The co-operative philosophy of credit unions can have two very different effects on managerial behavior and firm strategy. The first effect arises because, compared to pure profit-seeking firms such as banks, credit unions have an extended stakeholder approach to corporate governance based upon cooperative principles. Their operating philosophy is derived from mutual collaboration encompassing the provision of services to members at cost, the equitable treatment of members, and a broad notion of firm and community service. This favorable view of credit unions is further developed in Smith, Cargill and Meyer (1980), Smith (1984, 1988) and Davis (2001).
The second effect occurs because of the structural nature of credit unions. Since their governance policy is determined by a one member-one vote approach, managers of credit unions can become significantly entrenched, especially in larger institutions when ownership is highly diverse. As Fama and Jensen (1983a,1983b) note, members of cooperatives are less likely to remove incumbent management and vote at general meetings. Managers are consequently insulated from external and internal governance discipline, can become entrenched and exert undue control on the direction of the credit union.
Due to the increasing importance of credit unions worldwide, it is important to study the impact of corporate governance on issues like performance and risk strategy. There is little such research in financial cooperatives, especially credit unions. Exceptions include Karels and McClatchey (1999), who find that managers do not increase risk taking as a result of deposit insurance on US credit unions but that risk-taking decreases as membership base expands [Frame, Karels and McClatchey (2002)]. Davis (2001) argues that the one member-one vote system protects the cooperative philosophy of credit unions by constraining the ability of powerful members (as proxied by invested wealth) from converting the credit union to a stock based institution. On the other hand, research has shown that credit union managers are more likely, compared to their profit-seeking corporate counterparts, to act in their own interests. In particular, Leggett and Strand (2002) show that agency issues in credit unions increase as institutions become larger. In addition, Frame, Karels and McClatchey (2003) find that credit union managers expropriate cash arising from the tax advantages of cooperative institutions.
This paper presents new evidence on the effect of corporate governance on credit union managerial behavior by examining the impact of external discipline on operating performance. Specifically, we investigate how managers react to the imposition of new capital reserves legislation, an innovation that puts severe pressure on credit unions with low capital adequacy ratios. Two behavioral tendencies may manifest themselves. One, credit unions can improve their capital reserves to acceptable levels through increasing lending rates, and/or decreasing deposit rates, or cutting costs. We show that this approach will be unacceptable because it is contrary to the cooperative and extended stakeholder philosophy of equitable treatment, managerial interests and, more pragmatically, the credit union will likely lose business to competing institutions. Alternatively, managers could seek the least costly solution and undertake some form of accounting arbitrage by manipulating their accounting ratios without changing business policy [Jackson (1999:19)]. This would have little impact on the endogenous allocation of member services, but does not, in the short term, address the underlying risk issue.
The specific case studied is the imposition of the 1992 Australian Financial Institutions Code (AFIC) on credit unions in New South Wales, Australia. AFIC is particularly interesting because for the first time, credit unions were governed by the capital adequacy rules of the 1988 Basle Accord. At-risk credit unions, those with capital ratios below the standard Cooke Ratio of 8%, were forced to meet those capital adequacy ratios within a maximum period of three years and faced further censures in the meantime. The introduction of AFIC coincided with a period of reformation in the regulation of financial service providers that emphasized the preeminent role of risk capital and a call for ‘prompt corrective’ action in contrast the previous policy of regulatory forbearance [Dahl and Spivey (1995)]. As a result, during this period the cooperative philosophy of credit unions and the utility of entrenched managers were put under severe strain.
Moreover, this is now a global issue. Capital adequacy regulations are not unique to Australia. Over one hundred countries have now imposed some form of capital requirements on their financial institutions. Further, the treatment of risky capital is likely to become more homogenized across the financial sector with the introduction of the new Basle Accord in 2007. What makes Australian credit unions particularly well suited for this study is they faced a distinct deadlines for adherence to the new capital adequacy regulations, and had operations distinctly different from other financial institutions. Thus managers had to choose a response that counterbalanced the requirements of regulators and the needs of both members and themselves. This posed an extreme test of the extended stakeholder/cooperative philosophy of credit unions.
This paper builds upon the model of Smith (1988) by presenting two potential strategies that credit unions can follow increase profitability or window dress through accounting manipulations and test our data to see which is most prevalent. The results reveal that managers of at-risk credit unions (Cooke Ratio below 8%) are more likely to engage in accounting manipulations than implement efficiency improvements. In particular, the most common approach is to reclassify risky assets on the balance sheet so as to appear that capital ratios are improving, when in fact business strategy is unchanged.
The remainder of this paper is structured as follows. The next section describes the salient governance features of credit unions and the institutional aspects of the Australian Financial Institutions Code. Section 3 presents the data and reports univariate statistics. Section 4 introduces the econometric model and estimates the impact of AFIC on credit union operational efficiency. Section 5 examines the accounting manipulations that credit unions used in response to AFIC and section 6 contains the conclusion.
