A Call for a New Charter?

Dianne Molvig
May 26, 2010 | COMMENTS

It all started at a meeting in California in the fall of 2008. Those attending included Wendell “Bucky” Sebastian and other CEOs from a small group of credit unions, known as Open Financial Solutions, which Sebastian describes as “sort of a credit union think tank and R&D promoter.”

The CEOs' discussion circled around to the obstacles credit unions face in serving their members, reaching out to potential members, and ensuring lasting viability in a down economy. Brainstorming about solutions ensued.

“We were sitting around talking,” Sebastian recalls, “and Tom Sargent [CEO of First Tech Credit Union, Beaverton, OR ] asked, ‘Why not a new charter?' That set off all these bells and whistles in my head.” Sebastian kept chewing on the idea after he flew home to Tampa, FL, where at the time he was president and CEO of GTE Federal Credit Union (he's since retired).

“My wife thought I was nuts,” he says, “but I got up in the middle of the night and went to the kitchen table to start outlining the ideas that ended up being my suggestion for a new federal charter.” He moved ahead quickly. A week later, he was at another gathering, this time in Washington, D.C., at the Credit Union National Association's annual meeting of CEOs of the 100 largest U.S. credit unions. Sebastian presented his charter proposal to the group. Now nearly a year-and-a-half later, he says his enthusiasm for his proposal hasn't waned a bit.

“My personal belief is that credit unions are needed now more ever,” Sebastian says. “With a couple of changes—some of them substantial—to the federal charter, credit unions could be the financial institution of choice for 90 percent of Americans.”

Why a New Charter?

In the current financial services scenario, too many consumers get a raw deal, in Sebastian's view. That's because banks have an inherent conflict of interest that dictates their decisions and actions every single day. “In spite of all the fancy ads and the testimony on Capitol Hill,” he says, “when you cut through all of that, the banks' goal is to take as much money from their customers as they can and give that money to their stockholders. That is an absolute, complete conflict of interest.”

No such conflict exists in credit unions, whose sole purpose is to serve the financial needs of their member-owners, Sebastian points out. “Our alignment in the credit union model is perfect,” he says. “Now we need the wherewithal to compete.” And that, he contends, is where the current charter falls short. Noting that the Federal Credit Union Act dates back to 1934, while most state laws go back as early as 1925, the current charter is “antiquated,” Sebastian says. “It needs to be modernized. Credit unions can't compete with one hand tied behind their backs.”

Those words come from a man who's devoted a long career to credit unions. To provide a partial resume for those unfamiliar with his early history: Sebastian, a lawyer by training, launched Callahan & Associates with Chip Filson and Ed Callahan, now deceased, in 1985. Before that, Sebastian was general counsel for more than three years for the National Credit Union Administration (NCUA). During his NCUA tenure, one of his rulings stated that language in the Federal Credit Union Act referring to “groups having a common bond” permitted federal credit unions to include multiple groups in their fields of membership. “I said, ‘Groups has an “s” in it,'” Sebastian says. Hence, a credit union should not be limited to serving one group.

Eventually his ruling was chal­lenged in court, and the case came before the U.S. Supreme Court in October 1997. A few months later, the court ruled against Sebastian's inter­pretation. That sparked the ultimately successful campaign to pass HR 1151 in Congress, eliminating the single-group constraint.

Now once again, Sebastian is advocating against what he views to be constraints—ones built right into the federal charter itself. At the same time, he believes credit unions must be will­ing to give a little, too.

“Credit unions need some addi­tional authorities,” he says, “and I think they also should be willing to accept some additional responsibilities.”

This is about more, however, than credit unions gaining capabilities that would be nice to have. Sebastian feels it's a matter of survival. “With the con­straints on our charter and the increasing concentration of wealth and power in the commercial banks,” he says, “without these kinds of changes, credit unions will end up more or less extinct in 25 years.”

Still, he acknowledges, “Some of the ideas in here are things some of my colleagues wish I would never have brought up.”

Features of the New Charter

The new charter would create a new type of institution called a “federal financial services cooperative” (FFSC). The name is a clearer descriptor, Sebas­tian believes, eliminating the prevalent confusion that stems from combining the words “credit” and “union” into one term.

An FFSC would:

• Be a not-for-profit cooperative with a volunteer board elected by members.
• Be chartered, regulated, and insured by the NCUA, renamed the National Cooperative Regulatory Agency. The National Credit Union Share Insurance Fund would become the Federal Cooperative Insurance Corporation, or FCIC.
• Choose its own market (no field of membership).
• Have a one-time, nonrefundable member-joining fee, set by the FFSC.
• Have no restrictions on type of lending (business loans, mortgages, etc.).
• Be able to attract and hold alterna­tive and supplemental capital.
• Be subject to a risk-based formula to determine capital adequacy.
• Need to comply with Community Reinvestment Act (CRA) report­ing rules.
• Be subject to taxation on any earn­ings left after paying expenses, dis­tributing member dividends, and setting aside reserves of 12 percent of total assets.
• Cap CEO compensation at 20 times the average salary of all of an FFSC's employees.
• Automatically appoint the FFSC's CEO to be board treasurer.
• Disclose CEO and senior manage­ment salaries in the annual report.
• Be allowed to convert to another type of financial institution, such as a bank, only after distributing all existing reserves to current mem­bers/owners.

Credit unions wishing to retain their current charter could do so.

Those deciding to switch to FFSCs would incur no conversion cost. Con­version “should be easy and seamless,” Sebastian says.

Sticking Points: Taxation and CRA

These two provisions in Sebas­tian's plan set off red flags for credit unions, and he understands the concern. But as he sees it, taxation and CRA are necessary tradeoffs. “In a per­fect world,” he says, “you'd take all the good things and not subject yourself to any of the bad. I don't think that's realistic.”

But before judging these two measures in his proposal as “bad,” take a closer look, he urges. Note, for instance, the two critical words preced­ing taxation: subject to. Banks also are subject to taxation. “But the fact of the matter is,” Sebastian points out, “the vast majority of banks in this country pay no tax. Many have never paid any tax, or they've paid tax one year out of every 10.”

By the time an FFSC were to cover its expenses, distribute dividends, and set aside 12 percent reserves, it would have little or nothing left to be taxed, Sebastian maintains.

So why even bring up this thorny issue? As he sees it, this provision eliminates the bankers' loudest battle cry against credit unions: that taxa­tion exemption is an unfair advantage. “Everyone would understand why we'd pay no tax,” he says.

After all, no business pays taxes on earnings before operating expenses. Taxes on member dividends are paid by members, so that money wouldn't be taxed twice. “And,” Sebastian adds, “in an era when we're all concerned about safety and soundness, why on earth would you tax earnings before you put away reserves?”

As for CRA reporting, yes, it would mean another compliance burden, Sebastian concedes. But asking FFSCs to comply with CRA is fair from a pub­lic policy standpoint, he believes.

“Some of my dearest friends will vehemently disagree,” he says, “but the truth of the matter is that almost every credit union today is more or less a community charter. Most have either overtly or covertly become eligible to serve the general public.”

Some of the Advantages

Some would doubt the wisdom of stirring up the taxation and CRA issues with the new charter proposal. Sebastian takes an opposite view. “In my opinion,” he says, “the benefits of this charter dra­matically and immediately outweigh any perceived down-range bogeymen.”

Consider, for instance, his suggest­ed shift to a risk-based reserve formula. Currently, credit unions must reserve against even the usual, basic, conserva­tive investments they make, such as in government and government agency obligations—even though those invest­ments have the full faith and credit of the U.S. government behind them. Change that, Sebastian suggests, so reserves are based on the true risk level of loans and investments.

“Take a credit union thought of as being ‘in trouble' today,” he says. “Say it has a 5.5 percent reserves-to-total-assets ratio. If it had risk-based reserv­ing, that ratio would probably rise to 7 to 9 percent.”

Another benefit stems from allow­ing conversions to banks only after all reserves are paid out to members/owners. This removes the incentive to do such conversions in the first place—and also “eliminates the greed factor,” Sebastian says. As it is now, a few people make a lot of money off credit union conversions to mutuals and ultimately to stock-held banks, he contends, adding, “They can talk until doomsday about how they're doing it for altruistic purposes. It's just not true.”

A Few Reactions

Allowing credit unions access to alternative capital and the ability to choose their own markets are two measures that evoke wholehearted sup­port from Mary Cunningham, presi­dent and CEO of USA Federal Credit Union, San Diego, CA .

“I think the lack of access to alternative capital is the Achilles heel of the credit union movement in this country,” she says. “We've learned the hard way that no matter how well-capitalized you are, if a perfect financial tsunami comes along, we're all weak­ened.”

She also shares Sebastian's view that without substantial changes, the credit union movement won't survive. “I worry a lot about the dwindling credit union system based on our cur­rent charter flaws,” she says. “Think back 25 years ago to how vibrant the savings and loan system was, and look at where they are now. They've even lost their regulator because so few of them are left. That's the future of credit unions if we don't take charge and get some things changed.”

Cunningham agrees with Sebas­tian that the proposed charter would neutralize one obstacle: the endless onslaught of banking industry attacks on credit unions. “What he does is to take the wind out of their sails without crippling us,” she observes. “That paves the way for things to be a little smooth­er on Capitol Hill.”

But she takes issue with Sebastian on one aspect: allowing the old charter model to continue alongside the new one. That dilutes the ability to silence the banker critics. “Those who main­tain the old charter would just muddy that water,” Cunningham says.

Eric Bruen, CEO of Desert Valleys Federal Credit Union in Ridgecrest, CA, sees problems with the coexistence of old and new charters, for somewhat different reasons. He fears a fracturing of the industry. “That would make us less effective in our trade organizations, in our legislative action, and in serving our members,” he says.

Bruen also feels the new charter may “blur the line between banks and credit unions.” And although the new model calls for members/owners, “there are no field-of-membership restrictions,” he says. “How long will that stay mem­bers, or will it be shareholders?”

Nor does he share the pessimistic prediction about credit unions' future under the current charter. Saying they'll face extinction in 25 years is “like saying 25 years ago that every small business in America would be out of business because Wal-Mart was created,” he contends. “The reality is small businesses have flourished.”

Sure, Bruen adds, compliance and regulation pose growing problems for credit unions under the current charter. “But will we become extinct? I don't think so,” he says.

Bruce Rodela, president and CEO of Frontier Financial Credit Union, Reno, NV, finds “a lot of merit” in Sebastian's charter proposal. For instance, he strongly favors the risk-based capital formula.

“One of the biggest hindrances credit unions have now is the very parochial approach to judging the health of any given institution,” Rodela says. “The regulators say you have to reserve on your existing capital. That's ludicrous. You should be rated based on the type of risks you have in your loan underwriting and investing.”

But Rodela isn't sure a new charter option is necessary. Rather, the regulators could resolve this problem now. “It would take some effort from NCUA and perhaps the state regula­tors to come together and look at this,” he says.

Rodela also questions how one regulator would oversee both credit unions and the new FFSCs. “How would the regulator view both camps?” he asks. “If a few get in trouble, who pays for what? I could see perhaps some risk to the traditional credit union side up front as these new cooperatives are being structured.”

Still, even with questions and concerns, these CEOs agree the charter proposal warrants a good look. “I would support the dialogue,” Rodela says, “and see where it goes from there.”

As Bruen sees it, the credit union industry faces “fundamental change,” and that's not new. It dates back to the passage of HR 1151 in 1998, he says, which wrought changes in the size and scope of credit unions. Sebastian's proposal acknowledges that, Bruen says. “I commend him for having the guts to say it out loud. Any idea that addresses the fact that there has been a fundamental change in our industry is an opportunity for discussion to find solutions.”

This article was reprinted with permission from Credit Union Digest, the publication of the California and Nevada Credit Union Leagues.