Characteristics of Effective Credit Union Legislation Brigitte Goulard, Vice President, Policy African SACCO Regulators Round Table December 1, 2010

“Effective regulation and supervision of all financial institutions safeguard the stability of a country’s financial system and protect the savings deposits of its people.” Technical Guide, Credit Union Regulation and Supervision, World Council of Credit Unions

Seems simple but is it really?

What about?

What does an effective and secure legal framework look like post 2008?

A strong supervisory framework is built upon legislation that is: Predictable Proportional Prudential And that recognizes that financial institutions are run by human beings

Predictable Legislation Predictable legislation provides a credit union the clarity and certainty it needs to plan and invest for the future. Fundamental principle behind any legislation. Must be able to operate according to the rules and requirements it establishes. Example: Insurance retailing in Canada

Proportional legislation Proportional legislation recognizes the risks a credit union presents to depositors and the financial system as a whole and establishes appropriate rules to mitigate those risks.

Proportional legislation Credit unions are different from: Banks Other cooperatives And this distinctiveness must be taken into account when enacting legislation or regulations. Two points made here. Credit unions operate under a different sets of rules from other financial institutions and must therefore be treated as such. Credit unions are not banks nor are they non financial cooperatives. Let me give you a few examples: First in the States, the financial crisis resulted in a revision of the regulatory/legislative framework. Credit unions took the position that they had not caused the crisis and should therefore be treated differently from the banks. Credit unions do not have the large commercial portfolios of the banks, the risk from that perspective is mitigated. However, does not mean that they do not also face some risk: Ability to raise capital is constrained (big worry in Canada for the regulators) Governance is such an important aspect but often neglected

Prudential Legislation Key elements: Licensing and organizing requirements Capital requirements Definition of the powers and permissible activities Effective supervisory body Various elements for an effective and prudential framework. Eight characteristic (taken mostly from the WOCCU documentation) but added one. I will review them to some extent.

Prudential Legislation Key elements: Governance principles Deposit and loan concentration limits for members Recordkeeping and anti-money laundering policies Deposit insurance regime

Licensing and Organizing Necessary to respect the cooperative principles, but also regulations must define licensing requirements. To receive a license credit unions must comply with elements such as: Standardized accounting and reporting External audit Capital adequacy A few words about capital adequacy; Discussion in Canada with respect to the continuance of provincial credit unions under a federal regime: Capital has been a very important consideration. Our regulator has taken the position that it will be very demanding from this perspective. This will probably be one of the more important impediments to becoming a federal credit union.

Licensing and Organizing Provisions for loan losses Liquidity standards Internal controls Credit, collection and savings policies Must be in the best interest of the cooperative system. The WOCCU document again provides good guidelines as to the appropriate safety and soundness principles that can be implemented. For example, for loan loss provisioning, WOCCU recommends that at least 35% of the outstanding loan balance should be provisions for all loans between one and 12 months delinquents. And that 100% should be provisionned for loans past due more than 12 months. In terms of liquidity, WOCCU recommends credit unions maintain 15% of withdrawable savings in easily accessible instruments and accounts. Also need appropriate policies for credit, collection and savings and for investments. A few words of what is in the best interest of the cooperative system. Will it strengthen the system or weaken it. Interesting concept: particularly as in Canada Cus liquidity is pooled.

Prudential Legislation Capital requirements Establish minimum start-up capital Define what constitutes capital and determine capital adequacy http://www.osfi-bsif.gc.ca First a few words of start-up capital. Differs from banking regulations since in credit unions, member shares provide the initial funding base for credit unions. WOCCU document proposes that instead of focusing on start-up capital, key elements for regulators to consider granting a license could be: Submission of 300 signatures demonstrating commitment Presentation of a three year business plan Allowing a grace period to reach capital adequacy ratios and minimum start-up funding. Capital Adequacy CU capital is comprised of non-distributable reserves that are created or increased by appropriations of retained earnings, capital donations and other surpluses. All forms of capital must be permanent and non-withdrawable. Neither member shares, re-valued assets nor provisions are considered part of institutional capital. While start-up capital requirements may be lower in credit unions, greater emphasis must be put on credit unions’ capital adequacy ratios. According to WOCCU: the minimum capital to asset ratio for credit unions should be 10% of total assets. Components of capital include retained earnings, donations and statutory reserves. Member shares are not considered capital. In Canada: the capital adequacy guidelines sets out two minimum standards: an assets to capital or leverage multiple and a risk based capital adequacy ratio. The assets to capital multiple is an overall measure of the adequacy of an institution’s capital whereas the risk-based ratio focuses on risk faced by an institution For the leverage multiple: total assets must not exceed 20 times it capital. Superintendent may increase this multiple. Also fcu will be expected to meet a minimum riks-based Tier 1 capital ratio of 7% and a total capital ratio of 10%.

Advance and administer a regulatory framework that promotes the adoption of policies and procedures designed to control and manage risk; Monitor and evaluate system-wide or sectoral issues that may impact institutions negatively. Supervisory Body Mandate of the Office of Superintendent of Financial Institutions (OSFI): Supervise institutions to determine whether they are in sound financial condition and are complying with legislation Advise institutions when there are material deficiencies and require corrective actions Advance and administer a regulatory framework that promotes policies and procedures designed to control and manage risk. Monitor and evaluate system-wide issues that may impact institutions.

Governance Principles Essential component of success: Regulation must establish defined roles and responsibilities as well as controls for conflicts of interest. Two sets of guidelines: Prudential disciplines Rules of governance Must also set criteria for board members. Prudential disciplines: constrain the behavior of boards and managers within boundaries that protect member savings and the financial viability of the institution Rules of governance establish systems for internal control and oversight to address problems before external supervision is required. In Canada: complex set of related party rules to prevent conflicts of interest: result board members are very aware of the rules and take care not to contravene. A lot of attention given to governance when the new federal legislation was enacted. To make sure that cooperative principles were respected. Sometimes confusion with rules associated with shareholders. Important that they recognize the important value of the board in managing risk.

Loan Concentration Limits Different approaches to the setting of limits: In Ontario if a small institution: not allowed to lend commercially, If larger, yes, to a certain extent. At the federal level, If a bank: no limit, depends on the prudent person approach Other types of FI: 5% of regulatory capital Prudent Person Approach guideline: An institution is required to establish and adhere to “investment and lending policies, standards and procedures that a reasonable and prudent person would apply in respect of a portfolio of investments and loans to avoid undue risk of loss and obtain a reasonable return. In addition, in FI must comply with the statutory investment limits set out in the applicable legislation.

Human Nature Julie Dickson, Head of OSFI, Canada “Human nature should be at the forefront of efforts to avoid a repeat of the financial crisis, and single items such as the amount of capital held by banks should not be reled on to guarantee financial stability. We cannot be lulled into a false sense of security because some of the significant changes we are making to capital.” Julie Dickson, Head of OSFI, Canada

Deposit Insurance Regime Key to the financial stability of the financial system and the protection of depositors In Canada: federal vs provincial rules One of the only countries that did not increase its deposit insurance. Extremely important but must still impose market discipline. Principle of competitive balance.

BANK RUNS

Deposit Insurance Regime How much is necessary? Should it be the same as the banks?

QUESTIONS??