On building alliances: Credit Union Service Organizations

During my presentation at the Meeting of Directors of the Credit Union Central of BC in Vancouver last November, I encouraged the audience to consider alliances as an alternative to mergers, in order to solve some of the economies-of-scale problems facing a typical credit union. What I did not say is how an alliance works. To help credit union members understand what such an alliance may look like, I now present a brief description of one of the most successful alliances amongst small groups of credit unions-the Credit Union Service Organization (CUSO).

CUSOs are almost exclusively an American phenomenon, and are partly a response of credit unions to regulatory restrictions. But there is no reason why the concept would not work in other contexts, like Canada. In fact, experimentation by US credit unions and regulators over the last 30 years has lead to the development of a business form that appears to be quite suitable as an institutional framework to accomplish inter-credit union alliances and joint ventures. If interested in considering the alternative, one should inquire with local regulators what their position is with respect to this business form. The first CUSO was created in 1970. A survey of the National Credit Union Administration (NCUA) reported over 300 CUSOs in 1995, and about 3500 in 2003.This means that well over 35 million credit union clients in the United States receive services from a CUSO. The most popular CUSO form was and remains shared branching, followed by data processing, check clearing and financial and retirement planning services for credit union members. The current growth is both in numbers and variety of CUSOs, offering an expanding array of services.  I will now describe what an American CUSO is and how it works, and show how that idea can be applied, after small adaptations, to your own context.

What are American CUSOs?

CUSOs are corporations created by credit unions that are permitted by NCUA regulations to perform specific financial and operational services for member credit unions. CUSOs in which federal credit unions may invest or make loans are limited by the Federal Credit Union Act to providing services associated with the routine operations of credit unions. The services permitted include the sale of securities and insurance products, mortgage and other loan origination, data processing, trust services, credit card, automated teller machine, and debt collection services, among others. As part of loan support services, they can provide underwriting and processing services in connection with, for example, business loans for credit union members. However, making business loans is not a permissible activity. I present more details on permissible services later on.

Regulation restricts their customer base. They may serve only credit unions, members of the investing credit union or members of credit unions under agreement with the CUSO. Regulation also limits credit union's investment in a CUSO to a total of 1 percent of the credit union's paid-in and unimpaired capital and surplus in the shares, stock, or obligation of the CUSO. Loans credit unions provide to them may not exceed 1 percent of the their paid-in and unimpaired capital and surplus (independent of the 1 percent investment limit). Every project of CUSO must be subject to a legal opinion to insure the proposed structure is permissible and does not engage in unauthorized activities, and to ensure that potential liabilities are limited to the funds invested or loaned to it.

A CUSO in the US may be organized as a limited liability corporation (LLC) or as a limited partnership (LP), with the credit union participating as a limited partner only. Credit unions are not authorized to be general partner. This is to isolate the credit union from risks that may be assumed in the CUSO. Recently, most CUSOs have taken the LLC road due to tax reasons. In the US, CUSOs are for-profit subsidiaries of credit unions. A LLC is a pass-through tax entity with all items of gain, loss, income, deductions and credits passing through to the partnership members. This means the CUSO is taxed at its parent's rate of zero percent. Thus, whether offered through the CU directly or through the CUSO, the federal and state tax subsidies apply.

The usual method of splitting profits and loss is based on the percentage of ownership. However, many credit unions, using an old co-operative tradition, reward the users of the CUSO services by providing incentives to the owners to use them. CUSOs providing operational services use a tiered pricing structure that reward heavy usage. In CUSOs providing financial services, return is sometimes based on the volume of business that is generated by members. There can be a pay or play component where a credit union that is a heavy user of the CUSO services contributes less capital or lower fees.

There are two motives to create CUSOs in the US: i) to provide services to the credit unions seeking to exploit synergies of pooling; ii) to perform regulatory arbitrage by providing services credit unions themselves are not allowed to offer.  I call them P-CUSOs and R-CUSOs, respectively.  Both motives are complementary and many perform both function. However, some are created to perform regulatory arbitrage with no intention to seek synergies through pooling or vice versa.  P-CUSOs are setup when credit unions seek to obtain services exploiting advantages of economies of scale, by joining other credit unions in a long-term cooperative contract. Economies of scale are achieved by pooling the members' demands for the specified service. In the case of the United States, CUSOs compensate for limited pooling arrangements provided by their traditional integration bodies, a situation that is similar to many provinces in Canada. Some authors call the P-CUSOs strategic alliances. To the extent that they often require equity down payments by member credit unions, the appropriate term, to be consistent with the literature, is strategic joint venture (an alliance with equity commitment).

Stictly speaking, a CUSO is not necessary to exploit economies of scale-any credit union can procure large lots of an input, and then provide the services to other credit unions without the need of an additional structure. However, the other credit unions would be subject to the potential opportunism by the provider and vice versa. Thus the ownership interest in a CUSO represents a credible commitment on the side of the partners by creating a structure that protects their residual rights and commits members to respect the agreement.

R-CUSOs offer credit unions the opportunity to provide its customers a service which a regulation otherwise prevents them from offering, raise capital in the market, or earn commissions it is not allowed to as a credit union. For example, regulation says credit unions may not offer non-depository trust services, act as an active mortgage broker or property and casualty insurance agency. However the services can be provided through a CUSO. This regulatory arbitrage is possible because credit unions are permitted to enter into agreements with an insurance agency for the sole purpose of referring business to it. Thus, the credit union can create the CUSO which will become that agent. When these services are provided through it, financial risks are isolated from the credit union, yet the credit unions that invest in the CUSO retain control over the quality of services offered and the prices paid by the credit unions or their members.  The result is that some R-CUSOs are wholly owned by a single credit union, when the economies of scale are large enough. Two examples of wholly owned CUSOs are: i) Kinecta Financial and Insurance Services, wholly owned by Kinecta Federal Credit Union, a $US3 billion assets, 210,000 member financial cooperative in Manhattan Beach, California.; ii) CU Financial Services of Minnesota, Inc., a wholly owned subsidiary of Hoyt Lakes Community Credit Union.

The table below provides summary statistics about CUSOs in the United States for 2003. Of course, CUSOs can perform more than one task.

Source: NCUA-2003 Yearend Statistics for Federally Insured Credit Unions

This figure represents the number of CUSO Schedules completed by all credit unions. Since more than one credit union may have a loan to or investment in a given CUSO, this figure does not represent the total number of unique CUSOs. The data suggest that of the about 3600 CUSOs, about 600 are R-CUSOs, that is, CUSOs designed to perform regulatory arbitrage. The remaining 3000, are probably P-CUSOs although they may also perform some regulatory arbitrage.

Services CUSOs can and cannot offer

CUSOs can cover a wide range of financial services for members. Proceeding in a more systematic way, CUSOs offer to their member credit unions:

1.Operational and management services: credit card and debit card, ATM, accounting systems, data processing, management training and support, payment item processing, record retention and storage, locator, research, debt collection, credit analysis and loan servicing and coin and currency, correspondent; internet-based services for securities safekeeping and cash ordering; electronic fund transfer (EFT), sale or lease of computer hardware and software, marketing and coin and currency.

2.Services to members: financial planning and counselling, retirement counselling, investment counselling, discount brokerage, estate planning, income tax preparation, developing and administering individual retirement accounts (IRA), Keogh, deferred compensation and other personnel benefit plans; trust; acting as trustee, guardian, conservator, estate administrator, or in any other fiduciary capacity; real estate agency; agent for sale of insurance; personal property leasing; and provision of vehicle warranty programs. A CUSO must comply with applicable state and local laws when engaging in activities or services as listed previously.

3.Consulting services: charter conversions, ALM (asset-liability management) modeling, and strategic planning.

4.Property management: personal property leasing and developing of leasing plans; and

5.Other services, as determined by the director, that are associated with the routine operation of credit unions.

This is indeed a wide range of products and services that ought to cover the needs of any credit union. However this might not be so. US CUSOs are explicitly prohibited from doing certain activities. A major restriction is the prohibition of acquiring control, directly or indirectly, of another financial institution, or investing in shares, stocks or obligations of an insurance company, trade association, liquidity facility or other similar organization. This represents a significant restriction. What matters is not only the variety of products and services available-open markets also offer all those services-but the conditions of delivery. That is, how transactions are governed. The prohibition does not mean that CUSOs may not pool the demand of financial products and thus be able to negotiate better prices and service conditions with established suppliers. However, it will limit the governance options available to credit unions to control the provision of those services. That is, the "buy vs. make" choice (vertical integration) is eliminated by the regulator. Some European networks (and Desjardins, in Quebec) control several subsidiaries, including banks, investment banks, insurance companies, brokerage firms, etc. all with the function of producing financial services that are delivered through the network. The fact that these networks have chosen to "make" (i.e. acquire the producer of the input) suggests that there is an advantage in doing so, and that this restriction may potentially be costly to credit unions by limiting their competitiveness in United States' financial markets. Incidentally, this restriction does not apply to joint stock banks. These, through bank holding companies-of which the bank itself would be a "subsidiary"-can control a wide variety of types of financial intermediaries.

It remains to be seen whether CUSOs are good for Canadian credit unions. However, the description of the US CUSOs suggests that P-CUSOs may well constitute a type of alliance or joint venture worth considering.

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