Insight. Innovation. Industry.
Banking / Risk Management /  •

Squeeze Play

Credit union must move away from the margin model - or risk irrelevancy.

In baseball, the squeeze play is when the batter bunts the ball hoping the runner from third can make it home before a defensive player sends the ball there.

It’s called the squeeze play because it is a high-risk, sometimes low-reward play and often results in the player being tagged out. In the world of finance, squeeze play has a different meaning. In an era of historically low interest rates, it’s the reality of margin compression. And, just like a baseball team that would rely on bunts to win, credit unions that rely on the margin model risk losing relevance or even failure.

This past July, I spoke at the World Council of Credit Unions 2018 conference about the need for credit unions to diversify portfolios. Not surprisingly, the response to my presentation was well received, as the reality of margin compression isn’t just impacting Canada.

As Stijn Claessens, Nicholas Coleman and Michael Donnelly wrote in May 2016 for VOX, which presents policy analysis and commentary by leading economists: “Banking systems in many low interest-rate countries will face challenges. Until lost income can be offset through other actions, lower profitability will reduce financial institutions’ ability to build and attract capital, increasing their vulnerability to shocks and declines in market confidence.”

The need to diversify from the margin model has been the central point of the review and re-write of the Ontario Credit Union and Caisses Populaire Act, 1994 ever since we began working on new legislation six years ago. Like many of our colleagues, FirstOntario Credit Union (122,000 members, $5.2 billion in assets) was looking for ways to combat the margin compression.

The simple fact is: margins, worldwide, are getting more and more compressed. The Canadian credit union system is quick to point out across the country that margins hover between 2.2 percent and 2.4 percent with banks clocking in at 1.68 percent. However, margins only make up 45 percent of bank income. With credit unions, the income percentage is closer to 90 percent. According to the Canadian Bankers Association, five percent of bank income comes from fees. A full 50 percent of bank income from the Big 5: RBC, CIBC, Scotiabank, BMO and TD, comes from other income.

This means that banks, which have much lower cost of funds than credit unions, are able to still record growth by having more income sources to create capital through retained earnings. On the other hand, credit unions compete with banks, Fintech, unregulated lenders and each other.

Simply put, banks are the major competitors of the credit union system. Margins have been continuing to decrease for years and it would certainly be logical that if they are truly competing, eventually credit unions will be forced to match bank margins at 1.68 per cent. However, because of the lower cost of funds for banks, credit unions may even have to operate at slimmer margins (higher cost of funds) and building capital will be a grave challenge for credit unions.

The question remains, what will credit union profit and loss look like at those margin levels? And, if not raising and maintaining capital through retained earnings, how will credit unions raise capital? The math clearly shows the margin model as it stands is not sustainable.

So, in preparation for the Act review in Ontario, credit unionists sought guidance from similar industries including the Canadian pension industry. Much like credit unions, pension plans in the 1980s became over reliant on a single income source and were stagnant. The government took the lead and revised legislation to allow for pension plans to take advantage of different geographical investment areas and new investment streams. The result was that Canada had some of the strongest pension plans in the world.

In the Ontario Act review, the credit union system looked to do the same thing. We had four basic asks within a complete re-write of the Act. The first was to give credit unions new avenues to attract deposits and to do that we needed credibility in Ontario as a safe landing. We asked the provincial government to increase deposit insurance from the lowest in North America at $100,000 per member to the continental average of $250,000 per member. The second was to allow for loan syndication from across the country so we could create regional diversity in our loan book.

However, these changes still rely on the margin model. So the next two areas of change we sought were opening up the subsidiary ownership rules to allow for a parallel with banks. Finally, we asked that Ontario credit unions be allowed to own insurance brokerages.

We were able to achieve all of these changes or at least movements toward them. FirstOntario became one of the first in the credit union system to create a fundamental change in business structure to allow for one side of the business to focus on member services and the other to focus on non-margin income.

The Corporate Investment Division (CID) was created as that second focus with a goal of attracting 50 percent of total income from non-revenue sources. The goal of the CID is generating within five to seven years $80 million to $100 million in net revenue, representing at least 50 percent of the total credit union revenues. The corresponding income will flow through the credit union to strengthen its capital base.

In this way, the CID would generate net revenue to help sustain all four pillars of the FirstOntario business plan; this ultimately equals reinvestment into members and a reaffirmation of the cooperative nature of the credit union. A simple equation, revenue generated from CID can ensure competitive rates for existing and new members, regardless of margin challenges, to allow the credit union to remain competitive and cooperative.

Key to any investment strategy is maintaining cooperative values and the core credit union operating values. This means:

  •  We are entrusted with our member’s money and we need to ensure it is safeguarded, using comprehensive due diligence processes, third party expertise and ensuring relevant management practices;
  •  All investments will be risk rated and ensure compatibility within the Board’s risk tolerance;
  •  All investments are ethically and morally scrutinized to ensure compliance within our ethical policy;
  •  Manage and diversify growth with a strong focus on liquidity and capital;
  •  Our overarching mission, vision and values are the same;
  •  Our Corporate Social Responsibility mandate will guide us.

With these principals in mind, the FirstOntario CID is creating a well-diversied portfolio to create sustainable and predictable income while minimizing volatility. To date, FirstOntario is attracting 30 percent of our income from non-margin revenue sources. We have not hit our goal but we are well on our way. Maybe we’re not swinging for the fences but we aren’t relying on the squeeze play either. ◊

Kelly McGiffin is the CEO of Hamilton- and Niagara-based FirstOntario Credit Union. McGiffin has coached men’s softball in Canada for 30 years and won a gold medal as coach of Canada’s Men’s Softball Team at the 2003 Pan Americian Games.