Monitoring Credit Union Performance
The Board's Charge to Monitor Performance
A key responsibility of any board of directors is to assess the performance of the overall organization. For a traditional financial institution, the board represents the shareholder. Bank shareholders, for example, want the value of their investment to appreciate. Shareholders buy a claim on all future equity cash flows of the firm. When a shareholder sells their shares, they sell their claim on all future cash flows to the company. Any distribution to shareholders is divided according to the number of shares purchased by the shareholder.
Corporate investors are very interested in how much return they earn on their initial investment. Return to investors of a stock corporation can be easily and effectively measured by return on equity (ROE) or return on assets (ROA). ROE and ROA start with income, and scale that income by the shareholders' equity investment (in the case of ROE), or by the amount invested by all investors (in the case of ROA since assets are the same as liabilities and equity). In most industries, recognizing good performance is easy, the higher the return, the better. And to maximize return, the organization needs to maximize its net income.
Monitoring Credit Unions
With credit unions, this monitoring task is more complex. Credit unions are credit cooperatives. No independent equity investor has any claim on the future cash flow of the credit union; they can’t sell their stake in the institution. To benefit from the credit union, the owner/member must have money deposited or a loan outstanding from the institution. The only financial benefit to the member/owner is in the form of higher rates on deposit, lower rates on loans, lower priced financial services, and improved customer service. In many ways, the member's return is a function of how much business they do with the institution. Reported income does not adequately measure these concepts. So how can the board monitor credit union performance?
Does ROA Capture Credit Union Performance?
Increasingly, articles in credit union periodicals have mentioned using ROA, or return on investment, to assess performance. This advice is generally good when considering individual projects or investments, since the institution does not want to add a project that will add expense, but at the same time drains resources. However, to monitor the overall credit union it is insufficient.
ROA does a good job of capturing commercial bank performance because bank owners want to maximize profits. The easiest way to increase income, and therefore improve ROA, is to widen the net interest margin, or to improve the net non-interest margin. Understanding the credit union income statement will show why improving ROA is not the best measurement of credit union performance.
The statement of income is made up of four primary areas: interest income, interest expense, non-interest income, and non-interest expense. To illustrate, figures from the income statement of Acadian Credit Union for 2008 were used. Acadian was chosen for this illustration because in 2008 their interest income was the median among NCUA insured credit unions (making them the typical institution), and because they turned a positive net income in a year when that was not so easy.
Since assets don’t tend to shift quickly, higher ROA tends to be driven by changes in net income. To increase income, interest income and non-interest income should be increased, and interest expense and non-interest expense should be decreased. Most of those objectives are exactly opposite of the objectives of the credit unions owners/members.
Members who borrow would like to get a great interest rate on borrowed funds, therefore it would be inappropriate to seek to maximize interest income. In fact, better rates may have been what convinced them to join the credit union in the first place. At the same time, interest expense is the best way to distribute return to members who have large deposits, but don't borrow much. So it would not be appropriate to seek to minimize interest expense.
Commercial banks use fee income to generate larger profit margins, but credit unions would again be assessing fees on their owners, and therefore maximizing this revenue source may not be appropriate for the credit union. That leaves us with holding the line on non-interest expenses, but care must be exercised here so that service quality is not impacted. Member interests tend to squeeze all margins.
Net Income Measures Growth Potential
But that does not mean that credit unions should seek to minimize their net income. The most important use of net income is to grow the credit union. Research has shown that credit unions can benefit from economies of scale - meaning the larger the credit union, the more economically it can operate, the cheaper it will be able to loan funds, the more interest it can offer on deposits, and the more financial service that can be offered.
Regulators have placed capital requirements on all financial institutions. They must have a minimum proportion of equity to assets. If credit union assets need to grow to take advantage of economies of scale, they will have to grow their equity as well. And the only way they can grow their equity is by retaining it. A way of measuring equity growth is by calculating net income (which is potential additions to equity) divided by average equity for the year. This measure is the same as ROE, but for the credit union it measures how fast their equity is growing, and should be about the same as the target growth in assets.
Using Several Measures Together
Unlike other organizations where the profit motive is the primary objective, credit unions must balance the objectives of depositors, lenders, and growth. Some of those objectives are contradictory. The board is charged with assessing and monitoring the performance of the institution for all members. As such it makes sense that the credit union’s board must simultaneously monitor several metrics that seek to measure those objectives. Average deposit yields, average loan rates, non-interest income to assets, asset growth, and equity growth ratios would all be helpful. But none of them could be interpreted in isolation.
This same approach has been adopted among academic researchers of credit unions. To investigate what improves performance to credit unions, academic researcher try to measure the efficiency of the institution, and improvements to efficiency, or the return to the stakeholders (the depositors and borrowers simultaneously). Both approaches try to control for differences in preferences of the members (some credit unions may favor borrowers, while others may favor depositors with the rates they charge and pay). These approaches take several ratios into account simultaneously, which is what must be done by the board.
For more information, the reader is referred to the following links:
•Academic performance measures:
-Performance measure focused on returns: Journal of Banking and Finance 2008.
-Performance measure focused on efficiency: Federal Reserve Working Paper 2009.
•Practitioner performance measures:
-Ratio analysis: Credit Union Management 2010.
