CHAPTER 28 Credit Unions

Chapter Objectives n Describe the main sources and uses of funds for credit unions n Present the terms and concepts related to credit unions n Describe how credit unions are regulated n Describe how credit unions are exposed to various forms of risk n Evaluate the performance of credit unions

Background of Credit Unions n Credit Unions (CUs) are nonprofit, mutual organizations n Members have a common bond such as an affiliation with l Labor union l Church l University l Residential area n There are about 10,000 credit unions in the U.S. with approximately 20 million members n Total assets of CUs are less than one tenth the amount in commercial banks

Background of Credit Unions n Ownership of credit unions l Credit unions do not issue stock l Owned by depositors l Deposits are called shares, and the interest paid is called dividends l Because they are nonprofit organizations their income is not taxed l They can be either federally or state chartered

Background of Credit Unions n Objectives of credit unions l Satisfy their members u Offer interest on share deposits u Offer loans to members l What about earnings that the CU accumulates? u Offer higher rates on deposits u Offer lower rates on loans u Advertising costs

Background of Credit Unions n Size of Credit Unions l A few CUs have assets of more than $1 billion (e.g. the Navy Federal CU) l Most, however, are very small n Advantages of credit unions l Pay no federal income taxes l Employer-supported facilities l Exempt from anti-trust laws l Powerful grass-roots lobby and trade associations

Credit Union Disadvantages n Limited diversification l Economic risks impact funds providers and borrowers l High liquidity needs l Concentrated default risk n Management Concerns l Internal controls—separation of duties l Volunteers vs. professionals n Small Entities l Difficult to attain scale economies

Sources of Credit Union Funds n CUs obtain most funds through share deposit by members l Similar to passbook savings l Insured up to $100,000 n CUs also offer share certificates l Compete with CDs from commercial banks n Checking accounts are called share drafts l Compete with NOW accounts

Sources of Credit Union Funds n If CUs need funds temporarily, they can borrow from other credit unions or from the Central Liquidity Facility (CLF) l Acts as a lender for CUs much like the Fed’s discount window for banks l CLF is an emergency lending fund that is part of a larger internal system called the Corporate Credit Union Network, which is a “credit union for credit unions” n The primary source of capital for CUs is retained earnings

Uses of Credit Union Funds n CUs use the majority of funds for loans to members l Automobiles l Home improvements l Personal expenses l Some CUs offer mortgages n CUs also invest in securities

Regulation of Credit Unions n Federal CUs are supervised and regulated by the National Credit Union Administration (NCUA) l NCUA is composed of three board members appointed by the president u Grants and revokes Federal charters u Examines the financial condition of Federal credit unions

Regulation of Credit Unions n Risk assessment l NCUA examiners compare CU ratios with industry norms to identify problems l Employ the CAMEL system much like FDIC examiners u Capital, assets, management, earnings, and liquidity u Assign each CU into a risk category ranging from Code 1 (low risk) to Code 5 (high risk) u Less than 10 percent of CUs in Codes 4 or 5 u Alerts examiners to CUs experiencing problems l Corporate Risk Information System (CRIS) analysis

Regulation of Credit Unions n Capital requirements for Federal credit unions l CUs are subject to capital requirements of 8 percent of risk-weighted assets, 4 percent of primary capital (retained earnings and reserves) and 4 percent of secondary capital l CUs are regulated with respect to the types of services they can offer u Now able to offer mortgages and can sell mortgages they originate n State-chartered credit unions are regulated by states

Insurance for Credit Unions n Insured by the National Credit Union Share Insurance Fund (NCUSIF) (1970) l Administered by NCUA l 90 percent of CUs are insured by NCUSIF—all Federal CU are insured l Credit unions contribute annual insurance premiums of 1/12 of one percent of share deposits to the insurance fund l Provides for up to $100,000 in insurance l Low CU failure rates have meant that the reserves have been more than adequate

Credit Union Risks Liquidity RiskCredit Risk Interest Rate Risk

Credit Union Exposure to Risk n Liquidity risk l Localized depositors l Unanticipated surge of withdrawals l Short-term solution: borrow from the CLF n Credit risk l Concentrate on personal loans to members many of whom may be employed by same employer l Most loans are secured l Common concern: volunteer employees may not conduct a thorough credit analysis of loan applicants

Credit Union Exposure to Risk n Interest rate risk l More insulated from interest rate risk than banks l Assets (consumer loans) maturities are typically short term, matching the short-term liabilities l Because of the similarity in maturity in both assets and liabilities, the interest spread has been fairly stable for CUs

Exhibit 28.9 Interest Rate Spread of Federal Credit Union aa Year AverageYield onAssets Average Cost of Funds Average Interest Rate Spread Percentage

Performance of Credit Unions n CUs have been more profitable in the 1990s due to growth of CU assets and increased efficiency n CUs have been merging l More diversified member base l Achieve economies of scale l Offer a variety of new products such as traveler's checks, money orders, and insurance