Address by Anne Marie McKiernan, Registrar of Credit Unions to CUMA Spring Conference 2017

“Mind the Gap”

Chairman, Members of the National Executive of CUMA, ladies and gentlemen. Thank you for inviting me to address your Spring Conference. Your theme – “Challenges and Positive Responses” – seems particularly apt for the sector at this time, and this morning I will focus on challenges and developments in credit union business models.

But first I would like to talk briefly about certain weaknesses which we continue to see in credit unions arising from our PRISM engagement, the nature of which is fundamental to your core responsibilities to safeguard and protect members’ funds. I would like to be able to say that such failings are rare, but regrettably we are seeing too many cases of non-compliance with many regulatory requirements, and some cases of unacceptably poor systems and controls – including with such basics as bank reconciliations. These pose significant risks to members funds, by creating the conditions for misappropriation or loss.

Breaches of this nature will not be tolerated by the Central Bank and we will take enforcement cases against credit unions, to ensure the highest standards of regulatory compliance across the sector.

Such cases reflect very poorly on those credit unions’ management and Boards, and they beg serious questions of the effectiveness of internal and external audit functions, risk management and compliance functions. All of these parties have responsibility to “mind the gap” between the current culture and controls, and those that we expect to see in place to meet all requirements, which are there tp protect your members.

But today, I want to focus on the business model challenges of the sector and the critical leadership challenge facing many of your credit unions.

As your system consolidates, on the one hand we have larger more complex firms emerging, and, on the other hand, individual credit unions struggling to address underperforming business models and meet basic requirements. These place different demands on your leadership - to manage more complex operations; to restore viability; to prudently transform business offerings and related balance sheet management; to embed transfers; to reduce costs, and to develop new capabilities. And that has to happen while you improve standards of regulatory compliance, to address the weaknesses in governance, systems and controls, financial management and strategic planning that were set out in more detail in the Registry’s speech delivered by Elaine Byrne at the CUDA Conference in January.

So when it comes to addressing business model challenges, you need twin tracks:

• Attend to the requirements, in the current business, to meet your obligations to your members to safeguard their funds - by meeting our regulatory requirements, and
• Develop financial and operational strength, and capability, to manage the transition to different business model offerings and deal with the risks and regulatory requirements involved.

In other words, “Mind the gap”, between

• Your current v. your needed level of regulatory compliance. Given some of the issues we have found in recent supervisory engagements, I could characterize this as “Mind the basics”, and
• The sector’s current business model and capability, and the ambitious proposed or evolving business models, which often carry very much different risks and capabilities.

On business model transformation, we emphasise that credit unions own their business model. But as your Regulator, we have, of course, a strong interest in where this evolves, and we play a strong role in supporting your evolving aspirations – via our challenge for improvement and our risk assessment of your proposals.

In 2016, in recognition of the scale of effort required to “mind the gap” between current and future business model proposals, and to capably transition to them, we established a new function in the Registry to engage on business model change with credit unions - collectively, bilaterally, through representative bodies and with other agencies.

From all of our business model engagement in recent years, the three big recurring themes are :

1. Payment account services, including debit cards
2. Longer term lending, with an emphasis on mortgages and
3. Investment in social housing.

Today I will set out our main views on each of these areas.

1. Payment Accounts & Debit Cards

As you are aware, payment account services including debit cards require approval under the Additional Services framework and, given the technical complexities involved in this area, ideally in a shared service context.

This area can appear, at first, as deceptively straightforward – but it has, in fact, its own unique characteristics and risk profile. It is rapidly evolving, given digitisation; there is increasing EU legislative and regulatory requirements, including regulations providing for a new form of payment service providers; there are well-known challenges regarding how the evolving payments regulation fits with credit union legislation, and how to deal with specific features such as credit union share accounts. So any proposed development of payment account services needs to address these matters.

But aside from the unique payments services risk characteristics, there are also market factors to consider, which affect the economic costs of the service. The Irish market is considered quite mature regarding current accounts (some 5.3m) and debit cards (4.5m), with about 80% of credit union members having a debit card, no doubt linked to a current account with an alternative financial institution, in a market with historically low switching rates. And, while the second Payments Services Directive (PSD II) has been described as transformative (in that it opens payment accounts access to third party providers, enhanced consumer rights and strict security requirements), it will require a level of investment by providers, which has to be weighed against the relatively small membership base of some credit unions.

Success in the provision of such services is generally highly dependent on realising scale economies and on ongoing investment in operational efficiencies. Failing this, such services are loss making and require subsidy either directly or - more frequently - through cross selling profitable products and services.

Given all of these factors, we expect credit unions to have well-thought-through proposals, reflecting realistic costs and risks associated with payment account services including debit cards, and to factor in the impact on Return on Assets.

Not surprisingly, this is an area where there have been important gaps between the Registry’s views on the risks to be addressed and many of the sector’s initiatives. It is well known that we have had particular concerns regarding the sustainability of some of the proposals.

But the risks and challenges can be tackled. As flagged previously, in 2016 a group of larger credit union CEOs proposed an “everyday payment account” solution with significant functionality – consistent with the definition of payment services in EU legislation - which was approved by the Registry under the Additional Services Framework, subject to prudential conditions and requirements.

What this particular approach (MPCAS) demonstrates is that any proposal that realistically addresses the complexities and regulatory requirements associated with payment accounts and services including debit cards, and which deals proactively with challenges, will be successful in getting approval. Very importantly, we set out our risk management expectations of payment account services generally although attuned to that particular approved service.

Not surprisingly, we have suggested that larger credit unions are better suited to this service and its risks, until it becomes more established and can then cascade down to smaller credit unions. This recognises that the early stage investment in new initiatives can be greater than smaller credit unions can realistically bear.

As we have repeatedly said, we are open to credit unions to propose any alternative payment services model, for approval under the Additional Services Framework. The approval of one model does not preclude the approval of others. Our main caution is that, for shared services to achieve the necessary cost efficiencies, the market is not large enough to support multiple offerings of the same products and services, but that limit is not one confined to one service model. So far, we have not received any formal applications beyond MPCAS, although our sectoral engagement suggests that this is an area of active interest.

It is disappointing that significant amounts of time and effort have been used to portray one well-risk-managed proposal - which actively and quickly responded to our challenges - as the limiting factor on the success of others, rather than focusing those energies on moving forward to make other proposals fit for purpose.

For those credit unions for whom this is a viable service, I urge you to move ahead in a risk-focused way, building on the mapping provided by the risk management framework published for MPCAS, and scaling up or down in line with your aspirations in this area, and making your engagement with us as productive as possible.

2. Longer term lending

Probably the area that is most frequently referred to by credit unions – and by media, politicians and other stakeholders - as a way to expand your business model is longer term lending, specifically consumer mortgages, and the desire to change our long term lending limits to facilitate this.

At the Registry, we are clear that

1. We do not discourage competent credit unions from doing – and looking to do more - longer term lending. But credit unions need to better demonstrate:

• your aspirations: what do credit unions think are appropriate scale, timing and stages of development on mortgages, given that it is really a new business line for most of you?
• your understanding of the different balance sheet transformation risks involved in longer term lending - the need to better match funding and lending maturity brings a very different set of issues, which do not readily build on credit union sector existing capability;
• the financial impact on Return on Assets and on balance sheet structure;
• the new compliance and risk management considerations, including on collateral and legal risk, and
• the more onerous, and growing, regulatory framework – much of it non-domestic – that mortgage lending requires to deal with these greater risks, and must be factored into costs of participation. These include – but not limited to - the Mortgage Credit Directive (which includes knowledge and competency requirements), related EBA guidance, the Minimum Competency Code for mortgage lending, and the Macroprudential Framework rules.

2. Consumer mortgage lending is an activity that has its critical success factors and unique risk profile. Other providers of mortgages in the Irish market operate a high-volume, narrow-margin business, which relies on economies of scale to be profitable. There are many additional costs that are unique to mortgages; the workload to acquire new customers is substantial, including marketing and promotional costs; the fall-off rate from enquiries through to application and to approve/decline decisions is statistically high. Some of you will argue that you “know your customer” better, but it would be a mistake not to factor in significant costs as the price of ‘being in the mortgage market’ with any kind of scale.

3. For those reasons, shared services are a likely feature of any increased credit union mortgage activity, and we are engaging with a number of sector bodies to better understand their potential offerings, costings and coverage. But they are well shy of being imminently available.

4. It is not unusual to see costs absorb all revenues in the early years after granting mortgage loans – up to a half-decade is not unusual. So credit unions need to work though fully-costed models to understand the potential impact on RoA over the longer term.

There are many similarities in the challenges around mortgages and payment services : they both require scale for cost efficiencies and realistic loss-absorption capacity; they carry significant technical and resource capability needs; and they are subject to a significant and evolving regulatory and legislative framework external to credit union legislation.

To sum up, there is a need to “Mind the gap”, between

• your current stance and your aspiration regarding mortgages, and fully risk- assess and cost those aspirations;
• what you can realistically do within your credit union, and what you would be reliant on shared services for, but be realistic about costs, coverage and timeliness of shared service offerings;
• your current v. future capability needs, to manage the risks and regulatory requirements that greater mortgage activity would entail.

For these reasons, a greater movement into mortgages will suit only some larger and more capable credit unions, who can withstand the impact on RoA and the capability requirements.

Overall, mortgage lending is neither a simple solution nor a silver bullet to the declining income profile of credit unions. And it is particularly misleading to blame the long term lending limits for the failure to deal with the substantial issues I have mentioned above.

What is striking from our engagements is that, with a small number of notable exceptions, we see little exploration as to how credit unions intend to leverage long term lending to drive future profitability. This strategic clarity, Balance Sheet impact analysis and funding analysis is lacking. So, to facilitate credit unions in presenting more robust proposals, the Registry proposes to publish high level guidance in the coming months, setting out the key headings to be addressed in any long term lending proposals.

Also, we have not received any specific proposal on changing long term lending limits at the sectoral level, or any proposed risk management framework to accompany greater long term lending.

Bearing all the above factors in mind, when there is more clarity on how credit unions wish to prudently develop their longer term lending, taking account of risk appetites, pricing, funding capacity, asset and liability implications, underwriting expertise and financial and cost impacts, we will consider changes to the limits. Any such future changes associated with mortgages would be likely to be (i) accompanied by changes on funding requirements, to deal with maturity transformation risks and (ii) incremental and restricted to the most capable and financially sound credit unions - from which lessons can be learned before proceeding further - and based on a business case to be made by credit unions.

Before leaving long term lending, I have to say that we are surprised at how the debate on long term lending has polarised to mortgages. There has been very little engagement, and no proposals, on long term lending that is non-mortgage / non-home loan. What investigative work is underway on branching out to other short-to-medium term lending opportunities, that could play well to your strengths and capabilities in your communities and common bond?

Regarding the existing limits, we intend to publish, in coming weeks , our updated criteria and guidance for credit unions to apply for use of the discretionary higher limits for over-5-year lending (from 30% to 40% of the total gross loan book) and over-10-year (from 10% to 15% of the total gross loan book). These will include a requirement for credit unions seeking approval to submit a business case linked to their strategic plan.

3. Investment including Social Housing

The third major area of engagement on business models is to increase investment earnings on your surplus funds, with a specific focus on social housing-backed investments. Certainly it is easy to see how social housing proposals build on your social and community ethos. Because of common bond restrictions, sector-wide approaches to lending for social housing haven’t come to pass, so efforts have turned to investment-based proposals.

As we have stated previously, we are reviewing our investment regulations to consider including social housing-backed investments. But, as with mortgages, these will need to take account of maturity considerations and balance sheet impact.

Also, the interplay between a possible move to more longer-term lending, combined with longer-maturity investments, would lead to a vastly-different balance sheet management problem, than you deal with at present. How to appropriately lengthen your funding profile to accompany such changes, particularly if it required tying up the funds of ageing members for longer?

Also, we are very conscious that, while social-housing-backed investments, which are linked to Approved Housing Bodies who can access funding supports made available by government, are helpful in reducing some of the risks associated with this investment, they also leave your proposals quite dependent on the policies, timelines, funding needs and fee structures of many other parties.

Overall, our analysis and our engagement with you in this area suggests that it carries important risks and costs to balance against the possibilities. Overall, it doesn’t appear like a silver bullet either, for the scale of downward pressure on your RoA.

So, if the 3 major areas of business model focus - payments services, longer term lending and social housing investments – are not silver bullets, what else can be done? Clearly, each of the 3 areas have some potential success factors for some credit unions. But overall, it would be useful to have parallel tracks on the above 3 issues, to also deal with

• Leveraging your current capability and “know your member”, to turn savers into borrowers. We do see some notable successes, including among smaller credit unions in less economically-advantaged parts of the country, who have made successes out of member profiling, targeted marketing and promotion, social media and data analysis. There are experiences to be leveraged across the sector in this area, and overall it is less costly, more available and less dependent on external parties. I acknowledge it is not a complete solution but it is not to be ignored, while grappling with the bigger issues of transformation;
• Increasing focus on costs and shared services. We are concerned at little concerted effort to tackle what is an unsustainable cost base. In mergers, in particular, we are uneasy at the failure to drive out needed efficiencies, which are needed if larger entities are to be better able to tackle business model change.

The use of a shared service approach to bridge technical, operational, risk management and knowledge gaps is a key feature of business model evolution elsewhere. Of course, shared services are not a silver bullet either, but it is a key element of a broader strategy. Shared service arrangements require robust contractual frameworks, long term funding commitments and can be difficult to govern and manage, if not constituted correctly. While we welcome developments in this space we would also note that effort, focus and results may be dissipated and indeed risks amplified, if multiple share service firms replicate services to small groups of credit unions. Clearly, in order to deliver necessary scope and scale economies, shared services need to get critical mass and resilience.

Conclusion

Before closing, I want to acknowledge the efforts which you and your Boards and colleagues have taken, in difficult circumstances, to better position your credit union business model. But there is still considerable work to be done. While energy and focus may be on major new business lines, credit unions need to ensure that your core personal lending business, where you have recognised expertise, is not neglected, and your standards of financial, operational, risk and regulatory compliance management need to be fit for purpose for your current model before moving on to the next one.

Business model evolution is not about limits, it is about a broader based response to members changing needs and expectations. The bottom line is, of course revenue generation and specifically generating positive surplus to boost reserves, provide for ongoing investment in your business and deliver a return to your members.

Your leadership is needed to be more proactive in respect of your business model. The Registry cannot be the driver of business model development - that is your role.

The issues I have raised today are not to deter development in the areas I have covered, but to ensure realism and to give pointers on the critical issues to address. My challenge to you as the sector leaders is to collaborate better to achieve that vision; be realistic in assessing what you can do, how you can do it; and when you can do it; treat our challenge as an opportunity to improve the viability of your sectoral initiatives, and use energy and costs on forward-looking rather than reactive efforts.

Don’t just “Mind the gaps” – close them.

Finally, as it is International Women’s Day today, I will finish with a few words on an area where the credit union sector leads the rest of the Irish financial system. The Central Bank will today publish research on the gender breakdown of applications and approvals for controlled functions (both CF and PCF roles) in the Fitness & Probity regime. While the figures for the overall financial system are broadly consistently poor, the Credit Union sector fares much better. International research suggests that, for the advantages of gender diversity to be realised, critical mass is achieved when there are closer to 40% of females in senior leadership roles. So more progress is needed, but your sector is starting from a more positive base than others. The advantages of gender diversity include reduced risk of group-think, increased engagement and performance, wider talent pool, truer representation of customer base, wider ideas generation - among others. And diversity needs to be about far more than gender, but, on International Women’s Day, it is a good place to start. And finish, for now.