Background
Industry Background
11. Credit unions are regulated primarily by the Act. Since 2001, credit unions have also had to comply with the Securities Act 1978 requirement to enter into a trust deed with a trustee company, which acts as a front-line supervisor. The Ministry of Economic Development ("MED") intends to consider the need for the Securities Commission to have additional oversight of trustee companies, as part of its review of the Securities Act, which is due to commence in mid 2005. (trustee companies supervise other participants in the financial sector so the issue of additional oversight needs to be considered in that wider context).
12. Traditionally, credit unions have certain features that, in combination, set them apart from other deposit taking institutions. They are member-owned cooperatives established to provide savings and loans within the membership. Each member has one vote regardless of the amount of a member's deposits. They do not issue capital stock and, instead, build capital by retaining earnings. They may only serve customers that meet a common bond requirement (such as residing or working in a particular locality).
13. Over the last decade, the number of credit unions has fallen from 160 to around 57, including the two associations of credit unions: MU and the NZACU. The decline in numbers has come from amalgamations and closures driven by increased compliance and operating costs and, in some cases, management failings and misconduct. At the same time, the number of credit union members has remained fairly stable at around 180,000 to 190,000 and total assets have grown from around $350 million to around $490 million. This is very small by financial sector standards. The major trading banks each have assets in the tens of billions of dollars. The largest building society, Southland Building Society, has assets of $1.5 billion (three times the entire credit union movement). Currently, credit unions service about 0.3 percent of the household loan market.
History of Review
14. The impetus for the review has come primarily from NZACU, which believes that the Act is outdated and unduly restrictive. MU has, until recently, maintained that reforms sought by NZACU were unnecessary.
15. The review dates back to around 1995 when The Treasury consulted on the possibility of adopting a two-tier regime under which credit unions with more than $5 million assets would incorporate under the Companies Act 1993. The proposal met with objections from the industry and was not pursued.
16. In 1998, the Ministers of Revenue and Commerce reinitiated the review, focusing on whether: it was necessary to have specific legislation to recognise credit unions; the appropriate legal form for credit unions was that of a company under the Companies Act 1993; and credit unions should continue to enjoy a tax exemption.
17. Submitters were unanimously of the view that specific legislation for credit unions should be retained in order to protect their special character. While there was general agreement that the Act had a number of problems, there was wide divergence as to their cause and extent and the review was suspended. At this stage, the credit union sector was advised that broad ranging consensus was a prerequisite for reform.
18. In 2000, the government decided to defer a review of credit unions' tax status. No decisions are being made on the tax status of credit unions at this stage.
19. In December 2002, MED released another public discussion document, focusing primarily on proposals by NZACU to amend four areas of the Act: membership qualifications, legal status and validity of action, capital, and trust deed duplication. MED also sought feedback on the impact of those proposals on competitive neutrality in the financial sector and the need for a "conversion mechanism" to enable credit unions to choose to migrate to alternative governance regimes such as the Companies Act, if they would better suit members' needs and goals.
20. MU continued to object to most of NZACU's proposals. Subsequently, at the request of the former Minister of Commerce, Hon. Lianne Dalziel, the two associations developed a Statement of Agreed Principles. This document was submitted to the Minister in November 2003. To a large extent, it incorporates the NZACU proposals that were consulted on in 2002. One key feature of the proposals is that they are generally permissive rather than prescriptive, so individual credit unions would be able to weigh up costs and benefits in deciding whether to implement them.
Review of the Banking and Insurance Sector
21. The Treasury, the Reserve Bank and MED are in the early stages of scoping a review of aspects of the regulatory framework for the banking and insurance sector. The review will include consideration of a range of issues including whether the existing regulatory arrangements for banks and life insurance companies are appropriate and whether there is scope of greater trans-Tasman coordination or harmonisation.
22. Although the review may raise issues or identify principles and objectives that are applicable to all deposit takers, officials do not envisage that it will address small deposit takers such as credit unions unless there is a decision to create a single prudential regulator for all financial institutions or the review identifies competition or competitive neutrality problems that warrant action. Should the situation change, officials consider that the statutory amendments recommended in this paper would be unlikely to conflict with or foreclose any possible outcomes from the financial sector review.
The Joint NZACU-MU Proposals to Amend the Act
23. The intention of the Statement of Agreed Principles is that the proposals it contains should form the basis of amendments to the Act. NZACU considers the proposals to be minor and has, on occasion, expressed an assumption that agreement within the industry means that the proposals would be adopted automatically by the government. While my predecessor had clarified that this is not the case, the government wishes to consider the proposals in good faith, with a view to accommodating the industry's objectives as far as possible. Where it is not feasible to adopt a particular proposal, I recommend that officials should work with the sector to identify lower risk alternatives that go as far as possible towards meeting the credit unions' underlying objectives.
24. In analysing the current proposals, primary consideration has been given to the following objectives: investor protection; competitive neutrality; sound governance and risk management; contestability of the sector; ease of exit; facilitating adaptation of changing conditions; compliance costs; and regulation administration costs.
Membership Qualifications
Current Requirements
25. The Act limits membership of credit unions to people who meet a membership qualification rule that gives rise to a common bond - i.e. a common employer, residing or working in a particular locality, or membership of another association such as a trade union. The Registrar of Friendly Societies and Credit Unions (the "Registrar") can also approve an admixture of those qualifications or any other qualification that gives rise to a common bond.
Joint Proposal
26. The joint proposal suggests that credit unions should be free to determine their own membership qualification. Instead of approving the qualification, the Registrar should merely confirm that it is objectively verifiable (e.g. based on residence in a defined area rather than support for credit unions' values) and is sufficiently identified in each credit union's rules. The proposal also suggests that charities and incorporated societies should be able to join a credit union if they share an affiliation with the common bond of that credit union.
Comment
27. The benefits of this proposal are that it would facilitate credit unions' growth and make cooperative, lower cost savings and loan facilities available to more people. It would also overcome some of the problems that credit unions have encountered when they wanted to merge or move into rural areas that are not well served by any financial institutions. The Registrar reports that several mergers have taken place in recent years. Generally, these have been driven by the need to achieve the economies of scale needed to meet the costs of new technologies and the introduction of Securities Act trust deeds. A few credit unions have closed because the Registrar was not satisfied that proposed mergers would give rise to a common bond. The limits of geographical boundaries, have also, in some cases, prevented existing credit unions from extending their services to underserved communities that could not support their own credit union.
28. The extension of services to charities and incorporated societies would also facilitate growth by opening up a new market, albeit, one that shares the credit unions' "not for profit" philosophy. It would give those organisations an additional choice of financial service provider.
29. The potential for growth could raise issues about competitive neutrality, which may need to be considered in the context of the proposed tax review. The proposal also alters some of the fundamental characteristics that define credit unions as different from other financial service providers. Credit unions will be able to adopt any objectively verifiable membership criteria they wish, provided it is not inconsistent with the Human Rights Act. Technically, a credit union could open its membership to all people living in New Zealand. However, I consider that the most significant issue for the purposes of the current review is the possibility that credit unions' current governance, supervision and risk management structures are not strong enough to support considerable growth in membership, should it occur as a result of relaxing the bond requirement.
30. Early architects of the credit union movement regarded the common bond as a risk management tool, ensuring that those making lending decisions would know more about applicants and borrowers would be reluctant to default. However, the efficacy of the common bond as a risk management tool nowadays is not so certain. While it may hold true for very small credit unions, it is unlikely to work for large credit unions, particularly those whose membership criterion is based on locality, which may cover a whole region or a large city. So for many credit unions, it is already unlikely that the common bond requirement serves its original purpose.
31. The lack of investor protection afforded by the common bond and other features of credit unions' governance structure has contributed to a number of instances where credit unions have ended up in financial difficulty, to the detriment of their members. The introduction of independent trustee supervisors in 2001 appears to have had a marked, positive effect on credit unions' stability. However, it is possible that the buoyant economy is also assisting credit unions in maintaining adequate liquidity, so the effectiveness of current management processes and regulatory disciplines is not likely to be fully tested until a contraction in the economy places pressures on credit unions. Significant growth means that more individuals and organisations may be adversely affected by the failure of an individual credit union and the consequent economic impact on the community concerned may be noticeably higher.
32. Any risks that may be exposed by relaxation of the common bond can be monitored and, if necessary addressed on three fronts. The first is the role trustee supervisors, which, as already mentioned appears to have improved credit union management processes considerably. Secondly, as previously noted, MED will be able to consider the need for stronger government oversight of the trustee supervisors, during its review of the Securities Act. Thirdly, credit unions' governance provisions (such as the duties of trustees and committees, disclosure obligations, and the ability of creditors to petition for a wind-up) can be reviewed to ensure that they are as robust as those applicable to building societies and finance companies.
33. It should also be noted that, if, during the course of the review of the banking and insurance sector in the government decides to introduce a new regulatory body for insurers, it may consider extending that body to credit unions and other small financial institutions.
34. On balance, I believe that the risks associated with the proposal can be monitored and managed. They are therefore outweighed by the benefits of facilitating the growth of credit unions so I propose that credit unions be allowed to set their own objective common bonds and to offer services to charities and incorporated societies that meet their common bond. I also propose that consideration be given to the need to strengthen credit unions' governance provisions.
Trust Deed Duplication
Current Requirements
35. The Act prescribes the following controls on credit union borrowing, investing reserve ratios, and fee-setting:
- Credit unions may borrow - for short terms and for restricted amounts - only from other credit unions, friendly societies or associations of credit unions or by way of an overdraft from a registered bank.
- Credit unions cannot hold land or buildings for investment purposes. Surplus funds may be invested in accordance with the investment provisions of the Trustee Act 1956, or with an association of credit unions. Otherwise they must be kept on current account with a bank. Credit unions may make temporary loans to each other with the prior approval of the Registrar.
- A portion of each credit union's profits must be retained as capital to offset any losses on loans to members. Credit unions with at least four years operating experience and total assets of more than $500,000 must maintain a general reserve of at least 5 percent of those assets. Otherwise, credit unions generally have to have reserves of 10 percent or be building their reserves to that level by setting aside a certain percentage of gross earnings each year.
- Service fees must be set out in a credit union's rules. These rules can only be amended by special resolution of all the members, which means that fee changes can only be made if 75 percent of eligible voters vote in favour of the change.
Joint Proposal
36. The joint proposal suggests that the restrictions on investment, borrowing and reserves should not apply if these matters are addressed to a no lesser standard in a credit union's Securities Act trust deed. The joint proposal also suggests that credit unions should be allowed to adjust fees as permitted by their rules.
Comment
37. I agree that the requirement to amend fees by special resolution is impractical and prevents credit unions from responding to business needs as they arise. Credit unions should be permitted to determine their own rules for fee setting. This would enable credit unions to retain the current voting rule, if they wish to do so, or to authorise the management committee to set fees from time to time.
38. NZACU has taken the view that the restrictions on investing, borrowing and reserves conflict with or duplicate the trust deeds. In practice, there is no real conflict. The law does not prevent a trustee from imposing a higher standard than the Act, and in fact the trust deeds entered into by credit unions generally do contain requirements that mirror or are stricter than the Act. However, it should be noted that neither the Act nor the Securities Act requires trust deeds to address these matters. Any restrictions imposed by a trust deed are voluntary commitments agreed between each credit union and its trustee supervisors.
39. Provided the law is amended to make it clear that trust deeds must address these matters, I agree that, in principle, prudential requirements in the Act could be replaced by trust deed provisions. However, it will be necessary to carefully consider whether (a) the current statutory requirements are useful, (b) whether the Act should provide a minimum standard or whether credit unions and their trustee supervisors should have scope to negotiate lower standards and (c) whether any other safeguards, such as a requirement to report variations to the Registrar, are desirable. Any decision to vary any requirement in the Act must ensure that existing governance and prudential requirements are not diluted inappropriately and unacceptable risks are not introduced. In the case of investment powers, for example, allowing the trust deeds to waive the investment provisions of the Trustee Act 1956 could result in a lower standard of care with consequent risks to depositors. In the case of borrowing restrictions, safeguards may be needed to ensure that managers do not overexpose the credit union through unsound borrowing decisions.
40. It is also necessary to consider the implication of enabling credit unions to avoid the current statutory restriction on investing in building and land. Credit unions' primary purpose is to provide low cost savings and loans services to their members. To support that purpose, the World Council of Credit Unions ("WOCCU") recommends that 70 to 80 percent of a credit union's assets should be invested in loans to members and a reasonable percentage should be kept in liquid investments to meet members' withdrawal and loan demands. Investment in less liquid assets should be strictly limited. Permitting investment in property could lead to reductions in liquidity and in the amount of money available for loans to members. Consequently, making the current statutory restrictions optional may not be appropriate. However, at least for some credit unions, it may be possible to permit a limited amount of investment in property without undermining the fundamental purpose of credit unions or creating liquidity risks.
41. In view of the fact that the trust deed regime seems to be working well as a de facto front-line supervisor, I propose that the government agree in principle to allow credit unions to vary statutory borrowing, investment and capital reserve requirements, subject to further analysis and confirmation that this would not expose members to unjustifiable risks.
Capital
Current Requirements
42. Credit unions can only raise money by accepting deposits, charging interest on loans and investing surpluses. Although the Act says members' deposits are shares, technically, and for the purposes of the Securities Act, they are debt securities because they are withdrawable on demand. Each member must have a minimum of $10 in "shares", which are in fact deposits, as a condition of membership.
Joint Proposal
43. The joint proposal suggests that credit unions should be allowed to offer equity shares to their members. These would be non-withdrawable, transferable between members and, at the option of the credit union, preferred over deposits in a winding up of a credit union. Credit unions should also be able to determine their own minimum "shareholding" (i.e. deposit) requirements.
Comment
44. I understand that the objective of gaining authority to issue shares is to create a source of funding that would make it easier for credit unions to meet their capital reserve requirements. Although the Act requires established credit unions to maintain a 5 percent reserve, under their trust deeds, most credit unions have a reserve requirement of 7.5 to 10 percent. The reserve must be built from profits on loans and investments so it is difficult to maintain in rapid growth periods.
45. While I generally accept that credit unions would benefit from measures that enhance their financial stability, the proposal raises significant concerns. The idea that such investments should be recognised as capital yet preferred over the "ordinary" shares of the credit union is problematic. Generally, capital serves as a buffer to absorb losses and, in the case of deposit taking institutions, to protect depositors. However, the preference could mean that the shares would rank ahead of deposits in a winding up. This would negate the purpose of the capital reserve. It could even increase the incentives for depositors to withdraw their funds if they have fears over a credit union's soundness, potentially destabilising the credit union.
46. Trading such shares outside a credit union's membership circle would be inconsistent with the cooperative principles and fundamental purpose of credit unions. If, on the other hand, trading is limited to within the circle of membership, it seems unlikely that many credit unions would provide a viable market. Investors may find that they need to wait for some time to sell their shares. In a worst case scenario, they may be unable to divest their shareholdings except in a winding up of the credit union - an event that normally stems from financial failure and sometimes results in a loss to members. While the risk can be mitigated by adequate disclosure, I am concerned that many credit union members will be relatively unsophisticated investors who may not fully appreciate the risks of this type of investment.
47. For these reasons, I do not recommend this proposal. However, I am sympathetic to credit unions' desire to fund growth by finding alternative sources of capital. I therefore recommend that officials work with the industry to identify lower risk alternatives that may help credit unions achieve this objective to the extent possible.
48. I agree that credit unions should be able to determine their own requirements for the minimum amount that each member must deposit. As a safeguard, I recommend that credit unions be required to specify the minimum in their rules. Any change would therefore need to be approved by special resolution. This would mitigate the risk that the management committee could unilaterally raise deposit requirements to a level that excludes low-income members.
Legal Status and Validity of Action
Current Requirements
49. Credit unions do not have full legal personality. The Act requires credit union assets to vest in trustees who hold the assets for the benefit of members and have specific duties relating to investing surplus funds. On a day to day basis, credit unions are administered by a committee of management that is analogous to a company board of directors.
Joint Proposal
50. The joint proposal suggests that, just as trustees of charitable trusts can incorporate as a board under the Charitable Trusts Act 1957, the management committee of a credit union should be able to incorporate as a board. It would therefore be able to hold assets and represent the credit union and the role of trustees would be obsolete.
Comment
51. Over the years, a variety of reasons for this proposal have been put forward. At one stage NZACU proposed the development of its own regulatory body and said that incorporation and removal of the trustees would be necessary to enable the regulator to take control of credit unions in a crisis situation. More recently, NZACU has said that incorporation of a management board would remove any uncertainty or conflict between the trustees and management committee roles. The industry has also said incorporation would resolve any uncertainty about contracts with credit unions. NZACU favours incorporation of the committee rather than the credit union as a whole, on the basis that it retains the mutual nature of credit unions.
52. Officials advise that incorporating the management committee as a board would in fact have the effect of undoing the mutuality of credit unions by legally separating the board from the rest of the credit union. The proposal would also introduce uncertainties about the relationship between the committee and the credit union as a whole. Unlike the trustees of charitable trust boards, credit union management committees serve a clearly identifiable group of "owners" who are not involved in the day to day running of the business. Like the shareholders of any company, the members need a governance regime that clearly defines their relationship with and rights in regard to the organisation's management. Legally separating the management from the members would therefore weaken credit unions' governance structure significantly. For these reasons I do not recommend incorporation as a board.
53. I note, however, that the possibility of incorporating credit unions was thoroughly researched during the 1998 review, when officials recommended that credit unions should be able to incorporate under a modified version of the Companies Act 1993. This option continues to be feasible should the industry wish to reconsider it.
Current Requirements
54. The Act also controls the activities of associations of credit unions by requiring them to seek the approval of the responsible minister when they wish to provide certain services specified in the Act.
Joint Proposal
55. The joint proposal suggests that each association should be able to decide what services it can offer, in accordance with its rules, and that associations should be able to provide services to non-members as long as they provide services primarily to credit unions.
Comment
56. While I believe the Act should continue to specify the kinds of services that credit union associations can provide, I see no need to continue requiring them to obtain ministerial approval before offering those services. I recommend that this provision be repealed.
57. I note that an earlier version of this paper considered the possibility of permitting the associations to provide services to non-members. Officials advise me that this was based on a misinterpretation of the joint proposals so it not necessary to make any decision on the matter.
Other Issues
58. […].
59. […] [C]redit unions generally agree with the joint proposals relating to the common bond, the removal of limitations on investment and borrowing, and the ability to offer equity shares. […].
60. At present, one credit union has expressed the wish to convert from the credit union regime to an alternative regime. Because the Act does not provide a framework for conversion, a special Act of Parliament is needed to allow a credit union to move to a different regime without having to dissolve and start again. This is time-consuming and costly for the credit union concerned as well as for the government.
61. I am aware that NZACU opposes the introduction of a conversion mechanism because of concerns that conversion could be misused to allow reserves to be distributed. The industry may also be concerned about the potential "loss" of members. However, I believe that conversion is a matter for the members of each credit union to decide, not for the Association; and valuable House time should not be used for such matters. In the interests of efficiency, I recommend that "in-principle" approval be given for the Act to be amended to facilitate conversion to alternative regimes such as the Companies Act and/or the Building Societies Act.
62. I note that such conversions give rise to some tax issues. In the past, these have been resolved by the special legislation enacted for the credit union concerned. Officials will need to develop the proposal further to address these issues as well as determining which regime or regimes credit unions should be able to convert to.
63. […].
64. […].
65. […] [O]n the whole, the introduction of trust deeds has significantly improved credit unions' standard of governance. This has undoubtedly come at a price for credit unions but I believe it has provided a much safer system for the individuals who save with them. Other non bank deposit taking institutions are subject to the same regime and I am not convinced that it should be altered because it restricts credit unions' growth or trustee fees are charged on a commercial basis.
66. In addition, I do not consider it feasible to create a special government unit solely for supervising credit unions […]. The industry is too small to justify its own supervisory unit and it would probably be beyond the industry's means to meet the cost of it.
67. As previously noted, questions relating to the efficacy of the trustee supervisor regime can be addressed in the proposed review of the Securities Act, while the broader issue of the benefits of a government regulator may also be considered in the context of the review of the banking and insurance sector.
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