Remarks by Registrar of Credit Unions, Patrick Casey at ILCU 2022 AGM

Address by Registrar of Credit Unions Patrick Casey, to the Irish League of Credit Unions 2022 Annual Conference, 23 April 2022

President, ILCU Board members, ladies and gentlemen, I am delighted to be able to attend and address your 2022 AGM and to be here in Belfast, a place I have fond memories of from my college days.

I would like to thank your President Helene McManus and interim CEO David Malone for inviting me to speak today. We welcome their commitment to a constructive engagement in support of credit unions going forward.

We want to see a strong and sustainable sector serving local communities across Ireland. In a time of rapid change in retail financial services, achieving credit union sustainability will require a clear future pathway through business model transition. To succeed, it must be underpinned by your resilience and the effective delivery of services to meet members’ needs.

Credit union commercial and competitive challenges are well known – and they require commercial answers. Without business model transition by credit unions, many will face real financial viability risk.

The Central Bank’s multi-year strategic plan, published in November, reflects our emphasis on the need for ‘future focus’ to enable us to better understand, anticipate and adapt in the context of the far-reaching changes taking place within the financial services industry.

You must also be future focused. Now is the time for you to provide much needed clarity on your future strategic direction based on the scope of the existing regulatory framework. Now is the time for leadership to support credit unions to overcome their commercial challenges from the ground up.

In my address this morning, my remarks will centre on credit union resilience in the context of your future focus, mindful of our statutory mandate towards the sector, and the protection of member funds. I will cover the following topics:

1. The sector’s current financial resilience and viability risk;
2. Credit union lending – the challenge of growing market share whilst developing competence and capability in newer areas;
3. An assessment of the quality of credit union risk management - a fundamental capability and a key business enabler; and
4. Some critical areas of focus to strengthen resilience.

I will now address the first of these issues.

The sector’s current financial resilience and viability risk

Financial Conditions Report

 We published the 8th edition of the “Financial Conditions of Credit Unions (PDF 813.18KB)” in late 2021. There were positive trends in reported data, reflective of a return to more normal conditions.

While loan growth re-emerged during the 2021 financial year, it was matched by savings growth. The sector loan to asset ratio at c.27% remains close to historically low levels.
With a growing imbalance between savings and loans, credit union viability remains constrained by low loan to asset ratios, low investment returns and high cost income metrics. Broader economic uncertainties may amplify the risk outlook further.

In such circumstances, credit union capital adequacy is paramount. The average sector reserves ratio remained at c.16% during 2021. This reflects prudent decisions taken by boards – who have decided to retain reserves in excess of the 10% minimum requirement taking account of their circumstances and prevailing market conditions. Individual credit union capital reserves remain key to underpinning member confidence, particularly in times of economic uncertainty and where viability risk is so persistent.

Regulatory Capital

 Following the recognition of pension deficits in financial accounts, we plan to undertake capital adequacy analysis on a credit union basis.

As outlined in successive Financial Conditions reports, the scale of viability risk facing the sector is reflected in your key financial metrics. It is borne out by the incidence of individual credit union failure and the need for private sector recapitalisations to support restructuring over recent years. Therefore, any forward-looking scenario analysis we undertake on credit union capital adequacy, will highlight that broader viability risk.

Cognisant of viability risk and an imbalance between savings and loans, boards have continued to retain reserves well above regulatory minimum levels. Nonetheless, there are some in the sector who advocate for a reduction in minimum regulatory capital requirements or for the introduction of risk-based capital approaches seen elsewhere.

However, credit unions in those jurisdictions are at a more advanced stage of development having already transitioned their business models to more complex offerings. They have built much larger balance sheets with broader asset diversity, underpinned by advanced risk management capabilities. In many respects they are more akin to retail banks.

We would caution against an expectation that the introduction of a risk-based capital approach would be appropriate in an Irish context. After all, credit unions here are yet to transition their business model away from core savings and loans - on a basis that would warrant a complex, risk-based approach. Indeed our recent thematic review suggests much needs to be done to advance and mature credit union risk management capability.

The sector here continues to face a significant imbalance between savings and loans, which needs to be addressed through proactive asset and liability management by credit unions – not by lowering minimum capital requirements.

Importantly in the context of business model transition, the existing capital regime is not a barrier to lending, with no additional capital required to grow loans - ensuring you can allocate your assets towards member service provision and in particular lending, the main source of your income.

In short, reducing capital requirements in the face of pervasive viability risks would be contrary to members’ interests and the financial stability of the sector. Members are best protected by the maintenance of capital adequacy - both in percentage and absolute terms.

Other Market Developments

 As you know the financial services landscape is changing, with new providers expanding as others decide to withdraw. This presents opportunities and challenges. Importantly, credit unions already have regulatory scope to provide a broad range of services to meet their members’ needs.

Providing current accounts can help credit unions to become a primary financial service provider for members. Current accounts are now available in 69 credit unions and we welcome further applications for approval on an open and engaged basis. Any credit union proposing to offer current accounts to new customers, should ensure they have in place an effective, customer-focused, account switching process.

The provision of any new services should be undertaken prudently in line with a credit union’s strategy, capabilities and risk appetite, while of course contributing to your long term viability.

Turning to my second area of focus.

Credit union lending – the challenge of growing market share whilst developing competence and capability in newer areas

Lending is the principal source of credit union income, and income is the only source of capital. Therefore lending is critical to sustainability and member protection.

We support prudent diversification by credit unions towards a more balanced loan portfolio. Our 2020 lending changes enable diversification over time through:

• Unsecured personal lending up to 5 years – a core competence, where no regulatory lending limits apply;
• Unsecured personal lending of 5 to 10 years – a newer activity for many, again where no regulatory lending limits apply; and
• House and business lending – also new areas of activity where only a fraction of available capacity has been utilised, and where advancing competence and capability will take time.

Credit unions collectively retain over a one third share of the short term consumer loan market. A core competency and key income generator, such lending can be cost intensive.

Our recent Financial Conditions report shows many credit unions are increasingly availing of the flexibility to lend unsecured up to 10 years maturity. In 2021, there was a 27% increase in 5 to 10 year loans. While such lending commands less sector commentary than house lending, it is a far more significant contributor to income.

Lending capacity and utilization

For house and business lending, it is important to distinguish ‘available lending capacity’ from ‘actual levels of utilisation’.

Our 2020 regulatory changes provide combined house and business loans capacity of up to €2.5BN¹. At 30 September 2021, the total amount of house loans outstanding was €260M (or 10% of maximum capacity), and the total amount of business loans outstanding was €128M (or 5% of maximum capacity).

Today - half of all credit unions have decided not to engage in house lending. For those who do, activity is heavily concentrated in c.50 credit unions. The average capacity utilisation for all credit unions engaged in house lending is only 1.4% of total assets, a fraction of available^2.

Only five credit unions have notified us that they will utilise the 10% combined lending limit³, and only seven credit unions have applied for our approval for the 15% combined lending limit⁴. It is for credit unions to decide if they wish to avail of this increased capacity – when they do, we stand ready to discuss it with them on an open and engaged basis.

Regulatory lending limits are not the barrier to credit union house lending - so what is?

As new entrants, credit unions cannot establish a large foothold in the mortgage market overnight.

Building a sustainable mortgage offering will take time. It requires competing directly with others in an area of their core competence – ultimately by trying to capture market share from them while remaining profitable through the cycle.

The average credit union house loan advanced in 2021 was €100K (well below the overall market average of €249K⁵. With mortgage rates of c.2.0% on offer in the market, it is very challenging for credit unions to capture market share based on their existing house loan propositions.

Established and newer lenders have key commercial and competitive advantages over credit unions - including brand reputation and awareness amongst borrowers, scale and reach, differentiated product offerings and IT/operational capabilities. Regulatory limits cannot change this.

House lending is a specialist area, which requires scale and advanced competence and capability (i.e. dealing with liquidity transformation and interest rate risk). A range of domestic/EU legislative requirements also apply – such as the Central Bank’s mortgage measures⁶ and the Mortgage Credit Directive.

For smaller lenders, a lack of scale brings concentration risks - whereby losses on a small number of larger loans could have a very significant impact on a small capital base. Credit union failures due to secured lending issues from the recent past highlighted this particular vulnerability.

The fact that roughly half of all credit unions have decided not to engage in house lending, is likely a reflection of the complexity and commercial and competitive challenges involved.

The existing regulatory framework facilitates prudent credit union loan diversification over time⁷, as competence and capability develops. We caution against calls for further lending capacity to be made available now, bearing in mind the scale of unutilised available capacity at 90-95%. We suggest your energies and future focus are instead dedicated to leading and supporting credit unions as they try to develop their business models - across all lending categories - so vital to income generation and sustainability.

This brings me to the third issue I will address.

An assessment of the quality of credit union risk management - a fundamental capability and a key business enabler

Risk Management Thematic

 Risk management is a key line of defence for all businesses, including for financial service providers. For those engaging in house lending, advanced risk management capabilities are required to underpin their financial and operational resilience.

We have previously expressed (PDF 0.96MB) our supervisory concerns regarding recurring governance and risk management issues in credit unions . Our 2021 supervisory engagement involved a thematic review of credit union risk management, to assess its overall maturity and embeddedness.

We found some credit unions continue to view the implementation of risk management frameworks as an exercise in regulatory compliance. On the contrary, it is a fundamental capability and a key business enabler, one that underpins informed decision making. When one considers recent calls for a sizeable expansion in house lending, it brings the critical need for credit unions to advance their risk management capability into acute focus.

While it was encouraging to see examples of good practice during our review, risk management weaknesses were also identified.

I urge you to review our thematic review report (PDF 1.38MB). You should consider how our findings can support you in embedding a strong risk management culture in your credit union.

Moving to the last area I wish to address.

Some critical areas of focus to strengthen resilience

While effective risk management must be deployed right across all of the credit union’s activities, we thought it would be instructive to consider a number of topical areas, where proactive risk management is critical to your resilience.

Operational Resilience

Credit unions continue to become ever more reliant on complex IT systems, often involving third party outsourcing. Operational risk is impacted by the threats posed by IT/cybersecurity risks. Such risks must be fully addressed within your control framework and they represent good examples of where effective risk management is fundamental to your resilience.

Regulated firms are also expected to have effective governance, risk management and business continuity processes in place in relation to outsourcing. We published our cross industry guidance (PDF 1.4MB) on outsourcing to assist regulated firms in developing their associated risk management frameworks.

Accrued Interest

For a number of years now we have been highlighting that credit unions should be taking action on accrued interest issues. It is concerning that from our 2021 year-end engagement with credit unions, accrued interest is not being proactively addressed in all cases.

We expect where members have been affected by accrued interest issues, that they are advised of planned actions - including redress - in a timely manner.

Pension Costs

We have been highlighting pension costs and connected disclosure issues for some time now. While the scale of the deficit in the ILCU defined benefit pension scheme does not raise broader sector stability concerns, there will be financial impacts for all affected credit unions.

It is important that there is full clarity and transparency for members in the annual financial statements. Credit unions are therefore expected to take a prudent approach to the upfront recognition of associated financial impairments.

Boards should also fully understand the implications of any new pension arrangements on their credit union - including seeking third party advice as appropriate. Risk management considerations include financial, operational, legal and HR implications.

We will continue to monitor the financial resilience implications of pension issues on individual credit unions, and take action if needed, to protect members’ savings. Indeed, pension deficits represents a good example of why minimum capital requirements are so critical to protect members against unforeseen losses.

Climate Risk

Governor Makhlouf wrote to all regulated firms on climate issues in November 2021. We encourage you to consider the supervisory expectations outlined in his letter, including associated risk management of climate risk.

Investment Risk

Newly created vehicles are facilitating investment in corporate bonds and Tier 3 Approved Housing Bodies (AHBs). Some AHBs are evolving their business models, including moving into ‘cost rental’ housing. If credit unions propose to invest in an AHB, it is vital that they undertake robust due diligence to fully understand the underlying investment risk.

Policy Framework Review

I want to briefly comment on the Department of Finance-led review of the credit union policy framework. We continue to provide our input to this important process. We look forward to seeing the final output of the review, which will be factored into our future work plans.

Following the very significant credit union regulatory framework changes over recent years⁸, it is our expectation that the flow of such activity should slow. We believe it is more important that the sector’s leadership - its energies and its strategic focus - are targeted at leading and supporting credit unions in overcoming their commercial challenges.

Our current work-plans focus on engagement directly with credit unions – in terms of the effective implementation of the existing regulatory framework. This includes applications for increased house and business lending, for current accounts and for additional services. We see our role here as a key support towards prudent credit union business model transition.

Conclusion

We want to see a strong and sustainable sector serving local communities across Ireland.

Credit union commercial and competitive challenges are well known – and they require commercial answers in order to reverse the growing gap between members’ savings and loans. Without business model transition by credit unions, many will face real financial viability risk.

The regulatory framework is not a barrier to credit union commercial progression. Neither is regulatory flexibility a panacea to overcome the sector’s commercial and competitive challenges.

Delivering sustainability requires effective provision of services to members - which they need, which they choose to obtain from you over others, and which they are willing to pay you for on a basis that generates income through the cycle.

There is a desire among some in sector leadership for credit unions to engage in house lending, yet half of all credit unions have taken the decision not to provide house loans. Whilst sector advocacy may be wedded to house lending, it is important that credit unions pursue any newer member services in line with their own strategy, risk appetite and competence and capability – including in risk management where weaknesses are evident.

The commercial reality is that it is simply not enough just to have the surplus funds available for house loans. Credit unions must have more advanced competence and capability to compete with others for market share. You still need to build a compelling mortgage proposition which attracts borrowers – one that delivers a sustainable return for the credit union over the economic cycle. This is not a regulatory challenge, but a commercial one.

By building the necessary financial and operational resilience, you can safeguard your members while transitioning the business model through commercial-led change. This offers the right path towards your sustainability.

Thank you for your attention.

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¹Based on assumption that all credit unions utilise all available capacity based on September 2021 Prudential Return data.

²Relative to maximum capacity of up to 7.5%, 10% or 15% of total assets, depending on credit union size.

³ One of these credit unions has since been approved for the 15% combined lending limit.

⁴As at 13 April 2022, four credit unions have been approved for the 15% combined lending limit. Three applications from credit unions to avail of the 15%limit are currently being assessed by the Central Bank.

⁵ See BPFI mortgage drawdowns (XLS 97KB)

⁶ Central Bank mortgage measures

⁷There are three tiers under our 2020 revised lending framework changes as follows:
• A combined concentration limit for house and business loans of 7.5% of total assets for all credit unions.
• A 10% limit, conditional on a credit union satisfying asset size (at least €50 million) and regulatory reserves qualifying criteria and notifying the Central Bank in advance.
• A 15% limit for credit unions with total assets of at least €100 million, subject to Central Bank approval.

⁸ Since November 2014, the Registry of Credit Unions has issued five separate consultations in respect of important updates and reviews of various aspects of the regulatory framework for credit unions to ensure that regulations remain relevant and appropriate, in particular:
• CP88 Consultation on Regulations for Credit Unions on commencement of sections of the 2012 Act (2014/2015);
• CP109 Consultation on Potential Changes to the Investment Framework for Credit Unions (2017/2018);
• CP113 Consultation on Potential Amendments to the Fitness and Probity regime for credit unions (2017/2018);
• CP125 Consultation on Potential Changes to the Lending Framework for Credit Unions (2018/2019); and
• CP148 Consultation on Credit Union Exempt Services (2022).