Speech by Head of Financial Regulation, Matthew Elderfield, to ILCU Annual Conference

The Regulation of the Credit Union Sector

Good morning ladies and gentlemen.

Thank you for inviting me here today to address your annual conference in Limerick. I very much welcome this opportunity to set out my views on regulation in general, and, particularly, on regulation of the credit union sector.

I would like to address three very important topics here today:

First, I would like to explain our new regulatory approach and what it means for credit unions;

Second, I want to comment on the health of the credit union sector, and,

Third, I will discuss some of the key public policy issues we are working on with the League.

1. Our new regulatory approach and what it means for credit unions

Let me start by setting out our new approach to regulation of the financial services sector in general, and how we can tailor this approach to meet the special position of the voluntary credit union movement.

There is a clear need to overhaul our approach to financial regulation. The devastating impact of the global financial crisis on Ireland’s economy, finances and citizens is well known to you all and I will not use this occasion to analyse the causes and rehearse how we got here. But it is very clear that weaknesses in regulation contributed to the financial crisis in Ireland and that we need to address these weaknesses and also keep pace with best practice internationally, as regulators around the world are reassessing their approach.

In overhauling our approach to financial regulation, we intend to take a balanced and measured approach. In particular, I intend to implement a framework of assertive risk-based regulation underpinned by the credible threat of enforcement. We will insist that the biggest and riskiest firms manage themselves much better and that firms and their management are held more accountable for their actions. In this risk-based regulatory model we will calibrate the intensity of our regulatory standards and our day-to-day supervisory approach depending on the risk profile of the firms and sectors we supervise.

In practice, developing a new risk model will start with a process of setting out impact criteria. We will then categorise firms based on their size in order to set the appropriate level of regulatory resources and the frequency of engagement that should be applied in each case. We will have a more systematic framework for assessing aspects of risk at each firm, for example, the areas of governance, credit risk and operational risk. We will score firms on these criteria and discuss with them our views on their performance. This will help to provide clarity about our areas of concern and ensure focus and common understanding in the regulatory relationship. We want to ensure we have a better understanding of all business risks facing firms as well as the traditional regulatory assessment of control risks.

I described this risk-based approach as “assertive.” By this I mean that risk-based supervision is not just about identifying risk and pointing it out to a firm’s senior management to sort out as they think best. Our risk-based approach will insist that risks are not only identified but are also managed effectively.

This is an important area of emphasis in the new regulatory framework. I am asking my staff to have an open but challenging dialogue with the firms they regulate. For the high impact firms and those with a poor track record in particular, we need to be convinced that management actions do indeed mitigate risk. Where we remain unconvinced, we must be prepared, if necessary to act ourselves. Hopefully, this willingness to act will mean that senior management will take our concerns more seriously in the first place.

What does this new approach mean for the voluntary credit unions sector? I want to tell you very clearly here today that our new risk-based model means that we will not have a one size fits all approach. Regulation will be balanced and proportionate depending on the risk of the sector or firm in question. While we will improve our level of engagement across the board, a systemically important bank should expect a much more intrusive approach than, for example, a credit union with a lower risk profile.

Our approach will allow us to differentiate between the firms we regulate. This means that the rules for credit unions will not be the same as those applied to big systemically important banks.

Our approach will allow us to recognise the distinct and important role that credit unions play in Irish society. I understand and appreciate that credit unions are different. They have close links to their local community and play a vital role. They rely on you, the dedicated volunteers here today in this hall. I know we need to have a bespoke and differentiated approach to the regulation of credit unions, as we have had in the past.

Our risk-based supervision model will mean that our level of engagement will vary depending on the size and impact of each credit union. We will carry out a regulatory exercise where we will categorise all of the credit unions by size and potential impact. The biggest credit unions can expect more engagement from us as a result.

Our risk-based approach also means that you can “earn” a less intense level of supervisory engagement by having a well governed and well run credit union that scores low in terms of risk. Our approach will, as you can see, be proportionate.

We will consult with you on the design of our risk-based framework. We have a good working relationship with the leadership of the ILCU, so I am looking forward to your contributions and assistance in this process.

2. The health of the credit union sector

If I may, I would now like to discuss the health of the credit union sector.

In these difficult times good news is always welcome. And the good news is that the reserves and liquidity position of most credit unions have improved over the last 12 months. The adoption of the regulatory reserve requirement by the credit union sector and the efforts of individual credit unions to build their own liquidity buffers are to be commended. Your boards and management have worked hard to strengthen the financial position of their credit unions in recognition of the challenges ahead. I want to thank you for working hard to make these improvements.

But there have also been some worrying developments. In a difficult economic environment, credit union loan arrears have risen sharply over the last two years and the level of rescheduled loans has also risen as your members have come under increasing financial strain.

2010 will be another challenging year. As your members face difficult times, credit unions will have to remain vigilant. The impact of high unemployment and weak economic growth on the credit union sector will inevitably be significant. This year directors will again be required to strike a balance between dividend distribution policy and the retention of reserves to protect members’ savings and the future of their credit union.

This will be no surprise given the economic environment. In its latest quarterly bulletin, issued this month, the Central Bank warned about a further drop in employment this year, forecasting that it will be 2011 before output growth will be strong enough to exert any noticeable downward pressure on unemployment. We expect the economy to contract by a further 1.5 per cent this year on an average annual basis. However, on a positive note, we expect a modest upward trend to emerge in the second half of this year, followed by growth of about 2.8% in GDP in 2011. But we warn of the “significant headwinds” restraining domestic demand, namely downward pressure on employment and incomes and the need for households to maintain their savings from current income at relatively high levels in order to reduce their indebtedness.

Our job as a regulator is to look at downside risks and potential stresses. Can I encourage members of the boards of credit unions to also think carefully about these risks? What does this mean in practice? Let me ask you to do a few things:

• First, can I ask you to make sure that you are very confident about the status of any arrears? Have you really kicked the tyres and been prudent in assessing these and making the necessary provisions? Have you had someone take a look with a fresh pair of eyes?
• Second, have you thought about a scenario where things get worse still? What if there is a spike in arrears? What if your largest loans were to default - say some of your top 10 loans? What would that do to your bad debt provision? How would this impact on your overall reserves? Do you have any information about local economic conditions or the conditions of your borrowers that means you should be anticipating a potential problem? For example, are you seeing significant increases in requests by members to have their loans rescheduled? What does this mean for the financial position of the credit union? Have you identified loans that may be connected to each other in some way? If one of these loans defaults what is the likelihood of the other loans defaulting and what is the potential impact on the credit union?

In light of the answers to these questions, I encourage you to have a vigorous and challenging discussion around the Board table about what this means for your Credit Union. What actions do you think need to be taken? What does this mean for your dividend policy?

It is no surprise that the Credit Union sector is going to face further pressures because of the extraordinary economic circumstances facing Ireland. The members in this room are in the front line of the battle to ensure those problems are kept at bay. I’m asking you to keep up your good work and indeed redouble your efforts to make sure you are on top of any emerging financial concerns. For our part we are starting to do our own thinking around stress scenarios and will continue to work closely with credit unions to build and maintain levels of reserves, liquidity and provisions across the sector to provide a buffer against the challenges ahead.

3. Current policy issues

I would now like to take some time to run through some of the current policy issues affecting credit unions. This is a busy time in terms of the preparation of the legislative and regulatory framework for the credit union movement, so I thought it would be helpful to discuss the current situation.

The Financial Regulator recognises your concerns about the impact of Section 35 on Credit Unions. We understand and appreciate the problems that were caused by the current limits on the amount of lending greater than five years as a result of the need to reschedule loans. We think the approach proposed by the government in the latest legislation is sensible.

The proposed approach will allow credit unions to assist members who are experiencing financial difficulties by rescheduling their loans, whilst ensuring that the financial position of the credit union is not undermined. Under the proposal, all credit unions will be able to lend up to 30 per cent of their loan book over five years on the basis that conditions relating to liquidity, provisioning and the management and reporting of rescheduled loans are met.

The changes to primary legislation required to implement the proposal are included in the Central Bank Reform Bill 2010. This Bill is currently undergoing a short consultation process. Once the Bill is enacted the proposal will be implemented and we will communicate the detailed requirements to credit unions. We would like to recognise the commitment and input of the League over recent months into the framing of this important initiative for credit unions.

A key issue on the horizon is the review of the credit union sector. As you are aware, the Minister for Finance requested the Financial Regulator to arrange for a strategic review of the credit union sector to be carried out. In accordance with the Minister’s request to appoint consultants to undertake this review, a tender process is currently underway and this process will conclude by the end of June. It is intended that the work will start shortly thereafter and will be completed by the end of March 2011.

The scope of the review has been agreed with the Department of Finance and presented to the Irish League of Credit Unions and the other main credit union representative bodies.

The review will cover matters including a financial review of the movement and a risk analysis of the credit union sector, an examination of the external support mechanisms required for the protection of members’ savings, consideration of governance and competency standards as well as the regulatory and legislative framework.

It is intended that the outcome of the review will advise and inform an assessment of the future strategic direction of the credit union sector. A key focus of the work will be on how to protect the strengths of the movement whilst developing an enabling legislative and regulatory system that allows credit unions to expand services to their members in a prudent manner.

The consultants selected to conduct the review will be independent in their judgement and will consult widely with all stakeholders in the sector including the Irish League of Credit Unions during the process.

We will, as a regulator, listen hard to all of the concerns and propositions expressed. And we will certainly have a view ourselves as to the right way ahead. However, it is already obvious what some of the key issues will be.

The status of the stabilisation fund will be an important issue. The League has played an important role in maintaining the stabilisation fund and providing support to credit unions in difficulty. This has provided a degree of helpful stability to the credit union sector and this is welcome especially in the current economic and financial environment. However, it is important to normalise the role of the stabilisation fund and we understand the desire to have regulatory recognition for the fund. We intend to issue a public consultation paper on stabilisation arrangements shortly.

A more fundamental area of discussion between us in the review and in any new legislative framework will be whether it is appropriate to liberalise the activities available to credit unions. Our starting point is to be cautious as you would expect from a prudential regulator – we feel that the current framework has served us well. But we are open to discussion and well-reasoned arguments for change. However, I would advise you that any proposals will only be viewed as credible if they include a detailed analysis of the risks involved and clear and credible proposals to address those risks.

The review will also involve a debate about the appropriate standards that should apply to credit unions in areas such as consumer protection and corporate governance. Consumer protection remains a key priority for the Financial Regulator across the range of financial services providers and the strategic review will include an assessment of the current consumer protection provisions for credit union members. In terms of corporate governance, the review will provide an opportunity to seek views on the need for clearer standards in this area, including fitness and probity. A full discussion of the best approach for corporate governance is best done at another time and in the context of the review. But just let me take the opportunity to express my sincere thanks to the League for its important work in the area of staff education. Your education and training programme is recognised by the Financial Regulator as being of excellent quality. I would like to thank you for the time and effort you devote to this important task.

Conclusion

It is a busy time in financial regulation. This is to be expected because of the regulatory failures and financial crisis and continuing economic challenges.

This means there will be a busy agenda ahead for credit unions too. I have tried to sketch out the key issues that will be on your agenda. We are fully committed to consulting closely with the League to work through those issues.

In this spirit, it is my pleasure to let you know that we have announced today the appointment of James O’Brien as the new Registrar of Credit Unions. James is, I think, well known to many of you and an experienced supervisor who knows the credit union movement very well. I hope you will join me in congratulating James on his forthcoming appointment.

As a team at the Regulator, James, myself and our colleagues are determined to improve regulation but to take a reasonable and balanced approach. And as I have explained, this is not a one size fits all approach. We want to work with you to create a new regulatory framework for the credit union sector that reflects the important role that credit unions play in local communities all around Ireland.

Thank you for inviting me to address you today.