank’s discretion, making it costly for a bank to publish particulars of its loan portfolio. However, this makes it difficult for bondholders to monitor effectively ex post a bank management’s contractual behaviour. Another major factor that makes the banking firm different from other firms is the typically low equity-to-debt ratio of a depository institution. For example, for the banking firm we can think of all forms of deposit liabilities, primarily demand deposits and time deposits, as bonds. On the other hand, equity capital is only a tiny portion of a banking firm’s total assets; thus the typical modern bank has an equity-debt ratio of as little as 5 per cent. In contrast, for a typical non-banking firm, an equity-debt ratio of 60 per cent would be considered to be dangerously leveraged. It is generally accepted in the finance literature that a firm’s agency costs tend to rise as the debt- equity ratio rises, for the obvious reason that the equity holders are gambling with less than their own money, implying that they incur only an upside risk. Giving this generally accepted view, we must conclude that banks are inherently greater risk-taking enterprises than the typical non-banking firm.
3.2 How credit unions assure depositors
It is therefore clear that the banking firm is more prone to moral hazard problems than other types of firms. Indeed, for a bank legally constituted as a corporation the moral hazard problem is even more severe. Fbr example, it is more than reasonable to assume that equity owners and bank depositors are at least as risk averse as bank equity holders, ‘Under this assumption, it is generally accepted in the moral hazard literature that the first-best contract is for the side of the contract that has the superior knowledge to bear all the risk in that OCIRIEC 1996
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they have lower monitoring costs. Moreover, because bondholders are typically more risk averse than equity holders, and because bank claims are highly short term and very liquid, we should expect that depositors are, in fact, more risk averse than bank owners. This implies that, in order to reduce monitoring costs, bank equity holders should bear even more risk than corporations in other industries.Yet we see that limited-liability banks are the norm in commercial banking. The limited-liability structure of the modern bank corporation explains why it is necessary for the government, in order to reduce monitoring costs, overviews banks’ performance and restricts their investments. It can also explain, as will later be argued, the need for deposit insurance in commercial banking. However, it will also be argued that credit unions do not have the same moral hazard problems as the corporate bank and therefore should perhaps be less regulated. The first major organizational difference between a credit union and a corporate bank is that the credit union is a mutual, owned by its depositors. Since the credit union’s depositors are also its owners, there is no conflict of interest between depositors and equity owners as exists in the bank corporation, where there exists a clear pecuniary externality, stemming from ex post contractual opportunism on the part of management, because management is politically controlled by the depositor owners. The implication is that mutual banks need less government monitoring and investment restrictions. However, some regulation may still be necessary to assure against management fraud and incompetence. The above implies that many of the restrictions on the type of loans credit unions can offer should be eliminated.The reforms now being voiced ask for an increase in the size of loans credit unions can offer their members, and for the maximum repayment period for loans to be increased from five to ten years. It appears that there is little reason not to accept these proposals. Moreover, credit unions differ from other types of mutual banks in that the depositors are also the borrowers. This implies that the credit union’s portfolio is not sufficiently diversified. For example, if many members of a credit union should suffer an adverse economic shock, say for example due to loss of employment, then the credit union will suffer a large withdrawal of deposits, while a t the same time it will suffer a deterioration in its loan portfolio as borrowers will be unable to pay. Moreover, the more narrowly a credit union bond is defined the more exposed it will be to this kind of risk. One solution to this would be to increase the required reserves of credit unions during normal times so that in times of economic adversity the credit union can survive. However, this solution would be costly in terms of idle resources tied up in reserve capital rather than earning interest as
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part of the credit union’s loan portfolio. Another possibility is for credit unions to have access to some institution that would perform a lender-of-last-resort function similar to that enjoyed by commercial banks. One way of doing this is for credit unions to establish a deposit insurance scheme.
3.3 The impact of deposit insurance for credit unions
Up to a few years ago, it was generally accepted that deposit insurance led unambiguously to greater bank stability. However, after the US savings and loans crisis, there is increasing doubt in this regard. For example, though deposit insurance assures depositors that their investment is safe, the moral hazard risk, stemming from shareholders’ex post opportunistic behaviour, has simply been shifted from depositors to the other members of the insurance fund. The underlying reason is that once deposits are insured, a bank is more likely to undertake risky loans since part of the risk of default is now borne by the fund. For the case of the corporate bank, the transactions costs incurred by the deposit insurance fund are at least in part offset by the savings in monitoring costs for depositors. However, because the credit union is legally constituted as a mutual, following the introduction of deposit insurance there would be no transaction cost savings for depositors but new transaction costs incurred by the insurance fund. Moreover, these extra transaction costs must ultimately be borne by credit union members through increased deposit insurance rates. The above analysis would seem to suggest that it is less costly for credit unions not to introduce a deposit insurance scheme.Yet there are a number of reasons why such a scheme can in fact be economically efficient. One argument in favour of deposit insurance stems from the riskiness of a credit union due to the fact that both its assets and liabilities can be simultaneously affected by an adverse economic shock. If the shock is not nationwide but local then an insurance fund would be able to help a credit union to weather the crisis by sufficiently assuring its depositors to ward off any panic deposit withdrawal. In this way, the deposit insurance scheme would act as a substitute for portfolio diversification, which would not otherwise be possible because of the restrictions imposed on the individual credit union by its bond requirements. There is yet another reason why deposit insurance may increase credit union efficiency; in that an insurance fund may increase the average size of credit unions. Many UK credit unions presently operate with too few members, with the consequence that many are not minimizing their costs. Part of the reason may be that potential depositors are
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concerned with the viability of the credit union and therefore the safety of their deposits. If a credit union has deposit insurance, it will be able to attract new depositors and thereby it will be able to grow sufficiently to exploit cost savings resulting from scale economies. One problem with this argument is that deposit insurance can also attract into the industry many smaller than optimal credit unions. The reasoning here is symmetrical to that above in that, because depositors of credit unions with deposit insurance will be unconcerned about the safety of their deposits, small and therefore risky credit unions are able to form and transfer the riskiness of their investment on to the insurance fund. To assure against this tendency, the deposit insurance fund would need to impose minimum levels of capitalization and liquidity before granting insurance privileges to any credit union.
4 The evidence on existing credit unions’cost efficiency
4.1 The cost efficiency of existing credit unions
As pointed out above, deposit insurance can increase the size of credit unions. In this section evidence on the cost-effectiveness of credit unions with respect to size is examined. %ble 2 presents information on the cost structure of UK credit unions. The remuneration values documented in %ble 2 are defined to include salaries, wages, national insurance plus the treasurer ’s honorarium. Salaries as a proportion of total expenses declines, almost in linear fashion, from 34 per cent for credit unions with assets over $1 million to marginally less than 3 per cent for credit unions with an asset level between 2613 and $49,999. It is perhaps in this category of expenditure that the most visible demonstration of the subsidized nature of the operation of small credit unions emerges and, of course, by implication, the inherent difficulty in attempting to test for the existence of scale economies in the operation of credit unions. In addition, although the operation of larger credit unions is on a much more market-oriented basis, they also rely on unpaid volunteers, which introduces a bias into their relative expenditure on salaries. On average, occupancy costs account for 10 per cent of operating expenses for credit unions. For the industry as a whole, occupancy costs increase at a constant rate, from 8 per cent to 14 per cent up to the second highest category and then falls dramatically to 9 per cent for credit unions over fl million. Though subsidies, for example in the form of donated premises, may distort this picture, it appears that scale economies occur only at a relatively high level. The final cost category detailed in W l e 2 is headed ‘Other expenses: These expenses encompass OCIRIEC 1996
Assets Rernuneratlon (f) Occupancy costs (f) Other expenses (f) Total expenses (E)
over f 1,000,000 2,413,702 644,055 3.982.815 7,040,572 f 500.000 to f 999,999 395,843 231,621 978J60 1,605,624 !?250,000 to f4!39,999 120,547 81.720 450,542 652,809 f100,000 to f249,999 54,284 52.678 391,455 498,418 f 50,000 to f 99,999 7,m6 19,635 178,041 205,472 f613 to f49,999 11.444 33,982 375.198 420,624 Total 3,003,616 1,063,691 6,356,211 10,423,518
expenditure on postage, printing and travel; accountancy and audit charges; loan and share insurance; general insurance; plus miscellaneous related expenses. For smaller credit unions this class of expenditure makes up the bulk of their reported costs. This is no surprise, in that most credit unions from the outset are liable for almost all the respective cost components of ‘other expenses ’. In terms of the percentage weights, 89 per cent of operating expenditure goes on ‘other expenses’ for credit unions in the asset class E613 to 249,999.This percentage steadily drops as the asset size of credit unions increases. For creclit unions with assets over $1 million the comparable relative weight 1s 57 per cent. While the decline in this expense category’s share is dictated by the increased expenditure on staff remuneration, the pronounced nature of the decline may suggest that in this category of expenditure there is another potential source for the achievement of scale economies. ?\able 2 makes no reference to the important category of interest costs. This can, however, be defended on the basis that a significant portion of credit unions do not yet pay dividends (279 out of 597 registered UK credit unions did not pay dividends in 1994), because many are relatively new. This makes it difficult to get an unbiased estimate of interest payment costs. Moreover, any measure of return would not only have to take into account dividend payments but also the growth in net worth of the credit union as well. In summary it can be concluded that there is evidence of scale economies, particularly in the category of ‘other expenses: For a more rigorous treatment of scale economies in UK credit unions see McKillop et a1 (1995).
4.2 Credit unions and risk of default
In this section evidence on the riskiness of credit unions according to size classification is examined. From ‘Ihble 3 it transpires that
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although credit unions are performing sufficiently well in terms of their surplus after tax to total assets ratio, larger credit unions do significantly better than smaller credit unions. Comparative figures for the smallest asset range category and largest asset range category are respectively 2.714 per cent and 5.184 per cent. Figures for total reserves as a proportion of total assets are also reported in Table 3. Although all credit union asset range categories are below the stipulated minimum reserve ratio of 10 per cent, the overall picture is one of adequate reserves. However, it is also clear that larger credit unions tend to have slightly superior ratios than their smaller counterparts. Moreover, in term of size there seems to be a natural break, in that for the largest three categories the ratio ranges from 8.8 per cent to 8.9 per cent, while for the lower three categories the ratio ranges from slightly over 6.3 per cent to slightly under 7.2 per cent. In Table 3 information is also provided on bad-debt write-offs. On the whole, bad-debt write-offs appear to be more or less constant across credit union size with, if anything, smaller credit unions subject to a marginally lower level of write-offs. To summarize this section, the evidence shows that the UK credit union industry as a whole is not particularly risk taking. While they operate below the required reserve ratios, this does not appear to affect other measures of risk.
5 Conclusion
In this article we set out to determine whether the regulatory environment in the UK, as it is currently constituted, meets the needs of the credit union industry. In particular, attention focused on whether the present proposals for regulatory change would increase credit union efficiency. In the theoretical section it was stressed that there was no particular reason why credit union size should be
Table 3-UK credlt unions - risk and return, 1994
ASS& Surplus/assets ratio Reserves/assets ratio Bad debvassets ratio
Over fl,OOO,OOO €500,000 to f999,999 f 250,000 to f499,999 f100,OOO to €249,999 €50,000 to f 99,999 f613 to f49,999 Total
restricted, or why credit unions should not be allowed to offer larger loans to their members. This view is also borne out by the evidence that shows that credit unions are in fact relatively secure institutions, regardless of size. The role and impact of a deposit insurance fund was also considered. If it is accepted that such a fund would facilitate credit union growth, then a deposit insurance fund may be beneficial in that there appears to be opportunity for the achievement of economies of scale within the industry. Furthermore, deposit insurance may provide a substitute for credit union portfolio diversification, which can provide another efficiency reason for its support. One caveat however remains, and it is that before such a mechanism is introduced prospective members must meet minimum reserve and capitalization conditions.
REFERENCES
ALCHIAN A. and WOODWARD S., 1988,' The firm is dead, long live the firm: Journal of Economic Literature, 26,6&9.
McKILLOP D.G., FERGUSON C. and NESBITT D., 1995, 'Paired difference analysis of size economies in UK credit unions: Applied Economics, 27,529-37.
WILLIAMSON O., 1988, The Economic Institutions of Capitalism, Free Press, New York.
