Stabilisation Support Schemes

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7 Clorane BrookBallyfairThe CurraghCo Kildare

Registry of Credit UnionsFinancial Regulator

PO Box 9138College GreenDublin 2

24th September 2010By e-mail [email protected]

A personal submission on CP 44: Stabilisation Support

for Credit Unions

Dear Sir,

I am pleased to make this personal submission in response to theconsultation paper on stabilisation support for credit unions. The format ofmy response considers the international context for the design of moderncredit union financial safety nets in particular the design of and relationshipbetween 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 mightbe 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 onsafety net design. They may propose a reasonable basis for considering thebest design for the Irish credit union sector.

Yours faithfully,

Bill Hobbs24th September 2010

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mailto:[email protected]:[email protected]


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A PERSONAL SUBMISSION ON THE

CBFSAI CONSULTATION PAPER

CP 44

STABLISATION SUPPORT FOR CREDITUNIONS

BILL HOBBS24th September 2010

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I am pleased to make this personal submission in response to theconsultation paper on stabilisation support for credit unions. The format ofmy response considers the international context for the design of moderncredit union financial safety nets in particular the design of and relationshipbetween prudential regulation and supervision and deposit insurance.

My view is stabilisation, as a risk minimising objective of deposit insurance, isa fundamental requirement for modern credit union systems. How this mightbe 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 onsafety net design. They may propose a reasonable basis for considering thebest design for the Irish credit union sector.

Observations on the Credit Union Stabilisation

concept The financial safety net typically comprises three elements, prudentialregulation and supervision, a lender of last resort and deposit insurance. Thedistribution of powers and responsibilities between participants is a matter ofpublic 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 LOLRfacilities

Government backed statutory deposit insurance systems (DI)

In some systems the R&S and DI mandates are combined within one standalone system which is either a sub-function of a larger single regulatoryauthority or an independent participant in the overall financial servicessystem. In all cases the ultimate authorities are national ministries forfinance. In most cases, save for developing nations, national DI systems aremandatory requiring all credit unions to participate.

The R&S system operates as a risk manager identifying at risk operationsand engaging in early stage intervention. It may apply for and use fundsprovided by either stabilisation fund or deposit insurance fund managers. In

many cases these are one and the same as the 1DI fund provides solvencyfunding to prevent a larger call on its resources. The objective of any DI is toinsure customers deposits not to insure credit union solvency. Where theyexist, stabilisation funds are not managed as solvency insurance as thiswould give rise to unacceptable moral hazard risks.

1Canadian Provincial DGS are regulator, stabiliser and deposit compensator. In theUS the NCUA/NCUSIF operates an integrated system of R&S intervention, solvencyfunding and depositor compensation.

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Stabilisation is thus a risk management concept that seeks to sustainfinancial stability and minimise risks to deposit insurance funds. It is bestseen as the relationship between the complimentary risk minimisationmandates of R&S and DI systems and their participants. Typicallyresponsibility for operating a full risk management process is given to the

R&S authority with the DI system responsible for compensating depositors inthe event of credit union wind-down or failure. DI powers may include forpricing for risk, risk monitoring and providing funding for work out plans thatminimise the cost to the deposit protection funds. DI systems providestablisation funding only where it is the least-cost option.

Stabilisation systems are more than a fund from which financial assistancei.e. solvency support is provided. Typically their design is based on a processof early stage recognition of problems and intervention to prevent problemsfrom posing a risk to the fund. Modern regulatory and supervisoryapproaches adopt risk-based processes to monitor credit unions for signs oftrouble and engage in an escalating interventionist process up to and

including enforced mergers, organised wind-downs and purchase andassumption transactions.

Stablisation is also manifest within systems of early stage intervention whichprompt corrective action by R&S authorities. These are structuredcontingency risk planning and management approaches that assess and ratea credit unions risk profile into low, medium to high categories. Riskidentification in turn prompts corrective action of the R&S which engages inan escalating series of interventions to minimise the risk of failure. Typicallythese include taking over high risk credit unions through a system ofadministration, 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, operationalindependence from political and industry influence and one which operatestransparently with appropriate levels of public disclosure. Stablisation systemgovernance should be structured to minimise the potential for undue politicaland industry influence and conflicts of interest.

Stablisation is therefore a risk minimisation process; a continuum ofstructured interventions enabled by legislation and carried out by R&Ssystems. Measures aimed at rehabilitation may include the temporarysupport of an insolvent but otherwise viable credit union that candemonstrate a realisable recovery plan. In general the use of solvencyfunding or financial assistance such as loan guarantees is quite rare inmodern mature credit union systems as more often than not the credit unionis taking under control of the R&S authority who frequently appoint asupervisor to run the credit union until it can be wound down, merged etc.Stablisation funding is really only ever provided in cases where externalevents beyond the reasonable control of board and management havetemporarily undermined solvency.

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Where stabilisation funds (as distinct to stablisation systems) still exist, theseare used under robust supervision of credit union regulators who in exercisingtheir risk management powers may devolve supervision of at-risk creditunions to corporate credit unions. Such corporates, legislated for understatute are regulated and supervised credit union entities. When and ifappointed as supervisors, they may access legacy stablisation funds and or

obtain funding from the deposit insurance fund to provide temporarysolvency under agreed work-out plans with the system regulator. The key isthe decision to rehabilitate and provide funding is taken by that body havingthe powers to do so. In all cases this is the authority charged with regulationand supervision which may be either a stand alone regulator or depositinsurer/regulator. Thus while some but not all Canadian Provincial corporatecredit unions continue to maintain active stablisation funds these may onlybe used in agreement with the authority charged with risk minimisation.

Stablisation scheme options observations

Consideration of the appropriate stablisation system design should takeaccount of the existing regulatory and supervisory mandate. This answerswhat risk management powers and mandates a stabilisation system mighthave as its design must be cognisant of the organisational boundaries andpowers of existing mandates.

Given that the Central Banks mandate under public policy objectives asrecited in the Credit Union Act 1997 includes risk minimisation objectives, it isthe authority 2empowered to engage in risk minimisation. It is alsoresponsible and accountable to a higher authority from which it derives itspowers. 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 saythat powers are sufficient to effectively regulate and supervise credit unionsrather that regulation and supervision of credit unions by governmentagencies is considered a fundamental component of credit union safety nets.

Best practice and guidance preference is for risk minimisation (stablisation incredit union terminology) to have a legally enforceable statutory basis andreside within closely integrated but operationally independent R&S and DIsystems. This is not the case 3here at this time where both DI and R&S residewithin a single regulatory authority. While consideration as to whether this isthe optimal compensation design feature of a modern credit union safety netis outside the scope of the consultation document, some observations seem

appropriate.

Observations on DI design features

2Canadian Provincial laws enacted at the same time include specific sections dealing with depositguarantees, stabilisation and corporate credit unions.3As the extension of insurance coverage to credit unions in Sept 2008 was triggered by extraordinarycircumstances, the design features of an appropriate credit union DI system may not have been fullyconsidered.

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It is clear that close co-operation between the R&S and DI systems is requiredand design considerations rest with which agency has principal responsibilityfor stabilisation. In modern effective systems such authority rests either withthe 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 areindependent credit union R&S and DI systems deriving their authority fromGovernment 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 minimisationstablisation role and having independent powers of regulation, supervisionand intervention. Intuitively this makes sense as such a third party agencymandate would result in 4duplication of R&S and DI objectives, create hard toresolve inter-agency conflicts, be exposed to adverse selection, increasecosts and without state backing would not have the financial strengthrequired under crisis conditions. Moreover should the third party not be trulyindependent and governed in accordance with best practice principles then itcould be exposed to political and industry influence. Such a system could alsocontain inherent conflicts that could give rise to unique credit union moralhazard risks which are addressed later in this submission.

Thus one potential design could see R&S responsibility for the full riskmanagement process up to closure after which the DI would step in andcompensate savers. What minimisation role would a DI have? Internationallymodern credit union DI systems either provide for stabilisation funding ordirect the provision of funding by the manager of a legacy stablisation fund.As mandates require fund protection, they have a risk monitoring role andmay have stablisation enforcement powers to ensure compliance with R&S

work-out plans. DI authorities provide financial assistance only where theyare satisfied that the credit union has demonstrated a viable work out planand 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 alimited stabilisation mandate complimenting the R&S authoritys full riskmanagement system. Indeed this was the design of the 5ICUSP Bill publishedin early 2007 which, as it accords with international best practice, could beused as a template to inform the design of the appropriate DI system. Its bestpractice design features included mandatory participation by all creditunions, funding, reconstitution provisions and risk based pricing. Funding6

was envisaged by way of a contribution ranking as an asset on credit union

balance sheets. Scheme administration shortfall costs and individual creditunion risk premiums would be expensed. By insisting on reconstitution, co-insuring credit unions would be jointly and severally responsible for coveringany shortfall in the fund or costs of administration. This design feature turns

4More 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 dualcompensation (guarantee) and stabilisation mandate.6

Funding was not dependent on utilising existing stabilisation funds

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credit unions net worth into a supplementary off balance sheet fund ofinsurance reserves the scheme can draw on when needed. Besidesexpanding the size of the fund, it strengthens incentives for credit unions tomonitor 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 theDPS here. The current DPS design exposes credit unions to failure costs ofcommercial banking and banks to failure costs of credit unions. An enablingcredit union specific design feature could see the operation of a credit unionsub-fund through which credit unions co-insure one another.

The design of the current DPS system whilst providing for the possibility ofrisk based pricing- a risk minimisation tool - cannot provide for the differentsystems required to price unique credit union systemic and individual risk. Asa pay-box system and ex-post/ex-ante hybrid, it has design limitations thatinhibit the development of credit union risk based deposit insurancecoverage.

An additional and important benefit of an ICUSP type design is one where thecredit union ethos and co-operative principles are embedded within itsstakeholder governance model and the co-insurance aspect of a welldesigned credit union savings protection scheme that includes bothguarantee and stablisation elements.

The Statutory Stablisation Models (1) & (2) reflect a solution thatencompasses best practice in safety net design. In which case the designfeatures contained in the ICUPS Bill could inform a design that would embedcredit union co-operative principles within an operationally independentcredit union DI system which would be closely integrated with the Banks R&S

and DGS objectives.

Credit Union DI System Moral Hazard

How banking DI systems induce moral hazard is well understood. Bankmanagers may trade off deposit insurance and engage in looting the bank.Risk minimising safety net design features include risk based insurancepricing 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 poorgovernance and management, lax standards of compliance and captivity ofthe too big to fail director. Should stablisation be utilised or perceived asinsurance against credit union failure, this could amplify moral hazardbehaviour induced by a statutory deposit guarantee. Credit unions can anddo fail and no system should be utilised to prevent failure at all costs.

Whilst the objectives of self-regulatory safety net participant may incorporaterisk minimisation best practices, their governance, operations and utilisation

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of financial assistance may over time undermine system financial stability aspoorly governed and managed operations, that ought to be allowed fail ormerged, are permitted to continue as 7independent operations. In suchsystems an external shock could cause a solvency crisis for those weakenedcredit 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 routeto an optimal DI design solution for stabilisation as they do not fully accordwith international best practice and would require the establishment ofprivate safety net participant(s) whose operational independence could notbe assured to the same degree as a statutorily legislated, regulated andsupervised system. It isnt clear how best practice design features could becredibly deployed within such voluntary systems.

In this regard the IADIs Guidance paper on the Governance of DepositInsurance systems is instructive:

The sound governance of agencies comprising the financial system safety

net strengthens the financial systems architecture and contributes directlyto system stability. Operationally independent and accountable safety netorganisations with clear mandates and which are insulated from undue

political and industry influence provide greater integrity, credibility andlegitimacy than entities lacking such independence.

The deposit insurance system should have a governing body and thegoverning body should be held accountable to the authority from which thedeposit insurance system receives its mandate. The deposit insurancesystem should be structured such that the potential for undue political andindustry influence and conflicts of interest respecting members of thegoverning body and management is minimised.

This guidance has been re-iterated within an internationally agreed set ofCore Principles for Effective Deposit Insurance Systems published jointly bythe BIS and IADI in June 2009.

Credit Union Ethos Considerations

It is good that credit union philosophy has become a habit but not all habitsare 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 riskminimisation remit of statutory safety net participants.

In a recent research 8study to inform British credit unions on stablisation, itsauthor wrote Clearly, it would be unrealistic and inappropriate to consider

7Such systems may display tight common bond inflexibility and little if any of the consolidation andrationalisation activity found in those systems having long established statutory R&S and DI systems. Incomparison field of membership induces competitive incentives for credit unions to merge and enablesR&S intervention flexibility in arranging mergers.

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that ABCUL could implement a stand-alone stabilisation programme.Internationally, the trend is towards much greater Government regulatorinvolvement and away from free-standing private trade associationschemes.

Credit union philosophy doesnt hold that credit union owned and directed

self-regulatory, supervisory and stabilisation systems are fundamental topreserving the ethos. While stressing that the design of credit union safetynets must reflect the ethos, co-operative principles and uniqueorganisational, cultural and operational emphasis on serving their customerswho are also their owners, credit union leadership promotes statutory R&Sand DI systems worldwide.

The World Council of Credit Unions 9maintains:

Effective regulation and supervision of all financial institutionssafeguard the stability of a countrys financial system and protect thesavings deposits of its people.

While several models of credit union supervision have emerged, WorldCouncil of Credit Unions (WOCCU) maintains that the ministry oragency that regulates financial institutions should supervise creditunions through a specialized unit trained in their nature, risks andmethodologies.

WOCCU consistently finds that, in addition to stronger financialperformance, credit unions supervised by the financial sector regulatorenjoy greater public confidence and trust, which results in highermembership and savings growth.

Furthermore WOCCU advocates for credit union participation in nationalstatutory government backed DI systems.

In so far as preserving the credit union ethos is concerned statutorystablisation mechanisms have long since been deployed in other credit union10systems. There is no evidence that this led to a diminution of ethos. Indeedas system financial stability has been ensured, public confidence has beenunderpinned. In these systems, consolidation has led to economies of scaleand scope and greater investment in development. Membership has grownthrough expanded branch footprints, telephone and internet channelsoffering a full banking service.

8Stabilising 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 MooresUniversity, March 20109WOCCU: Technical Guide: Credit Union Regulation and Supervision

10Self-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 objectivesof risk minimisation to protect depositors and mandates defined within legislation that orders thestructuration of and relationship between safety net participants.

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Concluding comments

Deposit insurance systems are not designed to deal with systemicallysignificant failures or a systemic crisis and the costs of dealing with

systemic failures should not be borne solely by the deposit insurance systembut dealt with through other means such as by the state. In both normal andabnormal conditions the relationship between safety net participants iscritical. Thus stablisation powers must be must be seen as credible, legallyreliable and effective in implementing system wide resolution programmes ifpublic trust is to be maintained.

The appropriate design for stablisation should be based on clearunambiguous public policy objectives, have a sound legislative basis, propergovernance, clarity regarding participants roles, legal certainty regarding riskminimisation powers and be adequately resourced and funded for normalconditions.

It would appear then that the statutory stabilisation models (1) and (2)propose the appropriate path to the design of an important element of thecredit union financial safety net.

Bill HobbsSept 2010

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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

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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)

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