By John Lovallo
In the wake of the mortgage and banking crises, public opinion of the banking industry in general, but more particularly regarding the largest banking providers, has become decidedly negative. Even the recent wave of Occupy protests have singled out the major banks for particularly pointed criticism. “Bank Transfer Day,” bolstered by social networking, was picked up and encouraged by protesters across the country, and became a plus for those institutions perceived to be smaller and closer to the customer. Estimates of the impact vary, but some meaningful amount of assets was moved out of large banks to credit unions during the fall of 2011. This incident serves as a recent reminder that competition in the retail banking space is fierce, and that all participants must balance marketing pressures with regulatory obligations.
In many ways, the regulation of shareholder-owned banking institutions and credit unions is similar, as are the risks of non-compliance. Both types of institutions have requirements related to their capital structure; restrictions on their permissible activities; and are subject to examination and corrective action and/or penalties from their regulating bodies.
That said, there are two distinct regulatory differences between shareholder-owned banks and credit unions that will be at the core of debate regarding regulatory reform and economic stimulus in 2012: tax-exempt status and Community Reinvestment Act obligations.
It comes as no surprise to anyone in the banking sector that the tax-exempt status of credit unions is a huge benefit in the marketplace. The “savings” to credit unions from not having to pay taxes on their earnings enables them to offer consumer benefits such as free checking accounts, reduced fees and lower interest rates. In the world of consumer banking and finance, those are powerful benefits.
Tax-paying competitors argue that the benefits credit unions enjoy are unfair for several reasons. Among their reasons:
- Failure of credit unions to fulfill their tax-exempt mission
- Functional equivalency of services offered to the public
- Imposition of significant costs on taxpayers
Without question, the tax-exempt status of credit unions is their key structural differential that translates into an advantage with consumers. But banks, which have long argued for the tax treatment of credit unions to be reviewed in light of the points made above, are making a new push for review in light of a move by credit unions to expand their services into a traditional stronghold of banks: namely, small commercial lending.
Listed as the top priority for legislative action by the Credit Union National Association (CUNA) is passage of HR 1418 and S 509, which would lift the cap on “Member Business Lending” from its current level of 12.25 percent of assets to 27.5 percent of assets. CUNA’s promotional literature argues that passage could result in much needed small commercial lending, and suggests that, in the first year after passage, $13 billion in additional small business lending would occur and 140,000 new jobs would be created.
Banking representatives scoff at those numbers and counter with statistics suggesting there is no shortage of lending capacity to small businesses, only a shortage of demand.
Community Reinvestment Act (CRA)
Another key difference between shareholder-owned banks and credit unions is the former’s obligations under the CRA. Since 1977, all banks and savings associations must take substantial action to serve the credit needs of all members of their communities and avoid discrimination. This regulation requires examiners to review each institution’s operations across five performance areas comprising 12 assessment factors. Poor performance on CRA reviews can have serious consequences for the institutions in question, particularly when they seek to expand through merger, acquisition, or branching. CRA compliance is quite expensive for the institutions effected.
While credit unions were specifically created and given advantageous tax treatment due to their role in serving people of modest means, banking critics would argue that many credit unions have left that community focus behind.
Compliance and Risk Management Imperatives
In the legislative battle to win extension of credit union Member Business Lending while preserving tax-exempt status or to prevent it (depending on your point of view), the track records of the two types of institutions relative to compliance and risk management will be crucial. For credit unions to be successful, they will need to demonstrate a willingness to address critical comments relative to the CRA and a lack of expertise with risk management issues surrounding commercial lending.
One necessity for credit unions as they attempt to win congressional authorization for expanded business lending will be to demonstrate that they have best practice risk management programs in place that are scalable with the proposed increased lending activities. What would a best practice risk management program look like? Here are six absolutely essential components:
It must be comprehensive – it must take a global view of what could go wrong; involve every department, process, and person; and be constantly in action.
It must be detailed – deconstructing the business and seeking potential weak spots in the operations which can lead to risks.
It must be quantitative – assessing the significance of the potential risks identified in terms of hard numbers.
It must be responsive to identified risks in a structured, timely manner.
It must be proactive – seeking solutions that prevent risks from happening in the first place.
It must be effectively communicated both internally as well as externally.
An industry-wide failure to demonstrate these best practices would severely damage the push for enhanced Member Business Lending capacity.
Shareholder-owned banks and credit unions both operate under a set of regulatory requirements designed to ensure that they provide services in a fair and prudent manner. However, two significant differences in their regulation are front and center in the debate as to whether credit unions should be permitted to dramatically expand their role as lenders to small business: tax exempt status and Community Reinvestment Act obligations. Regulatory compliance histories and risk management experience will be important evidence in the debate.
Regardless of the outcome, all financial institutions will benefit, as will consumers, from implementation of the best risk management practices.