The Farm Credit System is a congressionally chartered enterprise that provides credit and services to agriculture. Divided into regional districts, this nationwide network of cooperatively owned banks and associations with almost $65 billion in assets provides credit to member-borrowers, including eligible farmers, ranchers, producers of aquatic products (fish farms), cooperatives, and certain farm-related businesses. One of the types of banks in the System is called a Farm Credit Bank (FCB). FCBs primarily provide loans to district associations, which in turn lend to their member-borrowers, primarily eligible farmers and ranchers. Congress required us in the Farm Credit Banks and Associations Safety and Soundness Act of 1992 (P.L. 102-552) to study how farmer and rancher member-borrowers of the Farm Credit System institutions might benefit if the 10 district Farm Credit Banks (and the Federal Intermediate Credit Bank of Jackson) merged into fewer regional Farm Credit Banks. The System is a government-sponsored enterprise (GSE). System institutions are privately owned, but Congress chartered the System to serve the public purpose of facilitating the flow of funds to agriculture. As table 1.1 illustrates, Congress established the System in several stages to supply credit needs associated with agriculture. The System is regulated by the Farm Credit Administration (FCA), which has enforcement authorities similar to other federal financial regulators. It issues regulations and examines System institutions for compliance with applicable laws, regulations, and safe and sound banking practices. In 1993, the Farm Credit System Insurance Corporation (FCSIC) became fully operational with certain limited oversight responsibilities that are closely coordinated with FCA. However, its primary purpose is to ensure the timely payment of principal and interest on all System-wide debt and, if needed, to assist System banks in the future. FCSIC controls the System’s Insurance Fund which is funded with premiums paid by banks and associations. The Agricultural Credit Act of 1987 significantly changed the structure of the System. Before the 1987 act, the System was organized into 12 districts, each with 3 types of banks supported by 2 types of associations. However, the 1987 act mandated certain structural changes and encouraged others, as shown in table 1.2. As a result of these mandated and voluntary changes, district structures within the System ranged, as of April 1994, from 1 bank and 3 associations to 1 bank and 66 associations. The System included 8 districts; the number of states in each district ranged from 1 to 11, as shown in figure 1.1. Table 1.3 provides a comparison of districts by assets, as of December 31, 1993. Between 1974 and 1994, the number of banks and associations in the System decreased from more than 1,000 to less than 250. (See table 1.4.) Over 85 percent of this consolidation occurred during the System’s financial crisis in the 1980s, when associations merged primarily to facilitate the movement of capital and eliminate inefficiencies. Following the 1987 act, the number of banks decreased from 37 to 15 as a result of mandated mergers between FLBs and FICBs in each district to form FCBs and a voluntary merger among BCs. Between April 1992 and April 1994, 8 banks voluntarily merged or consolidated, decreasing the number of operating banks in the System to 11. As of August 1, 1994, two additional mergers were being negotiated. Reasons commonly cited for the recent mergers included opportunities for competitive cost structures (reduced costs), higher quality of management, improved risk management and diversification, and improved financial condition. Some officials also cited opportunities to better serve the needs of their borrowers. The first voluntary FCB merger occurred in May 1992, when the St. Paul and St. Louis FCBs consolidated to form AgriBank, FCB. On October 1, 1993, the Jackson FICB merged with the Columbia FCB. On January 1, 1994, the Louisville FCB merged with AgriBank. On April 1, 1994, the Spokane and Omaha FCBs consolidated to form AgAmerica, FCB. Also, on March 15, 1994, the FCB and BC of Springfield and CoBank signed a letter of intent to pursue a merger. This consolidation would create the System’s first ACB, named CoBank ACB, which could offer credit and services to eligible farmers, ranchers, producers, and cooperatives. The proposed merger would become effective January 1, 1995. The Baltimore and Columbia FCBs also announced plans to merge in 1995. However, as with all voluntary mergers, both mergers are subject to board, stockholder, and FCA approval. The System operates on the following basic cooperative principles: Democratic control. Each member-borrower has a vote in the election of his/her association’s board of directors. Also, each association board of directors has a vote in the election of the bank’s board of directors, which generally consists of member-borrowers. Ownership by member-borrowers. Borrowers must purchase stock or participation certificates (nonvoting) as a condition of borrowing. Member financing according to use. Historically, borrowers purchased stock in the amount of 5 to 10 percent of the loan amount. The 1987 act and subsequent regulations reduced the minimum stock purchase requirement to 2 percent of the loan amount or $1,000, whichever is less. Limited return on capital (borrower stock). Stock is normally retired at par or face value. Dividends or patronage refunds may be paid occasionally. The amount of earnings paid out as dividends or patronage refunds depends on an institution’s need to retain earnings and build capital. Service at cost. The cooperative principle of service at cost generally involves setting interest rates to cover costs of ongoing operations, which include retained earnings, building capital, and meeting the 7-percent minimum permanent capital requirement. The System, like other GSEs, enjoys relatively easy access to the national capital market on the strength of its ties to the government. Rather than operating to generate the largest possible profits, the System generally operates for the benefit of its member-borrowers and has no pure profit motive. As a result, banks have historically charged the lowest possible rates consistent with safe and sound operations. In the mid-1980s, however, statutory changes concerning how interest rates were established led some banks and associations to offer more market-driven rates. While certain operating philosophies, such as capitalization, specific dividend policies, and supervision of association operations, may affect whether borrowers perceive banks and associations as cooperatives, the System’s cooperative structure is grounded in statute and regulation. Each bank in the System raises funds for its lending operations by issuing System-wide debt securities through the Farm Credit System Funding Corporation. Like other GSEs, the System raises funds on the national capital markets at a relatively low cost on the strength of its ties to the federal government. All System debt is ultimately the joint and several obligation of all System banks. This means that each FCB and BC may be called upon by the FCA to make payments on System debt regardless of whether it is primarily responsible for the liability or not. The System produces combined financial statements to reflect the interdependence of the banks and the joint and several nature of System obligations. FCBs make loans to and through their local associations. FCBs make wholesale loans to PCAs, ACAs, and FLCAs—also known as direct lending associations—which in turn make retail loans to eligible borrowers.Some FCBs are strictly wholesale lending banks, because all of their associations are direct lenders. Other FCBs make not only wholesale loans but also long-term (mortgage) retail loans through FLBAs, which act as agents for the bank in originating and servicing those loans. The 1992 act required that we study the potential benefits to System farmer and rancher borrowers of merging the existing regional banks into fewer regional banks. In conducting this study, we were asked to consider the impact of FCB mergers on the following factors: (1) any economy of scale benefits, (2) the level of services provided, (3) the cooperative nature of the System, (4) the issuance of System-wide bonds, (5) the bank-association relationship, and (6) jointly provided services. We also assessed other related factors that emerged as potentially significant in the course of our work. Since we initiated this study in March 1993, seven FCBs and one FICB have merged or consolidated; two additional merger discussions were underway as of August 1994. We focused on the short-term impact of these existing and planned mergers on affected associations and their farmer and rancher borrowers. To gauge the potential impacts, we reviewed the plans for merging the St. Paul and St. Louis FCBs, the Columbia FCB and Jackson FICB, the AgriBank and Louisville FCBs, and the Omaha and Spokane FCBs. To gain a historical perspective on the debate concerning the System’s structure, we reviewed various studies conducted by the System, the special committee commissioned by the 1987 act, and industry consultants on the System’s structure. Building on a recently completed report, we collected additional data on all FCBs and associations. We reviewed the philosophies, policies, strategic plans, annual reports, board minutes, and FCA examinations of the FCBs to obtain information on differences and similarities among the FCBs and districts. In some cases, this information was supplemented by interviews with bank and association officials. Although Congress asked us to determine the impact of mergers on farmer and rancher borrowers, we focused on associations as proxies for member-borrowers because FCBs provide funding and services to or through associations rather than directly to farmer and rancher member-borrowers. The associations, in turn, provide services and funding to the member-borrowers. The impact of FCB mergers on farmer and rancher borrowers primarily depends on how their associations are affected. Because all of the FCB mergers have occurred since 1992 (most since 1993), our analysis is of short-term impacts and not potential long-term outcomes. Our work focused on the six factors we were asked to consider. To provide balanced views, we met with over 75 bank and association officials. We mailed survey questionnaires to the chief executive officer (CEO) or president of every association and faxed surveys to each FCB CEO or president to obtain their opinions on FCB mergers. Eighty-eight percent of the association officials and 100 percent of bank officials responded.Because we surveyed every association and FCB in the System for which we had a record, and because we did not project the results to any larger population, our results were not subject to any sampling error. Nevertheless, all survey data are subject to various types and amounts of nonsampling error, such as the error that could result (1) if nonrespondents differ from respondents on some attribute measured by the survey or (2) from omissions and erroneous answers made by respondents. We are unsure of the exact magnitude of such errors but have no reason to believe that they were significant in this survey. Our survey results are presented in appendixes I, II, and III. In addition, we met with officials from FCA, FCSIC, the Funding Corporation, the Department of the Treasury, the Farm Credit Council (FCC), and the Economic Research Service of the Department of Agriculture. To determine potential economies of scale or cost savings, we relied on the audited financial data in the FCBs’ annual reports and unaudited operating cost data generated by the Funding Corporation when no comparable audited FCB data were available. For additional data on AgriBank and its associations, we relied on unaudited bank-generated financial data. However, we reviewed AgriBank’s 1993 FCA examination report to ensure that no material internal control and reporting problems were identified. We also reviewed estimated cost savings expected from the mergers provided in bank disclosure documents. We did not independently analyze the projections; however, FCA, the System’s regulator, found them to be generally reasonable and achievable. To determine the potential impact of mergers on the level of services provided by associations, we gathered information from associations on the level of services offered as of September 1993. We also reviewed merger plans to determine expectations, if any, of disruptions in the level of services or types of loan products available to borrowers. To determine the impact of mergers on the cooperative nature of the System, we gathered the opinions of bank and association officials. We also conducted an analysis of other cooperative systems and organizations to determine whether consolidation had affected their cooperative nature. We reviewed various academic articles to supplement our knowledge of the history of cooperatives. We performed similar work for the evaluation of the impact on System-wide bond issuance. To determine the potential impact on the bank-association relationship, we examined the current relationship in each district. For FCBs already in merger negotiations, we determined some of the potential impacts of the merger on the bank-association relationship as it relates to supervision, funding, and existing support services. To make this determination, we reviewed bank merger disclosure documents, policies and procedures, and bank and association survey data. We obtained information on supervision and existing support services from FCBs and associations. We also used data collected for our January 1994 report cited earlier (GAO/GGD-94-14), which included a review of the supervision and oversight provided by five selected FCBs (Omaha, Spokane, St. Paul, Western, and Columbia). We also gathered information on services that are jointly provided in the System. This included reviewing the history of several organizations that provide or have provided various types of services. These organizations included FarmBank Services, the Funding Corporation, Farm Credit Leasing Services Corporation (FCL), the Farm Credit Corporation of America (FCCA), and the Farm Credit Council (FCC). We met with officials from the existing organizations to determine the types of services being jointly provided and collected related documentation. We also discussed options to further utilize this authority and potential benefits to borrowers. We selected the oldest voluntary FCB merger, the May 1992 consolidation of the St. Louis and St. Paul FCBs to form AgriBank, as a case study to illustrate some of the possible short-term effects of mergers on associations and their borrowers. However, we did not attempt to draw conclusions about the long-term impact of this merger because we reviewed bank operations after its first 8 months and subsequent year of consolidation. This case study should not be generalized to other actual and potential mergers due to differences in district and bank structure and operation. We integrated our observations on this merger in chapters 2 through 4 as appropriate. Our work at AgriBank included observing operations during its 20 months of consolidation. We compared the resulting operations to AgriBank’s plans and projections, and we monitored actual savings to determine where and how savings were achieved. To obtain additional information, we interviewed bank officials and requested supporting documentation. We also interviewed FCA officials knowledgeable about the merger and AgriBank operations. Appendix IV provides the case study of the St. Paul/St. Louis merger. Our study was done between March 1993 and April 1994 at FCA headquarters in McLean, VA; the FCA field office in Bloomington, MN; AgriBank in St. Paul; and FCL in Minneapolis. Our work was done in accordance with generally accepted government auditing standards. We received written comments on a draft of this report from the Farm Credit System, through the Presidents Planning Committee (PPC), FCA, and FCSIC. In general the PPC, FCA, and FCSIC agreed with our conclusions and found the draft to be factually accurate. The full text of each entity’s comments and our responses are provided in appendixes VI through VIII. In addition, the PPC and FCA provided technical comments that have been incorporated throughout the report as appropriate. FCBs involved in mergers cited cost savings as one of the goals of merging. If FCB operations can be effectively consolidated or merged, the merged FCB may be able to reduce its operating costs by eliminating duplicative functions, thereby achieving economies of scale. The four merged FCBs projected bank-level cost savings of $5.1 million to $20 million annually per merger. Under certain conditions, the realization of the anticipated bank-level savings may eventually result in slightly lower interest rates for farmers and ranchers. Although the projected savings per FCB may appear substantial, the amounts for each FCB represented only a small fraction of total district operating costs (see table 2.1.), because most district operating costs are incurred at the association level. In terms of overall district operating costs, slight increases in association costs could easily offset projected merger-related savings at the FCB level. The overall (districtwide) cost-reducing effect of mergers may also be limited, in that bank mergers do not directly reduce the costs of the local lending network (associations and their branches). To provide a measure of the overall operating efficiency of the districts (banks and associations), we calculated operating rates—operating expenses per $100 of gross loans—between 1990 and 1993 and found that they varied somewhat throughout the System. (See table 2.2.) Although 1993 district rates ranged from $1.72 to $2.95, excluding the high and low rates, 8 of 10 were between $2.05 and $1.78. Some of this $.27 variation in operating expenses may have resulted from various organizational, structural, operational, and philosophical differences among the districts. We found that no one type of district structure or operating philosophy appeared to be consistently more efficient than another. For example, while Omaha and Louisville had the lowest operating cost rate in 1992 and 1993, they operated quite differently. The Omaha FCB provided its jointly managed districtwide FLBA/PCA with numerous support services and essentially operated as a single entity. On the other hand, the Louisville FCB operated as a strictly wholesale lender, providing few support services to its five ACAs (one had $2.5 billion in assets, the remaining four had combined assets of $.54 billion). Other wholesale FCBs, such as Springfield, Baltimore, and Columbia, had higher rates. If banks that belong to districts with different district operating rates merge, the rate for the merged district may be higher or lower depending on the characteristics of the districts. For example, premerger operating cost rates for the St. Paul and St. Louis districts were $1.91 and $1.96 respectively. AgriBank’s restated 1991 rate was $1.93. Thus, the new rate was higher than St. Paul’s but lower than St. Louis’. Following the merger in May 1992, the AgriBank rate increased slightly, in part because of higher association operating costs. In 1993, the district’s operating rate increased further to $2.05. For additional information on operating costs following the St. Paul/St. Louis merger, see appendix IV. The eight banks that merged between 1992 and 1994 projected bank-level annual ongoing merger-related cost savings between $5.1 million and $20 million. We did not independently verify the reasonableness of these projections; however, FCA found them to be generally reasonable and achievable. The merged banks expected to achieve most of their savings through staff reductions, office consolidation, more efficient use of technology, and a general reduction in other costs due to fewer employees. Projected savings net of any anticipated increases in association costs represented only 3 to 7 percent of total district premerger operating costs. However, it is often difficult to project and realize any merger-related cost savings because (1) projections are based on economic assumptions; (2) success depends on management’s ability to actually lower costs; and (3) there are many uncontrollable factors, such as inflation. Fifty-nine percent of association and bank officials surveyed believed bank mergers would lead to economies of scale. Another 24 percent believed they would negatively affect economies of scale. If economies of scale were achieved, we calculated that projected bank-only operating cost savings for each of the four mergers could translate to a 6 to 32 basis point savings for associations in those districts. A 32 basis point decrease in an association’s wholesale loan rate would be equivalent to a 6-percent rate being decreased to 5.68 percent. For borrowers, the impact of bank-level savings would depend on costs at the association level as well. For example, if a merged bank were able to lower its rates to associations by 32 basis points but association operating costs increased an equivalent of 19 basis points, the association could pass only 13 basis points of savings on to farmer and rancher borrowers provided all other operating goals remained constant. Under this scenario, a farmer or rancher borrower’s loan rate would decline 13 basis points. On a $70,000 loan, he or she would save $91 in interest costs on the loan annually. However, a bank may use any merger-related savings to cover other costs rather than lower rates. According to AgriBank officials, AgriBank used its savings to repay financial assistance and fund early redemptions of Assistance Preferred Stock. A significant amount of the merger-related savings was expected to come from staff reductions. As figure 2.1 illustrates, salaries and employee benefits accounted for the largest segment of System-wide FCB and association operating expenses in 1992. Likewise, salaries and benefits represented the largest operating expense category in each district. Depending on the district, these costs ranged from 52 to 65 percent of total operating expenses. Generally, the merged FCBs projected that a substantial portion of their operating savings would come from reductions in staff achieved by consolidating duplicative staff positions. For example, documents related to the 1992 St. Paul/St.Louis merger showed that 70 percent of the projected $10 million in cost savings would come from eliminating 142 employees. As of April 1993, AgriBank had reduced its staff by a total of 111. For a detailed discussion of bank-level staffing changes resulting from the St. Paul/St. Louis merger, see appendix IV. Other merged FCBs projected staff reductions of 50 to 90 employees, representing reductions in the range of 16 to 45 percent of the premerger staff. Although bank mergers are expected to result in lower staff levels, banks may delegate certain functions to their associations if the merged FCB chooses not to provide those functions. For this reason, associations in some merged districts expected to increase staff to perform services once provided by the FCB. For example, Farm Credit Services of the Midlands PCA/FLCA—the jointly managed associations in the old Omaha district—planned to hire additional staff following their FCB’s merger to provide certain services and functions formerly provided by their FCB. Conversely, AgriBank anticipated that centralization of the risk asset unit (RAU) at the bank level would result in a corresponding decline in association staffing. However, no decline occurred because the resources were used to staff expansion of other functions delegated to the associations. Although the initial FCB mergers focused on bank-level operating cost savings, association costs comprise most of the districts’ operating costs. The FCBs serve generally exclusive territories through their local associations. In many districts, associations commonly had local branches serving relatively small territories of the associations. In 1992, the number of branches per association ranged from 1 to 173. Also, total association operating expenses as a percent of total district operating expenses averaged 71 percent in 1992. FCB mergers consolidate FCB headquarters offices but not association facilities. Since FCBs generally do not compete with other FCBs in a given geographic region, mergers would not lead to substantial savings in “bricks and mortar” commonly associated with in-market mergers in commercial banking. Thus, a two-bank merger eliminates the need for one building; it does not reduce the number of associations or association branch offices. Some association officials believed that FCB mergers would result in more association mergers and larger associations able to function with less FCB support. Some mergers did result in associations having to provide certain services and functions previously provided by their FCB. However, we did not find a substantial increase in association mergers following the St. Paul/St.Louis merger. As of December 31, 1993, AgriBank had 50 associations, only 3 fewer than the 53 St. Paul and St. Louis had at the time of the 1992 merger. According to AgriBank documents, bank-only gross operating expenses declined $8.2 million (13 percent) in 1992. AgriBank projected it would achieve cost savings primarily by reducing staff and spreading other costs over a larger asset portfolio, not by shifting costs to associations. In 1992, AgriBank experienced a decline in every major operating expense category except “occupancy and equipment.” In 1993, each cost category experienced an increase over 1992 levels but the 1993 costs were still lower than 1991 levels. However, because a majority (71 percent in 1992) of the district’s costs are incurred at the association level, increases in association operating costs contributed to an overall increase in district operating costs. Since associations in other districts experienced similar increases, we believe the increase in association costs experienced in the AgriBank district is not necessarily attributable to the merger. The effect of association costs on districtwide costs in this instance illustrates the influence that association operating costs can have on district costs. (See app. IV for additional details.) Mergers may lead to greater economies of scale at the bank level through the elimination of duplicative functions and if achieved, potentially lower funding costs for their associations. Whether member-borrowers obtain similar savings depends on districtwide operating costs. The merged banks projected between $5.1 million and $20 million of bank-level operating cost savings per merger, which could translate to 6 to 32 basis points of savings for their associations if the savings were passed along in the form of lower interest rates. However, some merged banks expected increases in association costs following the merger, which could affect the amount of savings passed on to member-borrowers. Projecting and achieving cost savings through mergers are often difficult due to various uncontrollable factors. The System’s localized lending structure, which consists of local associations, often with numerous branches, goes largely unaffected after FCB mergers. Therefore, member-borrowers may not see substantially lower operating costs following mergers. Following the creation of AgriBank, while bank-only operating costs declined in 1992, the district’s overall costs increased slightly. The existing FCB mergers generally had little impact on the number of borrower services, the cooperative nature of the System, and System-wide bond issuances. However, mergers between certain banks could affect services to member-borrowers and the manner in which some cooperative principles are applied by FCBs. Before associations may offer financially related and technical services to member-borrowers, they must seek FCA and FCB approval to provide those services. FCB mergers could affect the level of services provided by associations if the merged bank authorized levels of service different from those that were available before the merger. Officials of merged FCBs generally expected their associations to offer the same or a wider variety of services to borrowers. None of the merged banks expected reductions in the level of services provided to borrowers. System banks and associations are cooperatives; they are owned by member-borrowers who must buy stock as a prerequisite for borrowing. Although we found no evidence that FCB mergers would affect the System’s cooperative nature, mergers could change the way certain cooperative principles are applied. Finally, since the banks issue System-wide debt securities collectively through the Funding Corporation, FCB mergers should have little impact on the issuance of System-wide bonds. We found that newly merged banks generally expected little or no change in the level of services provided to borrowers. At least one merger resulted in a wider variety of services and loan products being offered after the FCB merger. Generally, FCB mergers would affect the level of services an association provided its member-borrowers only if the FCB—which has the authority to approve or disapprove services its district associations may want to provide—forced the association to change the services offered before the merger. If the merged banks choose to increase the services and loan products offered in each district before the merger, some associations could enjoy greater flexibility in servicing their borrowers’ needs. However, if the merged FCBs force a reduction in an association’s level of services, the merger could negatively affect farmers and ranchers who formerly relied upon the discontinued services (if they were not able to obtain the same level of service from another provider). We found no evidence that banks planned to restrict association-provided borrower services after mergers. Selected FCB-conducted surveys of member-borrowers indicated that while most borrowers considered available services when choosing a lending institution, such services were not a primary consideration in their selections. Some associations have been able to generate significant fee income by effectively marketing and promoting their services. While most associations offered basic services, such as insurance, leasing, and fee appraisals, others offered a greater number and variety of services, as shown in table 3.1. According to bank documents, associations provide services on the basis of borrower demand. We found that FCBs generally authorized the services their associations wanted to offer. However, 27 percent of all association respondents surveyed noted that they would like to offer services that they were not yet authorized by their district FCBs to offer. These services included estate planning and System-wide bond purchasing programs. Although a bank may authorize a variety of services in a district, not all associations may choose to offer those services. For example, AgriBank associations from the former St. Louis district continued to offer fewer services than did associations from the former St. Paul district, although AgriBank had authorized the same services for each group of associations. (See table 3.2.) Seven of the 10 associations from the former St. Louis district indicated no additional services that they would like to offer. However, other associations listed additional services they would like to provide but that had yet to be approved by AgriBank. The merger of the St. Paul and St. Louis FCBs increased the number of services their respective associations could offer borrowers. The merged bank generally allowed its associations to offer any service that had been approved in either of the districts before the merger, thus making some services that had been available in only one district before the merger available districtwide. For example, before the consolidation, St. Paul associations were not authorized to offer title and aquatic facilities/equipment insurance, all of which were authorized by the St. Louis FCB. Conversely, St. Louis associations were not authorized to provide financial management services and could not independently offer leasing services to borrowers. These services were authorized in the St. Paul district. We found that the fundamental cooperative principles were still operative in the System and among the merged FCBs although they had evolved over time with changes in statutes and regulations. Because most of the cooperative principles are grounded in statute and regulation, additional mergers should not adversely affect the System’s cooperative nature. Related to the System’s cooperative nature is its tradition of local control, which refers to associations making lending, credit, and operational decisions with member-borrowers having an active voice in decision-making through their election of peers to serve as directors on association and bank boards. Although the amount of local control exercised in the System varies, changes in bank supervision and increased delegation of authorities as associations become direct lenders have generally promoted greater local control in many districts. Although we do not expect mergers to adversely affect the System’s cooperative nature or local control, past FCB mergers have resulted in the dilution of association voting strength as more associations shared in the ownership of each merged FCB. Additionally, some associations elected proportionately fewer bank directors following the mergers. However, each FCB merger has been approved by its stockholders, the associations, which are required to approve voluntary mergers. The trend of consolidation is not unique to the System; it has also occurred, for example, among the European Cooperative Banks, which share some similarities with the System. According to a 1984 System study, the number of European Cooperative Banks had declined due to consolidation. The study noted that while ownership and control were exercised from the bottom up, regional bank management was characterized by strong leadership that influenced the strategic direction from the top down. Like the European Cooperative Banks, the System has experienced substantial consolidation while maintaining cooperative ownership and local control through the trend toward wholesale lending and establishment of more direct lending associations. Democratic control, a guiding principle of the System, is not fundamentally changed by FCB mergers. Each member-borrower has a vote in the election of members to the association’s board of directors. Also, each association, as owner of the FCB, elects directors to the bank’s board, with its vote weighted in proportion to the number of voting stockholders in the association. In addition, all of the merged FCBs require that their elected directors be voting stockholders of an association. The directors of both associations and banks are responsible for the management and operation of their respective institutions. Regardless of mergers, System borrowers are required to purchase stock or participation certificates (nonvoting) as a condition of borrowing. As a result of this stock ownership requirement, borrowers own their local associations, which in turn own the FCBs. As owners of the banks, associations, through their directors, vote to approve or disapprove any voluntary FCB merger proposals. Thus, borrowers of the System continue to indirectly own the merged FCBs through their associations. Following mergers, financing for member-borrowers continues to be guided by the policy of “financing according to use.” This means that the amount of stock that a member-borrower is required to purchase is determined by the size of the member-borrower’s loan. Historically, the amount has been 5 to 10 percent of the loan amount. The 1987 act and subsequent regulations reduced the minimum stock requirement to 2 percent of the loan amount or $1,000, whichever is less. However, banks and associations may set stock requirement levels above the statutory minimum. In 1992, for example, AgriBank and its associations required initial investments that ranged from the statutory minimum to a maximum of 10 percent. Limited return on borrower stock remains an operating principle of the System as FCBs merge. That is, stock continues to be retired at par (face value), and dividends and patronage refunds continue to be paid occasionally. In the past, borrower stock was automatically redeemed when the loan was repaid. However, under 1987 act provisions, member-borrowers may be required to retain their stock for some period,whether or not they receive dividends or patronage refunds. After mergers, as before, banks and associations may periodically distribute earnings through dividends and/or patronage refunds. The amount paid out depends in part on an institution’s need to retain earnings and build capital in order to meet the regulatory minimum. In 1993, banks and associations paid combined cash dividends and/or patronage refunds varying from 0 to 33 percent of net income per district. This illustrates that mergers between certain banks could affect the amount of earnings returned to associations and member-borrowers. FCB mergers may affect the amount of dividends paid if merging banks have different financial conditions and/or dividend policies. Following the merger of the financially weaker Jackson FICB with the Columbia FCB, the merged FCB expected to pay significantly higher dividends to First South PCA than Jackson had paid. However, merger disclosure documents cautioned that there was no guarantee that such dividends would be paid. Other merged banks noted similar changes. For example, AgriBank’s dividend policy was different from the former St. Louis bank’s and would result in higher dividends for those associations. If the FCB paid higher dividends, associations may also be able to pay out higher dividends or lower their interest rates to member-borrowers. The notion of “service at cost” continued to guide the operation of many FCBs (and associations) after mergers, although the tradition has evolved as the result of statutory changes. Statutory changes in the mid-1980s concerning the manner in which interest rates were established resulted in some banks and associations offering more competitive or market-driven rates. Additionally, the 1987 act authorized FCA to establish minimum capital standards for all System institutions. While some banks still offer lower rates in lieu of higher earnings and greater dividends (“service at cost”), others prefer to charge rates that are more comparable to rates charged by other lenders and pay greater dividends. In 1993, System earnings exceeded $1 billion for the first time since 1982. The principle of local control dates back to 1916 and has been reinforced over the years. In fact, the 1971 Farm Credit Act, as amended, encourages farmer and rancher member-borrowers to participate in management and control of the System. Local control of the System is ensured most directly by the power of member-borrowers to elect the directors of their associations and, in turn, these association boards elect directors of their FCB. An important factor in determining how FCB mergers will affect local control is the general trend in the System toward more independent associations as more associations become direct lenders. As part of this trend, many banks have begun to make their associations more accountable for their financial well-being by delegating many responsibilities to them. FCB mergers would enhance local control if the merged banks promoted association autonomy and encouraged borrower involvement. A variety of factors are likely to affect the amount of association autonomy that evolves in districts. Each district, newly merged or otherwise, would have to reconcile the FCB’s need to oversee its associations and the interests of the shareholders if differences exist between the FCB and shareholders. Merged banks may also experience local differences in merged districts. Although 53 percent of general association survey respondents believed FCB mergers would negatively affect local control, only 28 percent (8 of 29) of AgriBank survey respondents believed the St. Paul/St. Louis merger actually had a negative impact on local control. Four of 10 bank officials responding to our survey believed mergers would negatively affect local control. Some bank and association officials focused on the loss of representation to a larger bank board (addressed in the following section), while others expressed concerns about potentially increased direction from the merged FCB. An FCB merger increases the number of associations affiliated with a single bank and dilutes individual association voting strength. For example, an association with 90,000 voting shareholders in a district with 100,000 voting shareholders would control 90 percent of the weighted vote. If that association’s FCB merged with an FCB in a district that had 150,000 voting shareholders, the number of shareholders or weighted votes in the merged district would be 250,000 (100,000 plus 150,000), thus diluting the association’s voting strength to 36 percent of the weighted vote. In addition to diluting voting strength, mergers also caused some associations to elect proportionately fewer bank directors. As table 3.3 shows, the total number of elected bank directors in a merged district was lower than the total number of bank directors the associations elected before the merger. In merged FCBs, each elected FCB director may be the only resident of his/her state elected to the bank board. FCB mergers are likely to have little or no impact on the issuance of System-wide bonds for several reasons. Although the System is a collection of institutions, investors essentially view the System as a single entity. This perception is reinforced by the joint and several nature of System-wide obligations, which ultimately makes all banks liable for System-wide and consolidated debt. From an investment perspective, joint and several liability removes much of the credit risk of individual district financial problems. The System also presents combined financial data to the investment community through the Funding Corporation. Additionally, investors rely on the strength of the System’s ties to the federal government because of the System’s GSE status. As of February 1994, Moody’s rated the System’s debt “Aaa,” the highest available rating. According to a Funding Corporation official, mergers would bolster the System’s safety if mergers resulted in larger, more financially stable institutions. Most bank officials surveyed agreed that mergers would not negatively affect System-wide debt security issuances. Some bank officials indicated that FCB mergers could enable some merged FCBs to utilize more favorable financing options. For example, one bank official noted that the merged bank was able to privately place its debt issuances following a merger, thus simplifying the issuance process. In managing their assets and liabilities, individual FCBs also use financing options such as interest rate swaps. For these types of transactions, the increased size and financial strength that result from mergers may offer the individual banks some advantages. We found that merged FCBs generally expected mergers to have no adverse impact on the number of services associations provide to borrowers. Some AgriBank associations were even able to offer additional services and loan products. Because the System’s cooperative nature is grounded in statute and regulation, FCB mergers are not likely to affect it. FCB mergers may affect an individual association’s voting strength and board representation. Although our survey revealed that many association officials were concerned that mergers would negatively affect local control, as of April 1, 1994, all voluntary mergers had been overwhelmingly approved by their stockholders. Additionally, most banks are moving toward wholesale lending relationships with their associations, which should promote greater association autonomy and local control. However, merged banks would still have to balance local needs and bank objectives. We also found no evidence that FCB mergers would have an adverse effect on the issuance of System-wide bonds because the investment community views the System as a single GSE entity, and all System banks are ultimately jointly and severally liable for debt issued by the System. Some System officials indicated that larger FCBs may have greater flexibility in asset/liability management because these transactions are based on each bank’s individual financial strength, and size is a factor. Of all the factors covered by our study, the bank-association relationship is likely to be most affected by FCB mergers. An FCB merger may alter the dynamics of the existing bank-association relationship in various ways. The degree of alteration is likely to depend upon the similarities and differences in the philosophies of the merging districts and the philosophy adopted by the merged institution. We identified three basic ways the FCBs and associations relate to each other. First, banks oversee or supervise the activities of their owner-associations based on existing statutes, regulations, and contractual duties. Second, banks and associations have a quasi-debtor-creditor relationship because FCBs are the primary funding sources for their district associations. Third, banks provide numerous operational support services to associations. The bank-association supervisory relationship is unique and complicated because ownership and supervision flow in opposite directions: associations own the banks, but banks have various authorities over association operations. FCB authorities emanate from statute, FCA regulation, and contractual arrangements between FCBs and their associations. FCBs exercise these authorities to varying degrees throughout the System. Some banks closely monitor association operations and are actively involved in association management; others are much less involved. The level of bank involvement often depends upon the association’s financial condition and whether it lends directly to member-borrowers (acts as a direct lender) or facilitates loans between member borrowers and the FCB (acts as an agent association). According to association officials we contacted, banks generally oversee various aspects of their operations, focusing on credit and other areas, such as strategic planning, policy reviews, and CEO salary approval. FCB statutory authorities over associations include powers to approve the appointment and compensation of chief executive officer and salary scale of staff, delegate power to associations, establish lending standards for associations, supervise associations, approve alternative funding sources, approve association investments, approve merger plans, approve service charges, approve loss-sharing agreements, and prescribe amounts held as surplus by associations. If the FCBs involved in a merger have different supervision or oversight practices, the resulting consolidation will affect the bank-association relationship of at least some associations and possibly their member-borrowers. However, many associations throughout the System indicated that their FCBs were generally less involved in their operations than they were a few years ago. Many attributed the change to their becoming direct lending associations. Given this general trend, FCB mergers are not likely to adversely affect association autonomy. Since all voluntary FCB mergers are subject to association approval, association boards have options available if they believe a merger would adversely affect their operation. An association could use its voting authority and elect not to approve the proposed merger. However, unless the association held a majority of the votes, the outcome would depend on whether other associations shared its view. An association, with the proper approvals, could also reaffiliate with another district with a structure more compatible with its needs. For example, the four smaller former Louisville associations with $451 million in assets chose to reaffiliate with the Columbia district rather than become part of the AgriBank district. Among other issues, they cited greater compatibility with the Columbia district than the merged AgriBank district. Although AgriBank has the same powers and responsibilities to supervise associations as did the St. Louis and St. Paul FCBs, 19 of 29 association officials responding to our survey indicated some change in FCB supervision and/or oversight following the merger. Both premerger banks shared similar supervisory policies; AgriBank’s policy is a combination of the two. Responses varied as to whether the merger actually led to more or less bank supervision. This variation may indicate that the FCB’s relationship with each association is unique because the level of supervision depends on the condition and performance of the association. Seven of the remaining 10 officials responded that there was no change in the supervision provided after the merger. In 1993, AgriBank drafted plans to change its supervision policy and forge a partnership with its associations. Noting the debate over how much control an FCB should exert versus the ability, opportunity, and prerogatives of associations to fulfill their missions, the bank drafted plans to change its operations. According to bank documents, AgriBank planned to stop trying to improve association business performance through such methods as “coaching” and “threatening.” Instead, the bank planned to use an incentive program to achieve and maintain association success. AgriBank planned to continue to provide feedback to association boards and management concerning association performance; it would, however, no longer offer recommendations for remedying weaknesses unless requested by the association. If the collection of an association’s loan was placed in jeopardy, AgriBank still intended to take the necessary steps to remedy the situation and avoid any adverse impact on the rest of the district. This course of action appears consistent with the general FCB trend toward less supervision and oversight. Merged FCBs continue to serve as the primary funding source for direct lending associations. Unlike independently negotiated debtor/creditor relationships, the FCBs and associations share a mandated funding relationship or quasi-debtor-creditor relationship. This funding relationship is governed by a general financing agreement (GFA) that establishes the terms and conditions of the associations’ funding. Associations have the authority to borrow from their district FCBs and must have the FCB’s approval to obtain funding elsewhere. Similarly, FCA requires FCBs to notify it at least 60 days before they take any action that would lead to the liquidation of an association. Unlike direct lending associations that originate, service, and own their loans, agent associations originate and service loans on behalf of the FCB. The service agreements that FCBs negotiate with their agent associations are similar to GFAs direct lenders have with the FCBs. FCBs may also establish service agreements with direct lending associations that service loans on behalf of the bank. These agreements outline performance targets, services provided by the association, and compensation to be paid by the bank. Most FCBs—merged and unmerged—are moving toward wholesale lending relationships with their associations. (See app. V.) FCBs have been encouraged to become wholesale lenders by efficiency and operational issues and by several changes related to capital accumulation and the status of borrower stock. Banks become wholesale lenders as they transfer their long-term lending authority to FLBAs (which then become FLCAs) or as FLBAs merge with PCAs to form ACAs. The Springfield, Baltimore, Columbia, and Louisville FCBs became strictly wholesale lenders through the creation of ACAs. These banks also sold or transferred all of their mortgage retail loans to their newly created ACAs. Although the Omaha and Spokane FCBs had only direct lending associations by the end of 1993, both still had large volumes of retail loans in their loan portfolios. The AgriBank and Western FCBs were still moving toward wholesale lending structures in 1993. In 1994, AgriBank transferred its direct long-term real estate lending authority to its remaining FLBA (making it an FLCA). Like Omaha and Spokane, however, a substantial amount (40 percent as of September 1993) of AgriBank’s retail loan volume remained at the bank level. The Wichita and Texas FCBs maintained traditional PCA/FLBA district structures with retail mortgage loans made through their agent associations (FLBAs). Another component of the bank-association relationship is the support services FCBs provide to their associations. While these services may facilitate an association’s ability to serve its borrowers, they are generally invisible to the borrower. These services often include data processing, marketing, training, and asset/liability management, as detailed in appendix V. On the basis of our analysis, we found the level of support services provided to an association depended in part on the association’s asset size and whether it was an agent or direct lender. Some FCBs provided many support services for their associations; others provided few. Because banks offer varying levels of support services to their associations, a merger may result in a change in the number of services available to some associations. For example, the Louisville FCB provided very few support services to its associations before merging with the AgriBank FCB. AgriBank provided dozens of services to its associations and planned to extend these services to the Louisville association. Similarly, the Spokane and Omaha FCBs offered different levels of support services to their respective associations before consolidating to form AgAmerica. AgAmerica did not plan to provide most of the support services formerly provided by the Omaha FCB. Therefore, Omaha’s jointly managed PCA/FLCA planned to provide many of those services for themselves or buy them elsewhere. However, Northwest Farm Credit Services, ACA, in the Spokane district was not affected because the Spokane FCB had provided few support services before the merger. Since support services provided by the banks facilitate association operations, there may be some indirect impact on member-borrowers. All of the banks provided their associations with data processing or information systems. According to disclosure documents and bank officials, merged FCBs try to achieve economies of scale by integrating their associations through use of a common system. During the integration, member-borrowers may encounter disruptions in the level and quality of association-provided services in areas such as billing and loan origination. A few associations in the AgriBank district said this was an issue following the merger. However, if the implementation is adequately planned and executed, such disruptions should be only temporary. In every merger to date, one merger partner’s associations adopted the other’s accounting, data processing, and information systems. AgriBank primarily adopted St. Louis’ system, Jackson adopted Columbia’s, and Louisville was adopting AgriBank’s. Spokane and Omaha planned to implement a joint management information system (MIS) venture with CoBank. AgriBank provided various support services to associations upon request. The bank’s 1993 vendor services catalog listed 37 support services including a variety of accounting, human resources, legal, marketing, and MIS services. If a particular offering was not used by associations, the bank generally discontinued the service. For example, AgriBank eliminated its sales management services and related staff resources due to low association usage. Although most services were optional, AgriBank required all associations to subscribe to key accounting and MIS services to achieve operating efficiencies across the district. The most significant implementation issue for AgriBank was the development and implementation of a common MIS. AgriBank adopted St. Louis’ core lending system, loan origination system, and computer hardware. The bank also retained some features of the St. Paul system. St. Paul associations were trained and converted to the St. Louis system. Agribank completed association personnel training and conversion in October 1993. On the basis of AgriBank associations’ responses to our September 1993 survey, we believe the conversion created some dissatisfaction about the merger. Associations in the former St. Paul district had problems with the MIS technology provided by AgriBank. Although the number of loan products and pricing options increased following the merger, some officials believed they lost some flexibility in customizing loan documents because of standardization required by the new system. A few former St. Louis association officials noted poorer service quality and less support for existing MIS services from the merged bank. It should be noted that our survey was conducted during the conversion process, and AgriBank officials expected associations to experience certain adjustment problems and disruptions during this period. FCB and association relationships vary throughout the System; therefore, certain FCB mergers could affect some bank-association relationships. Although all FCBs share the same supervisory authorities over association activities, most FCBs exercise these authorities to varying degrees throughout the System. How this relationship is managed affects association operations and how associations in turn relate to their member-borrowers. Since FCBs and associations share a mandated funding relationship, FCB mergers are not likely to change this arrangement. However, many FCBs are moving toward wholesale lending relationships with their associations. As of April 1, 1994, all merged FCBs had wholesale lending structures. In addition to funding, banks also provide numerous support services to associations to facilitate their ability to serve member-borrowers. While all FCBs provided certain basic services, such as data processing and information systems, many FCBs provided a variety of other support services to their associations. If banks that provide different levels of support merge, associations in one or both districts may be affected. One of the mergers resulted in an association having additional support services available to it, while another merger resulted in some associations providing support services (formerly provided by their bank) in-house or purchasing them elsewhere. FCBs throughout the System have consolidated certain duplicative functions and services to achieve economies of scale and/or reduce costs without merging. Banks own various entities that provide services to themselves, their associations, and their member-borrowers System-wide. Jointly provided services include System-wide and individual arrangements between or among banks to buy or sell specific services. According to System officials, district differences and a large number of banks made certain past System-wide joint efforts problematic. Bank mergers may ease efforts to achieve System-wide economies of scale because they tend to reduce the number of banks and districts that have to be accommodated in such efforts. In the past 20 years, System banks have established several organizations to provide common support and coordination services for the benefit of System banks, associations, and their borrowers. For example, the banks established a fiscal agent responsible for issuing bonds to fund the banks; this evolved into the existing statutorily based Funding Corporation. The 1971 Farm Credit Act authorized banks to provide joint services to themselves, their associations, and borrowers. The banks subsequently established FarmBank Services in 1975 to reduce costs and increase efficiencies by providing various support services System-wide. Also, the Farm Credit Council (FCC) was established in 1983 as the System’s trade association to provide governmental affairs support. Also in 1983, the System banks established the Farm Credit Leasing Services Corporation (FCL) to provide expanded leasing services to borrowers. In 1985, the Farm Credit Corporation of America (FCCA) was established to provide strategic leadership and planning for the System. FarmBank Services was merged into FCCA at that time. When FCCA dissolved in 1990, the Funding Corporation assumed its financial reporting responsibilities, and the service functions, including the responsibilities to assist in the development of consensus on System-wide issues, were transferred to FCC. The Farm Credit Act of 1971, as amended, provides, in general, that any System bank, or two or more banks acting together, may organize a corporation or corporations for the purpose of performing certain functions and services for or on behalf of the organizing bank or banks. Given the duplication of various functions throughout the System, opportunities exist for FCBs to jointly provide additional support functions, such as data processing, MIS, and administration, to reduce their overall operating costs. Within the System, a number of services are provided on a joint or System-wide basis to banks, associations, and member-borrowers. An example of a jointly provided service for banks is the data processing service that the Columbia FCB provided in 1993 to the Springfield FCB. System-wide bank services include those provided by FCC, the System’s trade association. In addition to its governmental and public affairs activities, through a wholly owned subsidiary (Farm Credit Council Services, Inc.), FCC provides many support services on a voluntary fee basis, including risk management, joint purchasing contracts, review and internal audit services, and human resource services. FCC estimates that it saves the System about $10 million annually as a result of the services it provides directly and/or manages for System institutions. Banks also own FCL, which provides leasing and related services primarily to eligible borrowers but also to banks and, in some cases, associations.According to an FCL official, its operations result in economies of scale and leasing expertise that would not be possible if leasing activities were decentralized at the district level. As owners of FCL, FCBs may also receive dividends from its operations. While some associations opt to independently provide leasing services, FCL is an example of the System using its authority to create a service organization to provide a service to borrowers. According to The Leasing and Financial Services Monitor, a trade publication, FCL posted the largest percentage increase in its lease portfolio among large independent leasing companies in 1992. Although FCL has sales offices throughout the country, it utilizes the existing association structure through a lease origination program that enables associations to originate leases for a fee. Seventy-seven percent of associations responding to our survey participated in the FCL lease origination program. FCL has leases available for various types of agricultural and nonagricultural items, from tractors and kiwi-defuzzers to office equipment and automobiles. According to System officials, past efforts to integrate certain services were unsuccessful because of differences in district bank operations. For example, in the late 1970s through early 1980s, several banks tried to integrate data processing, but the effort was aborted because no effective common approach could be developed. Because mergers result in fewer districts and banks with specific needs that a System-wide service would have to accommodate, mergers may facilitate the development and acceptance of System-wide services. In late 1993, CoBank and the Omaha and Spokane FCBs (now AgAmerica) began pursuing a joint venture to consolidate their data processing functions through the creation of a service corporation. In February 1994, FCA received an application for a service corporation charter stemming from this joint venture. In May 1994, FCA’s Board approved the request to form AgCo Services Corporation. This corporation is to provide CoBank and AgAmerica and their associations with all their MIS and electronic data processing services. AgCo is also to have the capacity to provide similar services to other FCS institutions. Mergers, which result in fewer banks and districts, may increase opportunities for the banks to jointly provide additional services on a System-wide basis and lower operating costs. While many joint efforts indirectly benefit member-borrowers through lower operating costs, FCL provides leasing and related services directly to member-borrowers. According to FCL officials, FCL is able to achieve a level of leasing expertise that would not be available through district-based individual leasing programs. Fewer FCBs may facilitate other joint projects since there would be fewer banks to accommodate. The latest joint venture, AgCo, illustrates this possibility. Joint efforts could benefit borrowers if they helped control operating costs through greater economies of scale.

Summary: Pursuant to a legislative requirement, GAO examined the potential impact of Farm Credit Bank (FCB) mergers on Farm Credit System borrowers and associations, focusing on the: (1) economies of scale; (2) level of services offered by FCB associations; (3) System's operation as a cooperative; and (4) bank-association relationship. GAO found that: (1) cost savings from FCB mergers through economies of scale may be difficult to realize, since the associations incur most of the district operating costs and their increased costs could more than offset any savings at the bank level; (2) associations in merged districts are expected to offer the same or increased services based on their borrowers' demands, but the banks can withdraw approval for existing services after merging; (3) mergers between certain FCB could affect the application of certain cooperative principles; (4) local control of merged FCB will continue, since local borrowers serve as association and bank board directors; (5) an individual association's influence will be diluted by the mergers, since each association will have proportionally fewer bank directors; (6) local control may increase as FCB lessen their supervision of associations which generally enjoy greater autonomy in operations; (7) FCB mergers should have little impact on systemwide bond issues, since all banks remain liable for the bonds; (8) FCB mergers could significantly change some bank-association relationships due to the merging of banks with varying oversight practices and association support services, but these changes may not directly affect member-borrowers; and (9) FCB mergers could spur jointly provided support services by reducing the number of entities involved and encouraging uniformity in borrower services.