Let me expand a little on the my last post, “Disengagement: the absent owners“. The issue in that post was based on my perceptions and insights. In this post I want to put the issue in ‘policy language’. This is the technocratic perspective I developed in my letter to the Minister early in February. And in my submission to the recent BCFSA consultation on credit union governance.
The Bank of International Settlements (‘BIS’) has published “Core Principles for Effective Banking Supervision“. This document is referenced by regulators in developed and developing countries. Notably, the publication includes 25 ‘Principles’ and 6 “Preconditions for Effective Banking Supervision”.
The BIS lists these ‘preconditions’, acknowledging that the ‘preconditions’ are “mostly outside the direct or sole jurisdiction of banking supervisors”:
The inclusion of “effective market discipline” is key here. The BIS model presumes well functioning ‘markets’. And particularly, they presume the informed & rational conduct of investors, clients, and suppliers. The essential presumption is that markets will provide feedback to a bank. If these ‘market participants’ lose confidence in the bank they will act. For example, depositors will move deposits or seek a higher interest rate. Thus, the investors and clients have leverage to curtail excessive risk-taking.
This framework is well presented in a recent paper, “Deposit Insurance and Market Discipline” (Deniz Anginer and Asli Demirguc-Kunt). I will highlight three key points from that paper:
- market participants need to have incentives to monitor banks.
- it’s essential for market participants to have access to relevant and timely information.
- market participants should have influence on bank risk-taking and management. This influence may be direct, such as by transferring deposits and loans, or selling shares. And this influence may be indirect, such as shareholder initiatives and contesting director elections.
In this international framework, the whole structure of ‘prudential regulation’, and deposit insurance, is premised upon this ‘market discipline’. If this ‘precondition’ of market discipline is not in place, the whole regulatory structure is undermined. That is the problem in BC credit unions.
The key ‘market participants’ in this case are credit union (a) member-shareholders and (b) depositors. I will offer my assessment:
- Member-shareholders lack incentives to monitor their credit union. Individually, they have very modest investments in the business, nominal shareholdings. And they have few social pressures on them to take an active interest (except for small closed bond credit unions).
- Depositors have no incentive to monitor their credit union because they have no risk of loss (deposits are insured 100%)
- Both have access to a limited information, largely determined by the directors and executive managers. And,
- Both have little influence over the management of risks within the enterprise. Ownership is widely held and difficult to mobilize. The withdrawal of one participant’s deposits (or shares) is unlikely to be consequential. And incumbent directors are inevitably re-elected.
The ‘market discipline’ in the BC credit union sector is very weak.
Decades ago, neighbouring credit unions did make interventions if they saw unusual risk-taking. They had an incentive indirectly because of the deposit insurance fund. In this way, nearby credit unions offset the weakness in ownership ‘market discipline’ outlined above. But, with the consolidation of credit unions, this compensatory mechanism is not as reliable.
And this discussion of ‘market discipline’ points to a gap in the application of this BIS framework. The BIS assessment methodology only evaluates compliance with ‘Principles’. For example, BIS Core Principle #13 “Corporate Governance” speaks to board competencies, practices and compensation. ‘Effective market discipline’ is assumed.
The draft BCFSA Governance Guideline follows this same logic. The draft BCFSA Governance Guideline places the focus on board competence and board composition. This approach may be consistent with the BIS model, but it is blind to the ‘market discipline’ or ‘absent owner’ problem. The presumption of robust owner involvement is not a sound presumption for BC credit unions. (See my previous post.)
Call it either ‘absent owners’ or a failure of ‘market discipline’.
The primary problem in BC credit unions is that of a disengaged membership (/ownership). The combination of ‘absent owners’ and rapid consolidation in the BC credit union system amplified the problem. The ‘absence of owners’ compel regulators and government to step up.
The government of BC has been a big ‘backer’ of credit unions. Especially with the 100% deposit guarantee since 2009, which has given BC credit unions a distinct competitive advantage. One can argue that the ‘absent owners’ have left the Minister, the ‘guarantor’, as a de facto owner. Should government exercise that option?
From a Minister’s perspective, BC regulated credit unions are a substantial asset. This BC incorporated deposit-taking sector claims @20-25% of the market and reports total assets @$80B. Net equity value is @$5B+ built over decades. This is great, but this provincially incorporated sector is in decline. One BC credit union transitioned to a ‘Federally Regulated Financial Institution’ (FRFI) a few years ago, and three others are now in the application process (totaling @$22B in assets).
Without legislative changes, rapid consolidation will likely continue. Today there are 23 BC incorporated credit unions. The trend suggests we will have @5 large BC credit unions within 5 years. Some will convert to, or be acquired by, FRFI’s. Potentially, significant ‘BC assets’ will go to ‘Federal Credit Unions’, headquartered in Toronto, Calgary or Swift Current.
Yes, Swift Current. Another noteworthy credit union merger was announced this week. The Saskatchewan based FRFI, Innovation Credit Union (based in Swift Current), is acquiring/merging with the Alberta based ABCU. This will be the first such ‘inter-provincial’ merger. Previously, no federal credit unions had branch networks in more than one province. The trend is clear. Local CU’s merge into regionals, regionals into provincials, and then into FRFI’s spanning several provinces.
The Australian academic Kevin Davis has studied the same trends in credit unions in his country. He has highlighted the vulnerability of the co-operative ownership and the likely ‘expropriation’ (or ‘demutualization’) of these community-based enterprises. Canadian consolidation is following this path.
In my view, since credit union owners have largely vacated the field, the only player left is government. The people of BC and the Minister have @$5B+ accumulated equity stake in these institutions. The Minister must decide how the value in these institutions will be preserved, or how the value will be distributed. The Minister must determine how the province gets fair value for the guarantee it has provided. And the Minister must determine if there is a future for a BC-based ‘banking’ sector.
The Minister and BCFSA are left with few options:
- Accept consolidation & the decline of the BC incorporated credit union sector; the loss of local service providers.
- Amend legislation to incentivize and resuscitate ‘market discipline’ (AKA local ownership). OR
- Amalgamate all BC credit unions into a new crown corporation (similar to Alberta Treasury Branches) to ensure the future of a BC-based financial services provider.
I restate these options differently in this post, but the conclusion is similar to the last. I will expand on these options in upcoming posts.
We are all enjoying the useful post-remunerative employment of your ample analytic capacities! This is a great context piece that raises valuable questions.