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7 Clorane Brook Ballyfair The Curragh Co Kildare Registry of Credit Unions Financial Regulator PO Box 9138 College Green

Dublin 2 24th September 2010 By e-mail

A personal submission on CP 44: Stabilisation Support for Credit Unions
Dear Sir, I am pleased to make this personal submission in response to the consultation paper on stabilisation support for credit unions. The format of my response considers the international context for the design of modern credit union financial safety nets in particular the design of and relationship between prudential regulation and supervision and deposit insurance. My view is stabilisation, as a risk minimising objective of deposit insurance, is a fundamental requirement for modern credit union systems. How this might be best designed into the financial safety net is discussed in my submission. It appears to me of the models/options listed in the consultation document, models (1) & (2) reflect international best practice and current guidance on safety net design. They may propose a reasonable basis for considering the best design for the Irish credit union sector. Yours faithfully,

Bill Hobbs 24th September 2010



BILL HOBBS 24th September 2010


I am pleased to make this personal submission in response to the consultation paper on stabilisation support for credit unions. The format of my response considers the international context for the design of modern credit union financial safety nets in particular the design of and relationship between prudential regulation and supervision and deposit insurance. My view is stabilisation, as a risk minimising objective of deposit insurance, is a fundamental requirement for modern credit union systems. How this might be best designed into the financial safety net is discussed in my submission. It appears to me of the models/options listed in the consultation document, models (1) & (2) reflect international best practice and current guidance on safety net design. They may propose a reasonable basis for considering the best design for the Irish credit union sector.

Observations on the Credit Union Stabilisation concept
The financial safety net typically comprises three elements, prudential regulation and supervision, a lender of last resort and deposit insurance. The distribution of powers and responsibilities between participants is a matter of public policy choice and individual country circumstances. Modern credit union financial safety nets typically comprise: • • • Government regulators and supervisors (R&S) Regulated and supervised corporate credit unions providing LOLR facilities Government backed statutory deposit insurance systems (DI)

In some systems the R&S and DI mandates are combined within one stand alone system which is either a sub-function of a larger single regulatory authority or an independent participant in the overall financial services system. In all cases the ultimate authorities are national ministries for finance. In most cases, save for developing nations, national DI systems are mandatory requiring all credit unions to participate. The R&S system operates as a risk manager identifying “at risk” operations and engaging in early stage intervention. It may apply for and use funds provided by either stabilisation fund or deposit insurance fund managers. In many cases these are one and the same as the 1DI fund provides solvency funding to prevent a larger call on its resources. The objective of any DI is to insure customers’ deposits not to insure credit union solvency. Where they exist, stabilisation funds are not managed as “solvency insurance” as this would give rise to unacceptable moral hazard risks.

Canadian Provincial DGS are regulator, stabiliser and deposit compensator. In the US the NCUA/NCUSIF operates an integrated system of R&S intervention, solvency funding and depositor compensation.


Stabilisation is thus a risk management concept that seeks to sustain financial stability and minimise risks to deposit insurance funds. It is best seen as the relationship between the complimentary risk minimisation mandates of R&S and DI systems and their participants. Typically responsibility for operating a full risk management process is given to the R&S authority with the DI system responsible for compensating depositors in the event of credit union wind-down or failure. DI powers may include for pricing for risk, risk monitoring and providing funding for work out plans that minimise the cost to the deposit protection funds. DI systems provide stablisation funding only where it is the least-cost option. Stabilisation systems are more than a fund from which financial assistance i.e. solvency support is provided. Typically their design is based on a process of early stage recognition of problems and intervention to prevent problems from posing a risk to the fund. Modern regulatory and supervisory approaches adopt risk-based processes to monitor credit unions for signs of trouble and engage in an escalating interventionist process up to and including enforced mergers, organised wind-downs and purchase and assumption transactions. Stablisation is also manifest within systems of early stage intervention which prompt corrective action by R&S authorities. These are structured contingency risk planning and management approaches that assess and rate a credit unions risk profile into low, medium to high categories. Risk identification in turn prompts corrective action of the R&S which engages in an escalating series of interventions to minimise the risk of failure. Typically these include taking over high risk credit unions through a system of administration, supervision or conservatorship whilst a work-out is arranged. Naturally to be effective stabilisation intervention must be legally enforceable and carried out by an authority having the credibility, integrity, operational independence from political and industry influence and one which operates transparently with appropriate levels of public disclosure. Stablisation system governance should be structured to minimise the potential for undue political and industry influence and conflicts of interest. Stablisation is therefore a risk minimisation process; a continuum of structured interventions enabled by legislation and carried out by R&S systems. Measures aimed at rehabilitation may include the temporary support of an insolvent but otherwise viable credit union that can demonstrate a realisable recovery plan. In general the use of solvency funding or financial assistance such as loan guarantees is quite rare in modern mature credit union systems as more often than not the credit union is taking under control of the R&S authority who frequently appoint a supervisor to run the credit union until it can be wound down, merged etc. Stablisation funding is really only ever provided in cases where external events beyond the reasonable control of board and management have temporarily undermined solvency.


Where stabilisation funds (as distinct to stablisation systems) still exist, these are used under robust supervision of credit union regulators who in exercising their risk management powers may devolve supervision of at-risk credit unions to corporate credit unions. Such corporates, legislated for under statute are regulated and supervised credit union entities. When and if appointed as supervisors, they may access legacy stablisation funds and or obtain funding from the deposit insurance fund to provide temporary solvency under agreed work-out plans with the system regulator. The key is the decision to rehabilitate and provide funding is taken by that body having the powers to do so. In all cases this is the authority charged with regulation and supervision which may be either a stand alone regulator or deposit insurer/regulator. Thus while some but not all Canadian Provincial corporate credit unions continue to maintain active stablisation funds these may only be used in agreement with the authority charged with risk minimisation.

Stablisation scheme options – observations
Consideration of the appropriate stablisation system design should take account of the existing regulatory and supervisory mandate. This answers what risk management powers and mandates a stabilisation system might have as its design must be cognisant of the organisational boundaries and powers of existing mandates. Given that the Central Bank’s mandate under public policy objectives as recited in the Credit Union Act 1997 includes risk minimisation objectives, it is the authority 2empowered to engage in risk minimisation. It is also responsible and accountable to a higher authority from which it derives its powers. This policy objective, governance and mandate of the Irish credit union R&S system is in line with international best practice. This is not to say that powers are sufficient to effectively regulate and supervise credit unions rather that regulation and supervision of credit unions by government agencies is considered a fundamental component of credit union safety nets. Best practice and guidance preference is for risk minimisation (stablisation in credit union terminology) to have a legally enforceable statutory basis and reside within closely integrated but operationally independent R&S and DI systems. This is not the case 3here at this time where both DI and R&S reside within a single regulatory authority. While consideration as to whether this is the optimal compensation design feature of a modern credit union safety net is outside the scope of the consultation document, some observations seem appropriate.

Observations on DI design features

Canadian Provincial laws enacted at the same time include specific sections dealing with deposit guarantees, stabilisation and corporate credit unions. 3 As the extension of insurance coverage to credit unions in Sept 2008 was triggered by extraordinary circumstances, the design features of an appropriate credit union DI system may not have been fully considered.


It is clear that close co-operation between the R&S and DI systems is required and design considerations rest with which agency has principal responsibility for stabilisation. In modern effective systems such authority rests either with the R&S system or the DI where R&S and DI are one and the same authority (Canada) or DI is administered by the R&S system (US). These are independent credit union R&S and DI systems deriving their authority from Government ministries of finance. There is no modern system where stabilisation rests with a third entity, whether statutory or private, designed to fulfil a full risk minimisation stablisation role and having independent powers of regulation, supervision and intervention. Intuitively this makes sense as such a third party agency mandate would result in 4duplication of R&S and DI objectives, create hard to resolve inter-agency conflicts, be exposed to adverse selection, increase costs and without state backing would not have the financial strength required under crisis conditions. Moreover should the third party not be truly independent and governed in accordance with best practice principles then it could be exposed to political and industry influence. Such a system could also contain inherent conflicts that could give rise to unique credit union moral hazard risks which are addressed later in this submission. Thus one potential design could see R&S responsibility for the full risk management process up to closure after which the DI would step in and compensate savers. What minimisation role would a DI have? Internationally modern credit union DI systems either provide for stabilisation funding or direct the provision of funding by the manager of a legacy stablisation fund. As mandates require fund protection, they have a risk monitoring role and may have stablisation enforcement powers to ensure compliance with R&S work-out plans. DI authorities provide financial assistance only where they are satisfied that the credit union has demonstrated a viable work out plan and the R&S is satisfied this will not create a risk to the fund. The optimum solution may be for a stand alone credit union DI system with a limited stabilisation mandate complimenting the R&S authority’s’ full risk management system. Indeed this was the design of the 5ICUSP Bill published in early 2007 which, as it accords with international best practice, could be used as a template to inform the design of the appropriate DI system. Its best practice design features included mandatory participation by all credit unions, funding, reconstitution provisions and risk based pricing. Funding 6 was envisaged by way of a contribution ranking as an asset on credit union balance sheets. Scheme administration shortfall costs and individual credit union risk premiums would be expensed. By insisting on reconstitution, coinsuring credit unions would be jointly and severally responsible for covering any shortfall in the fund or costs of administration. This design feature turns

More so the case in small countries having a small pool of experienced regulatory and deposit insurance professionals. 5 The Bill would have seen the establishment of a credit union savings protection company with a dual compensation (guarantee) and stabilisation mandate. 6 Funding was not dependent on utilising existing stabilisation funds


credit unions net worth into a supplementary off –balance sheet fund of insurance reserves the scheme can draw on when needed. Besides expanding the size of the fund, it strengthens incentives for credit unions to monitor one another. Generally it is important that system co-insurance funds be ring-fenced within either the credit union DI or a sub-fund created within a wider DI such as the DPS here. The current DPS design exposes credit unions to failure costs of commercial banking and banks to failure costs of credit unions. An enabling credit union specific design feature could see the operation of a credit union sub-fund through which credit unions co-insure one another. The design of the current DPS system whilst providing for the possibility of risk based pricing- a risk minimisation tool - cannot provide for the different systems required to price unique credit union systemic and individual risk. As a pay-box system and ex-post/ex-ante hybrid, it has design limitations that inhibit the development of credit union risk based deposit insurance coverage. An additional and important benefit of an ICUSP type design is one where the credit union ethos and co-operative principles are embedded within its stakeholder governance model and the co-insurance aspect of a well designed credit union savings protection scheme that includes both guarantee and stablisation elements. The Statutory Stablisation Models (1) & (2) reflect a solution that encompasses best practice in safety net design. In which case the design features contained in the ICUPS Bill could inform a design that would embed credit union co-operative principles within an operationally independent credit union DI system which would be closely integrated with the Bank’s R&S and DGS objectives.

Credit Union DI System Moral Hazard
How banking DI systems induce moral hazard is well understood. Bank managers may trade off deposit insurance and engage in looting the bank. Risk minimising safety net design features include risk based insurance pricing and strengthening R&S prompt corrective action powers. Credit union “moral hazard” behaviours differ from banking. Looting is not a feature. Within credit union systems moral hazard manifests itself in poor governance and management, lax standards of compliance and captivity of the “too big to fail” director. Should stablisation be utilised or perceived as insurance against credit union failure, this could amplify moral hazard behaviour induced by a statutory deposit guarantee. Credit unions can and do fail and no system should be utilised to prevent failure at all costs. Whilst the objectives of self-regulatory safety net participant may incorporate risk minimisation best practices, their governance, operations and utilisation 7

of financial assistance may over time undermine system financial stability as poorly governed and managed operations, that ought to be allowed fail or merged, are permitted to continue as 7independent operations. In such systems an external shock could cause a solvency crisis for those weakened credit unions and trigger system wide problems for the whole system. It seems then that options/models (3), (4), (5) and (6) may not offer a route to an optimal DI design solution for stabilisation as they do not fully accord with international best practice and would require the establishment of private safety net participant(s) whose operational independence could not be assured to the same degree as a statutorily legislated, regulated and supervised system. It isn’t clear how best practice design features could be credibly deployed within such voluntary systems. In this regard the IADI’s Guidance paper on the Governance of Deposit Insurance systems is instructive: “The sound governance of agencies comprising the financial system safety net strengthens the financial system’s architecture and contributes directly to system stability. Operationally independent and accountable safety net organisations with clear mandates and which are insulated from undue political and industry influence provide greater integrity, credibility and legitimacy than entities lacking such independence. The deposit insurance system should have a governing body and the governing body should be held accountable to the authority from which the deposit insurance system receives its mandate. The deposit insurance system should be structured such that the potential for undue political and industry influence and conflicts of interest respecting members of the governing body and management is minimised.” This guidance has been re-iterated within an internationally agreed set of Core Principles for Effective Deposit Insurance Systems published jointly by the BIS and IADI in June 2009.

Credit Union Ethos Considerations
It is good that credit union philosophy has become a habit – but not all habits are philosophical. Stablisation as a concept has evolved as credit union systems have matured. Originally a self-help concept it is now regarded as falling within the risk minimisation remit of statutory safety net participants. In a recent research 8study to inform British credit unions on stablisation, its author wrote “Clearly, it would be unrealistic and inappropriate to consider

Such systems may display tight common bond inflexibility and little if any of the consolidation and rationalisation activity found in those systems having long established statutory R&S and DI systems. In comparison “field of membership” induces competitive incentives for credit unions to merge and enables R&S intervention flexibility in arranging mergers.


that ABCUL could implement a stand-alone stabilisation programme. Internationally, the trend is towards much greater Government regulator involvement and away from free-standing private trade association schemes.” Credit union philosophy doesn’t hold that credit union owned and directed self-regulatory, supervisory and stabilisation systems are fundamental to preserving the ethos. While stressing that the design of credit union safety nets must reflect the ethos, co-operative principles and unique organisational, cultural and operational emphasis on serving their customers who are also their owners, credit union leadership promotes statutory R&S and DI systems worldwide. The World Council of Credit Unions 9maintains: • Effective regulation and supervision of all financial institutions safeguard the stability of a country’s financial system and protect the savings deposits of its people. While several models of credit union supervision have emerged, World Council of Credit Unions (WOCCU) maintains that the ministry or agency that regulates financial institutions should supervise credit unions through a specialized unit trained in their nature, risks and methodologies. WOCCU consistently finds that, in addition to stronger financial performance, credit unions supervised by the financial sector regulator enjoy greater public confidence and trust, which results in higher membership and savings growth.

Furthermore WOCCU advocates for credit union participation in national statutory government backed DI systems. In so far as preserving the credit union ethos is concerned statutory stablisation mechanisms have long since been deployed in other credit union 10 systems. There is no evidence that this led to a diminution of ethos. Indeed as system financial stability has been ensured, public confidence has been underpinned. In these systems, consolidation has led to economies of scale and scope and greater investment in development. Membership has grown through expanded branch footprints, telephone and internet channels offering a full banking service.

“Stabilising British Credit Unions; A research study into the international rationale and design of credit union stabilisation programmes.” Paul A Jones, Research Unit for Financial Inclusion, Liverpool John Moores University, March 2010

WOCCU: Technical Guide: Credit Union Regulation and Supervision


Self-regulatory stabilisation systems once a feature of US and Canadian credit union self-directing systems have long since given way to statutory R&S and DI systems having clear public policy objectives of risk minimisation to protect depositors and mandates defined within legislation that orders the structuration of and relationship between safety net participants.


Concluding comments
Deposit insurance systems are not designed to deal with systemically significant failures or a “systemic crisis” and the costs of dealing with systemic failures should not be borne solely by the deposit insurance system but dealt with through other means such as by the state. In both normal and abnormal conditions the relationship between safety net participants is critical. Thus stablisation powers must be must be seen as credible, legally reliable and effective in implementing system wide resolution programmes if public trust is to be maintained. The appropriate design for stablisation should be based on clear unambiguous public policy objectives, have a sound legislative basis, proper governance, clarity regarding participant’s roles, legal certainty regarding risk minimisation powers and be adequately resourced and funded for normal conditions. It would appear then that the statutory stabilisation models (1) and (2) propose the appropriate path to the design of an important element of the credit union financial safety net.

Bill Hobbs Sept 2010


Useful Informative Documents
Credit Union Savings Protection Bill 2007 No. 15 of 2007: Ireland The Credit Union Act 1998, Part XXXIV CUDGC, Saskatchewan, Canada The Credit Union and Caisses Populaires Act (Consolidated) : Manitoba, Canada The Federal Credit Union Act, Revised June 2007: USA Credit Union Risk-Based Supervisory Framework: Monitoring, Staging and Intervention, Credit Union Deposit Guarantee Corporation, Saskatchewan, Canada Credit Union Deposit Insurance Corporation of British Columbia, Financial Institutions Act, 1994, Part 9, Division 3 stabilisation: BC Canada Credit Union Deposit Guarantee Corporation, Manitoba, AR 2009 “Deposit Insurance and Credit Unions: An International Perspective” Hannafin and McKillop: “An examination of the key factors of influence in the development process of credit union industries.” Sibbald,Ferguson,McKillop: Annals of Public and Cooperative Economics 73:3 2002 Submission to Basel Committee on Banking Supervision and International Association of Deposit Insurers “Core Principals for Effective Deposit Insurance Systems” World Council of Credit Unions May 15th 2009 “The relationship between credit union objects and cooperative philosophies”: Ward and McKillop “Guidance for Developing Effective Deposit Insurance Systems” (Basel: Bank for International Settlements): Financial Stability Forum (FSF), 2001, “Deposit Insurance: Obtaining the Benefits and Avoiding the Pitfalls,” Garcia, Gillan GH., (1996): IMF Working paper 96/83 (Washington: International Monetary Fund) “Deposit Insurance: A Survey of Actual and Best Practices”: IMF Working Paper 99/54 “Deposit Insurance: Actual and Good Practices”: IMF Occasional Paper “Deposit Insurance, Moral Hazard and Market Monitoring”, ECB Working Paper No. 302 (Frankfurt: European Central Bank); Gropp, Reint and Jukka Vesala, 2004 “Instituting a deposit insurance system: Why? How?” Blair, Carns and Kushmeider, 2006. Journal of Banking Regulation Vol 8, 14-9 Palgrave McMillan Ltd “General Guidance to Promote Effective Interrelationships Among Safety Net Participants” ,“General Guidance for Developing Differential Premium Systems” ,“General Guidance for Resolution of Bank Failures”, “Governance of Deposit Insurance Systems, Guidance Paper,”: International Association of Deposit Insurers (IADI) “Contingency Planning: A practitioners guide drawing from lessons learned from dealing with bank failures”; LaBrosse and Walker, 2006, Journal of Banking Regulation Vol 8, 1 51-65 Palgrave McMillan Ltd


“Similarities and dissimilarities in the collapse of three state chartered private deposit insurance funds” Walker F Todd (1994) Working Paper 9411, Federal Reserve Bank of Cleveland. “Carved in Sand: A Report on the Collapse of the Rhode Island Share and Deposit Indemnity Corporation” ;Gregorian, Vartan; prepared for the governor of Rhode Island, March 14, 1991 “Stabilising British Credit Unions; A research study into the international rationale and design of credit union stabilisation programmes.” Paul A Jones, Research Unit for Financial Inclusion, Liverpool John Moores University, March 2010 “Development best practices in credit union supervision”: World Council of Credit Unions (2002)