Demutualisation Risks and Credit Unions

1. Demutualisation Risks and Credit Unions Kevin Davis Commonwealth Bank Chair of Finance University of Melbourne and Chairperson, Melbourne University Credit Union

2. Demutualisation – A common theme • Irish Nationwide Building Society (INBS) • April 2003 AGM stoush • a litany of cases illustrating how woefully inadequate accountability remains in the financial services industry • “new legislation is expected later this year that will facilitate building societies in giving up their mutual status, enabling them to be taken over immediately. Currently, a society that ends its mutual status must remain independent for five years thereafter.” The POST.IE Tues, April 29, 2003 • “Riches even beyond those he [the CEO] currently enjoys await. However, the interests of members who own institutions like Irish Nationwide appear to rate a dismal and distant second.”

3. Demutualisation – A common theme • Standard Life (UK Insurer) • “Standard Life gets tough with carpetbaggers” • The Guardian March 28, 2002 • Increase number of member signatures required to call a special general meeting from 50 to 1000. • The number of members required to nominate a director will also rise sharply to 250 from the previous level of just two. • Standard Life says the increase will "provide a balance between democracy - calling a meeting for good reasons - and the potential for a small group of members to cause the company to incur significant costs". A demutualisation bid two years ago, only narrowly defeated, resulted in costs for the insurer of nearly £11m.

4. Demutualisation – A common theme • National Mutual (UK Pensions Firm) • The Guardian, Saturday March 17, 2001 • 105-year-old pensions company • one of the last bastions of mutuality in the insurance world • set to ditch its member-owned status after announcing it is putting itself up for sale.  250,000 policyholders, 150,000 of whom hold with-profits policies • only this latter group would receive windfallsobservers have claimed payouts could average £3,000-plus. • National Mutual … is talking to potential buyers as part of a review of its mutual status.

5. Demutualisation – A common theme • IOOF Friendly Society (Australia) • October 17, 2001announcement of demutualisation plan • “a logical progression for the financial services group and its members. A demutualisation will allow for the reserves to be distributed to members in the form of shares and also provide access to capital to support our growth plans.” • “although the existing mutual structure of IOOF had served the group well, IOOF is now beginning a new phase of its corporate lifecycle.” • 70,000 members. • Fixed entitlement of 140 shares plus additional variable allocation of shares according to a formula based on the type, number, size and duration of policies held. • likely market price of a share would be between $2.70 and $3.15.

6. Demutualisation – A common theme • Principal Mutual Holding Company (US Insurance Company) • “Demutualization will help us leverage our strength and leadership in a rapidly changing financial services industry. Demutualization provides us with the capital structure needed to pursue growth through strategic acquisitions, to develop new products and services and to invest in technology. We believe that pursuing these strategic opportunities will strengthen our leadership position, provide additional security for customers and be in the best interests of our policyholders.” • eligible policyholders allocated at least 100 shares • IPO (2001) took place at USD 18.50 per share

7. Demutualisation and Credit UnionsA coming theme? • Australia • Sunstate – 1997 • demutualisation via merger with First Provincial Building Society • City Coast – Australian National Merger 2003 • Attempted intrusion by Illawarra Mutual Building Society • Canada • Surrey Metro – 1999 • Had non - voting traded shares • Members rejected sale to Canada Trust

8. Demutualisation and Credit UnionsA coming theme? • USA • At least 24 Credit Unions have converted to or merged with a mutual savings bank • IGA Federal Credit Union • 1998 converted to mutual savings bank. • 1999 converted to stock company • stock only offered to credit union members for $8 per share • 2001 merged with First Penn Bank • PSB Bancorp acquired Jade Financial Corp (holding company of IGA). IGA stock sold for $13.55 per share. • “Converted CU Members Recover Capital From Bank Takeover” CU Journal Daily for 11/07/00

9. Is Demutualisation a New Phenomenon? • No • US mutual S&L’s since mid 1970s • US Life Insurance Companies 1910 onwards • UK Building Societies late 1980s • Australian Building Societies 1980s • Australian Life Insurance Companies 1990s • Mutualisation has also occurred • Some US Life Insurers between 1914- 1960

10. Is Demutualisation a Growing Phenomenon? • Probably Yes • Life Insurance, Building Societies/S&L’s, Friendly Societies, Stock Exchanges, Credit Information Bureaus • But • The stock of mutuals is declining, unless new mutuals created • Has the mutual concept become irrelevant or non-competitive as a form of organisation of financial firms? If so is that due to • An inherent self destructive life cycle • Inadequate adherence to mutual principles • Changes in the economic environment • Legislative biases against mutuals

11. Expropriation or Efficient Mutation? • Why the demutualisation trend? • Is it a case of some self interested individuals profiting at the expense of others? - Expropriation • If so, who is doing what to whom? • Is it a case where all stakeholders are better off? – Efficient Mutation • Are mergers between mutuals any different in principle (or effect) to demutualisation? • Changing entitlements of members • Control rights • Rights to accumulated wealth

12. Mutuals versus Stock CompaniesSources of (Dis)advantage • Stakeholder conflicts • Owner – customer • Borrower – lender • Governance and control • Stakeholder social relationships and information • Goal setting and Objectives • Unwritten (implicit) contracts between stakeholders – mutual self help, intergenerational • Market discipline and efficiency • Taxes • Cooperation between non-competing mutuals

13. Has the Mutual Advantage Disappeared? • Prevalence of Government Depositor Protection • Mutuals were potentially safer • No separate group of owners • Managerial risk aversion • Capital Accumulation • Inherently incompatible with mutual status • Incentives for expropriation

14. Has the Mutual Advantage Disappeared? • Growth, Mergers, and Weakening Common Bond • Member involvement and Governance • Loss of informational advantages • Determining agreed communal objectives • Competition • Declining member loyalty • Less flexibility in setting goals • Repressive regulation may limit ability to offer “one-stop-shop” range of financial products desired by members. • Between “cooperating” mutuals

15. Mutual v Stock PerformanceAcademic Studies • Demutualisation (US Insurance and Thrifts) • All major stakeholders appear to benefit • Also true of “mutualisations” • Stock price gains on listing day for subscribers are substantial (20+%) • Investors view change as beneficial, or • Reflects privatisation of communal wealth • Converted US (New England) thrifts failed in mid 80s at higher rate than mutuals • Despite higher capital ratios • Mutual v Stock Thrifts efficiency (US, Australia) • 2 of 3 studies suggest mutuals more efficient • But many studies suggest economies of scale

16. Does Demutualisation Improve Performance? • Casual Empiricism • Australian Building Societies • Many have since disappeared (acquired) • Australian Life Offices • Disappeared, Poor performance • UK Building Societies • 4 of 10 have merged or been acquired • Net interest margins of mutual building societies smaller, better products, financial inclusion • (BSA – “The Case for Building Societies”)

17. Common Conversion Arguments • Need for Capital • Growth constrained • Increased Accountability • Increased shareholder effectiveness • Clearer Goals • Profits (v balancing diverse member concerns) • Market Discipline • Share price signals • Aligning Stakeholder Incentives • Managerial stock ownership and remuneration • Escaping Legislative Constraints

18. Academic Studies and Conversion Reasons • Insiders do well from demutualisation • Share allocations, profit gains • Takeover regulation may also facilitate managerial entrenchment • Mutual holding companies may facilitate external capital and insider control • Current members and carpetbaggers do well from demutualisation • Likelihood of conversion increases with • size, importance of non-financial business, net worth • Strength of demand and competition • Conversion accompanied by increased risk taking

19. Demutualisation Risks – I I I • Internal • Greedy management and members • Willing to give up benefits of mutual form for conversion of communal wealth to private wealth • Losers are future members and society • Interlopers • Carpetbaggers • Irrelevance • If the mutual is indistinguishable from others (goals, services, financials), who will support its continuance • There may be no mutual advantage or • Mutuals behave like the others

20. Demutualisation Risks – the fundamentals • Capital Accumulation • Communal v Private Wealth conflicts • Are there alternative structures (compatible with mutuality goals)? • Size and Mergers • Participation rate declines as bond widens • Accounting performance appears to decline • Despite cost economies • Managerial “rents” increase • Larger accumulated capital encourages carpetbagger interest and insider incentives to demutualise • Governance and One member one vote • has little rationale when membership involvement / affinity is low • facilitates insider entrenchment

21. Conclusion • Mergers, Increasing Size and Industry Concentration • May reflect cost efficiencies or • Managerial ambitions but • Reduce benefits of mutual structure • Increase likelihood of demutualisation • Even if mutual form is socially beneficial.