Principal-agent problem, part 1: banks

As the financial sector melts down, one wonders which institutions are the safest: smaller local banks, money center banks, super regionals, credit unions. Credit unions are certainly something to think about because they offer high rates of deposit interest and low rates on loans.

I don’t know if credit unions are safer than banks across the board, but I willing to bet they are because they avoid the principal-agent problem.


A ‘credit union’ is described on Wikipedia like this:

A credit union is a cooperative financial institution that is privately owned and controlled by its members. Credit unions differ from banks and other financial institutions in that the members who have accounts in the credit union are the owners of the credit union and they elect their board of directors in a democratic one person-one vote system regardless of the amount of money invested in the credit union.


And therein lies the key advantage of credit unions: they are owned by the members themselves. As a result, they are much more likely to be conservative and there is a much smaller chance of a principal-agent problem.

Much the same dilemma is apparent on Wall Street. Almost all the big Wall Street firms were partnerships owned by their employees. Goldman Sachs, Morgan Stanley, Salomon (now a part of Citigroup), and Lehman all went public in the last years. The result has been a massive increase in risk as the principal-agent problem is clear. But, that’s a topic for later.

Wikipedia says this about the principal-agent problem with credit unions:

Credit unions may be viewed as non-profit organizations, or alternatively as for-profit enterprises charged with making a profit for their members (who receive any profits earned by the cooperative in the form of reduced interest rates on loans, or as dividends paid on savings, which are taxed as ordinary income).

This debate reflects credit unions’ unusual organizational structure, which attempts to solve the principal-agent problem by ensuring the owners and the users of the institution are the same people. In any case, credit unions generally cannot accept donations and must be able to prosper in a competitive market economy.

USAA: a credit union-like company

I happen to be a member of the co-operative USAA, which I think is a good example of how these types of organizations work.

They are a AAA-rated full services co-operative that is much like a credit union. Let’s take a look at their financials (PDF), as they have them posted online.

USAA is a member-owned full service financial services company specializing in insurance. Its members are made up exclusively of present and former military personnel and their dependents. It is not publicly traded and issues dividends only occasionally to members in the form of their Subscriber’s Savings Accounts. On the USAA website they describe themselves this way:

Our Mission

The mission of the association is to facilitate the financial security of its members, associates, and their families through provision of a full range of highly competitive financial products and services; in so doing, USAA seeks to be the provider of choice for the military community.

The Value of Membership

USAA is not a publicly traded company, so we don’t answer to stockholders — we answer to our members. They rely on us to suggest products and services that meet their financial needs. In fact, some of our best advice costs absolutely nothing. Advisors in our Financial Advice Center are here to answer questions, large and small, at no charge.

Financial Strength

When members join USAA, they join generations of military families who have depended on us to provide superior products and services in an atmosphere of financial strength.

USAA maintains superior ratings from all three of its rating agencies. In fact, it is one of just two U.S. property and casualty companies with the highest ratings from A.M. Best, Moody’s Investors Service, and Standard & Poor’s.


If you look back at my analysis on deleveraging, you’ll note I mentioned that Citibank has a typical bank’s profile at 17x assets to equity. How does that compare to USAA?

USAA had over $67 billion in assets at the end of 2007 on equity of $14.3 billion, a leverage ratio of 5 times. Do they have exposure to CDOs, SIVs and RMBSs? Are they likely to have massive losses from subprime lending? I can’t say. I don’t have comprehensive financials for the company.

I do know they are AAA rated if that means anything anymore. There are fewer than 10 S&P 500 companies that still are AAA-rated in the U.S. because of debt levels. None of the publicly-traded U.S. regionals, none of the money center banks, and none of the global commercial banks can say this. This suggests conservative and cautious, the way bankers used to be.


This rather flimsy analysis doesn’t prove or disprove anything, frankly. But, hopefully, it will give you food for thought about which financial counterparties are trustworthy and which ones may not be. How many times have you heard about credit unions blowing up because of massive exposure to derivatives?

In Australia, credit unions are at risk of demutualising because they operate under financial institutions law rather than co-operative legislation.

I know that many co-operatives in the UK de-mutualised and became public companies, because the money was too much for their shareholders to turn down. (I remember a funny Cold Feet episode where the character David Marsden was talking to his wife about investments and how they had struck it rich in a building society demutualisation scheme — pop culture as a sign of market euphoria). Suddenly, the principal-agent problem was real.

Now, many of those same institutions are in financial trouble because of excessive risk taking over the past years. This includes HBOS (which is a merger of Bank of Scotland and the Halifax, a former mutual company), Bradford and Bingley, Abbey National (now a part of Banco Santander of Spain), and, most famously, Northern Rock.*

Member-owned building societies and credit unions are inherently more risk-averse institutions because they are owned by their members. If one is concerned about the riskiness of the local bank, a member-owned cooperative like a credit union may be the way to go.

As far as demutualisation goes, it’s looking like a bust for shareholders in the UK.

Related articles

Once there were building societies. Then they became banks, and it all went wrong, The Independent, 7 Jun 2008

B&B and the perils of demutualisation, eFinancial News, 09 Jun 2008

*Personal disclosure: I have a life assurance policy with the Abbey.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More