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 RCUConsultation@centralbank.ie

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

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 A PERSONAL SUBMISSION ON THE

CBFSAI CONSULTATION PAPER

CP 44

STABLISATION SUPPORT FOR CREDIT UNIONS

BILL HOBBS
24th September 2010

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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.

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
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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.

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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.

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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

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

2
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.
4
More so the case in small countries having a small pool of experienced regulatory and deposit insurance professionals.

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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. Funding6 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, co-insuring credit unions would be jointly and severally responsible for covering
any shortfall in the fund or costs of administration. This design feature turns 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 a credit union risk based risk 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
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

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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 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

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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.

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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 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.

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“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
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WOCCU: Technical Guide: Credit Union Regulation and Supervision

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In so far as preserving the credit union ethos is concerned statutory stablisation mechanisms
have long since been deployed in other credit union 10systems. 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.

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

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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.

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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
th
Principals 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 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)

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