from the Richmond Fed

— this post authored by Sabrina R. Pellerin

The first U.S. credit union – St. Mary’s Cooperative Credit Association in Manchester, N.H. – opened its doors in 1908 with the mission of meeting the personal financial needs of a targeted community: French-American mill workers. Those who helped organize St. Mary’s believed that access to credit for poor working families would improve their well-being. Today, this same credit union is a full-service financial institution, renamed St. Mary’s Bank, and is open to anyone willing to purchase one share of “capital stock” for $5. The evolution of St. Mary’s resembles that of the entire credit union industry with the expansion in both its membership base and its services.

Unlike banks, which operate to maximize stockholder wealth, credit unions are owned by their members, or depositors, and are therefore considered to be cooperatives. Membership in a credit union is limited to individuals who are part of a well-defined community or share a “common bond,” such as the mill workers at St. Mary’s. Common bonds can be based on employer, membership in an organization, or residence within a well-defined geographic area. For example, HopeSouth Federal Credit Union restricts membership to persons who “live, work, worship or attend school” in Abbeville County, S.C. Each credit union is required to define the specific common bond that establishes the “field of membership” from which it can draw its members.

As is typical of cooperatives, credit unions are structured as nonprofits and are democratically owned and operated with each member having one vote regardless of the amount of deposits held. Moreover, members elect unpaid officers and directors from within the credit union’s field of membership. As of December 2016, there were approximately 5,919 credit unions operating in the United States (compared to 5,198 commercial banks) serving 109.2 million members. While large in number, their combined assets of $1.3 trillion are less than the asset holdings of any one of the top four commercial banks.

Some observers find that credit unions today are largely indistinguishable from banks, while others believe that their structure and member-driven community focus makes them unique. Unlike banks, federal and state credit unions have been exempt from paying federal corporate income taxes since 1937 and 1951, respectively.

Critics of the tax exemption say that a series of relaxed rules over the decades have allowed for direct competition between banks and credit unions, and they argue it has created an unfair and artificial competitive advantage for credit unions.

While the debate has been raging for decades, in the last year, the agency responsible for overseeing credit unions, the National Credit Union Administration (NCUA), proposed and implemented further relaxations of some of its restrictions on credit unions’ member business lending and fields of membership. These restrictions are unique to the credit union industry, and the rule relaxations were met with opposition by bank advocacy groups and other observers who claim the changes expand the field in which credit unions can apply their cost advantage. According to the NCUA, these rules enhance credit unions’ ability to meet the demands of an evolving financial services industry and remove unnecessary impediments to credit union growth. It’s the latest chapter in a long-standing and sometimes acrimonious debate.

Credit Unions Then and Now

Credit unions arose as a solution to meeting consumers’ demands for credit at an affordable cost – particularly for individuals who did not have established credit. To substitute for collateral, credit unions leveraged social connections among a community of members. Specifically, their distinct niche was extending small-value, unsecured consumer loans to members who shared a common bond.

With a cooperative structure, members of early credit unions had something to lose (reduced earnings or loss of deposits) if a fellow member failed to repay on a loan and thus had an incentive to monitor the character and economic prospects of one another to determine a borrower’s creditworthiness. Moreover, the community ties led to social pressure for repayment, lowering the probability of defaults on loans.

While many cooperative features of credit unions remain intact, credit unions have changed dramatically since the early 20th century. For instance, in 1970, the Federal Credit Union Act was amended to create a regulator to oversee federal credit unions – the NCUA – and extended deposit insurance protection to credit union members through the creation of a new insurance fund (similar to the Federal Deposit Insurance Corporation, created for commercial banks nearly 40 years prior). With the advent of deposit insurance, credit union savers no longer had a strong incentive to monitor or apply social pressure to credit union borrowers because their investments were protected by the insurance fund, increasing the similarities between banks and credit unions.

The business of consumer lending has changed drastically as well. Starting with the introduction of FICO scores in 1989, financial institutions could consider credit scores when deciding whether to extend a loan. This financial sector innovation diminished, to some extent, the importance of relying on social bonds to assess creditworthiness.

Furthermore, technological changes and increased competition have made it much easier for consumers to gain access to financial services. For instance, credit cards have increasingly become a substitute for the small-value consumer loans that credit unions have historically specialized in. According to John Tatom of Johns Hopkins University, an economist and tax expert, people who use credit unions are not as unique as they once were because they now have access to a wider range of financial services and providers. Tatom says that times were very different in the early 20th century when credit unions were first gaining popularity, noting that people who were going to credit unions then “were people who really did not have as much access to the financial system. Banks didn’t want their business – they couldn’t as readily use bank deposit facilities or get bank loans.”