Cooperative bank-sponsored cyclist in France, where such banks control nearly 60 percent of bank branches (photo: Franck Faugere/DPPI)
REGULATING COOPERATIVE BANKS
Yet the ways they differ from commercial banks are largely ignored by financial regulators, and cooperatives still operate with governance structures designed for small, community-based entities.
Cooperative banks arose in 19th-Century Europe as small institutions serving the financial needs of local customers. But they have grown and proliferated, in some cases becoming more dominant in the retail sector than their commercial bank counterparts.
In France, for example, cooperatives control nearly 60 percent of bank branches and 25 percent of banking system assets. In Austria, they account for nearly 53 percent of branches and about 35 percent of assets, and in Germany about 40 percent of branches and 10 percent of assets. In terms of consolidated equity, five of the 25 biggest banks in Europe are cooperatives. Although they are particularly numerous in Europe, their presence is growing worldwide.
Yet, cooperative institutions operate largely under the radar of financial regulators, in a prudential framework generally designed for commercial banks. For example, the 2004 Basel II Revised Capital Framework, aimed at preserving capital adequacy in banks, does not mention cooperatives, and the accord's third pillar, market discipline, has significantly reduced effectiveness for cooperative banks.
Stable returns
Financial stability analysis usually pays relatively little attention to cooperative banks. Moreover, IMF research and policy advice have devoted substantial attention to the relative merits of public and private ownership of banks, but not to cooperative ownership. Scholars have not focused much on cooperative banks either.
A new IMF Working paper (Hesse and Čihak) finds that, on balance, using a measure of soundness called the z-score, cooperative banks enhance overall financial stability. Although they are generally less profitable and less well-capitalized than commercial banks, they have more stable returns. But in financial systems with a high presence of cooperatives, weak commercial banks are less stable than they would be otherwise.
Cooperatives compete with commercial banks, but are not subject to profit maximization goals, respond to a wide variety of stakeholders rather than stockholders, and operate under different governance and disclosure structures than their commercial bank competitors (Fonteyne).
How cooperatives are governed
The cooperative ownership form is characterized by one-member, one-vote decision-making and a focus on pursuing specific interests of members rather than on maximizing profits. Shares in a cooperative company don't represent true ownership, but rather a nominal claim on part of the cooperative's capital that can be redeemed but not sold. Profit distribution is often restricted and not necessarily proportional to members' shareholdings.
Financial sector cooperatives are usually consumer cooperatives, aiming to maximize their member's consumer surplus—the difference between what a consumer is willing to pay for a service and what he actually pays (see Box).
Measuring Consumer Surplus
Consumer surplus is the difference between the maximum amount of money a person would be willing to pay for a good or service and the actual price. If, for example, a pair of shoes was worth $90 to a consumer while the tag price was $55, then the $35 difference would be the consumer surplus.
Commercial enterprises, such as a commercial banks, generally seek to maximize their profits—the difference between revenues and costs. So they seek as high a price (interest rate) as possible for what they sell (lend) and as low a price (interest rate) as possible for what they buy (borrow).
On the other hand, the stated aim of many cooperatives, including many cooperative banks, is the maximization of consumer surplus, while aiming for some level of profit to keep the enterprise healthy. Theoretically, a cooperative, in which owners are borrowers and lenders, would seek to keep lending rates as low as possible and deposit rates as high as possible.
The durability of cooperative banks can be explained by their evolving comparative advantages. They were devised to overcome problems many ordinary people, in particular farmers and artisans, faced in obtaining bank credit, at a time when banks had little ability to assess people's creditworthiness or enforce small-scale loan contracts.
As small institutions in tightly knit communities, cooperative banks could rely on peer pressure to help guarantee loan repayment. In that way, they resemble today's microfinance institutions, which have been growing in popularity and influence in developing countries as a means of providing small loans to impoverished people who are poor credit risks.
But the continued success of cooperative banks appears increasingly driven by the upper hand banks have gained on information. That has made trust an important consideration in a consumer's choice of bank. Because they are consumer owned and non profit-maximizing, cooperative banks have an advantage in earning this trust.
No final owners
Nevertheless, cooperative banks face challenges rooted in their institutional setup. Most cooperatives were designed to perpetually accumulate capital, by limiting both members' ownership rights and profit distribution. As a result, the economic value of a cooperative, net of debts and the nominal value of member shares, constitutes an intergenerational endowment without final owners.
In some ways, this endowment is akin to a foundation, meant to benefit a class of people. It is available for use by current members, with the understanding that they will grow it and pass it on to the next generation of members, with cooperative bank managers as custodians.
Because the members have only a fixed-value claim on the cooperative, their incentive to exert effective oversight over management is lower than that of shareholders in a joint-stock company. As cooperatives get bigger, ordinary members become one class of stakeholder, while managers and employees emerge as new stakeholders with interests that are not necessarily aligned with those of the other members (often employees are also owners). That means the need for member oversight of management can increase even as the incentive to do so declines.
Moreover, in a standard investor-owned institution, control is proportional to ownership and larger shareholders can be expected to take an oversight role to protect their investment. In a one-member, one-vote arrangement the incentive to vote is low for the average member. But for those owners with a direct stake in the institution's behavior, such as borrowers and employees, there is a much increased incentive to vote, in favor of policies that are beneficial to them.
Reduced market discipline
In general the consumer surplus of borrowers exceeds the consumer surplus of savers. Reduced market discipline and often lower disclosure requirements can also hinder governance, resulting in a higher risk of imperiling the endowment.
While most cooperative banks are small, they are often part of networks that centralize certain business functions to reap economies of scale and scope and provide financial backstops for any member cooperative that faces problems. The degree of operational integration within these networks differs significantly—from very limited to so extensive that the network in effect constitutes an integrated banking group. The trend has been toward greater integration.
Networks may include checks and balances that reduce governance problems at individual cooperatives, but the governance of a network as a whole constitutes a new challenge. With increased integration and centralization, managers and board members at individual cooperatives face conflicting incentives. They are supposed to oversee the center while being dependent on it for their own success and in many cases being subject to oversight by the center.
Cooperative banks and financial stability
What do cooperative bank ownership and the competitive dynamics between cooperative and commercial banks imply for financial stability? By pursuing objectives other than profit maximization, cooperative banks could increase the fragility of financial systems. In particular, they could deliver financial services at below-market prices, at the expense of both their own capitalization and the profitability and soundness of competing banks.
Difficulties in adjusting to adverse circumstances and raising capital could render cooperatives more vulnerable to extreme shocks. Also, their focus on traditional bank lending to members, whose characteristics usually are similar, tends to imply relatively large and correlated exposures to credit risk. On the other hand, cooperative banks generally have lower incentives to take on risks.
The z-score soundness measure—which estimates the likelihood that a company will run out of capital on the basis of its capitalization, profitability, and the volatility of its returns—indicates that cooperative banks tend to be more stable than commercial banks. This is because of the much lower volatility of cooperatives' returns, which more than offsets their lower profitability and capitalization.
Mutual suport mechanisms
This lower return volatility may result from the fact that in normal times cooperative banks pass on most of their returns to customers as consumer surplus (offering them better deals, so to speak, than they can get elsewhere). But in weaker periods they are able to retain these returns. To some extent, the mutual support mechanisms within networks of cooperative banks may also reduce volatility.
But the econometric estimates also suggest that a higher presence of cooperative banks tends to significantly reduce the soundness of weak commercial banks in the same financial system. This can be explained by the fact that a higher presence of retail-focused cooperative banks tends to push commercial banks towards less stable revenue sources such as corporate banking or investment banking.
Overall, though, a higher presence of cooperative banks appears to have a slightly positive impact on the stability of the banking sector as a whole.
Policy implications
The analysis suggests that policymakers' and banks' attention should focus on the interaction between governance mechanisms and financial stability. There are three major risks:
• The survival of cooperatives might be endangered by their lower flexibility and constraints on raising capital, admittedly an extreme situation.
• Competition from cooperatives can hurt weaker commercial banks.
• Cooperatives' governance mechanisms and growing endowments may push them into risky ventures in which they have no comparative advantage.
Key to addressing these risks is an increased ability of cooperatives to raise and shed capital as needed. Policymakers also need to ensure that competition among different types of banks takes place on as level a playing field as possible. Prudential authorities need to take into account the dynamics of competition among different ownership forms.
Crucially, adaptations are needed to cooperatives' governance systems, which were designed for different times and circumstances. While no miracle solutions seem available, improvements could include strengthened disclosure requirements; measures to increase member involvement; deliberate exposure to market mechanisms; specific prudential oversight; and a clear separation between external and internal governance systems in networks.
Some form of independent external oversight also appears warranted, particularly with respect to decisions affecting the endowment. Addressing these challenges would help cooperatives position themselves to continue fulfilling their missions and enriching the retail banking landscapes in many countries, to the benefit of consumers.
This article is based on IMF Working Paper No. 07/159, "Cooperative Banks in Europe—Policy Issues," by Wim Fonteyne and IMF Working Paper No. 07/02, "Cooperative Banks and Financial Stability," by Heiko Hesse and Martin Čihák. Copies are available online at www.imf.org.
