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

2
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.
1
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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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.

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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

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.

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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, 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

4
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

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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

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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
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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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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
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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.

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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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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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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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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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