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Membership growth, multiple membership groups and agency control at credit unions.

Abstract

Starting in 1982, the federal credit union regulator allowed credit unions to add multiple membership groups. The policy was disallowed by the U.S. Supreme Court in 1998, but revalidated by the U.S. Congress later that year. Allowing credit unions to attach multiple membership groups has contributed significantly to rapid growth in the industry. As credit unions add unrelated groups and expand, the prospects for separation between ownership and control increases, creating potential agency control problems. This potential is compounded by the one member, one vote governance structure of credit unions. This research finds empirical evidence that agency problems grow as credit unions add membership groups and members. If a credit union takes on more than one membership group, and as membership increases, management is apparently able to channel residual earnings away from members (in the form of higher net interest margins) toward itself (higher salaries and operating expenses). (C) 2002 Elsevier Science Inc. Al l rights reserved.

JEL classification: G21; G28; G34

Keywords: Credit unions; Corporate governance

1. Introduction

Over the past two decades, the United States credit union industry has enjoyed phenomenal growth. As Fig. 1 shows, industry assets grew at an average annual rate of almost 11% over this period. Much of the growth can be attributed to a decision in 1982 by the National Credit Union Administration (NCUA), the regulator of federally chartered credit unions, to allow different membership groups to affiliate. After the U.S. Supreme Court ruled that the NCUA's multiple group policy violated the Federal Credit Union Act, Congress validated the regulator's actions with legislation in 1998.

These recent events may affect the balance of power between management and owners of credit unions. Credit unions enjoy subsidized earnings because they are not subject to federal income taxes, unlike that of all other depository financial institutions (banks and savings institutions). Managers may be able to claim a larger share of the tax-subsidized earnings by taking advantage of the governance structure. A credit union is a tax-exempt financial cooperative where the providers of inputs (depositors) are also the users of outputs (borrowers). The deposits represent ownership shares in the institution; however, each depositor/shareholder claims only one vote in the governance, regardless of the dollar volume of shares/deposits held. It is worth exploring whether the growth in membership groups and size fostered corporate governance concerns at credit unions.

Corporate governance continues to be of interest in the Finance literature. (1) However, most of the work has dealt with stockholder-owned organizations, while cooperative or mutually owned organizations (which are legally owned and controlled by members or patrons) have garnered less attention. This paper adds to the research on cooperative institutions, in particular to that for credit unions. Moreover, this research examines how growth of an institution can affect corporate governance.

This research finds that membership growth can undermine the control by members/ patrons, allowing management to pick up a larger share of the institution's earnings. Therefore, it appears that membership growth and the federal multigroup policy can foster management control issues at credit unions.

2. Literature review

There has been a longstanding discussion in the Finance literature on the extent to which management serves its own interest instead of those of members/patrons in a cooperative organization. Seminal papers by Fama and Jensen (1983a, b) theorized that management's authority is restrained by the ability of cooperative shareholders as a group to liquidate their claims even without engaging in a proxy battle or tender offer. (They note that voluntary liquidation is rarely chosen, however.) Kane and Hendershott (1996) argued that the field of membership and cooperative structure of a credit union encourages management to align its objectives with those of membership, curbing managerial excesses. On the other hand, Rasmusen (1988) and Fama and Jensen argued that cooperative members/patrons may be less likely than stockholders to exercise control over management by participating in board meetings or voting. They also argued that the boards of directors for cooperatives are less likely than the boards of stock corpo rations to monitor or replace management.

Staatz (1987) presented three reasons why management and member/patron goals can diverge in a cooperative organization:

* Management performance cannot be monitored through market values nor challenged by a threat of a hostile takeover.

* Lack of a secondary market for cooperatives restricts the ability of members/patrons to diversify their portfolios. As a result, they may be more risk-averse than management.

* Members/patrons have a claim on residual earnings only as long as they actively participate in the organization.

The extent to which cooperative credit institution management serves its own interests has been considered in some recent empirical works. Mester (1991) found that mutually owned thrift institutions operate less efficiently than their stockholder-owned counterparts; she interpreted the results to be evidence of self-serving management. Stewart (1997) observed the existence of higher management perquisites at credit unions, when compared to mutual savings banks.

Recent legislation has changed the environment for credit unions and created a need to extend this literature. Until the 1980s, membership in any credit union was limited to a group with a single common bond--i.e., members had to have some affinity with each other, such as working for the same employer, belonging to the same association, or residing in the same community. In 1982, the NCUA began permitting credit unions to add unrelated membership groups to the field of membership -- creating multiple common bond credit unions. The United States Supreme Court declared this policy illegal in 1998. Later that year, Congress overturned the ruling by enacting the Credit Union Membership Access Act (P.L. 105-219, August 7, 1998). The Act allows a federal credit union to add unrelated groups of up to 3000 individuals to its field of membership. However, this limit is effectively meaningless since 99% of all existing employee groups are beneath this size threshold (U.S. Department of Commerce, 1997). The Act also al lows the NCUA to permit a group of more than 3000 to join an existing credit union if it determines that the added group is unable to form a credit union on its own.

This policy has facilitated growth of credit union membership through mergers and additions of unaffiliated groups. While the number of credit unions declined from 16,594 in 1982 to 10,628 in 1999, the average credit union size more than quadrupled over this period, from US$81/2 million in 1982 (1999 dollars) to US$39 million in 1999. Much of the growth of individual institutions has come from the addition of unrelated groups among credit unions. At the end of 1999, there were 3192 federally chartered credit unions with multiple groups charters.

Many years ago, Berle and Means (1932) hypothesized that, as ownership and control become separated, corporate governance becomes less efficient. The current questions are: how do (1) multiple membership groups and (2) additional membership impact corporate control in credit unions, given their special governance structure? Some recent literature has begun to explore these issues. Johnson (1995) examined state chartered credit unions in Utah and found that open field of membership credit unions were less likely to maximize member benefits and were more inefficient than closed field of membership credit unions. Gorton and Schmid (1998) found that the performance of Austrian cooperative banks tends to deteriorate as the number of members increases, suggesting separation of ownership and control. Leggett and Strand (1999) found evidence that management has served its interests by adding membership groups at federal credit unions.

3. Agency control issues

An agency problem exists if an organization is not being managed so as to maximize the owners' welfare; that is, if residual earnings are not being allocated solely to the benefit of owners. (2) For a credit union, the supposed beneficiaries of residual earnings are depositor/ shareholder owners. (3) Borrowers and potential depositors within the field of membership can also be considered as appropriate beneficiaries in that most credit unions are explicitly established to suit the needs of a group, should any constituent choose to participate. If, on the other hand, management somehow claims a meaningful portion of residual earnings -- by distributing undue benefits to officers and other employees -- then there is an agency problem.

There are several reasons for this potential emergence of agency problems as credit unions grow and add membership groups. First, the growth has encouraged professionalization of management, potentially distancing management from membership. As recently as the 1970s, volunteers from the field of membership managed most credit unions. But as institutions grew larger by attaching groups, full-time management -- not from any of the groups -- was needed. According to a recent survey, 64% of all credit unions, with 94% of the credit union members, now employ full-time managers (Credit Union National Association, 2001). Second, as membership expands, member/owners may become less concerned with monitoring management. With the distinctive "one member, one vote" governance structure in credit unions, each member can feel disempowered as the institution adds members; many members no longer exercise their ownership rights and responsibilities in overseeing management.

According to a recent survey (Credit Union National Association, 1999), voter participation rates in board elections decline as credit unions become larger. For extremely small credit unions (under US$200,000 of assets), the participation rate is 26.1%. Voter turnout drops to a low of 6.2% for credit unions with US$200 million to US$500 million of assets. The survey also shows that single-bond credit unions have a higher voter turnout rate than multigroup credit unions.

Moreover, management has incentives to grow an institution. A survey by the Rosen et al. (1996) Credit Union Executive Society (1996, p. 8) found that "there is a strong positive relationship between chief executive officer's compensation and credit union asset, membership, and loan portfolio size."

Thus, relaxation of common bond restrictions may have permitted dissociation of management from membership. It may therefore have fostered divergence of motives, which increases the chance of agency problems.

4. Hypothesis

The absence or existence of agency problems in credit unions should be apparent from the allocation of residual earnings. The residual can be allocated toward depositor and borrower members/owners and potential members in the form of some combination of high deposit interest rates and low borrowing interest rates -- in other words, a low net interest margin. On the other hand, a higher net interest margin suggests that the residual is being allocated away from owners and potentially toward management. (4)

More direct evidence of management's claim on residual earnings is seen in operating expenses and payroll. Management can divert residual earnings toward itself by increasing salaries or nonpecuniary expenses (for training, working conditions, travel, etc.). To test for such diversion, one can look for high levels of either direct employee compensation or overhead expenses relative to the average assets of the institution -- i.e., increased inefficiency.

In summary, higher levels of any of the following variables would suggest the existence of credit union agency problems: (1) net interest margin, (2) employee compensation relative to assets, (3) operating expenses relative to assets, or (4) return on average assets. The question is whether these symptoms of agency problems become more pronounced as credit unions add members and employee groups.

5. Data

To examine these issues, financial reports for 1999 from individual credit unions were employed. A "call report" is supplied to the NCUA semiannually by each federally insured credit union, including both federally charted and state-chartered, federally insured institutions. The dataset was restricted to allow analysis of the impact of growth and multiple employee groups. Since only federally chartered credit unions are affected by NCUA's multiple group policy, state-chartered credit unions were excluded from the analysis. Moreover, a credit union's field of membership can be defined as a workplace or association tie or as a community. Call report data acknowledges whether an employment/association-based credit union is composed of multiple groups but not whether a community-based credit union has resulted from merger of institutions (with the community redefined to encompass a larger area). Therefore, community credit unions were also excluded. Finally, any credit union that did not report information regar ding salaries and benefits was also excluded from the sample. The resulting sample includes 5822 noncommunity-based, federally chartered credit unions.

There are some significant differences between single and multiple group credit unions. As Table 1 shows, multigroup credit unions are larger and have more members than single-group institutions. Multigroup credit unions also have higher loan-to-deposit ratios and better asset quality (measured by the ratio of delinquent loans to total loans) than single bond credit unions, on average. Furthermore, multigroup credit unions have lower average capital-to-assets ratios than single-group credit unions. This difference might reflect the increased risk associated with institutions being closely linked to a single employer. There is not any real difference in profitability, measured by return on assets.

The descriptive statistics provide some evidence that single-group credit unions managed expenses more efficiently than their multigroup counterparts in 1999. Operating expenses averaged 18 basis points lower while salaries and benefits averaged nine basis points lower (relative to average assets) for single-group institutions. Net interest margins were essentially equivalent for the two groups. However, firm conclusions cannot be drawn without considering the impact of control variables, asset size in particular.

6. Empirical tests

The search for evidence of agency problems was conducted using linear regression analysis. Regressions were run separately with three dependent variables: those listed above as signs of agency problems. To test for evidence of agency problems, the number of current members and a dummy variable for multiple membership groups were utilized as independent variables. Since the data identifies whether a credit union includes multiple membership groups but not how many there are, a dummy variable was used. Following Johnson (1995) and Stewart (1997), five variables were used to control for operational differences among sample members: asset size, number of members, capital-to-assets ratio, asset quality (nonperforming loans to total assets), and portfolio composition (total loans to total deposits). A sixth control variable was also used to proxy the competitive pressures in local markets: the Herfindahl--Hirschman Index of the concentration of bank deposits.

The results shown in Table 2 provide evidence of agency problems as credit union membership grows. The coefficient on the number of members is positive and significant at a 0.01% level of confidence in all of the regression equations, except for the regression with return on average assets as the dependent variable. For each 1000 members added by a credit union, the net interest margin increases by one basis point, on average. Employee compensation and operating expenses (as a percent of assets) also rise with membership. These results certainly indicate that management benefits from membership growth.

As to the effect of adding multiple membership groups, the results here are also telling. Multgroup credit unions are significantly less efficient, with higher salaries/benefits and operating expenses, relative to assets, than single-group institutions. The significantly positive coefficients indicate that operating expenses are an average of 1/4% of assets more for multiple-group institutions while salaries and benefits are 1/8% of assets higher, ceteris paribus. The net interest margins for multigroup institutions is also an average of seven basis points higher than for single bond institutions and is statistically significant at 2% level of confidence.

However, the number of members and the multiple group dummy do not have any impact on profitability of credit unions as measured by return on average assets.

As a follow-up, the impact of the type of membership group was added as control variables. Table 3 shows the results of regressions which are equivalent to those discussed above except that dummy variables are added for four types of occupational groups: government, manufacturing, military, and services.

After adding indicator variables for the common bonds occupational type, the evidence still indicates the existence of agency problems. The effect of multiple groups remains significant and positive for the regressions with net interest margins, operating expenses, and salaries and benefits as the dependent variables. However, interest margins appear to be slightly lower for credit unions affiliated with the manufacturing sector (the coefficient on the manufacturing affiliation dummy variable is significant and negative). Additionally, credit unions with a manufacturing common bond also have a lower return on average assets. There is not any statistical difference in operating cost as a percent of assets by common bond type. The only evidence of selective effects by affiliation type on employee compensation is that credit unions associated with the service industry apparently pay more (the coefficient is positive and significant). Thus, agency problems appear to be somewhat more severe for credit unions that are not affiliated with manufacturing firms.

7. Conclusions

The statistical evidence clearly suggests that, as credit unions add membership groups and members, benefits are transferred from members to management. Management is able to channel residual earnings away from members--in the form of higher net interest margins--toward itself--in higher salaries and operating expenses. Any economies of scale from growing an institution are offset due to increasing separation between ownership and control.

The federal policy of allowing credit unions to grow through adding unrelated groups exacerbates the problem. It has enabled credit union management to increase membership by adding new groups, instead of by further penetrating the existing potential membership base.

Much of the competitive advantage derived by credit unions over other depository institutions arises from their exemption from federal income taxes. This paper has demonstrated that as credit unions expand by adding unrelated groups and members, management can claim a larger share of the tax-exempt earnings. The broader public policy question then is: to what extent do credit union member shareholders, as compared to management, receive the benefits from the tax exemption? The answer to this question may raise questions about the exemption.

[FIGURE 1 OMITTED]
Table 1

Descriptive statistics--average

Sample averages                       Full sample  Single group

Observations                          5822         2596
Government affiliation                 989          384
Manufacturing affiliation             1494          681
Military affiliation                   147           33
Services affiliation                  1246          504
Assets ($ millions)                    $38.5        $18.4
Members                               7019         3053
Capital/assets                          14.0%        15.9%
Loans/deposits                          73.8%        72.1%
Return on average assets                 0.68%        0.67%
Delinquent loans/average assets          1.36%        1.74%
Net interest margin                      4.34%        4.35%
Operating expenses/average assets        3.87%        3.69%
Salaries and benefits/average assets     1.91%        1.82%

Sample averages                       Multiple group

Observations                          3226
Government affiliation                 605
Manufacturing affiliation              813
Military affiliation                   114
Services affiliation                   742
Assets ($ millions)                    $53.5 *
Members                               9984 *
Capital/assets                          12.5% *
Loans/deposits                          75% *
Return on average assets                 0.68%
Delinquent loans/average assets          1.08% *
Net interest margin                      4.32%
Operating expenses/average assets        3.98% *
Salaries and benefits/average assets     1.97% *

* Statistically different from single group at a 0.1% level of
confidence.
Table 2

Regression results

                                                  Operating expenses/
                             Net interest margin  average assets

Constant                       1.77 (27.6) *        2.21 (25.1) *
Assets                        -0.000002 (-7.1) *   -0.000004 (-10.6) *
Loans/deposits                 0.028 (40.1) *       0.022 (22.5) *
Capital/assets                 0.030 (12.7) *      -0.007 (2.2) **
Delinquency rate               0.117 (17.2) *       0.115 (12.4) *
Herfindahl- Hirschman Index   -0.00008 (-4.6) *    -0.00011 (-4.6) *
Members                        0.000009 (5.4) *     0.000025 (9.3) *
Multiple groups                0.069 (2.3) **       0.262 (6.5) *
Adjusted [R.sup.2]            33.5%                15.6%
F statistic                  395.3                145.4

                             Salaries and benefits/  Return on
                             average assets          average assets

Constant                       0.99 (19.3) *          -0.08 (-1.28)
Assets                        -0.000002 (-7.5) *       0.000000 (0.8)
Loans/deposits                 0.013 (22.0) *          0.007 (9.5)
Capital/assets                -0.005 (0.8)             0.034 (14.0) *
Delinquency rate               0.003 (5.3) *          -0.179 (-25.1) *
Herfindahl- Hirschman Index   -0.00007 (-4.8) *        0.00001 (0.4)
Members                        0.000008 (6.1) *        0.000000 (0.5)
Multiple groups                0.127 (5.3) *          -0.020 (-0.7)
Adjusted [R.sup.2]            11.6%                   13.7%
F statistic                  103.5                   125.5

Student's t statistics are in parentheses.

* Coefficients designated with a * are significant at a 1% level.

** Coefficients designated with a ** are significant at 5%.
Table 3

Regression results -- multiple group dummy variables

                    Net interest        Operating expenses/
                    margin              average assets

Members               0.000009 (5.4) *   0.000020 (8.9) *
Multiple groups       0.066 (2.1) **     0.305 (7.2) *
Manufacturing        -0.138 (-3.5) *    -0.052 (-0.9)
Government           -0.024 (-0.5)      -0.059 (-1.0)
Services              0.021 (0.5)        0.105 (1.9)
Military             -0.155 (-1.7)       0.112 (0.9)
Adjusted [R.sup.2]   33.7%              15.9%
F statistic         232.5               87.3

                    Salaries and benefits/  Return on
                    average assets          average assets

Members              0.000004 (5.9) *        0.000000 (-0.2)
Multiple groups      0.127 (5.0) *          -0.001 (0.04)
Manufacturing       -0.011 (-0.3)           -0.222 (-5.3) *
Government          -0.019 (-0.5)           -0.024 (-0.5)
Services             0.080 (2.4) **         -0.120 (-2.7) *
Military             0.910 (1.2)            -0.082 (-0.9)
Adjusted [R.sup.2]  11.7%                   14.4%
F statistic         61.4                    77.6

Student's t statistics are shown in parentheses.

In addition to the dummy variables listed above, these regressions used
the same independent variables as in Table 2. The coefficients and
significance for the independent variables not shown are not
substantially different from the results of Table 2.

* Coefficients designated with a * are significant at a 1% level.

** Coefficients designated with a ** are significant at 5%.


Accepted 30 August 2001

(1.) See, for examples, Emmons and Schmid (1999), Gorton and Schmid (1998), Leggett and Strand (1999), and Valnek (1999).

(2.) According to the Palgrave Dictionary of Money and Finance, "Agency problems arise when a principal hires an agent to perform certain tasks, yet the agent does not share the principal's objective" (Reicheistein, 1992, p. 23).

(3.) Several different models are employed to test the extent to which there is an agency problem. Generally, these models can be classified into: (1) maximizing the net gain to savers and borrower (Smith, 1984), (2) maximizing efficiency (Murray & White, 1980) and (3) maximizing growth (Pearce, 1984).

(4.) Depositor members also receive some benefit if the institution retains earnings to strengthen its capital, making it more safe and sound. This benefit is small if: (1) the typical member deposit is less than the US$100,000 federally insured limit or (2) the institution is already well capitalized. Since most credit union accounts are small and most credit unions are well capitalized, member/shareholder gain little from retained earnings, and most members are better served by a low net interest margin.

References

Credit Union National Association. (2001). Credit union services profile. Madison, WI: Credit Union National Association.

Berle, A., & Means, G. (1932). The modern corporation and private property. New York: William S. Hein & Co.

Credit Union National Association. (1999). Credit union services profile. Madison, WI: Credit Union National Association.

Emmons, W. R., & Schmid, F. A. (1999). Wages and risk-taking in occupational credit unions: theory and evidence. Federal Reserve Bank of St. Louis Review, 81, 13-28 (March/April).

Fama, E., & Jensen, M. (1983a). Agency problems and residual claims. Journal of Law and Economics, 26, 327-350.

Fama, E., & Jensen, M. (1983b). Separation of ownership and control. Journal of Law and Economics, 26, 301-326.

Gorton, G., & Schmid, F. (1998). Corporate governance, ownership dispersion, and efficiency: empirical evidence from Austrian Cooperative Banking. Unpublished manuscript of March 13, 1998.

Johnson, R. E. (1995). Field of membership and performance: evidence from the State of Utah. Madison, WI: Center for Credit Union Research, University of Wisconsin-Madison, and Filene Research Institute Center for Credit Union Research.

Kane, E., & Hendershott, J. (1996). The federal deposit insurance fund that didn't put a Bite on U.S. taxpayers. Journal of Banking and Finance, 20, 1305-1327.

Leggett, K., & Strand, R. (1999). Credit union expansion and agency problems. The Southern Business and Economic Journal, 22, 78-90 (January).

Mester, L. J. (1991). Agency costs among savings and loans. Journal of Financial Intermediation, 1, 257-278.

Murray, J., & White, R. (1980). Economies of scale and deposit taking financial institutions in Canada. Journal of Money Credit and Banking, 12, 58-70.

Pearce, D. (1984). Recent developments in the credit union industry. Federal Reserve Bank of Kansas City Economic Review, 69, 3-19.

Rasmusen, E. (1988). Mutual banks and stock banks. Journal of Law and Economics, 31, 395-421.

Reichelstein, S. (1992). Agency. The new palgrave dictionary of money and finance. New York, NY: Stockton Press.

Rosen, A. S., Lusk, A. A., & Kim, J. S. (1996). 1996 Credit Union Executive Society compensation manual. Madison, WI: Credit Union Executives Society.

Smith, D. (1984). Theoretic framework of the analysis of credit union decision making. Journal of Finance, 39, 1155-1168.

Staatz, J. (1987). Recent developments in the theory of agricultural cooperation. Journal of Agricultural Cooperation, 2, 74-94.

Stewart, Y (1997). Who receives the benefit of credit unions' tax exemption? An examination of net interest margins and agency cost. Unpublished dissertation, University of Tennessee, Knoxville, TN.

U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the Census, (1997). Statistical abstract of the Unites States: 1997. Washington, DC: Government Printing Office.

Valnek, T. (1999). The comparative performance of mutual building societies and stock retail banks. Journal of Banking and Finance, 23, 925-938.

Keith J. Leggett *

* Corresponding author. Tel.: +1-202-663-5506; fax: +1-202-828-4547.

E-mail address: kleggett@aba.com (K.J. Leggett).
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Author:Leggett, Keith J.; Strand, Robert W.
Publication:Review of Financial Economics
Geographic Code:1USA
Date:Jan 1, 2002
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