Regulators Speach to National Supervisor Forum

The full text of this important speach is reproduced here as published on the IFRSA website:

National Supervisors Forum
Annual General Meeting
3 & 4 November 2007
Speech by Brendan Logue
Registrar of Credit Unions

I am very pleased to be invited here again to your AGM which we regard as an important event for all supervisors and their credit unions also. It is very gratifying to see the National Supervisors Forum going from strength to strength as is clearly evidenced by the huge attendance at this weekend’s event.

Much has changed in the financial world since we met this time last year – the international markets in credit have contracted sharply giving rise to the so-called credit crunch.

Many blue chip shares have fallen sharply and the value of other investment instruments have been destabilised. It is therefore opportune to look carefully at the new financial environment in which credit unions now find themselves.

Anyone who has visited the United States over the past 10 years and who has watched television, cannot but have been struck by the heavy advertising of loans secured by mortgages on residential property. Very seductive advertisements, promising a reduction in monthly repayments by rolling up credit card and other debts into a single easily repayable mortgage loan, have been heavily promoted. These offers were pitched at people who, in many instances were not required to show proof of earnings or who already had a poor credit history. Loans for house purchase were also promoted in the same fashion. The American Dream was offered to all in the form of owning their own house and paying for it at affordable repayment terms.

However, many people who availed of these offers, foolishly or carelessly, signed up to mortgage backed loans not realising that, in many instances, and contrary to the normal American practice, the loans were based on variable rates of interest which kicked in after an initial fixed interest period. The frenetic promotion of these financial products reached such a pitch that the so-called Ninja mortgage was born - “No income / No job / No assets”. Lending was done on the sole premise that the property on which the loan was secured would always hold its value.

All that it would take to bring this house of cards toppling down was an increase in interest rates. Suddenly the repayments that many borrowers thought were fixed, increased dramatically.

This credit crisis might have been more easily contained within the borders of the US had it not been for the repackaging and onward sale of these sub-prime debts by the primary lenders to other financial institutions internationally. The accelerating collapse of the sub-prime market in the US very rapidly affected the worldwide banking system, causing serious losses to many European banks and resulted in the need to rescue others such as IKB in Germany and Northern Rock in the UK.

There are lessons for the credit union movement in what has happened. These lessons relate both to lending and investing by credit unions. Lax standards in lending inevitably lead to losses for the lender and misery for the borrower. Reckless investment practices have the same effect.

Consequently I would like to address some remarks to you on both topics. The relaxation, in recent years, of the lending terms operated by credit unions has increased the risk profile of the loan portfolio of the movement. It is not so long ago that credit unions made loans on much stricter terms than is currently the case. Loans were limited to a low multiple of the existing savings and income of the member. Business lending, such as is sometimes seen today involving loans over six figures, was unknown. Loans for speculative property developments were equally unusual.

The substantial inflow of liquidity to credit unions together with certain ill conceived strategies within the movement have increased the pressure for credit unions to move into the mainstream lending market, in competition with the banks. This has sometimes been done without due regard to the borrower’s ability to repay, in the absence of any credible credit check or without the taking of viable security.

Credit unions should now critically re-examine their credit policies in the light of the changing external environment. The Irish economy is not suffering a credit crunch to the same extent as the US but it is clearly the case that credit is tightening and that bad debts among credit unions are increasing.

Based on our recent inspections of credit unions we have found that in all cases where we have commissioned an in-depth analysis of a credit union’s loan portfolio, that substantial additional provisions for bad and doubtful debts have been identified.

The Credit Union Act, 1997 lays specific obligations on individual supervisory committees in credit unions to inspect and verify the accuracy of the books and records of the
credit union. Specific emphasis is laid on the verification of the loan records of the credit union.

In order therefore, to assist credit unions in the governance of the credit and credit control functions in the more difficult economic environment now developing, my department has issued a new guidance note on the credit and credit control functions. This document will have been received by credit unions within the last week. The guidance note should assist the relevant committees for the lending and credit control functions.

I recommend that all supervisory committees familiarise themselves with the contents of this easy-to-read document. I particularly wish to draw the attention of supervisors to the sections on Provisions for Bad and Doubtful Debts, Commercial Loans, Lump Sum Repayment Loans, Loan Rescheduling, and Security for Loans.

It may be the case that with margins in credit unions declining, that pressure may be felt by boards to maintain the dividend level of the credit union over and above that which would be fully justified by the underlying financial results of the year in question. Such pressure may result in a temptation to artificially increase the credit union’s surplus, by a variety of means.

The understatement of the provision for bad and doubtful debts is a feature of this tendency which we have commonly detected in our inspections. Various unacceptable devices to achieve this have been uncovered by our inspection teams. These include inappropriate rescheduling of overdue loans, the issuance of top-up loans in arrears situations or the exclusion from the provision calculation of overdue loans where security is held.

Supervisors should be alert to such practices and it should always be borne in mind that the board has a statutory obligation to show a true and fair view of the financial affairs of the credit union and to account for the savings of their members. The interests of the credit union are not served by any fudging of hard issues facing it in respect of bad debts or any other issue.

I would also like to draw the attention of supervisors to their obligations in respect of investments held by their credit unions.

Investments now constitute the single biggest asset class held by credit unions and, as such, require the same degree of oversight and analysis as do loans. It is vitally important that consideration of the security, liquidity and risk profile of the investments of credit unions are given due care and attention by supervisors. In many respects the overview of the investment process is a more difficult task than that of loans. Investments come in many types from many product producers and can contain a wide variety of terms and conditions. Add to this the fact that the management of many investments, once purchased by the credit union, are outside the control of the credit union.

It is therefore very important that before any investment decisions are made that full cognisance is taken of all the terms and conditions of the investment. All investments
should carry a capital guarantee by a reputable guarantor and be available for encashment without excessive penalties, if the need arises, in accordance with the credit union’s
investment policy. Of equal importance is the need for an assessment of the competence and probity of any investment advisor which the credit union uses. Scrutiny of the degree
to which such advisors are independent in the provision of investment advice is prudent. It is not acceptable for a board to blindly follow the advice of an investment advisor or broker. It should be remembered that in such situations the broker is generally not exposed to the risks associated with the investment. The authority for investment decisions and the responsibility for the consequences of such decisions rests with the board of the credit union. This responsibility cannot be delegated or outsourced.

Certain specific issues of a technical accounting nature have arisen with regard to investments. Investments must be valued in the credit union’s balance sheet in accordance with the stipulations of Section 110 of the Credit Union Act. This section stresses two important principles: firstly, investments must be accounted for in a prudent fashion and secondly, no unrealised surpluses may be taken into the income and expenditure account. Both of these principles have been tested in recent times in respect of certain investment instruments held by some credit unions. A number of credit unions hold investments which do not deliver a return on a year-by-year basis but promise a return on maturity of the contract at the end of a defined period. In many instances such periods may extend as far out as 6 or 7 years from the original purchase date of the instrument. Arising from this, it is now not uncommon for credit unions to accrue such returns in their income and expenditure account, before they are received. If however, the contract under which the investment was made is conditional in any way, e.g that the investment must be held until maturity before any return crystallises, then it could be questioned whether it is prudent to accrue such income. Whatever about this point, such accrued income should never be used to support the payment of a dividend. All such accrued income should be credited to a reserve pending realisation of the return and not distributed until then.

Another area where concern exists about accounting for investments is the question of their valuation. Investment values should be stated in the balance sheet at the lower of cost or net realisable value. This is the normal and traditional accounting convention in respect of the valuation of investments held by credit unions. We have noted that some credit unions have unilaterally adopted the accounting convention known as “Fair Value” under whose provisions it is acceptable to recognise gains in investments which have not been realised. Significant doubts arise as to the legality of the application of Fair Value accounting to credit unions and subject to further legal review there is a strong possibility that such accounting treatment will be found to be in breach of the provisions of Section 110 of the Credit Union Act. We are currently in discussions with representatives of the accounting profession on this matter and it is likely that an exposure draft of a practice note on the audit of credit unions’ financial statements will be issued soon by the Institute of Chartered Accountants which will refer, among other matters, to this issue.

In this regard supervisors will be aware that the Irish League of Credit Unions issued a circular concerning the accounting treatment of investments dated 27 September 2007. This circular implies that Fair Value accounting is an acceptable policy for credit unions. I would like to point out that this circular has no standing with the Financial Regulator nor indeed within the accounting profession.

Supervisors as signatories of the credit union’s annual accounts have an implied obligation to see that proper accounting standards are employed. I urge all supervisors to see to it that the provisions of Section 110 of the Credit union Act are strictly observed. Should supervisors be in
any doubt as to the interpretation of these provisions they should consult their auditor or their legal advisor. Staff at my own office will be happy to discuss the issues surrounding this matter with supervisors or directors, should they so wish.

I know that many supervisors perform their role in sometimes difficult circumstances.
I would therefore like to reassure supervisors that their role is highly valued by the Financial Regulator and you can be assured that we will do what we can to support supervisors
in the discharge of their statutory duties.

My general impression with regard to the evolution of the relationship between credit unions and their members is that more emphasis is placed on the growing of lending and other
services to members than is placed on the rights of savers.

The role of the supervisory committee is an important counterbalance to this tendency and one which is vital for the protection of savers’ interests.

Could I thank you again for this opportunity to address this meeting. I would be happy, if time permits, to address any questions which delegates may have on the matters I raised.