1 August 2005 Credit Union Demutualization Kevin Davis Commonwealth Bank Group Chair of Finance Director, Melbourne Centre for Financial Studies Chairman, Melbourne University Credit Union

2 August 2005

3 Demutualization Methods Pure Distribution: allocate tradable shares to members free of charge according to some rule –e.g. equal amounts or related to years of membership/ value of relationship Subscription: sell tradable shares (perhaps some at a zero or subsidized price to members) Merger/Takeover: Non-mutual acquirer allocates or sells shares in itself to members of the mutual in exchange for their ownership of the mutual.

4 August 2005 Demutualization Methods - Problems Pre demutualization the mutuals market value is unknown –some multiple of net tangible assets – maybe 3-4 times Post demutualization, the market value is determined by the stock market price of its shares Pure distribution doesnt require estimating the value, and 100% of it goes to members Subscription requires estimation of value and risk that outsiders get an inappropriate share of the value Merger requires estimation of value of mutual, of supposed synergy benefits and value of combined entity. Risk that owners of acquirer get inappropriate share

5 August 2005 Some Demutualization Principles If a demutualization occurs, all the extant value belongs to, and should accrue to the membership –But is it past, current or potential members? Because valuation is complex, demutualization should be pure –Capital raisings can occur subsequently after market has established the value of shares –Takeovers/mergers can occur subsequently after market has established the value of shares Additional legal costs of two transactions probably less costly for members than value loss due to gains of external subscribers or acquirer shareholders in non-pure demutualizations.

6 August 2005 Demutualization and Member Benefit A Cautionary Tale Announcement: Merger of mutual with non mutual. Members of mutual get 200 shares in non mutual –Pre announcement share price = $8 –Post announcement share price = $10 Mon-mutual is worth $8,000 and has 1,000 shares on issue Mutual was actually worth $4,000 Merged entity worth $12,000, has 1,200 shares on issue Mutual members get shares worth $2,000 for sale of mutual Owners of non-mutual get increase in value from $8,000 to $10,000

7 August 2005 What is a Mutual Worth (Part1)? How can the market value be determined? Value often determined by multiples –Capitalization (multiple) of earnings (P/E ratio) But earnings (profits) are not the mutuals objective Past earnings not a good indicator of what the demutualised profit oriented company would make –Multiple of Net Tangible Assets (P/NTA ratio) Value comprises both book value plus franchise value – the ability to use tangible and intangible assets to create value for owners

8 August 2005 Price /Net Tangible Asset Multiples Australian Finance Sector: 26 August 2005

9 August 2005 Credit Union Value Credit Unions have built up –significant Net Tangible Assets by accumulation of surpluses –Significant Franchise Value NTA (Members Funds) can be calculated Franchise Value is hard to estimate – but significant This value is owned communally

10 August 2005 Credit Union Value For large credit unions, the total communal value is big enough to attract interest This communal asset is poorly protected from expropriation Converting communal wealth into private wealth by demutualization is attractive (to some). –But at what price to society, and which private interests are best served?

11 August 2005 What is a Mutual Worth (Part 2)? Mutuality is –A particular form of governance and ownership structure –A structure which involves a particular specification of the organizations objective function

12 August 2005 Mutuality benefits The mutual governance structure –Gives management significant discretion –Is suited to cases where activities are relatively routine, transparent, low risk Typical original credit union activities Scale and Sophistication –Bring professional ambitious management with other objectives – including expansion into new areas –Mutual governance not ideal in this situation –Solutions Demutualise – loses other benefit of mutuality Stick (return) to the knitting –Probably too late in many cases – but not for the rest of the movement

13 August 2005 Mutuality benefits Non-mutuals must have a profit focus –Attempts to impose social conscience and non- commercial goals on non-mutuals are virtually impossible Inconsistent with their raison d'être Competition and profit seeking causes lowest common denominator to prevail E.g. Triple bottom line hard to implement

14 August 2005 Mutuality benefits Mutuals have communal benefits as their raison d'être –Benefits may be financial rewards for members of the community –Past, present, and future Community wide goals Mutuals focused on a particular community (a limited common bond) can better identify those goals –Bendigo Bank community bank model illustrates

15 August 2005 Mutuality benefits Mutual governance structure gives managerial flexibility to identify appropriate mix of communal benefits and pursue them. –Better chance of good outcomes when community is relatively well delineated Lots of communal organizations and dispersion of managerial discretion across those organizations (rather than concentration in a few hands)

16 August 2005 The Implications Continuing concentration into a smaller number of large credit unions signals the death knell of the movement. –Greater incentive for demutualization –Less ability to focus on communal goals –Managerial incentives to move into areas where the mutual model isnt the best form of governance.

17 August 2005 The Future? The mutual credit union model is best suited for –Smaller, community focused, organizations –Specialized, simple and limited product range organizations

18 August 2005 The Future? Can smaller, limited product range, community based, institutions exist and survive? –Bendigo Bank community bank model seems to suggest so Has found a way of minimizing compliance costs Has overcome capital constraint Enables customers of community bank to access a wider range of services from the parent organisation. Why cant the credit union movement find a model which achieves the same good outcomes?

19 August 2005 The Future? Two reasons for the movements inability to prevent mutual self destruction –The dominance of large credit unions and professional managers in setting movement goals and strategy –The concurrent growth of self interest, particularly when the identification with a particular community served by the credit union has disappeared.

20 August 2005 The Future? The formation of mutual credit unions involved an implicit intergenerational contract, where social capital was built up to be passed on to future members of that community. –The commitment is a bit like that in marriage – and we know whats happened to that!

21 August 2005 For ever ! THEN

22 August 2005 Till I can do better ! NOW