With now over 200 loss making operations, Ireland's network of independent stand alone mini-banks will almost certainly face a major run on savings later this year.
Once savers figure out their credit union can’t pay a dividend and will be unlikely to be able to pay next year as well, they will move in droves to high street government guaranteed banks.
Why can’t credit unions pay a dividend?
The straight forward answer is the business model, as practiced in Ireland, hasn’t been working that well for a while. Credit unions have not been making enough loans. They should have been lending more and investing less over the past ten years.
Their main source of income should be interest paid on loans supplemented by fee income from sales of other products and services with a contribution from money invested in liquid investment assets. Seriously underlent, lower margin investments account for at least 50% of income earning assets. Far too much is tied up in illiquid instruments that are also significantly loss making.
Irish credit unions are at best 50% lent and many are operating at far lower levels. This means that in almost all cases loan interest income does not cover the costs of running their savings and loans operations. The problem is that credit unions cannot now increase lending. The scale of the economic recession and increase in consumer credit risk makes safe lending far more difficult. To make matters worse because credit unions have money tied up in illiquid investments they haven’t the free money to lend.
On top of this people are taking their money out chasing higher high street rates. At the same time loan repayments are rapidly declining as people default on loan repayments. Cash flow or money to fund withdrawals and new loans is very tight. So tight, that the regulator has instructed a large number of credit unions to restrict new loans to percentage of monthly net cash flow (loan repayments + new deposits).
The cash flow scenario is ripe for a liquidity collapse forcing the closure of a large number of credit unions.
Some are borrowing from others to support liquidity shortfalls but inter-credit union lending is fraught with default risks few will have the financial competence to assess or understand.
It is even said that some have engaged in cross-border transactions to massage liquidity positions in advance of making regulatory returns.
Investment and loan losses, which will plunge many into the red, can only be financed from already thin capital reserves. Just how many are exposed to insolvency risk or will have seriously impaired solvency levels is unknown. For sure many will be unable to increase lending volumes off their deficient reserve levels.
Plans by the regulator to regulate capital adequacy through a 10% "statutory reserve to total assets ratio" are meeting with trade body resistance that appears to taking on a political dimension. The question is will the Irish Finance Minister prevail upon the regulator to forebear as has happened in the past? Or will the Minister and his officials back up the Regulator? Irish government officials have a reputation for not being entirely supportive of the credit union regulator in the past which has led to enforced forebearance particularly withy investments. Had the regulator's requirement to restrict investments been agreed to in 2004/05, tens of millions would not have been lost last year.
So where does this leave credit unions?
One can predict a series of high profile loss making credit unions causing a collapse in trust and confidence in all credit unions. This would result in a run with many forced to close their doors as they run out of cash to fund withdrawals. In this scenario no credit union will be safe and no matter how financially robust all will suffer. This could happen either this year or next year.
Sticky plaster solutions will be applied – credit unions may be allowed to raid the family silver to pay dividends – but dipping into reserves has to be paid for next year and the year after.
There may also be an “investment loss” support scheme – where government guarantees are provided to allow credit unions use impaired assets as security for emergency liquidity lines. But again this will have to be paid for and losses financed over time.
Whether the outcome is a "Big Bang" run on savings or a credit union bail out process the net effect is the same. Credit union balance sheets are seriously damaged and can only be repaired from lending income. And credit unions are very poor at lending especially in a high risk economic environment.
The upshot is a period of self-enforced mergers as weaker credit unions vote to amalgamate with stronger neighbours – where there is one. Others may well opt to close. In a few short years numbers will dramatically decline – probably by more than half.
Left to chance, shrinking the sector to a financially stable size will be a chaotic shambles unless that is Government intervenes and forces change to the way Irish credit unions are structured, governed and managed. Such intervention may well be the price of providing state support.
Inevitable, avoidable and preventable the Irish credit union crisis will cause many to take stock of safety and soundness of the credit union business model. Before they do they need to understand what went wrong in Ireland and how a generation of directors and their trade body failed to modernise and allowed credit unions become dysfunctional investment managers. It is a story of poor governance, leadership and management. It is also a story of political capitivity which enforced regulatory forebearance.
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