Credit reports: catalyst to bringing cooperative financial services to more people

In the United States, in the early 1900s—before there were even laws allowing credit unions to form—tight-knit groups of people organized credit unions. Usually, these people already knew each other because they worked together, went to the same church, or lived in the same community.

In the 1910-1930s, as legislative bodies passed credit union laws, the practice of keeping the credit union to a tight group was codified into law as “fields of membership” having a “common bond”.

The field of membership (FOM) is a description of the group of people who have something in common (the common bond) that qualify for membership in the credit union. Over time, FOMs have expanded beyond small groups, and now include much broader communities: counties, multiple groups of people, cities, large organizations, and—in the case of Washington and Michigan—the entire state.

What was the reason for the original small FOMs, and what changed so that credit unions began to serve broader groups?

The Federal Reserve Bank of Atlanta observed that:

The [Federal Credit Union Act in 1934] neither elaborated on this definition at the time nor stated the reason for the [small FOM] requirement. Some courts have inferred that the purpose of the 1934 common bond requirement was to facilitate safe and sound operations.[1]

In other words, the tight field of membership was used as a means of managing risk. By keeping the group small, limited to people that knew each other, the credit union could exert pressure on borrowers to repay loans. They could also know who better to make loans to, because they knew the person’s character.

“Credit risk” is the risk that a borrower won’t repay a loan, thereby causing a loss to a credit union. Each time a credit union makes a loan, it takes on credit risk. Keeping the credit union to a small group of people that knew each other and if someone wasn’t paying back their loan—and thereby harming the rest of the group—was an effective way to manage credit risk.

The tight-knit FOM was a means of managing credit risk.

What changed? Other means of managing credit risk came along: accessible credit reports.[2]

Credit reports and credit reporting had been around for many years, but not until the 1970s did the large credit bureaus with their generally available and purchasable credit reports come into heavy use by lenders.[3] The Fair Credit Report Act (FCRA) of 1971 helped move things along.[4]

As the Federal Reserve Bank of Atlanta observed in the same Economic Review:

Common bond requirements have become less important for the analysis of credit risks with the development of credit reporting services and other advances in collecting, transmitting, and analyzing credit information that have made it less costly to assess the likelihood of default on a particular loan.

With this new method of evaluating credit risk, credit unions no longer needed to rely on personal knowledge of a person’s character. Rather, with independent, unbiased information, they could make informed decisions about who to make loans to. Credit risk was managed, and credit unions could lend to expand beyond their smaller groups, and gain the benefits of economies of scale.

This is precisely what started to happen in the 1980s. As regulators began to change rules to allow for broader fields of membership, to offset the risk posed by narrow fields of membership, and gain economies of scale, credit unions decided it would be advantageous to do so. The process has continued to today, and the credit union industry reaches more consumers than ever.

Notably, the credit union income tax exemption has never been tied to narrow fields of membership. Rather, the official records of Federal credit union legislation have always tied income tax exemption to the not-for-profit cooperative structure of credit unions.

Also of note, today’s privacy laws would restrict employees or volunteers of a credit union from knowing about a co-worker’s or acquaintance’s financial habits, thereby rendering reliance on personal knowledge an unsuitable form of evaluating credit risk.

Credit reports not only allowed credit unions to broaden fields of membership, but also facilitated privacy—something consumers value highly.