This article was first published on ChipFilson.com.

With exquisite timing during this week’s credit union GAC convention, the Washington Post published an opinion article with the title: TARGETING THIS $2.8 TRILLION TAX SHELTER COULD SOLVE A BIG U.S. PROBLEM

The opinion was authored by Scott Hodge, described as a tax policy fellow and past president of the Tax Foundation.

Hodge provides multiple examples of successful tax-exempt, very profitable organizations, such as AARP, the Academy of Arts and Sciences, the Kaiser Foundation Hospital system, and the PGA, as fellow travelers in the tax-exempt panoply of unfair competitors.

Here is Hodge’s paragraph singling out the credit union exemption:

With more than $2.3 trillion in assets, the tax-exempt credit union industry has long outgrown its Depression-era roots. Originally exempted to serve working-class people of “small means” who lack access to banking, credit unions are now indistinguishable from commercial banks. They offer mortgages, auto loans, credit cards and investment services—and they’re using tax free cash to buy banks. In the past decade, credit unions have purchased nearly 100 commercial banks, converting taxpaying businesses into tax-exempt ones. Imagine Gold’s Gym buying your local YMCA.  

His example of co-ops buying banks has logic and common sense. As one observer has stated, “I’d invite anyone willing to discuss the original purpose of credit unions and why neither the FED, OCC nor the FDIC wanted to regulate them. Short answer: Credit Unions are not banks. They are member-owned cooperatives created as a safety net and alternative to banks. As a result, credit unions were granted nonprofit status, were not taxed, and were placed under social services.”

But would that be a sufficient response to this recurring threat?

History of the tax exemption

State chartered credit unions received their federal tax exemption via an IRS ruling. Federal credit unions are tax-exempt under the Federal Credit Union Act. One consequence of these two processes is that some states have passed franchise or other taxes on state charters. Another critical difference is public disclosures. State charters must file an annual IRS 990 with facts on salaries and benefits of highly compensated employees and list all charitable donations and political contributions.

Coops’ special service purpose was endorsed by FDR in this 1936 note to the Treasury Secretary. The President encourages publicity for these new institutions, supervised by the Department of Agriculture, saying they are popular.

In the modern era of an Independent NCUA regulator, the agency’s first two board chairs were not hesitant in their support of credit unions’ tax status. (Photo from 1981, left to right: Larry Connell, PA Mack, Ed Callahan.)

Today’s NCUA board has been agnostic on credit unions’ tax exemption, saying the issue is up to Congress. This is similar to the Board’s silence on the bank purchases referenced in the Post opinion, even though NCUA approval is required for every transaction.

How the tax exemption formed the industry

For the first 100 years of credit union formation, all were started with no financial capital, with minimal share donations by the organizers. Today, NCUA requires at least $500,000 in equity to receive a charter, but that is not how 99% of active credit unions today achieved their net worth.

Until NCUA insurance was required for all FCUs in 1970, member shares were equity, ranking last in payout priority in the event of failure. One of CUNA’s concerns about a federal insurance program was that it would reduce members’ ownership attention.

During the bank holiday in FDR’s first year in office, when many customers lost savings due to bank closures, credit unions noted that not a single state charter failed in this period. There were no FCUs until 1934, but just like the states, all member shares were at risk.

Federal share insurance was not passed because of member losses or credit union failures. Rather, it was a reward for performance that demonstrated member shares were as safe as insured deposits in banks. It was not until the mid-1980’s that the Public Accounting Standards Board classified credit union shares as liabilities and not equity in GAAP presentations.

The imposition of bank capital concepts

Even after multiple coop share insurance programs were available, until passage of the Credit Union Member Access Act (CUMAA) in 1998, reversing a Supreme Court interpretation of NCUA’s field of membership rule, credit union capital adequacy was determined on a flow, or earnings set aside requirement.

Net worth was created by allocating 6% of income into a statutory regular reserve account until that total was at least 4% of risk assets. At that level, the transfer was lowered to 5% until a ratio of 6% of risk assets (primarily loans) was achieved. Retained earnings were on top of this required capital account. The tax exemption on net income was a critical factor in co-ops’ net worth buildup.

A 6% ratio of total net worth to assets was considered well-capitalized. However, CUMAA changed the capital creation from a coop model to a banking concept. Now the required ratio was determined by the amount of capital on hand at any point in time versus the flow of earnings into reserves. To be well-capitalized, credit unions needed to have at least 7% net worth at all times.

For almost 100 years, the tax exemption was critical to building total capital. This was the sole source of the credit union’s net worth. This process took time before startups could become financially self-sufficient without sponsor support or location and convenience advantages.

Member loyalty was the intangible but essential foundation because reserve accumulation could take a generation or more to become self-sustaining. Growing a credit union’s balance sheet from 1998 was now internally governed by the credit union’s growth of equity, or ROE.

The financial ethos today: CEOs born on third base

In his brief history of FCU supervision, Ancin Cooley points out (link) how this founding role of credit unions has been eroded as the founders and builders have left the scene.

Few CEOs today have had to worry about building capital and ROE performance. There is no external market accountability, as there is no stock to be valued and traded. The industry’s average capital ratio is 11%, far above the 7% well capitalized rule requirement. Risk-based capital measures are even greater.

Most newly hired or promoted CEOs, especially in the three decades since CUMAA in 1998, are unaware of how the wealth legacy they now direct was built by generations of member loyalty.

A baseball metaphor for this historical blind spot of incoming CEO’s is useful: “Some people are born on third base and go through life thinking they hit a triple.”

And so the focus of these newcomer CEOs, often with board blessing, is how to take the credit union to a new institutional level. Not how to enhance the well-being of the member-owners whose relationships were the unique foundation of cooperative success.

Excess capital makes the allure and seeming ease of purchasing banks or other third-party assets, and moving beyond community to a financial intermediary, a ready breakout strategy. With the help of brokers and financial consultants, the option is hard to resist. Organic growth seems so commonplace and difficult versus using surplus funds to acquire assets originated by others.

Instead of fulfilling cooperative purpose, the acquisition or “transfer of control” (mergers) of existing assets becomes the go-to success tactic. A coterie of consultants, lawyers, financial agents, and lobbyists will facilitate these instant growth possibilities.

Responding to the tax-exempt challenge

Last week, GAC attendees heard urgent appeals for political action protecting the credit union tax exemption. But is that the best framing of the challenge?

Should the question instead be, if our organization were to be taxed, would that change our mission? If the answer is yes, then maybe the first response is to discuss whether the vision-mission statement needs a review. And secondly, what changes are needed for credit unions to continue their unique role for members, their community, and in the overall financial markets, whatever the tax status?