Stabilisation Support Schemes Bh0910


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Submission on Central Bank consultation on credit union stabilisation

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Stabilisation Support Schemes Bh0910

  1. 1. 7 Clorane Brook Ballyfair The Curragh Co KildareRegistry of Credit UnionsFinancial RegulatorPO Box 9138College GreenDublin 224th September 2010By e-mail RCUConsultation@centralbank.ieA personal submission on CP 44: Stabilisation Support for Credit UnionsDear Sir,I am pleased to make this personal submission in response to the consultation paper onstabilisation support for credit unions. The format of my response considers the internationalcontext for the design of modern credit union financial safety nets in particular the design ofand relationship between prudential regulation and supervision and deposit insurance.My view is stabilisation, as a risk minimising objective of deposit insurance, is a fundamentalrequirement for modern credit union systems. How this might be best designed into thefinancial 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 proposea reasonable basis for considering the best design for the Irish credit union sector.Yours faithfully,Bill Hobbs24th September 2010 1
  3. 3. I am pleased to make this personal submission in response to the consultation paper onstabilisation support for credit unions. The format of my response considers the internationalcontext for the design of modern credit union financial safety nets in particular the design ofand relationship between prudential regulation and supervision and deposit insurance.My view is stabilisation, as a risk minimising objective of deposit insurance, is a fundamentalrequirement for modern credit union systems. How this might be best designed into thefinancial 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 proposea reasonable basis for considering the best design for the Irish credit union sector.Observations on the Credit Union Stabilisation conceptThe financial safety net typically comprises three elements, prudential regulation andsupervision, a lender of last resort and deposit insurance. The distribution of powers andresponsibilities between participants is a matter of public policy choice and individual countrycircumstances.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 iseither a sub-function of a larger single regulatory authority or an independent participant in theoverall financial services system. In all cases the ultimate authorities are national ministries forfinance. In most cases, save for developing nations, national DI systems are mandatory requiringall credit unions to participate.The R&S system operates as a risk manager identifying “at risk” operations and engaging in earlystage intervention. It may apply for and use funds provided by either stabilisation fund ordeposit insurance fund managers. In many cases these are one and the same as the 1DI fundprovides solvency funding to prevent a larger call on its resources. The objective of any DI is toinsure customers’ deposits not to insure credit union solvency. Where they exist, stabilisationfunds are not managed as “solvency insurance” as this would give rise to unacceptable moralhazard risks.Stabilisation is thus a risk management concept that seeks to sustain financial stability andminimise risks to deposit insurance funds. It is best seen as the relationship between thecomplimentary 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&S1 Canadian Provincial DGS are regulator, stabiliser and deposit compensator. In the US the NCUA/NCUSIFoperates an integrated system of R&S intervention, solvency funding and depositor compensation. 3
  4. 4. authority with the DI system responsible for compensating depositors in the event of creditunion wind-down or failure. DI powers may include for pricing for risk, risk monitoring andproviding funding for work out plans that minimise the cost to the deposit protection funds. DIsystems 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 supportis provided. Typically their design is based on a process of early stage recognition of problemsand intervention to prevent problems from posing a risk to the fund. Modern regulatory andsupervisory approaches adopt risk-based processes to monitor credit unions for signs of troubleand 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 correctiveaction by R&S authorities. These are structured contingency risk planning and managementapproaches 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 escalatingseries of interventions to minimise the risk of failure. Typically these include taking over high riskcredit unions through a system of administration, supervision or conservatorship whilst a work-out is arranged. Naturally to be effective stabilisation intervention must be legally enforceableand carried out by an authority having the credibility, integrity, operational independence frompolitical and industry influence and one which operates transparently with appropriate levels ofpublic disclosure. Stablisation system governance should be structured to minimise the potentialfor undue political and industry influence and conflicts of interest.Stablisation is therefore a risk minimisation process; a continuum of structured interventionsenabled by legislation and carried out by R&S systems. Measures aimed at rehabilitation mayinclude the temporary support of an insolvent but otherwise viable credit union that candemonstrate a realisable recovery plan. In general the use of solvency funding or financialassistance such as loan guarantees is quite rare in modern mature credit union systems as moreoften than not the credit union is taking under control of the R&S authority who frequentlyappoint 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 thereasonable control of board and management have temporarily undermined solvency.Where stabilisation funds (as distinct to stablisation systems) still exist, these are used underrobust supervision of credit union regulators who in exercising their risk management powersmay 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 ifappointed as supervisors, they may access legacy stablisation funds and or obtain funding fromthe deposit insurance fund to provide temporary solvency under agreed work-out plans with thesystem regulator. The key is the decision to rehabilitate and provide funding is taken by thatbody having the powers to do so. In all cases this is the authority charged with regulation andsupervision which may be either a stand alone regulator or deposit insurer/regulator. Thus whilesome but not all Canadian Provincial corporate credit unions continue to maintain activestablisation funds these may only be used in agreement with the authority charged with riskminimisation. 4
  5. 5. Stablisation scheme options – observationsConsideration of the appropriate stablisation system design should take account of the existingregulatory and supervisory mandate. This answers what risk management powers and mandatesa stabilisation system might have as its design must be cognisant of the organisationalboundaries and powers of existing mandates.Given that the Central Bank’s mandate under public policy objectives as recited in the CreditUnion Act 1997 includes risk minimisation objectives, it is the authority 2empowered to engagein risk minimisation. It is also responsible and accountable to a higher authority from which itderives its powers. This policy objective, governance and mandate of the Irish credit union R&Ssystem is in line with international best practice. This is not to say that powers are sufficient toeffectively regulate and supervise credit unions rather that regulation and supervision of creditunions by government agencies is considered a fundamental component of credit union safetynets.Best practice and guidance preference is for risk minimisation (stablisation in credit unionterminology) to have a legally enforceable statutory basis and reside within closely integratedbut operationally independent R&S and DI systems. This is not the case 3here at this time whereboth DI and R&S reside within a single regulatory authority. While consideration as to whetherthis is the optimal compensation design feature of a modern credit union safety net is outsidethe scope of the consultation document, some observations seem appropriate.Observations on DI design featuresIt is clear that close co-operation between the R&S and DI systems is required and designconsiderations rest with which agency has principal responsibility for stabilisation. In moderneffective systems such authority rests either with the R&S system or the DI where R&S and DIare one and the same authority (Canada) or DI is administered by the R&S system (US). Theseare independent credit union R&S and DI systems deriving their authority from Governmentministries of finance.There is no modern system where stabilisation rests with a third entity, whether statutory orprivate, designed to fulfil a full risk minimisation stablisation role and having independentpowers of regulation, supervision and intervention. Intuitively this makes sense as such a thirdparty agency mandate would result in 4duplication of R&S and DI objectives, create hard toresolve inter-agency conflicts, be exposed to adverse selection, increase costs and without statebacking would not have the financial strength required under crisis conditions. Moreover shouldthe third party not be truly independent and governed in accordance with best practiceprinciples then it could be exposed to political and industry influence. Such a system could also2 Canadian Provincial laws enacted at the same time include specific sections dealing with deposit guarantees, stabilisation andcorporate credit unions.3 As the extension of insurance coverage to credit unions in Sept 2008 was triggered by extraordinary circumstances, the designfeatures of an appropriate credit union DI system may not have been fully considered.4 More so the case in small countries having a small pool of experienced regulatory and deposit insurance professionals. 5
  6. 6. contain inherent conflicts that could give rise to unique credit union moral hazard risks whichare addressed later in this submission.Thus one potential design could see R&S responsibility for the full risk management process upto closure after which the DI would step in and compensate savers. What minimisation rolewould a DI have? Internationally modern credit union DI systems either provide for stabilisationfunding or direct the provision of funding by the manager of a legacy stablisation fund. Asmandates require fund protection, they have a risk monitoring role and may have stablisationenforcement powers to ensure compliance with R&S work-out plans. DI authorities providefinancial assistance only where they are satisfied that the credit union has demonstrated aviable 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 limitedstabilisation mandate complimenting the R&S authority’s’ full risk management system. Indeedthis was the design of the 5ICUSP Bill published in early 2007 which, as it accords withinternational best practice, could be used as a template to inform the design of the appropriateDI system. Its best practice design features included mandatory participation by all creditunions, funding, reconstitution provisions and risk based pricing. Funding6 was envisaged by wayof a contribution ranking as an asset on credit union balance sheets. Scheme administrationshortfall costs and individual credit union risk premiums would be expensed. By insisting onreconstitution, co-insuring credit unions would be jointly and severally responsible for coveringany shortfall in the fund or costs of administration. This design feature turns credit unions networth into a supplementary off –balance sheet fund of insurance reserves the scheme can drawon when needed. Besides expanding the size of the fund, it strengthens incentives for creditunions to monitor one another.Generally it is important that system co-insurance funds be ring-fenced within either the creditunion DI or a sub-fund created within a wider DI such as the DPS here. The current DPS designexposes credit unions to failure costs of commercial banking and banks to failure costs of creditunions. An enabling credit 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 of risk based pricing- arisk minimisation tool - cannot provide for the different systems required to price unique creditunion systemic and individual risk. As a pay-box system and ex-post/ex-ante hybrid, it has designlimitations that inhibit the development of a credit union risk based risk deposit insurancecoverage.An additional and important benefit of an ICUSP type design is one where the credit union ethosand 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 bothguarantee and stablisation elements.The Statutory Stablisation Models (1) & (2) reflect a solution that encompasses best practice insafety net design. In which case the design features contained in the ICUPS Bill could inform a5 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 6
  7. 7. design that would embed credit union co-operative principles within an operationallyindependent credit union DI system which would be closely integrated with the Bank’s R&S andDGS objectives.Credit Union DI System Moral HazardHow banking DI systems induce moral hazard is well understood. Bank managers may trade offdeposit insurance and engage in looting the bank. Risk minimising safety net design featuresinclude 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. Withincredit union systems moral hazard manifests itself in poor governance and management, laxstandards of compliance and captivity of the “too big to fail” director. Should stablisation beutilised or perceived as insurance against credit union failure, this could amplify moral hazardbehaviour induced by a statutory deposit guarantee. Credit unions can and do fail and nosystem should be utilised to prevent failure at all costs.Whilst the objectives of self-regulatory safety net participant may incorporate risk minimisationbest practices, their governance, operations and utilisation of financial assistance may over timeundermine system financial stability as poorly governed and managed operations, that ought tobe allowed fail or merged, are permitted to continue as 7independent operations. In suchsystems an external shock could cause a solvency crisis for those weakened credit unions andtrigger 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 DIdesign solution for stabilisation as they do not fully accord with international best practice andwould require the establishment of private safety net participant(s) whose operationalindependence could not be assured to the same degree as a statutorily legislated, regulated andsupervised system. It isn’t clear how best practice design features could be credibly deployedwithin such voluntary systems.In this regard the IADI’s Guidance paper on the Governance of Deposit Insurance systems isinstructive:“The sound governance of agencies comprising the financial system safety net strengthens thefinancial system’s architecture and contributes directly to system stability. Operationallyindependent and accountable safety net organisations with clear mandates and which areinsulated 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 the governing body should beheld 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 and7 Such systems may display tight common bond inflexibility and little if any of the consolidation and rationalisation activity found inthose systems having long established statutory R&S and DI systems. In comparison “field of membership” induces competitiveincentives for credit unions to merge and enables R&S intervention flexibility in arranging mergers. 7
  8. 8. industry influence and conflicts of interest respecting members of the governing body andmanagement is minimised.”This guidance has been re-iterated within an internationally agreed set of Core Principles forEffective Deposit Insurance Systems published jointly by the BIS and IADI in June 2009.Credit Union Ethos ConsiderationsIt 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 safetynet 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 that ABCUL could implement astand-alone stabilisation programme. Internationally, the trend is towards much greaterGovernment regulator involvement and away from free-standing private trade associationschemes.”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 stressingthat the design of credit union safety nets must reflect the ethos, co-operative principles andunique organisational, cultural and operational emphasis on serving their customers who arealso 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 governmentbacked DI systems.8 “Stabilising British Credit Unions; A research study into the international rationale and design of credit union stabilisationprogrammes.” Paul A Jones, Research Unit for Financial Inclusion, Liverpool John Moores University, March 20109 WOCCU: Technical Guide: Credit Union Regulation and Supervision 8
  9. 9. In so far as preserving the credit union ethos is concerned statutory stablisation mechanismshave long since been deployed in other credit union 10systems. There is no evidence that this ledto a diminution of ethos. Indeed as system financial stability has been ensured, publicconfidence has been underpinned. In these systems, consolidation has led to economies of scaleand scope and greater investment in development. Membership has grown through expandedbranch footprints, telephone and internet channels offering a full banking service.Concluding commentsDeposit 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 bythe deposit insurance system but dealt with through other means such as by the state. In bothnormal and abnormal conditions the relationship between safety net participants is critical. Thusstablisation powers must be must be seen as credible, legally reliable and effective inimplementing system wide resolution programmes if public trust is to be maintained.The appropriate design for stablisation should be based on clear unambiguous public policyobjectives, have a sound legislative basis, proper governance, clarity regarding participant’sroles, legal certainty regarding risk minimisation powers and be adequately resourced andfunded for normal conditions.It would appear then that the statutory stabilisation models (1) and (2) propose the appropriatepath to the design of an important element of the credit union financial safety net.Bill HobbsSept 201010 Self-regulatory stabilisation systems once a feature of US and Canadian credit union self-directing systems have long since givenway to statutory R&S and DI systems having clear public policy objectives of risk minimisation to protect depositors and mandatesdefined within legislation that orders the structuration of and relationship between safety net participants. 9
  10. 10. Useful Informative DocumentsCredit Union Savings Protection Bill 2007 No. 15 of 2007: IrelandThe Credit Union Act 1998, Part XXXIV CUDGC, Saskatchewan, CanadaThe Credit Union and Caisses Populaires Act (Consolidated) : Manitoba, CanadaThe Federal Credit Union Act, Revised June 2007: USACredit Union Risk-Based Supervisory Framework: Monitoring, Staging and Intervention, Credit Union DepositGuarantee Corporation, Saskatchewan, CanadaCredit Union Deposit Insurance Corporation of British Columbia, Financial Institutions Act, 1994, Part 9, Division 3stabilisation: BC CanadaCredit 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 2002Submission to Basel Committee on Banking Supervision and International Association of Deposit Insurers “Core thPrincipals for Effective Deposit Insurance Systems” World Council of Credit Unions May 15 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 paper96/83 (Washington: International Monetary Fund)“Deposit Insurance: A Survey of Actual and Best Practices”: IMF Working Paper 99/54 “Deposit Insurance: Actual andGood Practices”: IMF Occasional Paper“Deposit Insurance, Moral Hazard and Market Monitoring”, ECB Working Paper No. 302 (Frankfurt: EuropeanCentral 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 forDeveloping Differential Premium Systems” ,“General Guidance for Resolution of Bank Failures”, “Governance ofDeposit 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 FTodd (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 unionstabilisation 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) 10