Address by the Registrar of Credit Unions Anne Marie McKiernan to the National Supervisors Forum

5 November 2016

Good morning ladies and gentlemen. Thank you for the invitation to speak here today and address your very important board oversight role in your credit unions. Your role has two important stakeholders. The first, and most important, is your members, to whom you must provide assurance that your Board is properly discharging its strategic leadership and oversight function to ensure that member funds are protected. Secondly of course is the Registry, to which you report issues of concern. Where the relationship between Board and Oversight Committee is working properly, your regular reporting to the Board on their performance, and areas for improvement, helps support the development of a positive, challenging and risk sensitive culture within your credit union. This is the culture we observe in the better performing credit unions and culture within credit unions generally is a key theme in my remarks this morning.

Regulatory action

It has been an eventful week. The Central Bank has taken action to liquidate Rush Credit Union Limited. This option, while regrettable, was necessary given the scale of issues in Rush credit union, which are at the extreme end of what we see. We identified ongoing failures of governance, controls and lending practices, which the credit union was given ample opportunity to deal with.

What are the messages for credit unions and for you as supervisors from the events of this week? First, it is important to emphasise that liquidation is not a decision we take lightly. But as Regulator of the sector we are making it clear that we are willing and prepared to take whatever action is necessary to protect the savings of credit union members. We take our strongest action where we see egregious failures in any credit union, particularly a failure to put in place, operate and test the systems and controls that are necessary to protect your members and your credit union. It is very clear that where proper and appropriate systems are not in place, and where there is insufficient challenge, there is a serious risk of fraud or other loss to members which can lead ultimately to the loss of the credit union itself.

In coming weeks, we will publish detailed documents on the actions that were taken, over a lengthy period, in relation to Rush Credit Union. It is important for Boards, management and for you as members of Oversight Committees to be mindful of the risks and keep the issue of atypical behaviours on your radar. In your role, it is important to pay particular attention to the Board’s performance in delivering on its obligations to ensure effective systems and controls to protect members funds.

We at the Registry work to ensure that any failure will be well-managed so that financial loss or loss of services for members is avoided as far as possible. The 11,000 members of Rush Credit Union were fully protected by the Central Bank’s Deposit Guarantee Scheme, which guarantees savings up to €100,000 in the event of failure. The Scheme and the Provisional Liquidators of Rush will arrange to pay verified depositors in full, as soon as possible, and no later than 20 days.

I want to reiterate that the Central Bank is fully supportive of the sector and is committed to the development of a strong and sustainable sector that also protects members savings. We are very conscious of the demand for credit union services by the people of Rush and Lusk and we are working with sector to find a solution to restore credit unions services in the area.

Responsible Governance and Management

We have many lessons to learn from the financial crisis and a central lesson is the importance of responsible governance and management, especially in financial institutions. Responsible governance and management is fundamental to the protection of members funds and assuring viability. The regulatory framework for the credit union sector is built around the principles of responsibility, accountability, prudence, and compliance. These principles underpin sound standards and practices and inform our risk-based supervisory approach and expectations. They are also central to our vision of ‘strong credit unions in safe hands’.

We see ‘strong credit unions’ as being financially strong and resilient, enabled by sustainable, member-focussed business models, with effective governance, risk management and operational frameworks.

Credit unions are ‘In safe hands’ when they are voluntarily governed, professionally managed and staffed by competent, capable, honest people who understand and prudently manage the risks the credit union is exposed to, while successfully meeting their members’ product and service expectations.

At the Central Bank, we believe that the combination of the detailed governance requirements for credit unions introduced from 2012, and the tailored Fitness & Probity regime introduced in 2013 has contributed to an improvement in standards of governance in the sector. But, while some progressive credit unions embraced these standards, we are concerned to see that changes in governance culture have taken so long to embed in other credit unions. Overall, at the sector level, governance weaknesses remain a concern. Functions and structures set out in the strengthened regulatory framework, including internal audit, risk management and compliance requirements, are designed to support improvements in governance culture. We understand that these take time to embed, but further progress is required if the sector is to reach the standard required to appropriately protect the financial stability of the sector and the funds of your members.

One of the key tests of culture is Board and manager willingness and ability to ensure that all business activities - existing or new - comply with the law, regulations, prudential requirements and expectations. There should be no conflict between business activity and compliant behaviours and actions. We expect to see evidence that risk management and compliance functions are appropriately used to provide this assurance.

Some of the behaviours we see, indicative of a prevailing weak culture, include

• Resistance to change and/or resistance to the new strategies the credit union needs to implement, to drive increased customer demand for products and services;
• Boards not fully informed by management, who themselves may not be fully aware, of the nature of risks the credit union is exposed to or about to take on;
• Quite serious risk and compliance matters not being meaningfully addressed or included in board reporting and decision making processes;

Dysfunctional board dynamics, such as:

• Unchallenged dominance of a small number of directors or the CEO/Manager, and/or conflict at Board or Manager level;
• Blurred lines of responsibility between Board, Manager and Directors;
• Decisions based on uninformed opinion, poor quality risk analysis and contradictory assumptions, or rubber stamping proposals;
• Insufficient attention to risk, compliance and internal audit obligations;
• Lack of responsiveness to viability threats.

These behaviours are often the root cause of supervisory concerns, as they can set the tone for the whole operations of the credit union.

Instead, the “tone from the top” needs to be one where the relationship between Board and Management is the exemplar for appropriate behaviours in your credit union, one which demands that risks are prudently managed, compliance is assured, and business model weakness and threats are promptly attended to. My message today, to you as supervisors, is that in assessing board performance, you should expect the documenting of, and the visible demonstration of, attention to business model weaknesses and threats; properly-informed risk assessments; and understanding of - and compliance with - the spirit as well as the letter of prudential standards. Where you note weakness, you should bring this to the attention of your Board in the first instance, and where concerns are not being addressed, you should discuss with the Registry officials.

Fitness and Probity

During 2016 we carried out a Fitness and Probity thematic review. Our objective was to examine whether a sample of credit unions are fulfilling their obligations regarding persons holding a Controlled Function (CF), and also the role of the nomination committee within the Fitness and Probity regime. The sample of credit unions selected for inspections was a mix of large and small, industrial and community, and rural and urban credit unions. At this stage, we have completed our inspections and are collating our findings. Today I will share some preliminary findings.

We have noted varying compliance levels across the sample of credit unions. Perhaps not surprisingly, in general the medium and larger credit unions demonstrated better compliance levels than smaller credit unions. In particular, those sample credit unions who have fully engaged with the F&P framework are now reaping the benefits, including gathering information to inform planning and decisions for filling key positions in the credit union, and addressing key skill gaps.

However, at the other end of the scale, we have seen examples of some credit unions taking a more “tickbox”-type approach, settling for minimalist compliance. We were disappointed to find examples of:

• Lack of process and documentation for F&P, instead relying on local or personal knowledge;
• Lack of meaningful succession planning;
• Credit unions not following aspects of guidance provided by Central Bank.

These are preliminary findings, and more work is being done to analyse the information collected. But overall, I want to stress the importance of a culture of responsibility and accountability at the top of the credit union, rooted in strong analysis of the risks and issues to be addressed, and demonstrated through the sound operation of governance frameworks and management systems and controls. The Fitness & Probity regime is one part of that, and provides a driving force for better analysis of Board or management skill requirements, aligned to the strategic aspirations of the credit union and identifying candidates who can make a better impact on the future evolution of the credit union. It is clear that significantly more work is needed within credit union Boards, Board Oversight Committees and management, to embed this framework. Given the importance of culture and governance to the overall performance of your credit union, this is an area which we will monitor closely.

Systems and Controls

As your regulator, I want to stress here today the importance we place on appropriate systems and controls. I am concerned to note that irrespective of the enhanced regulatory framework that was introduced since 2012, we are still seeing evidence of fundamental weakness in a number of credit unions, particularly in the area of operational risk and financial control.

The weaknesses which the Registry supervisors have identified range from:

• Inadequate operational practices, including failure to separate duties and responsibilities, leading to instances of financial fraud and losses;
• Deficient controls and operating structures in relation to IT systems, resulting in over and under charging of interest on members loans; and
• An absence of basic financial accounting systems, such as an automated general ledger or functional bank reconciliation processes, leading to uncertainty over the integrity of books and records.

Where we have found a weakness in systems and control, the remedial actions required, by their nature, often result in significant cost for the credit union and there is the potential for long lasting reputational damage. At this time when credit unions should be seeking to leverage the improved economic environment and the potential provision of new products and services, it is particularly important to be able to rely on effective systems and controls. For these reasons, a key area for supervisory focus for 2017 will be on systems and controls within credit unions. While effective systems and controls are essential for all credit unions, proportionate to the nature and scale of their business, we expect highest standards from our largest credit unions, given their size and growth potential.

Restructuring

We have seen a significant transformation in the Irish credit union landscape in recent years. I want to acknowledge today the significant efforts of credit unions in undertaking mergers and then moving on to the reforms needed to drive benefits from scale. Today, there are 291 active credit unions, a significant fall from 357 this time last year, and we are projecting a figure of closer to 280 by end-year. As you know, the Registry now has responsibility for managing transfers of engagement with credit unions, now that ReBo is in the final stages of completing the in-flight mergers. While the vast majority of restructuring has been voluntary, there has been a number of cases where we have used our powers to expedite consolidation of a number of distressed entities, using the private fund of the Irish League of Credit Unions, thus saving the taxpayer approximately €25 million. These cases have often involved capital shortfalls arising from loan write-offs, falling fixed asset values and significant viability weaknesses.

But consolidation alone will not guarantee stronger future viability. The significant challenge now is for post-transfer credit unions to leverage their increased scale to achieve greater operational efficiencies, and provide that broader range of products and services to meet members needs and expectations. We do see that larger credit unions generally enjoy slightly better gross return-on-assets, reflecting some better cost efficiencies, but much more needs to be done to realise cost efficiencies across the sector, where the average cost-to-income ratio is 70%, leaving little headroom for any increase in provisions, investment in new systems and products, building reserves and paying dividends.

The key to achieving business model potential is in credit unions collaborating to use shared service facilities and form strategic alliances with third party service providers. This approach has been used successfully in other countries and certainly there is much to be learned from their experiences.

Business Models and the Future

But before addressing future challenges, we should look at the challenges of the present. Much focus, in recent years, has been on ensuring credit unions safely navigated the crisis, and now the focus has shifted to dealing with the fundamental weaknesses in the business model and membership base of the sector, which act as a drag on your sector's potential to benefit from the economic upturn.

The key issue for the sector is how to grow lending in a sustainable way, to reverse the declines in loan to asset ratio (now 27%), loan interest income and in yields on surplus funds, and to control rising costs. I acknowledge the scale of this particular challenge, especially in a heavily-deleveraged Irish lending environment. For example, the household lending market has shrunk by 42% from the 2008 heights of over €153 billion to c €89 bn now, while over the same period credit union lending fell 45%. Credit unions have always represented a significant element of the 1-5 year segment of that market and that share has remained relatively static, but current levels of lending serve merely to offset the level of loans maturing. Accordingly, we are not seeing any meaningful growth in net lending across the sector. In many respects credit unions have become victims of their success in attracting and retaining household savings, but which are not then being intermediated into loans.

An important first step in dealing with the significant lending challenge is for credit unions to examine the potential within their current business model. One of the key challenges is to seek to convert members to borrowers, through utilising more focused marketing and distribution channels to reach your membership. Central to this is analysis of common bond penetration, segmentation of your membership - especially demographic needs and trends - and speed of engagement and decision making.

The business model that served the movement so well over the past 50 years needs some transformation if credit unions are to be the borrower of choice for existing and potential members. Understanding your membership’s needs includes recognising that they require different communication, marketing and distribution channels for the services you provide. Older customers are likely to place a premium on the personal interface at their local branch. For other, particularly younger, members, and especially “millennials”, the focus is on access to services via digital devices. More credit union business will be transacted online and this is an area with its own unique risks which will require significant investment.

This year, in particular, we are seeing a shift in the typical duration of lending as credit unions of all sizes are increasing their level of longer term lending both in the over-5 year and over-10 year bands, albeit more pronounced in the larger (€100 million-plus) credit unions. While we can see longer terms loans as part of a balanced portfolio, it is important for credit unions in their analysis to consider the impact on your interest yield, your ROA and importantly on your balance sheet structure, knowing that longer term lending requires more funding certainty to balance the liquidity risks. This is even more the case for mortgages, where there is a range of additional EU and domestic legislative and regulatory compliance challenges, which need to be properly understood.

This is not to discourage those credit unions competent to do so from engaging in this sort of lending. The important point is to understand the impact of any proposed changes on your projected surplus, on your balance sheet and on your compliance and risk management considerations. Review of trends in other jurisdictions would suggest that this area - as with many others - is one where sectoral collaboration and initiatives such as shared services are essential, to share technical expertise and risk management competence.

At the Registry, we are always willing to engage with credit unions on their proposed business model changes. In recent months we have established a new unit on Business Model and Engagement with a mandate to engage on business model changes, collectively or bilaterally or through engagement with central representative bodies or other agencies, to drive forward well developed proposals grounded in an deep understanding of the risks involved.

One such new service which has now been approved is a Member Personal Current Account Service (MPCAS). This represents a significant and positive development for many credit unions who wish to provide current account services and payment instruments such as debit cards to their members. Key to our engagement has been the need to evidence well developed business proposals reflecting appropriate understanding of risk, governance and control implications.

Using the Additional Services Framework in Sections 48-52 of the Credit Union Act, we have defined and described MPCAS as an important new service for eligible credit unions. We are also providing for a full range of fees and charges, enabling credit unions to develop their revenue models.

Most importantly, we are providing for shared service facilities, which approved credit unions will use to develop and implement services in a standardised way.

My office will publish details of MPCAS and our approval process, along with details of the application requirements and related guidance, over the coming week. We expect to hear from eligible credit unions wishing to apply for this additional service over the coming months. Initially, credit unions that have close to or in excess of €75m in total assets are eligible to apply. There are about 65 credit unions in this cohort, collectively having €8bn in assets. Depending on their success in collaborating to implement a viable business, it is possible to envisage smaller credit unions being able to offer the service in time.

Conclusion

The credit unions sector has been on a journey of dealing with significant challenges and much progress has been made in embedding the requirements of the strengthened regulatory framework, in addressing viability challenges through restructuring and in working towards business model development. Nonetheless, much more needs to be done to ensure that the our regulatory requirements are met, in a way that demonstrably ensures your members funds are adequately protected and your sector is safe and viable into the future. I urge you all to use your Board Oversight role to push forward further and necessary improvements in governance and risk management standards, and that you reflect on the nature of the culture within your credit union as reflected in your observations of the Board.

We have seen two important recent actions regarding credit unions – the liquidation of Rush, and the approval of MPCAS service for an initial group of credit unions – both contain salutary lessons. When we publish our Resolution Report on the failings in Rush, it will provide an essential reminder of the importance of the basic standards of governance, controls, systems and credit standards. At the other end of the spectrum, the approval of MPCAS provides an example of how progressive credit unions, which have the culture and capability, can undertake suitable development of their business model. I urge you to consider the lessons from failure and success in these two events, and apply the learning to your own credit union. Your members deserve nothing less.