Are Irish Credit Unions Safe?

In a Irish Times online poll 41% answered no and 59% yes. The result must be a concern given recent media stories highlighting significant regulatory concerns over rising loan losses. Twenty credit unions are said to be facing solvency problems with many more having to increase loan loss provisions again this year.

ILCU does a McCreevy on loan modification, demanding light touch regulation

Ireland’s new financial regulator Elderfield would do well to read into the McCreevy saga.

Earlier this decade the Minister believing he had stuck a bargain with the ILCU discovered that no sooner was the ink dry on the page but the deal was undone. ILCU couldn’t deliver on their side of the bargain. The deal would have resolved the long running conflict sparked by the Ministers and Revenue Authorities desire to tax savers dividends – to apply DIRT. McCreevy discovered that ILCU couldn’t deliver. To make matters worse it did a U turn blaming the Minister for intransigence and undertook an intense emotionally charged lobbying campaign threatening to run candidates in a national election campaign. The emotional card played, claimed old age savers would be penalised if DIRT was deducted.

The saga ended when Taoiseach Bertie Ahern, faced with revolt from independent TD’s whose support he needed for his wafer thin majority forced McCreevy into an embarrassing climb down. McCreevy predicted non-DIRT accounts would become a haven for tax evasion. He appears to have been right as balances ballooned to over €9bn. Despite the introduction of a Dirt alternative fully 90% of savings remain in non-DIRT accounts.

The recent manifestation of the ILCU double shuffle is seen in ILCU’s dramatic U turn on Section 35 amendments contained in Ireland’s clean up of its regulatory system. Changes to credit union laws will allow them to lend for longer periods. They will be able to lend up to 30% of loans over 5 years. This change was lobbied for by trade bodies ILCU and CUDA to allow credit unions reschedule bad loans. This loan modification (rescheduling) forbearance programme they say will allow bad loans to once again become good ones. But the regulator had a few conditions such as mandating loan loss provisions, liquidity and solvency standards and proper credit risk assessment of rescheduling applications.

When new loan limits were announced the Mount Street double act “Bailey & Brennan” were effusive in their welcome of Section 35 changes. Here’s what they had to say:

“Commenting on the announcement, Mark Bailey, President of the ILCU, said “We had a meeting with the Minister for Finance about this issue and he was very anxious to help credit unions help their members. He asked that this issue was resolved between the ILCU and the Registrar of Credit Unions to offer all credit unions and their members more flexibility and clarity on the issue of loan repayment. We are satisfied to have brought about a conclusion to these negotiations as we have been lobbying for this intensely over the past number of months”.

The other half of the double act, Brennan added:

“Whilst recognising the benefits that this announcement will bring to credit union members and ILCU affiliated credit unions, there are also conditions attached to rescheduling of loans, certain provisioning against bad debts and particular liquidity levels must be maintained. There are also clear definitions of what constitutes a rescheduled loan. All applications must be supported by appropriate fact finding and loans can only be rescheduled in agreement with the member. Regular evaluations of said loans by credit unions will be put in place in order to provide reports to their respective boards. This new arrangement is good for our members and good for credit unions”.

So there you have it. The scene was set for a Mount Street Shuffle. Faced with angry members, including a bunch from Cork threatening an EGM, the shuffle began and with considerable egg on chin Mount Street did a U turn, alleging it had been deceived. The regulator has snuck in stuff it hadn’t agreed to.

But have a look at the statements above. The conditions agreed to by Mount Street are:

1. Provisioning against bad debts
2. Liquidity levels
3. Definition of rescheduled loans
4. Fact finds – proper credit assessment
5. No selling of loan modifications – borrowers must ask for it
6. Careful monitoring of modified loans

It was known back in March the regulator would require provisions to be made at 20% of the modified loan. CUDA were agitated about this aspect. In fact CUDA wanted the limit to be 30% of assets and not loans and didn’t want to have to provide as it reckoned once modified a bad loan becomes good.

Chief bank regulator Elderfield and new credit union regulator James O’Brien must be wondering when is a deal a deal ? Can credit unions ever stick to a bargain? Faced with worsening bad debts and severe stability problems with a growing number of credit unions, they are being subjected a “McCreevy”.

Of course the real underlying issue is not so much the regulatory conditions but that the regulator is to be finally permitted to issue mandatory legally binding rules - something that has galvinised credit union activists who want to preserve the light touch regulation the have fought to hard to maintain.

ILCU lobbies hard for light touch regulation

The muftis of mount street have called the faithfull to jihad and issued a fatwa on the regulator. Phone lines are buzzing to the sound of die hard activist lobbying.

Just when will Irish credit union activists listen to and understand the mood music coming from the regulator and department of finance. Both bodies realise the sector is heading towards a crisis, a tipping point beyond which the sector will spiral out of control. Yet credit unionists have the gall to attack a regulator and minister and demand light touch regulation. The minister has agreed to extend loan limits to allow credit unions rescheduled bad loans and is to give the regulator the wherewithall to control for lending risks. The same minister has taken over two building societies in recent weeks.

Are they serious? The state is on the hook after implicitly guaranteeing €11.5bn in household savings held in credit unions. Do credit unionists believe the state will allow moral hazard to go unchecked within a sector not known for its professional management or governance. A sector in which some credit unions have yet to hold their agms for last year. A sector in which twenty credit unions are in serious trouble. A sector that has shown an inability to respond to change for over two decades.

After losing hundreds of millions in investments they should never have made and lent recklessly during the boom many credit unions are struggling with a disintegrating loan book. Caught in the glaring sun of the worst of economic recessions loan books are wilting in the heat as arrears climb towards 15%. They will be lucky if they stop at 20%. At the same time new loan issues have collapsed which will shrink total loans and loan income.

Have any bothered to project forward financial performance taking account of known risks? How many have even bothered assessing loans properly. 100 loan reviews later and the regulator found between 85-95% hadn’t properly provided for bad debts. Without doubt the larger credit unions were reviewed. Which means the top 100 who book 80% of all loans and hold 80% of all savings are a weeping stick of gelignite primed to go off later this year.

Informed media commentators and analysts have spotted the warning signals:

Irish regulators solvency claim angers credit union chief
Regulator fears over rising credit union arrears
Credit union debt is a timb bomb for the whole sector
credit unions show cracks from legal sledgehammer
credit union groups want to avoid paying for sins
fallout from credit unions likely to reach stock exchange
credit unions face solvency issues
no property issues a credit unions but arrears loom
regulator predicts difficult year ahead
credit unions receiving cash support
central liquidity fund for credit unions needed

St Anatomy illustrates what's to happen next?

The board of St Anatomy is on the warpath, cussing the registrar for its most recent brazen move to reign in Anatomy's right to run its own affairs without interference. After all no Irish credit union has ever needed a red cent of tax payers money. Of course the fact that St Anatomy has benefitted from state aid for the past 35 years since it was founded is lost on the board. Thing is nearly every red cent of its reserves represent taxes foregone by the Irish state. And of course there's the ubiquitous share account with its DIRTless status which members of Anatomy piled their money into ignoring the optional special DIRT bearing share account.

Anatomy is blissfully unaware of the consequences of its coming of age as a regulated credit co-operative. Having a typical underlent overinvested balance sheet Anatomy has lived within an impermeable bubble carefully crafted using a rhetoric that believes credit unions are different from banks - they are of course a form of banking called a credit co-operative which needs careful prudential governance, management and regulation.

Why is it on the warpath. Well the Government has agreed to extend loan limits allowing Anatomy to lend up to 30% of its loan book over five years. That's good as Anatomy has a big problem with arrears and would like to cut their members come slack by rescheduling loans to make them more affordable. But the Registrar for Credit Unions has attached some quite nasty conditions. It says that if a loan is rescheduled then Anatomy will have to provide 20% in bad debts - 15% up to 2011 and after that 20%. Worse still is a payment is missed then it will have to provide 100% of the net loan balance (after adjusting for attached share balances).  And even more disgraceful the regulator wants loan repayment capacity to be assessed! Anatomy is not even a member of the Irish Credit Bureau and prefers to assess loans on past performance.

Anyhow Anatomy has a problem its directors cannot see - its heading towards a cliff edge with no brakes; Here's what it is:

St Anatomy Credit Union

Provincial Town
Population 20,000
Members 15,000

Balance Sheet
Assets
Loans                                44
Provisions                          (2)
Cash/Liquidity                   15
Investments                       35
Property                             8

Liabilities
Shares (Non-Dirt)            75
Shares (Dirt)                    15
Deposits                            1

Reserves
Regulatory                         9
Other                                0

Anatomy has 15% of its loans in arrears or €6.75m and moves to reschedule on customer request €4m triggering a provision requirement of 15% or .6m. At the same time it will write off .5m and provide an additional 1.5m which includes a large developer loan of 1m which it is providing in full. Between provisions and write downs the bill comes to 2.1m. It has 2m in an investment having a market value of 1.25m and needs to write down .75m. But it’s also 1m shy of its regulatory reserve target of 10m leaving it with a min surplus target of 3.85m before a dividend can be declared.

Anatomy is a typical credit union with median margin profile on loans and investments and has a cost income ratio of 50%. It can expect to generate net income of €2.94m. So it can meet its bill for bad loans and investments of 2.85m which leaves .09m for topping up its reserves to 9.09m. But it cannot declare a dividend for the second year running.

Anatomy heads into next year with further demand for rescheduling as loans in arrears increase to 20% of the non rescheduled book. The loan portfolio is aging as new loan volumes decline by 25% resulting in a drop in total loans to 40m of which 7.2m is non-performing and 4m rescheduled. The decline in loans issuance is more than matched by a drop in savings levels down 10m. Anatomy has been unable to reduce its costs on line with its shrinking balance sheet. It also discovers that loans issued in 2009 and 2010 are showing an alarming spike in arrears profile which is down to its customers use of the credit union to fund income shortfalls including mortgage repayments.

CUDA shines a light on its philosophical approach to lending

Last week it was the turn of CUDA to promote its brand of credit unionism. It too appeared before the Joint Commitee on Economic Regulatory Affairs. Rather like ILCU, you can read it’s version of bread buttering here:
http://debates.oireachtas.ie/DDebate.aspx?F=ERJ20100216.XML&Ex=All&Page=1

There were no surprises. It said that it supported the single regulatory authority –the Central Bank Commission and the statutory function of the current Register of Credit Unions. But it went on to critique the regulator for its “one size fits all” approach to prudential supervision. Problem is the legislation only allows for a one size fits all approach.

It maintains that credit union member consumer protection should differ from consumer protection afforded the other forms of member owned banking – that of member owned and governed building societies. The ambiguity wasn’t missed on politicians who realise of course that outside of their core savings and loans business credit unions have to comply with mandatory consumer protection codes and minimum competency requirements.

CUDA’s promotion of longer term lending limits for credit unions was quite illuminating. It wants lending limits over five years of 30% and wants this calculated on total assets and not the loan portfolio. And it seems to have a problem with a prudential liquidity requirement complaining that it’s an arbitrary figure plucked from thin air. Makes you wonder where the arbitrary 30% loan limit is coming from? CUDA of course didn’t provide any cogent rationale why it wants a 30% to total loans lending flexibility.

One wonders how many of its member credit unions applied for and were approved for the increased lending limits allowed for under the Ministerial review of lending limits 2007 which resulted in legislation permitting credit unions lend 40% over five years and 15% over ten years subject to a regulatory application and approval process introduced in October 2007.

In quite an extraordinary unreconstructed pre-Lehman view CUDA said “One of our philosophical issues in using liquidity as the benchmark for longer term lending is that the level of capital is more important than liquidity. This has proved to be the experience with other credit union movements and in various banking sectors. Using liquidity is not best regulatory practice.”

To wit the response from a bemused politician was “I would always like to have cash in the bank. It is the best form of capital.”

CUDA's Version of Loan Flexibility
Here’s some maths to illustrate CUDA’s point of view. The average credit union is about 50% lent – some are far lower. So let’s take a 50% one and one at 42% which is closer to the median.

Say we look at a credit union with total assets of €100m:

(1) shows the effect of raising the current limit by 10% as a  percentage of total loans and (2) the CUDA version of relating the entire 30% limit to total assets.

The effect of (2) is quite dramatic. Is CUDA really serious about increasing the loan exposure over five years from €10m to €30m, an increase of €20m with 60% of the loan book lent out for over five years? Were a credit union to achieve 70% of total assets in loans under CUDA's version this would allow for 43% of lending over five years of more. This may be an achievable long term goal but the risk implications of the resultant asset/liability mismatch and required prudential safeguards were not addressed.

What’s the rationale for longer term lending – to be able to accommodate loan rescheduling for financially vulnerable borrowers? Or to make more loans between five and ten years? Well it says it’s to do both.

Maybe CUDA thought they could pull the wool over the eyes of the politicians by claiming that rescheduling wouldn’t really lead to higher risks or require adequate provisioning. Maybe it thought politicians would share its “philosophical” approach to liquidity not being as important as capital.

If you extend the duration of any loan portfolio then you widen the mismatch between assets and liabilities. In effect three risks are amplified: liquidity, interest rate and credit risk. Longer term lending is riskier. But CUDA doesn’t appear to think so ….

Enter the Mythical Member Argument .....

It seems what credit unions really need is to reschedule loans. An example was provided of a member of 40 years, married with two children who realising he cannot afford his repayments any longer approaches his credit union before he defaults to see what can be done. The credit union is now on notice the borrowers’ ability to repay within the terms of his contract is impaired and suggests rescheduling the loan over a longer term, thus reducing his repayments to a level he can afford. Thus the need for longer term lending limits.

Now according to CUDA this doesn’t necessarily give rise to a provision as loan repayments would be affordable under the new agreement. So what part of this is odd?

Well the insistence there is no increase in credit risk ! According this logic in all cases of rescheduling (a) because the new repayment is now affordable a provision doesn’t apply and (b) 30% of the loan book will be required to fund the rescheduling scheme. That’s unless there’s a huge demand for borrowings over five years from credit unions which contradicts the actual experience of a decline in demand for loans.

Suppose there is a demand for loans over five years then it begs the question what are the loans for? Cars? Houses? Holidays? Rescheduling other debts? Probably the latter.

So there you have it: an argument to increase lending risk, lesson liquidity, lower provisions for rescheduled loans and increase the default risk on loan portfolios. Widening the asset liability mismatch appears to be an acceptable moral hazard dimension of a philoposphical approach to prudential management.

It would have been a Punch and Judy show had the issues not been so serious. CUDA was claiming that the current and proposed 10% increase in current lending limits were undermining the dividend based business model without providing a scintilla of proof why this was the case. Strangely there was no mention at all of its own previous identification of the core problem:

“ it is incorrect to blame the decline in key credit union metrics on action or the lack of action by Government or the Financial Regulator. Instead, the central thesis of this paper is that the challenges now facing credit unions result, to a large extent, from the reluctance of many in the movement to accept a fundamental reality: The business model still employed by many credit unions is largely unchanged from the one that was developed – and worked very well – in an Ireland very different from today…… The reality that must be confronted by credit unions is this: Their products, delivery systems, marketing approaches, and methods of management and governance – all the elements of the credit union business modelwere designed for an Ireland that barely exists any more. It is not that credit unions failed to change in the past 20 years. It is that Ireland has changed so much more, and so quickly, it has almost left them behind.” CUDA 2006

ILCU demands fall on deaf ears?

Joint committee on Economic Regulatory Affairs hears of ILCU fears that regulation may become too robust

Murphy’s Law dictates that a buttered slice of bread will invariably land buttered side down should you drop it on your lap. On the 2nd February last, the ILCU brought the entire loaf and proceeded to butter both sides before dropping it on its lap.

You can read of its bread buttering episode here: http://debates.oireachtas.ie/DDebate.aspx?F=ERJ20100202.xml&Node=H2#H2

It’s once again a story of unreconstructed Irish brand of credit unionism combining with a trade body’s corporate ambition to become an in-system regulator. ILCU wants to become the central governing corporate body for every registered credit union. This ambition bears some resemblance to federalist systems found at the heart of European credit co-operatives, Canadian Des Jardins and to a lesser extent Canadian Credit Unions. Key to these systems working is the notion of devolved supervisory authority from state regulators -a form of state and private system supervision and regulation.

Rather than argue for a proper Irish federalist co-operative system, ILCU wants to turn the clock back to the good old days when it held the credit union regulator captive of its corporate designs. The days when under the Department of Enterprise Trade and Enterprise (DETE) it almost managed to get its savings protection scheme – an ad-hoc insystem regulatory process – approved under section 46 of the 1998 credit union act.

(In 2001 on announcing the enactment of section 46, the departmental press release says that only non-affiliates of ILCU need comply, implying of course that ILCU’s scheme was an approved one. Which of course it wasn’t and it remains unapproved to this day.)

Promoting a return to the past, ILCU built its argument on fears that the Central Bank Commission will regulate and supervise credit unions as banks. There isn’t a scintilla of factual evidence to back this assertion.

At this time the Financial Regulator is engaging consultants to produce a report:

The Minister for Finance has directed the Financial Regulator to carry out a strategic review of the credit union sector in Ireland. This will involve an examination of the structure, operation, regulation and legislation of the credit union sector with a view to providing a report making recommendations, including specific proposals to strengthen prudential soundness, which will advise and inform an assessment of the future strategic direction of credit unions. CBFSAI 22nd December 2009.

In fact ever since the establishment of IFRSA in 2003, the experience has been of an effective regulatory approach being executed for credit unions - appreciative of their organisational form. For example fitness and probity, consumer protection, minimum competency codes are to be developed specifically for credit unions whose core business is not regulated under codes of business conduct applying to banks.

In referring to separate regulatory authorities ILCU said : “All large developed countries of the Western world that have credit union movements have separate regulation for them.” They do of course have separate “regulations” but not all have separate “regulators” for example Australia and the UK.

It seems the only argument ILCU could make related to “some” volunteers experiencing an overzealous approach by the regulator. Is ILCU dealing in rhetoric and perceptions rather than facts or reality? It appears so.