As Prepared for Delivery on January 23, 2020
Based upon my experience as an M&A, corporate and tax attorney and CPA for approaching 40 years, it is clear to me that market forces and arm’s-length negotiations have driven the recent spate of mergers between credit unions and community banks. Interestingly, some argue that credit unions are using their tax-exempt status as a means to gobble up community banks like a game of financial Pac-Man. Those who advocate for this position contend that credit unions and community banks were created on a level statutory and regulatory playing field except that credit unions were inexplicably given an “unfair” tax-exempt status. As a former tax attorney, I find this perspective inconsistent with the law.
Let’s take a look at the Federal Credit Union Act.
Banks, by contrast with credit unions, may issue both equity and debt capital in public offerings and private placements for regulatory capital purposes and community banks may often avoid corporate level income taxation by making a taxpayer-subsidized S corporation election under the Internal Revenue Code. Under the Federal Credit Union Act, however, credit union authority to raise capital for both the risk-based net worth ratio and the net worth ratio tests is materially limited. First, under the Federal Credit Union Act, credit unions are limited to issuing debt, as opposed to equity instruments. Stated another way, the act does not authorize credit unions to issue equity capital in a private placement or a public offering.1 Second, even where the act provides the authority to issue debt, the permissibility of counting that debt towards the risk-based net worth ratio or the net worth ratio is statutorily limited to complex credit unions, low-income credit unions, and new credit unions.2
Under current NCUA regulation, credit unions without a low-income designation may only build regulatory capital through the retention of earnings. Credit unions, accordingly, are placed at a competitive disadvantage to community banks with the latter’s ability to raise common stock and other equity and debt capital in public offerings and private placements.
The Federal Credit Union Act also places limits on credit union growth through the field of membership, member business lending, investment authority, and other statutory restrictions. These limitations explain why relatively few banks elect to merge with a credit union or convert to a credit union charter, even though credit unions are not subject to federal corporate income taxation. That is, the quid pro quo for the credit union income tax exemption imposes meaningful statutory restrictions on the ability of credit unions to raise regulatory capital and conduct their business operations in a manner parallel to and competitive with that of banks.
Specifically, banks — particularly those community banks that avoid corporate level income taxation by making a taxpayer-subsidized S corporation election under the Internal Revenue Code – are, understandably, loath to voluntarily accept, whether through a market driven, arm’s length merger with a credit union or otherwise, any of the following four competitive disadvantages to and statutory constraints on their business models and operations in return for a credit union charter:
- Relinquish their ability to raise common stock and other equity and debt capital under the Federal Credit Union Act’s capital restrictions,
- Limit their customer base materially under the act’s field-of-membership restrictions,
- Restrict their commercial and corporate lending activity, and the fees generated thereby, under the act’s member business lending restrictions; and
- Narrow their profitable investment activity under the act’s investment authority restrictions.
In contrast, credit unions and the NCUA must operate strictly within, among others, these four statutory limitations in a fully accountable and transparent manner. Simply put, if the credit union tax exemption was of such value to community banks relative to the statutorily enacted competitive advantages granted to community banks and denied to credit unions, many more community banks would have merged with a credit union or converted to credit union status a long time ago.3
Ironically to some, I suppose, based upon an objective analysis of the applicable governing statutes and regulations, one could argue that the overall most favorable organizational structure for a community financial institution is that of an S corporation electing community bank.4 After all, those institutions avoid corporate level income taxation as well as the equity and debt capital, field of membership, member business lending, investment authority, and other statutory limitations applicable to credit unions. In any event, we should remain mindful that it is not intellectually possible to address the credit union tax exemption, and the tax policy underlying that exemption, in a fair-minded and objective manner without also acknowledging the competitive restraints placed on credit unions under the Federal Credit Union Act relative to those placed on community banks under their governing statutes, as well as the ability of community banks to avoid corporate level income taxation by making a taxpayer-subsidized S corporation election under the Internal Revenue Code.
After representing the so-called money-center or too-big-to-fail banks for much of my legal career, teaching tax law at a law school and a business school, and serving as a member of the TARP Congressional Oversight Panel and the NCUA Board, it is apparent to me that credit unions and community banks are often materially different financial institutions with specifically tailored and targeted business models, operations and ambitions. The overwhelming majority of these institutions – whether credit unions or community banks – are growing, thriving and prospering and have, from all indications based upon the facts before us today, little interest in changing the status of their organizational charter. If, on occasion, market forces and arm’s length negotiations indicate that a merger or other business combination between a credit union and a community bank makes economic sense, the proposed rules before us this morning will assist both parties in negotiating, documenting and closing their transaction in a fully accountable and transparent manner.
In closing, I must admit that the endless Hatfield-McCoy carping between credit unions and community banks has grown tiresome and of little purpose except, perhaps, as a marketing tool for some. Instead, these financial institutions should acknowledge that their future viability is not so much threatened by the other but will rest on how they respond to the economic and operational challenges presented by, among other matters, the following six issues:
- The branch network of the largest money center banks;
- App-based and other remote and electronic means of providing financial services;
- Fintech and other non-traditional financial firms;
- Cybersecurity and other emerging threats;
- The continuing innovation in the delivery of financial services that will evolve in unexpected and surprising ways; and
- The maintenance of sufficient regulatory liquidity and capital and the avoidance of lending and investment over-concentration.
As a safety and soundness, prudential regulator, this is what keeps me up at night. I am far less concerned that a credit union and a community bank may determine that it is in their mutual economic interest to merge together, regardless of whether the credit union or the community bank continues as the surviving financial institution. These transactions reflect market forces and are negotiated in an arm’s length manner. The NCUA and other financial regulators should respect the independent, market driven business decisions of the interested parties, unless safety and soundness, consumer protection and related matters indicate to the contrary.
1 We have not canvased state law to determine how a particular state may treat this issue with respect to its federally insured state-chartered credit unions.
2 This highlights the limited exceptions where debt raised may be counted towards regulatory capital or used to determine if action under prompt corrective action is warranted. This may occur in the following instances: (1) LICUs - the FCUA requires that subordinated debt (secondary capital) count toward a LICU’s net worth under 12 U.S.C. 1757a(c)(2) and 1790d(o)(2); (2) Complex Credit Unions (defined as credit unions with more than $500 million in assets) - under 12 U.S.C. 1790d(d), the Board must establish regulations that “shall include a risk-based net worth requirement for insured credit unions that are complex, as defined by the Board based on the portfolios of assets and liabilities of credit unions”; this permits, but does not require, inclusion of subordinated debt in the RBNWR requirements for complex credit unions; note that a complex credit union can also be a LICU; and (3) New Credit Unions (defined by statute as those in existence for less than 10 years and with $10 million or less in assets) - under 12 U.S.C. 1790d(b)(2), the Board must prescribe a system of prompt corrective action for new credit unions; this permits the Board to consider subordinated debt issued by a new credit union when imposing prompt corrective actions, but it does not allow the subordinated debt to be directly counted toward net worth; for example, if a new credit union falls within a certain prompt corrective action category that might otherwise require certain corrective actions, the Board could consider the subordinated debt of the new credit union in deciding whether to forgo application of the action that would otherwise apply.
3 The idea that banks are queued around the NCUA headquarters in hopes of merging with or converting to credit union status is an urban legend. As such, we should dispel the notion that community banks are somehow an endangered species at the hands of the credit union community.
4 Matters of federal taxation reside solely within the domain of Congress and not with the NCUA or any other financial institutions regulator.