RepoRt

Governance Challenges in Credit Unions: Insights and RecommendationsDionne Pohler

Assistant Professor, Centre for Industrial Relations and Human Resources, University of Toronto

Acknowledgments

This report would have never been produced without the support of three organizations and their people: Filene Research Institute, the Canadian Credit Union Association, and the Centre for the Study of Co-operatives at the University of Saskatchewan. It is impossible to properly acknowledge every conversation, interview, conference, workshop, presentation, or paper that contributed to these ideas. There are hundreds of cooperative board directors, managers, employees, members, regulators, and co-op developers and academics that provided me with hours of their time over the past few years in conducting my ongoing research on cooperatives, and allowed me to participate in workshops, events, and meetings that helped me better understand the unique governance challenges in cooperatives, and credit unions in particular.

Filene thanks our generous supporters for making this important research possible.

Table of Contents

4 executive SummaRy

7 chapteR 1

Introduction

11 chapteR 2

Governance Research: A Brief Overview and Relevant Frameworks

14 chapteR 3

Governance Insights and Recommendations for Credit Unions

22 chapteR 4

Conclusion

23 endnoteS

24 RefeRenceS

30 additional ReSouRceS

32 liSt of figuReS

33 about the authoR

34 about filene

Dionne PohlerAssistant Professor, Centre for Industrial Relations and Human Resources, University of Toronto

meet the authoR

overview

As governance arrangements of credit unions continue to evolve, this report examines the characteristics of the well-governed credit union, and explores the value and risks associated with cooperative governance models.

Credit union boards have traditionally been comprised of directors democratically elected by the members, but they are facing increased regulatory pressure to model their board governance structures after those often seen in investor- owned banks. Are credit union boards able to provide effective strategic direction and oversight of senior management and internal control systems? Should changes be made to board selection processes to ensure directors have the necessary competencies to appropriately assess risk and approve and monitor strategic plans? What key issues need to be considered as the governance arrangements of credit unions continue to evolve?

What is the Research about?

In particular, this report focuses on the following:

→ Is cooperative governance less effective or riskier than other forms of governance?

→ Can credit unions reconcile traditional grassroots democratic governance with increasing competitive and regulatory pressures to “professionalize” the composition of their boards?

→ What does “good governance” look like in credit unions today?

Based on more than four years of research on governance and strategy in cooperatives, credit unions, and their second- and third- tier organizations, as well as a systematic review of the academic and practitioner governance literature, this report compiles key insights with associated recommendations for credit union regulators and leaders to consider when proposing changes to board governance guidelines, processes, and practices in credit unions. Figure 1 outlines the broad perspective on governance adopted in this report.

Executive Summary

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What are the credit union implications?

The key recommendations based on this model of governance are summarized below.

policy

→ Policymakers should examine the unique role played by credit unions in striking a balance between competition, consumer access, and stability in the financial services industry.

→ Regulators should develop a separate set of governance guidelines for credit unions that recognize the unique strengths and risks of cooperative governance and business models.

→ Financial regulators should be careful when adopting requirements that intentionally or unintentionally force credit unions to pursue growth strategies or operate more like banks.

growth

→ Credit unions adopting growth strategies should critically reflect on their rationale and purpose for pursuing growth and be clear about the trade- offs. More so than other types of organizations, credit unions should explore innovative ways to create economies of scale to improve member services.

figuRe 1

GoveRnAnCe MoDel

GovernanceSet of formal and informal arrangements by which power is

allocated and exercised (who gets to decide what)Legal framework

Informal norms

(e.g., unwritten policies: board-management interactions; stakeholder

consultation practices)

Formal rules

(e.g., written policies: voting rights and decision-rules;

board selection)

Coordinating and safeguarding exchangesMaintaining internal and external legitimacy

Adapting to change and responding to uncertainty

Organizationalstructure

Organizationalculture

Local context

Source: Pohler, Fairbairn, and Fulton 2017.

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→ As credit unions grow, they should be careful to safeguard two key sources of competitive advantage vis-à-vis the banks—the “local” differentiator and member focus.

→ Growing credit unions must redefine their “communities” and revisit their roles and responsibilities in relation to the communities in which they are embedded.

member-focused governance

→ Credit unions should recruit board members for values fit and diversity in perspectives, in addition to demographic diversity and specific industry experience and technical skills.

→ Credit unions should provide ongoing education, training, and information on cooperative governance and business models to credit union directors and leaders.

→ All nomination procedures, evaluation criteria, and processes for director selection should be open and transparent. Proposed changes to credit union board nomination and election processes should be decided on by members. Board directors, not senior managers, should be primarily responsible for driving conversations about changes to governance with members.

governance of credit union partnerships and associations

→ For second- and third- tier credit union governance frameworks to be most effective, these associations and organizations should be designed by the key credit union players themselves pursuing answers to the following questions:

⋅ How do we meet two related credit union organizational objectives: efficiency through centralized coordination and local autonomy and control?

⋅ What is our shared long- term vision?

⋅ What are the formal governance structures and informal norms that will shape “who gets to decide what and how” in our second- and third- tier organizations and associations?

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chapteR 1

IntroductionMany credit unions began as small, closed- bond or community- embedded financial service organizations where the senior manager and employees knew every member personally and board members were often directly involved in the credit union’s operations. Numerous mergers and consolidations, particularly over the past few decades, have led to a decrease in the number of credit unions and a simultaneous increase in the size of the largest credit unions. While even the largest credit unions are still much smaller than the major investor- owned banks, Canadian credit unions collectively manage billions of dollars in assets and serve millions of members across the country.

Governance Challenges in Credit Unions: Insights and Recommendations

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As credit unions diversify their product offerings, grow in members and assets, and expand the scope of operations to include multiple communities and even provinces, they face more risk and greater competition, which requires developing new strategies and structures to adapt to changing and more diverse member preferences. Growing credit unions also become subject to increased public and regulatory scrutiny, particularly with respect to the effectiveness of their board governance. Questions have been raised about whether credit unions should consider changing board selection processes to ensure that directors possess the required knowledge, skills, and abilities (i.e., competencies) to manage increasingly complex financial institutions (e.g., Goth, McKillop, and Wilson 2012).

Credit union boards, like the boards of other cooperatives, are traditionally comprised of directors democratically elected by the members. Regulators, credit union leaders and members, and outside observers have suggested that credit union boards may not be able to provide effective strategic direction or oversight of senior management and internal control systems. Past and recent Canadian cooperative failures (e.g., Co- op Atlantic, Saskatchewan Wheat Pool) highlight the critical importance of boards in ensuring effective cooperative governance. Democratic selection processes cannot guarantee that elected directors, or the board as a whole, will possess necessary competencies or experience (Goth, McKillop, and Wilson 2012). Some credit unions have thus moved toward minimum qualifications for board members (beyond legal requirements) and/or board recommendations of candidates.

Democratic selection processes cannot guarantee that elected directors, or the board as a whole, will possess necessary competencies or experience.

Moreover, attendance at annual general meetings and member voting in board elections is waning, and credit unions struggle to encourage ongoing and active member engagement in governance. Member apathy as demonstrated by very low voter turnout at annual general meetings creates a risky situation whereby a small percentage of the membership could actively control the organization, supporting private agendas via special resolutions. Some propose credit unions should use their bylaws to create protections against this risk, particularly as credit unions grow.

These governance proposals often face opposition from certain member constituencies. Many credit union leaders, members, and outside observers have argued that changing the grassroots approach to selection of board directors undermines the essence of a credit union, reduces responsiveness to members, and has the potential to lead to demutualization. These contentious debates are not restricted to credit unions. Many member- based organizations, including cooperatives in other industries (e.g., Mountain

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Equipment Co- op [MEC]), have struggled with these same issues (McGlashan 2016; Silcoff and Strauss 2015).

Credit unions have also been restructuring their second- and third- tier organizations (i.e., organizations owned and operated by groups or networks of credit unions such as Central 1 or the Canadian Credit Union Association) in response to their changing needs, as well as competitive and regulatory pressures. Credit union survival depends on creating economies of scale and efficiencies through partnerships with other credit unions and even other organizations, but shifting responsibility for projects, functions, and activities raises additional governance challenges for credit union leaders and regulators.

This report explores the following questions:

→ Is cooperative governance less effective or riskier than other forms of governance?

→ Can credit unions reconcile traditional grassroots democratic governance with increasing competitive and regulatory pressures to “professionalize” the composition of their boards?

→ What does “good governance” look like in credit unions today?

credit union landscapeCredit unions play a significant role in many countries around the world. In Canada, credit unions have been integral to the development, competitiveness, and ongoing stability of the financial services industry (Conference Board of Canada 2015). Credit unions historically addressed different market frictions by forming and prospering in communities where major financial institutions either would not invest or could not survive, and by providing loans to individuals and businesses who would otherwise not be able to secure access to credit. Credit unions have also proved quite resilient. During the 2008 financial crisis, credit unions arguably demonstrated greater stability than other types of financial institutions (Klinedinst 2010; Smith and Woodbury 2010).

During the 2008 financial crisis, credit unions arguably demonstrated greater stability than other types of financial institutions.

However, credit unions are also facing a number of serious challenges. Shifting community demographics and member preferences, narrow margins, and rapidly advancing technology and digital platforms are leading to increased competitive pressures. New capital and liquidity standards and changing federal and provincial tax treatment have created additional pressures to find economies of scale and efficiencies in both individual credit unions and the credit union system as a whole.

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The combined pressures led to a wave of mergers in Canada that reduced the total number of credit unions from approximately 1,500 in 1985 to 281 in 2016. While the largest credit unions are still relatively small compared to the major banks, credit unions are managing over $200 billion in assets and over 5.5 million Canadians are members of a credit union.1

Regulatory landscapeSince the 2008 financial crisis, regulators worldwide have paid greater attention to corporate governance, especially to the responsibilities and required competencies of boards of directors in providing effective oversight of financial institutions.

For instance, in January 2013, the Office of the Superintendent of Financial Institutions (OSFI) in Canada updated its corporate governance guidelines to reflect “best” practices and is currently reviewing the expectations of boards of directors of federally regulated financial institutions. While most credit unions fall under provincial jurisdiction in Canada, provincial regulators closely monitor OSFI’s policies and periodically update their own governance guidelines as well.

Most regulators—including OSFI—recognize that financial institutions may develop different corporate governance practices, due to differences in size, ownership structure, operational complexity, and risk profiles. One of the benefits of provincial regulation for credit unions has been greater flexibility in the application of principles across a variety of different settings, and the adaptation of principles to take into account the unique governance challenges across credit unions. Provincial regulators also have a more in- depth understanding of local markets and dynamics, and the associated risks of various credit union business models.

One of the disadvantages of provincial incorporation and regulation, however, is that it limits the scope of credit union activities. Provincial incorporation also makes it difficult for members to remain with their credit unions if they move to another province, and for credit unions to offer products and services to new members across the country. Many credit union partnerships across provinces would be overly cumbersome or impossible without federal incorporation.2

In 2012, legislation came into effect that would allow credit unions to incorporate federally and operate outside their respective provincial jurisdictions. In July 2016, New Brunswick–based UNI became Canada’s first federal credit union. Coast Capital Savings in British Columbia received approval from its members in December 2016 to pursue a federal charter, and other credit unions are currently considering the federal option as well.

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chapteR 2

Governance Research: A Brief Overview and Relevant Frameworks

A review of the academic theory and research on corporate governance suggests an overwhelming concern with solving principal- agent problems—that is, ensuring management works toward the best interests of the owners (Shleifer and Vishny 1997). Most research in this tradition has focused on understanding and solving governance problems in publicly traded investor- owned firms—for instance, by ensuring the presence of outside directors on boards and by tying executive compensation to firm performance. Research in this area is generally incorporated into well- known guidelines like the Business Roundtable’s “Principles of Corporate Governance” (2016).

While best practices in corporate governance often end up working their way into the practices adopted by a variety of different organizations and the regulations that have been developed for these organizations, caution is advised. Researchers are paying greater attention to the unique governance challenges that attach to different organizational types, such as those in the public sector, cooperatives, federations, and other democratic member- based organizations (Dixit 2002; Spear 2004; Pohler, Fairbairn, and Fulton 2017). Adopting best practices or even best principles in corporate governance (i.e., CEO compensation practices and board composition) or adapting regulations initially developed for investor- owned firms (i.e., required officials and positions on boards) may lead to unintended consequences for organizations that are not profit- maximizing, such as credit unions.

Adopting best practices in corporate governance may lead to unintended consequences for organizations that are not profit- maximizing, such as credit unions.

Credit unions, as financial cooperatives, are different from investor- owned firms in the following ways (see Fulton and Pohler 2015; Hart and Moore 1996):

→ Credit unions are owned by their members, who are also the predominant users of their services, rather than by a set of investors (i.e., shareholders).

→ The primary goal of credit unions is something other than maximizing profits.

→ Credit unions are less able to rely on extrinsic incentives and contracts with management.

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→ Credit unions rely on internal monitoring by members and boards to solve agency problems.

→ Credit union board directors in Canada often receive compensation, but not in the form of actively traded shares.

→ Credit unions more heavily rely on the intrinsic motivation, mission orientation, and values fit of both board members and managers.

→ Credit unions face greater coordination costs associated with democratic governance processes, particularly when there is even modest heterogeneity among members (Hansmann 1988; Porter and Scully 1987).

Notwithstanding these unique characteristics of credit unions vis-à-vis investor- owned banks, credit union governance frameworks must still address classic principal- agent problems (i.e., managerial opportunism). The agency problem is one of the primary reasons that concerns have been raised about the composition of cooperative boards (Cornforth 2004). Indeed, professional management has been shown to take over most of the strategic decision- making activities in agricultural co- ops, pushing the board into a less strategic and more supervisory role (Bijman, Hendrikse, and van Oijen 2013), and co- ops have failed in the past due to the inability of boards to rein in powerful and overly optimistic managers (Birchall 2014; Fulton and Larson 2009a, 2009b; Myners 2014). On the other hand, some scholars suggest managers with a prosocial (“mission”) orientation are more likely to self- select into cooperatives, reducing the potential for opportunistic behavior (Fulton and Pohler 2015).

Agency problems are not the only governance challenges facing credit unions, or even the most important ones. Governance theories that place less emphasis on opportunistic behavior, such as stakeholder or stewardship theories (e.g., Davis, Schoorman, and Donaldson 1997; Donaldson and Davis 1991), provide more insights into the governance of cooperatives. Stewardship theories highlight the importance of both the board and managers in helping an organization understand and navigate its responsibilities to various stakeholders. For instance, credit union leaders report struggling with decisions to close branches and are often the last businesses to turn off the lights in small communities (Johnson 2015). As a function of the local ownership and governance arrangements, credit union leaders are more likely to take into account their impact on the development and success of the communities in which their members live and work.

Interestingly, investor- owned firms are adopting governance arrangements that are commonplace in credit unions. Given some of the spectacular governance failures that have occurred over the past decade in investor- owned firms, practitioners have been advocating for investor- owned firms to adopt certain governance approaches that have long been a direct function of cooperative ownership and governance models, such as

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long- term orientation, multi- stakeholder engagement and consideration, and community and social responsibility (Barton 2011). In Canada, regulators are considering proposed enhancements to the Federal Financial Consumer Protection Framework (e.g., by requiring a subcommittee of the board to oversee compliance with consumer protections). Recent updates to the Business Roundtable governance principles (2016) suggest that investor- owned firms are beginning to adopt broader perspectives on governance that include greater consideration of the needs of various stakeholders.

Practitioners have been advocating for investor- owned firms to adopt certain governance approaches that have long been a direct function of cooperative ownership and governance models.

There is an increasing recognition that much of what is deemed to be important to effective organizational governance is somewhat elusive and less formal—that is, effective governance is inextricably tied to the orientation (i.e., short term versus long term) and culture (e.g., tone at the top) created by the board, the paradigms and biases of organizational leaders, and the nature of the relationships between stakeholders. As a result, governance research is moving toward developing a better understanding of board ethics, mental frames, conflict resolution, and board- stakeholder relationships, with a key focus on understanding decision- making processes and outcomes (Osterloh, Frey, and Zeitoun 2011), particularly under rapidly changing conditions and environmental uncertainty (Kodeih and Greenwood 2014; Loasby 2001).

Governance in all organizations is ultimately about who gets to decide what and how.

Governance in all organizations is ultimately about who gets to decide what and how. Political economy models of organizational governance bring ideas together across the governance literature to highlight how different governance arrangements allocate power and authority inside organizations, resulting in a particular set of distributional consequences for stakeholders. Ideas about what constitutes “good governance” (i.e., whether a governance framework is effective or not) have been expanded to include the ability of any governance framework to go beyond principal- agent problems to solve a broader set of challenges (see Pohler, Fairbairn, and Fulton 2017):

1. Managing strategic interdependencies (i.e., the relationship between the board and management, between service suppliers and individual credit unions, and among credit unions).

2. Establishing and maintaining legitimacy among internal and external stakeholders.

3. Adapting and responding to changing and uncertain environments.

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chapteR 3

Governance Insights and Recommendations for Credit Unions

Governance has been a growing area of concern for cooperative leaders. The Centre for the Study of Co- operatives at the University of Saskatchewan conducted surveys of credit union and cooperative CEOs, board members, managers, and academics across Canada about what they viewed as the most pressing concerns facing cooperative organizations. In 2017, governance was highlighted as one of the top five primary areas of concern (Figure 2), an increase in its importance compared to 2016 (Russell 2017).

figuRe 2

ToP Co-oP IssUes 2017

Number of responses

The co-op di erence

Public awareness

0 2 4 6 8 10 12 14 16

Competitiveness

Youth engagement

Governance

Cooperation among co-ops

Relevance

Technology

Member engagement

Maintaining co-op identity

Access to capital

Innovation

Government relations

Large business economy

Growth

Managing organizational change

Climate change/sustainability

Management practices

Co-op development

16

13

13

1 1

10

9

8

8

8

7

7

6

6

6

5

3

3

2

1

18

Source: Russell 2017.

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effectiveness and Risk in cooperative governance and business models

To survive in increasingly competitive environments, the cooperative model must have the potential to generate greater efficiencies and/or value for members, to make up for the higher coordination costs associated with democratic cooperative governance (e.g., Hansmann 1988; Porter and Scully 1987).

While cost of capital is particularly difficult to measure in cooperatives (Pederson 1998), cooperatives may be able to operate with a lower cost of capital (or, equivalently, to pay a lower return on capital) relative to investor- owned firms because members hold multiple contracts with the cooperative—as capital providers, as patrons, and as members (e.g., Hueth 2015).3 It has also been proposed that, notwithstanding challenges associated with scale and higher costs of governance, cooperatives may be able to leverage efficiencies in implementation (Pohler 2016) and pay lower salaries because managers and employees receive “mission” compensation due to the intrinsic motivation associated with working for a cooperative (Fulton and Pohler 2015). Moreover, because member feedback is built directly into the model in two major ways—members are both owners and customers—cooperatives may be able to provide members with more optimal products and services than comparable investor- owned firms. People also desire to have a voice in organizations that have a substantial impact on their lives (Budd 2004), and cooperatives provide this voice in governance to their members. Finally, trust plays a critical role in the financial services industry, where credit unions often benefit from a better reputation than the banks among certain stakeholder groups because of the broader public and social value they create in their communities (Fairbairn, Ketilson, and Krebs 1997).

The advantages, however, may slowly be eroding, especially if credit unions become increasingly perceived more like “banks” (Pohler 2017), or if important internal and external stakeholders become increasingly unaware of the cooperative difference (Co-operative Innovation Project 2016).

The advantages may slowly be eroding, especially if credit unions become increasingly perceived more like “banks.”

There is little evidence to suggest that cooperative governance is riskier than other forms of governance. Credit unions may face some risks associated with their small scale—e.g., difficulty accessing liquidity and (in)ability to properly diversify—however, credit unions also partner with each other in a variety of ways to mitigate some of these risks (Liew and Grant 2014). Credit unions may also face lower risks than banks because they undertake

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activities that make them less sensitive to business cycles and macroeconomic shocks (Smith and Woodbury 2010), and because members have less incentive to default on loans due to their ownership stake (Liew and Grant 2014). Elected board directors may also have a lower risk tolerance because they care about their reputation in the community (Johnson 2015). After the 2008 financial crisis, many argued that cooperatives and credit unions were more resilient and stable than their investor- owned counterparts (Birchall and Ketilson 2009; Klinedinst 2010; Smith and Woodbury 2010). Indeed, it was the numerous regulatory and corporate governance failures that occurred in banks—not credit unions—worldwide that directly contributed to the crisis.

Notwithstanding this, cooperatives and credit unions are not immune from governance failures. Recent cooperative failures have been attributed to ineffective board governance (Fairbairn, Fulton, and Pohler 2015). Moreover, credit union mergers and consolidations that have occurred over the past few decades may have masked problems by removing risky credit unions from the system, though an argument could be made that the mergers themselves were due to successful regulatory processes and governance oversight (Bauer, Miles, and Nishikawa 2009).

Contrary to popular discourse and despite the substantial amount of research attention that has been paid to composition of board directors and board leadership structures in investor- owned firms, there is still little consensus about the nature of the links between board composition and organizational outcomes, and very little empirical evidence that ties elements of firms’ governance structures to firm financial performance (Dalton and Dalton 2011). Moreover, recent research suggests that having “experts” as board members does not necessarily make them more effective or less risky. Almandoz and Tilcsik (2016), for instance, examined board composition in new community banks in the United States and found that a higher proportion of domain experts on the board was not associated with any greater returns; however, the greater the proportion of domain experts, the higher the likelihood of community bank failure under conditions of significant decision uncertainty.

Recent research suggests that having “experts” as board members does not necessarily make them more effective or less risky.

To date, there has been almost no convincing research on the relative performance effects of different credit union governance arrangements or board structures.4 Very preliminary research on the effects of board structure changes on the performance of European producer cooperatives suggests that where the operational business is controlled by outside professional managers, cooperatives perform better, and larger boards may increase performance despite theoretically higher costs of coordination (Hanisch 2016).

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Other research on cooperative boards in the United States has shown that the relationship between board size of cooperatives and financial performance is fairly complex; large boards may reduce certain aspects of firm performance, but the boards have to be quite large—over 27 members—and even then the results are somewhat mixed (Bond 2009).

Hanisch also found that European producer cooperatives are attracting increased outside capital through innovations in ownership, governance, and legal structures (Hanisch 2016, cited in Marshall 2016). Hybrid arrangements and other growth strategies, particularly mergers and consolidations, generate new governance challenges. Increasing geographic scope, size, and member diversity dramatically affects the effectiveness and efficiency of cooperative governance and may reduce member control.

Birchall (2013, 2015) highlights five key cooperative governance challenges associated with growth or increasing size:

→ The ownership rights (and influence) of members become increasingly diluted.

→ The complexity of the business increases.

→ Members are more likely to free- ride on others’ participation (the collective action problem).

→ Cooperatives become more susceptible to agency problems.

→ It becomes increasingly difficult to focus on member needs.

Moreover, growing credit unions may lose the ability to address local community needs and market frictions—for instance, through targeted community donations or providing services to individuals and businesses that are underserved by banks.

The research on European producer cooperatives suggests that as cooperatives grow and face increased regulatory and competitive pressures, they are more likely to move toward professional boards, allow outside members on management and supervisory boards, replace general assemblies with member councils, and substitute geographical representation on boards with directors who have greater product expertise (Hanisch 2016). It remains to be seen if these changes actually improve co- op performance.

Reconciling conflicts between the cooperative logic and the banking logic

A body of research has emerged on organizations that attempt to reconcile seemingly conflicting market and social values, especially in the financial services industry (see Almandoz 2012; Battilana and Dorado 2010; Jay 2013; Kent and Dacin 2013; Marquis

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and Lounsbury 2007; and Pache and Santos 2013). Credit unions constantly struggle with balancing cooperative values with evolving member preferences and the need for competitiveness and efficiency. However, many credit union leaders do not frame it in this way, choosing instead to see the model as a source of competitive advantage rather than a disadvantage. These credit union leaders view collaboration and cooperation, particularly between credit unions, as the only way forward.

One practice that numerous cooperative leaders have identified as being important is adopting a policy of openness and transparency with members about the trade- offs and rationales for everything from growth to closing a community branch and streamlining governance processes. Indeed, there is a culture of collaboration and openness with various stakeholders that can be observed across cooperatives, and in particular in the credit union system, that would be difficult to find elsewhere. Credit unions have even been known to collaborate with other potential competitors in the financial services industry to improve member services.5

While there are as many variants to credit union governance as there are credit unions, most credit union leaders indicate that retaining board connection and accountability to the membership is critical; however, they differ in preferred strategies and approaches.

Credit union leaders have identified a key challenge: how to reinterpret cooperative values and principles—such as member- focused governance and concern for communities—in an era when financial transactions are increasingly virtual, technology is evolving quickly, and changing member preferences and loyalties place substantial pressures on credit unions to respond quickly. In this environment credit unions have the advantage of smaller size, which allows them to remain more flexible and innovate in ways that would be difficult for larger bureaucratic organizations. However, economies of scale provide many additional advantages to investor- owned firms, which are often much larger than co- ops. Moreover, certain types of growth are important for the ongoing sustainability of cooperatives (McKinsey & Company 2012).

A number of suggestions and considerations have been put forward by credit union and cooperative leaders who have struggled with these issues in their own organizations:

→ Proposed changes to credit union board nomination and election processes should be decided on by members. All nomination procedures, evaluation criteria, and processes for director selection should be open and transparent.

→ If credit unions adopt minimum standards and/or board nominations/referrals for director positions, giving members as much choice as possible may increase legitimacy.

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→ Checks and balances need to be built into the DNA of any credit union board to ensure accountability to the members, whether or not the members select the directors.

→ Credit union leaders should openly embrace debate and respond directly to controversy over changes to governance structures and board selection processes, but should seek to achieve a resolution to the debate so that the credit union can move forward with its strategy.

→ Board directors, not senior managers, should be primarily responsible for driving these conversations with members.

→ Credit unions adopting growth strategies should critically reflect on their rationale and purpose for pursuing growth, and be clear about the trade- offs associated with growth. More so than other types of organizations, credit unions should explore innovative ways to create economies of scale and efficiencies, and to improve member services.

→ As credit unions grow, they should be careful to safeguard two key sources of competitive advantage vis-à-vis the banks—the “local” differentiator and member focus, both of which are key to their brand and ongoing public trust.

→ Credit unions must redefine their “community” and revisit their roles and responsibilities vis-à-vis the communities in which they are embedded, particularly as they grow.

→ Credit unions must understand the needs of their current members (and potential members) and consider how to redefine their relationship with members as consumer interactions with technology and financial products/services change.

→ Credit union leaders should leverage their unique model to find efficiencies, and to provide products and services that members value. What credit unions lose in decision- making efficiency they must be able to recoup through either more efficient implementation or enhanced member value.

→ Credit unions should adopt a variety of metrics to assess governance effectiveness:

⋅ Measures of direct member engagement in governance (e.g., percentage of members’ voting, attendance at annual general meetings) should not be the only indicators.

⋅ Member retention, “share of members’ wallets,” and enhanced member financial literacy and well- being are equally important to the sustainability of credit unions.

⋅ Public awareness of the credit union difference is critical to maintain external legitimacy.

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good governance in credit unionsAs credit unions grow, their democratic governance structures may become too cumbersome to survive in an industry that is rapidly changing. However, credit unions have the advantage of more patient capital and are not subject to the tyranny of the quarter (McKinsey & Company 2012). As credit unions grow, they often seek to centralize certain governance and operational processes and practices for efficiency (e.g., voting, member councils) and decentralize certain governance processes and practices for effectiveness (e.g., representation, member input and feedback). For instance, some credit unions have adopted nested governance arrangements for board selection that mirror representative political democracies. Other credit unions have chosen to keep their governance structures more streamlined, but work to create formal mechanisms to receive member input directly at the board level. Some larger credit unions have adopted processes for online voting and virtual member participation at annual meetings.

There is substantial variation and experimentation in governance arrangements across credit unions. Only time will tell whether there is room for many different approaches to credit union governance or if one approach will dominate. However, a few key ideas emerged in interviews with credit union leaders:

→ Build multiple criteria into any consideration of credit union board composition. Recruit board members for values fit and diversity in perspectives, in addition to demographic diversity and specific industry or technical skills and experience.

→ Create robust board evaluation and succession management processes, no matter how boards are selected.

→ Provide ongoing education, training, and information on cooperative governance and business models to credit union directors and leaders.

The landscape will also be shaped, importantly, by the extent to which credit unions choose to either directly compete with each other or to cooperate. For credit unions to prosper, there must be informal collaborative partnerships between credit unions as well as formal networks and organizations to share risk and navigate the complexity of the credit union system and financial services industry. Current regulatory frameworks already force some of this collaboration on credit unions (Pigeon 2015).

For credit unions to prosper, there must be informal collaborative partnerships between credit unions as well as formal networks and organizations to share risk and navigate the complexity of the credit union system and financial services industry.

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Leaders of second- and third- tier credit union organizations and associations suggest that governance challenges faced by these organizations are often more acute than in primary cooperatives. Another recent report focused on credit unions in Canada highlights some of these issues and outlines key governance design principles that may foster greater cooperation among credit unions (Fulton, Fairbairn, and Pohler 2017). Governance frameworks for system- level structures can and should look different than governance in individual credit unions. For instance, a voting model based on stakeholder groups is often used in second- and third- tier cooperative organizations rather than the “one member, one vote” method. Some of these organizations may not even be incorporated as cooperatives, but they still seek to operate by a set of cooperative principles and remain accountable to their credit union members.

For system- level governance frameworks to be effective, they should be designed by the credit union actors themselves providing answers to the following questions (Pohler, Fairbairn, and Fulton 2017):

→ How do we meet two related credit union organizational objectives: efficiency through centralized coordination and local autonomy and control?

→ What is our shared long- term vision for all member credit unions?

→ What are the formal governance structures and informal norms that will shape “who gets to decide what and how” in our second- and third- tier organizations and associations?

⋅ What rules constitute which credit unions are members, and what commitments and investments are required from each member?

⋅ How will we deal with “free-riding” of individual credit unions?

⋅ How will we efficiently and effectively hold decision makers accountable to both the members of individual credit unions, but also to the member credit unions as organizations? How do we ensure that the governance framework will remain responsive to the evolving needs of a diverse set of credit unions?

⋅ How do we address problems of “twin-hattedness” (i.e., directors holding positions on both primary credit union boards and second- or third- tier boards)?

⋅ How will we structure ownership, operations, and board selection processes so that governance is not dominated by professional directors and managers, but is being led by people with the required technical skills?

The answers to these questions will evolve as the credit union system undergoes a substantial restructuring. The ongoing and future conversations may be contentious, but hopefully productive.

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chapteR 4

ConclusionCredit unions have made many contributions to the competitiveness, stability, and resilience of the financial services industry. It is imperative that regulators, credit union members, boards, and managers recognize that credit unions may not survive as consumer- owned and controlled financial services organizations if they are required to adapt governance frameworks developed for banks.

Effective regulatory oversight of credit unions and development of effective governance frameworks should be rooted in a deep understanding of the differences in cooperative governance and business models. Credit unions do not necessarily face any more or less risk than investor- owned banks, and they are not necessarily any more or less effective. However, regulators should take care to ensure that they do not unintentionally compound these risks and make credit unions less effective through an application of problematic frameworks and regulatory approaches.

Credit union leaders should be aware of how growth and changes to board selection processes and composition may affect accountability to members. Effective governance arrangements should be developed with a focus on how the co- op model can be leveraged to address the unique and unprecedented challenges facing credit unions today.

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Endnotes

1 Statistics obtained from the Canadian Credit Union Association are based on credit unions and caisses populaires affiliated with the association. See also Brizland (2013).

2 There have also been concerns raised from groups such as the International Monetary Fund (IMF), the Bank of Canada, and the Canadian Bankers Association about Canada’s patchwork regulation in the financial services industry, with associated calls for credit unions to operate within the same regulatory framework as the banks (Shecter 2014). While raising these concerns is understandable, especially postcrisis, these reports and calls are not usually grounded in a detailed assessment of the different level and type of risks inherent in credit union governance and business models (see, for instance, IMF 2014).

3 For instance, member- owner returns may flow through cash distributions (e.g., “patronage refunds” and equity redemptions) and through patronage transactions directly (e.g., reduced price for purchases); distributions may be fully fungible across these two channels depending on the tax policies and absent concerns about redistribution across members with longer and shorter patronage histories (Brent Hueth, personal email communication with author, August 23, 2017). Members may also value broader social benefits derived from cooperative ownership.

4 Some links have been proposed between robust CEO evaluation processes and credit union financial performance (Chen, Spizzirri, and Fullbrook 2010); however, causal relationships cannot be inferred from the methods used.

5 Credit unions have not historically been subject to the same antitrust laws that exist for many other organizations, likely because they are owned by consumers, so there is less need to ensure consumers are protected from predatory practices, though individual credit unions are not necessarily immune from these issues (Pohler 2017).

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page 32 liSt of figuReS filene ReSeaRch inStitute

List of Figures

5 figuRe 1

GoveRnAnCe MoDel

14 figuRe 2

ToP Co-oP IssUes 2017

page 33 about the authoR filene ReSeaRch inStitute

About the Author

dionne pohlerAssistant Professor, Centre for Industrial Relations and Human Resources,

University of Toronto

Dionne Pohler is an assistant professor at the University of Toronto and a Filene Research Fellow. She studies the design and implementation of organizational governance arrangements and how governance affects stakeholder outcomes. Other research investigates the impact of strategy, HR practices, unions, and laws on employees and organizations. Current projects focus on cooperative governance, particularly in co-op federations and the Canadian credit union system. Dionne helped create a cooperative development model in western Canadian rural and Indigenous communities as part of the Co-operative Innovation Project, which led to the creation of a nonprofit organization, Co-operatives First, of which Dionne was a founding board member. She is the recipient of three international awards for her research and two university teaching awards. She has also received several major government and industry research grants.

page 34 about filene filene ReSeaRch inStitute

About Filene

Filene Research Institute is an independent, consumer finance think and do tank. We are dedicated to scientific and thoughtful analysis about issues affecting the future of credit unions, retail banking, and cooperative finance.

Deeply embedded in the credit union tradition is an ongoing search for better ways to understand and serve credit union members. Open inquiry, the free flow of ideas, and debate are essential parts of the true democratic process. Since 1989, through Filene, leading scholars and thinkers have analyzed managerial problems, public policy questions, and consumer needs for the benefit of the credit union system. We support research, innovation, and impact that enhance the well-being of consumers and assist credit unions and other financial cooperatives in adapting to rapidly changing economic, legal, and social environments.

We are governed by an administrative board comprised of influential executives. Our research priorities are determined by a national Research Council comprised of leaders and credit union CEOs.

We live by the famous words of our namesake, credit union and retail pioneer Edward A. Filene: “Progress is the constant replacing of the best there is with something still better.” Together, Filene and our thousands of supporters seek progress for credit unions by challenging the status quo, thinking differently, looking outside, asking and answering tough questions, and collaborating with like-minded organizations.

Filene is a 501(c)(3) not-for-profit organization. Nearly 2,000 members make our research, innovation, and impact programs possible. Learn more at filene.org.

“Progress is the constant replacing of the best there is with something still better.”

—Edward A. Filene

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Publication #439 (11/17)