Academic journal article Federal Reserve Bank of St. Louis Review

Wages and Risk-Taking in Occupational Credit Unions: Theory and Evidence

Academic journal article Federal Reserve Bank of St. Louis Review

Wages and Risk-Taking in Occupational Credit Unions: Theory and Evidence

Article excerpt

Credit unions are regulated and insured depository financial institutions dedicated to the saving, credit, and other basic financial needs of selected groups of consumers.(1) Previous research has tended to suggest that credit unions operate inefficiently. In particular, given widely dispersed ownership and - in the case of employer-based or occupational credit unions - the presence of one or more sponsors primarily engaged in non-financial activities, there are reasons to believe that a managerial agency problem may be important.

In this article, we present a simple model of an occupational credit union in which the manager wishes to engage in expense-preference behavior. The sponsor must choose whether to accept this behavior and deduct the monetary equivalent from the manager's wage - what we call the Demsetz solution, as described in Demsetz (1983) - or to offer higher, so-called efficiency wages to discourage it. We show how wage expenses and risk-taking by the credit union are intimately connected.

We simulate the theoretical model to build intuition about the relationship among credit union size, wages, and risk-taking. Then we provide empirical evidence that supports a link between the size of occupational credit unions and the levels of wage expense and risk-taking. In particular, larger credit unions tend to have higher wage expenses and take less risk. We also document an important role for external control mechanisms, namely, local deposit-market competition. Wage expense is higher and risk-taking is lower in credit unions that face a less competitive local deposit market.

The article is organized as follows: The first section reviews previous research on credit unions. The second section presents our simple model of a credit-union sponsor who chooses both the compensation scheme for the credit-union manager and the amount of risky lending the credit union will do. This model nests both the Demsetz wage regime, in which the manager is allowed to shirk, that is, loaf on the job, but is paid a low wage, and an efficiency-wage regime, in which the manager is promised a high wage but is punished severely if caught shirking. The third section presents a nonstochastic simulation, comparative-statics results, and testable hypotheses. The simulation illustrates that the optimal choice of a compensation regime depends on the configuration of parameter values and exogenous variables that happen to exist. The fourth section contains a description of our empirical methods and results. The final section presents our conclusions. An appendix provides details on the empirical methodology, the dataset, and the variables we employ.


It is useful to distinguish between two main approaches taken in economic research regarding credit unions. One approach focuses on the legal structure of credit unions as consumer-owned cooperatives and explores how credit unions produce and distribute financial services. We refer to this branch of the literature as the structural approach to credit unions. The other approach - and the one this article follows most closely - focuses on the important yet largely extralegal and unregulated relationship between the management of a credit union and its members and sponsor(s). We call this the agency approach to credit unions.

The Structural Approach to Credit Unions

Early theoretical research on U.S. credit unions in the structural tradition includes Taylor (1971), Flannery (1974), Smith, Cargill, and Meyer (1981), and Smith (1984). These papers highlight an important conflict of interest that arises between members in determining the policies of the credit union. Savers - members who have deposits in the credit union but insignificant or no loans outstanding - want the highest possible deposit interest rate, while borrowers - members who have borrowed a significant amount of money from the credit union relative to their deposits - prefer the lowest possible lending rate. …

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