Measuring Credit Union Output That Matters

Credit union consultant Mike Higgins often devises fresh measures designed to tease real trends from the statistical noise.

His latest is a measure of operational efficiency that he said measures the types of output credit unions consider important.

Higgins explained the measure, which he calls the “economy of scale ratio,” in a Filene Research Institute blog called “Maximizing Efficiency of Operations: The ‘New Currency‘” posted May 2.

The ratio compares operating expenses less operating income, or “net costs,” as the numerator to the period’s average loans plus average “relationship shares” as the denominator.

He defines relationship shares as regular savings, regular checking, money market accounts and the NCUA’s “All Other Shares” account (as a proxy for health savings accounts). It excludes share certificates and IRA/KEOGH accounts.

The economy of scale ratio is essentially net cost per unit of output.

“The economy of scale ratio is the net cost to produce a unit of greatest strategic value,” he wrote. “The credit union with the lowest net cost producing the most high-value items has a competitive advantage.”

Higgins wrote that efficiency of operations equips credit unions to handle change and competitors.

“It’s a sustainable advantage too because it cannot be copied or purchased, it must be earned,” he wrote. “In simple terms, efficiency of operations can be thought of as a cost advantage where output per dollar of input exceeds that of others.”

Operational efficiency is not always shown when non-interest expenses are measured a percent of average assets.

“Not all assets have equal value. The expense-to-asset ratio treats them as if they do,” he wrote. “It ignores the funding side of the balance sheet which is equally important as the asset side.”

For example, he found a group of credit unions with expense-to-asset ratios exceeding 4%, which would rank them among the worst performers, yet they had a return on assets in the top 20th percentile. “The reason? This group generated non-interest income at the 95th percentile,” he wrote.

Likewise, high net interest margins, which are part of the traditional efficiency ratio, does not mean productivity is strong, while a low margin does not mean productivity is weak.

“Member-favorable pricing (a cooperative principle) purposefully worsens the efficiency ratio,” he wrote.

Higgins drilled down on 585 credit unions with assets ranging from $300 million to $12 billion. In aggregate, the sample encompassed $1.1 trillion in assets, or about half of all credit union assets.

He computed their economy of scale ratios based on data for the 12 months ending Sept. 30, 2023. He sorted them into three groups of 195 credit unions:

• Greatest Economy of Scale is less than 1.30%.
• Middling Economy of Scale is 1.30% to under 1.60%.
• Least Economy of Scale is 1.60% or more.

The Greatest Economy’s loan balance per dollar of non-interest expense is 28% greater than the Middling Economy and 48% greater than the Least Economy groups. Nearly the same advantage applies to its relationship share balance.

And the Greatest Economy group also beats the others in the numerator. Its non-interest income per dollar of non-interest expense is 16% greater than the Middling and 30% more than the Least economy groups.

Economy of scale reduces a credit union’s reliance on net interest margin to cover operating expense, allowing a more “member-friendly” margin. The net loan spread (loan yield minus net charge-offs and the dividend rate) of the Greatest Economy was 12% less than that of the Middling and 16% less than that of the Least Economy groups.

The Greatest Economy group also had Operating ROA (which substitutes net charge-offs for loan loss provisions) that 29 basis points higher than the Middling and 64 bps higher than the Least Economy groups.

Higgins found the economy of scale generally favors larger credit unions. Average assets were $2.8 billion for the Greatest Economy, $1.5 billion for the Middling Economy and $1.1 billion for the Least.

Higgins reported there were plenty of exceptions. One in five of the Greatest Economy credit unions had less than $1 billion in assets, the smallest being $270 million, “which demonstrates that economy can be realized on less scale.”