Tuesday, October 14, 2014

Why the Status Quo Must Change - What Banks Can Learn from Credit Unions

Credit union membership declined from June 30th 2013 to June 30th 2014 at 54% of all credit unions, according to NCUA data.  Median credit union membership was also down
0.4%. for the same period. Overall credit union membership grew 3.7%. Also, during the same period the NCUA approved 234 credit union mergers and 20 were closed by NCUA supervisory action. The number of credit unions is reducing by about three to three and a half percent a year.

The primary reason cited for credit union mergers according to the NCUA is to offer expanded member services.  U.S. financial institutions under a half billion dollars in assets have a difficult expense and income challenge, due in most part by non-existent economies of scale. As margins shrink, the mega banks get more efficient and technology demands and expenses increase, this challenge is going to become even more difficult to manage.

A look inside these numbers reveal what most industry analysis have been saying, the large get larger and the small are getting smaller.

Membership in credit unions with assets:
  • Over one billion dollars grew 6.2% 
  • Between half billion and one billion grew 4.3%
  • Between 250 million and 500 million grew 1.5%
  • Between 100 million and 250 million grew 1.4%
  • Less than 100 million shrank by half percent.  

Only 7% of all credit unions, 456 out of 6,558 exceed a half billion dollars in assets. Long-term, even the best credit union executive management teams will be extremely challenged to operate viable credit unions under half billion dollars in assets unless they identify and serve a special niche and recognize that their ability to compete in the digital banking space will become more and more difficult. Credit unions must find a way to achieve greater economies of scale to reduce operational and technology costs. 

The chart below shows the inefficiency of credit unions as their size decreases.

What is an acceptable efficiency ratio target? There are several high‐performing credit unions nationwide that have set long‐term targets to move toward a 50% efficiency ratio. Cornerstone Advisors, Inc. recommends that all credit unions target at least a ratio below 70% and more optimally somewhere between 60 – 65%.

For comparative purposes, the operating efficiency ratio for all banks average 65%. Community Banks’s average efficiency ratio is 73%

Banks under a half billion dollars in assets face the same challenge as their similarly sized
credit union peers, the inability to achieve economies of scale to move their operational
efficiency to the level believed necessary to be able to compete long-term in the retail financial services space. Where banks have an advantage over credit unions is that 19% of banks (1,090) are over a half billion dollars in assets compared to only 7% of credit unions (456).  As of June 30th, 2014, there are 12,315 credit unions and commercial banks. Both are shrinking at 3% to 4% a year. Of the 12,315 financial institutions, only 12.5% exceed a half billion dollars in assets. 10,769 banks and credit unions have an asset based of less than half billion dollars. How do they continue to compete? Through cooperation and collaboration!

The most effective way to for banks and credit unions under a half billion dollars in assets to achieve economies is through a cooperative effort that provides technology solutions and combines back-office operations for multiple banks or credit unions. Credit unions have used with mixed results “credit union service organizations” (CUSOs) designed to provide either operational or technological economies of scale. CUSOs are generally non-profit entities that are owned in-part or wholly by the credit unions that use the CUSO’s services.

As a former executive of a core data processing CUSO I have seen the strengths and weaknesses of the CUSO models. Generally the most successful CUSO’s focus their services around transaction processing and transactional services, where economies of scale can be achieved. The less successful CUSO’s tend to focus on the development and deployment of their own proprietary technology solutions. 

Why are technology/software development CUSOs less successful? Software development, technology hosting, support, installation, data conversion and distribution is expensive and capital intensive, and generally cannot be spread over a large and diverse base of customers. A CUSO by its nature serves a limited number of credit unions. The limited number of credit unions is a catch 22. The capital required to fund a technology CUSO is too high for the limited number of credit unions and the CUSO needs capital to grow.

I believe the successfully CUSO model must adjust from being transaction orientated to being both transaction/back-end oriented and a technology aggregator. By combining transaction processing with non-proprietary technology solutions, CUSOs have an opportunity to deliver:

  1. Lower back-office/back-end operational costs
  2. Favorable technology pricing through aggregation and distribution

There is a CUSO network that has successfully moved towards a hybrid of this model, 
Michigan based CU Answers, Xtend and eDOC, who are all part of the cuasterisk.com brand, a network of credit union owned CUSOs. These three entities are headed in the right direction, although they rely on the development of their own technology solutions. Their primary market is smaller credit unions, however, the true value of this solution must be recognized by credit unions of all sizes. 

For this CUSO model to work, the CUSO must have strong and focused management with a clear mandate and vision. Too often CUSO boards consisting in-part or in-whole of credit union CEOs that own the CUSO, but have little knowledge about the business the CUSO undertakes. The result is they fail to establish a clear vision, set a clear mandate and metrics and fail to see the big picture, instead focusing CUSO management on their individual credit union requirements/expectations. My best recommendation to CUSO owners, hire qualified management team, hold them accountable and then get out of the way. 

Bankers and larger credit unions executives ask, “Why would I want to partner with a competitor”? Good question, and the answer are simple, “Survival”. The end isn’t coming today or tomorrow, but what about five or ten years from now? The consolidation numbers are real and are not going to slow down. In fact, I expect consolidation, mergers and acquisition to start growing at a faster pace. 

The time is quickly approaching when bankers and credit union executives must begin to consider alternative business models in order to remain sustainable. Back-office/back-end processing is a transaction commodity process that does not offer a sustainable competitive advantage. The right technology vision and solution mandate will allow common back-office processing, achieving transactional and back-office economies of scale while offering a customizable user and staff interface, workflow, business rules and data analytics  that can be customized by each credit union or bank without adversely affecting the technology platform and follow-on upgrades. Think of Salesforce and similar SaaS platforms that are customizable and unique to each company, but still run on a common platform in a cloud environment.

Survival of banks and credit union under a half billion dollars in assets may be dependent upon them competing on the front-end and cooperating on the back-end.  

What is the triggering event that will cause banks and credit unions to examine and take action on this idea, or is the inertia so great that it is like a frog placed in cold water that is slowly heated a boil? 

What is the water temperature at your credit union or bank?   

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