Market Rates & Commentaries

25 July,

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Does Germany hold the key to a European recovery?

No central banker has come out and said it yet, but the reality is that most of them are pretty much out of ideas as to what to do next to revive their struggling economies. Apart from in the US where the economy is performing reasonably well, all conventional and non-conventional measures tried by central banks to date have had limited success, and it’s difficult to know what more they can do. Mario Draghi has probably come closest to admitting defeat when, on several occasions recently, he has told euro zone governments that they now need to play their part via their fiscal policies.

However, the large European economies that are most in need of fiscal stimulus – France, Italy and Spain – are the ones that can least afford it. All are either in breach of the EU’s annual budgetary limits, or have existing levels of debt that are far in excess of what is safe or healthy, and so none of them is in a position to either cut taxes or increase government spending.

There is little doubt that when Draghi talks about fiscal stimulus, it is Germany that is uppermost in his mind. Germany’s economic success means that it now has very significant current account and budgetary surpluses – i.e. it exports far more than it imports, and its government’s tax intake far exceeds expenditure.

Last year it had a record current account surplus of almost €250bn – that is the net inflow of funds into the economy at the expense of its trading partners. In 2015 it also had a government budget surplus of around €35bn (1.2% of GDP). It was expected that the arrival of over 1 million migrants into Germany over the past year would prompt a major increase in Government spending, but figures released last week show that the surplus actually increased in the first 6 months of 2016. The German Government clearly has considerable scope to increase expenditure, and if it did so it would inevitably have a positive spillover effect on the rest of Europe.

It can be argued that the average German worker has not benefited to any major extent from German’s economic and industrial success. There was a time when German trade unions were very powerful, and average wages rose very much in line with the growth of the economy. But changes made to employment law by Helmut Kohl in the 1990s greatly reduced the power of the unions, and since then German wage growth has been pretty modest.

Because of the strength and wealth of the German economy, many analysts believe that the German consumer is a potentially powerful economic force which is being held back by the excessive conservatism of both industry and government. They argue that Germany needs to share its success by granting bigger wage increases to its workers and cutting taxes. The belief is that if more money can find its way into the pocket of the average German consumer, he or she will buy more French wine, Belgian chocolates and Irish whiskey, and take more holidays in Italy or Spain.

So far Germany is not getting the message. From an economic perspective it is a highly conservative country with a strong emphasis on saving for a rainy day, and doesn’t understand or approve of the more spendthrift habits of many other European countries. It is the only euro zone country which has consistently opposed the low (or negative) interest rate policies of the ECB, because of the impact it has on savers. Unlike in most other countries, it is German savers rather than borrowers who receive most of the public and political sympathy. There is no doubt that Germany is going to come under increasing pressure to loosen its purse strings and help out its neighbours, but this would involve a major change in the German economic mindset, and there is no indication that it will happen any time soon.

Reality Check for Irish Banks

Eight years after the financial crisis began, the results of stress tests on European banks released by the European Banking Authority (EBA) recently showed that the two Irish banks included in the tests – AIB and Bank of Ireland – compared very poorly with their peers in terms of their ability to withstand another major economic downturn.

As with previous stress tests, the EBA considered an “adverse scenario” in which the global economy suffers a severe recession, equity markets tumble and interest rates rise sharply, and they project the impact this would have on each bank’s capital position. It shows that in this scenario, by 2018 AIB’s key capital ratio – known as the Fully Loaded Common Equity Tier 1 Ratio (CET1) – would have fallen to 4.31%, the second lowest of the 51 banks in the test. Bank of Ireland’s CET1 would have fallen to 6.15%, the fourth lowest of the 51 banks.

Unlike previous stress tests, this one did not set “pass” or “fail” levels, but the pass level of 5.5% in previous tests is generally seen as the minimum required. AIB was one of only two banks to come in below that level – the other one being Banco Monte dei Paschi, which we discussed in previous Investment Notes and which showed a negative CET1 position in the adverse scenario (i.e. the bank’s capital was completely wiped out).

AIB and BOI have some justification in arguing that the timing and methodology of the tests were particularly unfavourable towards their current positions and business models, but there is no doubt that the results were a disappointment and will have implications for both banks. BOI may have to review its intention to start paying a dividend again by 2017, as future profits may have to be retained in the bank to strengthen the capital position. Shareholders’ disappointment at this is reflected in a 14% fall in the share price since Friday. As virtually all AIB shares are owned by the state, there is no meaningful AIB share price, but the results have made the already difficult task of offloading that shareholding even more challenging. It also means that any hopes that the exchequer might start to earn a dividend from the bank will be put on hold as any profits need to be retained.

For comparison purposes, the table below shows the results for various credit union counterparty banks, including their actual CET1 as of December 2015, the projected CET1 as of December 2018 under the adverse scenario, and where each one ranks among the 51 banks under that adverse scenario:

CET1 December 2015 CET1 2018 – Adverse Scenario Adverse Scenario Ranking (51 Banks)
AIB 13.11% 4.31% 50
Bank of Ireland 11.28% 6.15% 48
RBS 15.53% 8.08% 38
KBC 14.88% 11.27% 15
Lloyds 13.05% 10.14% 18
Rabobank 11.97% 8.10% 37
BNP Paribas 10.87% 8.51% 33
Santander 10.19% 8.20% 35
BBVA 10.27% 8.19% 36

Could Helicopter Money Take Off?

In the past, the management of monetary policy by central banks was quite simple. When economic growth slowed they reduced interest rates to discourage saving and encourage borrowing, thereby increasing spending and getting economies moving again. When growth threatened to get too strong and inflation risked getting out of control, they increased rates again to put a gentle brake on economic activity.

After the crash in 2008 central banks began to realise (some a lot sooner than others) that policies that worked in the past wouldn’t be enough this time, and other ideas would be required. The Federal Reserve began its first Quantitative Easing (QE) programme in November 2008, and continued with similar measures until late 2014. While the US economy is still not growing at rates that were the norm before the crash, it can be argued that QE helped to prevent a 1930s-style depression that many had feared, and bring US employment back below 5%.

The Bank of England has also had a series of QE programmes, beginning in March 2009, and again it can be argued that they were successful given that the UK avoided the deep and prolonged recession suffered by many of its European neighbours. However, following the recent referendum the chances have increased that the BOE may have to revive its QE activities to counter the negative economic impact of Brexit.

At this point there is little evidence to say that the ECB’s QE policy has been a success. Much of the Eurozone is experiencing little or no growth, and the inflation rate is stuck at 0.1%, well below the target rate of 2%. The ECB shoulders much of the blame as its actions have arguably been too little too late (it didn’t start QE until March 2015, almost 6½ years after the Fed). The ECB is also now facing the problem that having bought €60bn of bonds per month since the programme began (increased to €80bn in recent months), it is now running out of bonds that meet the criteria which govern which assets it is allowed to purchase. A new policy may be needed.

Japan is another country that has had a notable lack of success in reviving its economy despite many years of near-zero or negative rates and repeated doses of QE from the Bank of Japan. The BOJ actually introduced a form of QE as far back as 2001, and there is speculation now that it may again be the first central bank to introduce another unconventional form of monetary policy, namely “helicopter money”.

The term “helicopter money” was first used by the Nobel-winning economist Milton Friedman who said that one sure-fire way of getting an economy moving was for someone to get up in a helicopter and drop bundles of $50 notes down on the general populace. While nobody is currently talking about dropping money from a chopper, other policies which would have broadly the same impact are being actively debated. In its simplest form, helicopter money could involve a central bank lodging a certain amount of money into the bank account of every man, woman and child in a country, with no requirement to repay that money.

If Japan were to introduce a form of helicopter money it would almost certainly be in a more complex and indirect form than that, but regardless of what form it might take, it would be very closely monitored here in Europe. The ECB resisted QE for a long time on the basis that it was too unconventional for its tastes. Helicopter money would be an even more radical departure, but nothing should be ruled out at this point.

Address by Registrar of Credit Unions to CUMA Spring 2016

Mr. Chairman, Members of the National Executive of CUMA, ladies and gentlemen. Thank you for inviting me to address your Spring Conference.

This morning I would like to focus on the ongoing restructuring of your sector and the importance of taking the steps necessary to reap benefits from mergers that are completed.  I will also update you on where we at the Registry will focus in our supervision of merged credit unions and to also set out the Thematic reviews we have planned for this year. I will also comment on the latest position with the implementation of our new Regulations. Finally, I would like to give you some insight into developments with respect to the business model.

But first, I would like to pay tribute to you as credit union managers for your tireless work and determination in supporting your boards to achieve the necessary restructuring of your sector, embedding  regulations and improving the financial and operational situation in your credit union. Credit unions have played  a critical role in the financial sector and in communities across Ireland for over half  a century. Your commitment to protect your credit union’s unique position in your community, while also supporting your voluntary ethos and continuing to serve your members to the best of your ability is highly valued and valuable, providing choice and access in the financial sector.

At the Registry we are committed to playing our part  in the development of  a resilient and development-focused credit union sector. We see four main requirements for this to happen : further restructuring; a substantial and sustained increase in the active borrowing membership; a marked increase in core lending, and business model development in a multi-step, well-managed way.

1:    Restructuring  

After a slow start, I think it is fair to say that the sector has moved significantly with respect to the need for, and momentum and activity towards, restructuring.  Since its inception in 2013, the Credit Union Restructuring Board (“ReBo”) has worked tirelessly to advance the voluntary and incentivised restructuring of the credit union sector. I want to acknowledge the progress that has been made and significantly facilitated by ReBo.  In 2015 alone, the sector restructured from 383 to 335 active credit unions, an important achievement.

ReBo has indicated that about 70 projects, involving potentially over 120 credit unions, are at different stages in the restructuring process. The Registry will continue to work closely with ReBo to assess each individual transfer project. The key risk parameters that are assessed include the current and projected financial position, governance standards and operational capabilities of  the credit unions on both a standalone and combined basis.

As you are aware, ReBo will only be in a position to support those transfers where a high level business case has been approved and a letter of support has been issued by ReBo on or before the 31 March.  From 1 April, credit unions that do not have this approval from ReBo but who want to progress  a voluntary restructuring solution, should contact us at the Registry of Credit Unions. Our aim with restructuring is to help put the sector on a sounder footing and contribute to the maintenance of financial stability and well-being of credit unions generally. We will issue formal communication in coming weeks to the sector outlining our intended approach to the restructuring process post ReBo.

A key driver in restructuring is the willingness of  financially strong and well governed credit unions with a strong operational profile to act as transferees.  I would encourage potential transferee credit unions – not already doing so – to consider the strategic opportunities offered by mergers.

As you might expect, as we move along in the restructuring phase, we are now seeing some new trends and issues.  More mid-sized credit unions are assessing merger opportunities, including with each other, and some proposed link-ups present special challenges regarding clarity of leadership, governance and strategic focus going forward. An important consideration in our on-going supervisory approach with credit unions will be to ensure an appropriate focus on viability and strategic planning, and to engage with both potential transferor and transferee credit unions to progress mutually beneficial restructuring projects, and also to address challenges as we see them.

We are often asked how much restructuring is needed, and what is the target number of credit unions? As I have iterated before, there is no target number. But there is an implicit target state, where credit unions are resilient and viable on a forward-looking basis, and are providing the services that members want via the channels that members expect. Clearly, we are some way from that target state, and I would continue to urge credit unions to consider whether restructuring – as a transferor or transferee – provides the prospect for a better future for their members.

One issue to flag is that there may be some credit unions willing to merge but unable to find a suitable partner. In some cases, this may arise alongside viability challenges.  In particular, I am reflecting on cases where a credit union is unlikely to generate a sufficient Return on Assets to deliver a return for members, or may be operating at a loss and actually eroding the capital reserves of the credit union. In such instances, where the credit union’s business model is no longer viable, it is not acceptable to wait until they are approaching regulatory reserve minima before prompting necessary action. For those credit unions, our engagement focus is on understanding their contingent strategies, including the trigger point at which a credit union may seek voluntary dissolution if there is no other viable strategy available.  I appreciate that these are just some of the hard decisions that you and your Boards may have to take, but it has the benefit of bringing a focus on future viability and introduces clarity about the future. Without such clarity, some credit unions could drift into regulatory insolvency and potentially resolution, where decisions about their future would be largely taken out of their hands.

2: Post-Merger Supervisory Engagement  

The motives for restructuring within the credit union sector are to support stability and to facilitate wider services for members facilitated by increased capacity and capability.  At the Registry, we want to ensure that these potential benefits from mergers can be realised, so as to put the sector in the best position to deal with its financial challenges and focus on business model development opportunities.

We are, therefore, focusing a number of our supervisory engagements towards entities in a post transfer environment. We will seek to assess

  • Progress in implementation of  the merger integration plan;
  • Progress in delivering the benefits and cost efficiencies which the transfer was intended to achieve;
  • Evidence of a shared understanding of, and action on, strategic and operational priorities;
  • Whether internal controls, policies and procedures are appropriate and are uniformly applied;
  • Strategic leadership of the board necessary to ensure a progressive and developmental orientation in the merged entity.

We recognise that embedding a new culture requires time and focus. However, I would say that, based on the sample of post-merger engagements we have undertaken so far, we are not – as yet – seeing the anticipated benefits of transfers and mergers coming through, to the degree expected or needed, in order to put credit unions on a sounder path forward.

It is critical that, post-transfer, there is continued focus on achieving the strategic and business model expansion goals, as well as the risk minimisation approaches, that are the target of the transfers. It is vitally important to use the potential for financial and operational efficiencies, and the broader capabilities of merged entities, to continue to attract younger active members and to facilitate business model development.

On the subject of involuntary restructuring, it is also worth taking stock of what has been achieved and what we have learned. Using our resolution powers, the Central Bank has undertaken three Directed Transfers and one liquidation since 2013. In the fourteen months since our last High Court action using our resolution powers, we have been able to avail of an alternative approach, using your sector’s private fund instead of taxpayers’ money. Under this approach, eight credit unions which failed to meet our minimum regulatory reserve criterion have been transferred with capital support, under legal agreements which provide appropriate safeguards to minimise risks to the greatest extent possible. The combination of these transfer and resolution cases was successful in removing the riskiest credit unions and at the same time safeguarding members funds, without disruption or contagion across the sector – a not insignificant achievement.

In reviewing the main causes of difficulty in these most problematic cases, three issues stand out :

  1. The number of instances in which the credit union undertook major investment in its own premises during the boom period (which subsequently had to be written down substantially);
  2. The scale of losses on loan portfolios (sometimes up to half the loan book), and
  3. Governance and controls failings.

While these experiences were not unique to those entities – but symptomatic of the broader over-exuberance in the economy and especially the property/financial sector connection – there are important lessons to be taken from them. These include the need to continue to implement sound and cautious lending practices especially in an environment of heightened confidence, and the need to ensure that investments and development decisions in a credit union take account of the possible reversal of business conditions – whether cyclical or structural.

3:   Thematic Reviews

At the Registry we constantly review engagement with the sector to ensure it is appropriately aligned with our priorities for the sector and any emerging risks. As part of this process, we will, in 2016, embark on a number of thematic inspections. These reviews will supplement the bilateral onsite engagement we already have in place through PRISM and provide valuable information and guidance for credit unions.  While narrower in focus, thematic reviews examine particular areas key to the proper operations of credit unions.

Our first two thematic reviews will be on Management and Oversight of Outsourced Activities, and Review of the implementation of Fitness & Probity due diligence requirements.

Management and Oversight of Outsourced Activities

Our thematic review of the management and oversight of critical outsourced activities is to understand better where risks arise, are held, are managed and reviewed with respect to outsourced arrangements. A credit union is only as strong as the weakest link in its outsourced processes. Risks that can arise through outsourcing include inability to execute transactions; inability to confirm balances or financial positions; inadequate control systems or culture. We will seek to confirm that credit unions are meeting their members needs and evolving business offerings through their outsourced arrangements, and that the content of SLAs are appropriately challenged to ensure they provide the appropriate level and type of services required.

Review of Fitness & Probity due diligence requirements

With regard to a thematic review of the due diligence process with respect to Fitness & Probity requirements, our focus is to ensure that the governance of credit unions is strengthening in line with our regulatory requirements. We will include a focus on the role of the Nominations Committee, in particular the process for identifying suitable candidates, and the consistency of the criteria applied with special emphasis on Control Functions.

We will shortly communicate with you more formally on the scope and timing of these planned thematic reviews. These will consist of desk-based and onsite elements. The typical sample size will be such that lessons learned from the exercise can be extrapolated across the sector. While we will address any issues identified directly with the credit union(s) concerned, we will also communicate our findings in aggregate to the sector. This will outline the standards achieved and also our expectations in the areas examined. For the credit union sector and, particularly for you as managers and for your boards, this is intended to build a clear understanding of the nature of the particular risks and set out the risks that should be considered and, where necessary, addressed in the context of your own governance and control framework.

4:   Business Model Development

We know that your credit unions are working to overcome the many challenges you face, especially the declining core loan income and ageing membership base and the need to attract new younger active borrowers by offering the services they want via the channels they expect.  The key to overcoming these challenges will be the development of appropriate, viable and sustainable business models.  At the Registry we are now starting to see more initiatives or proposals for new products, service s or link-ups with other bodies.  As you explore options for your future business model and your specific proposals, this should help to further clarify what is – and what is not – beneficial for, and realistically achievable by, your sector.

It is important to be clear that it is not the role of the Registry to develop the future path for the sector. That is for the sector itself to decide. Whether that path involves widescale consolidation, further restructuring and the development of a variety of business models or confederation, it will be up to credit unions to take the decisions and to manage the risks involved.

At the Registry we are not seeking to constrain your business models, but to ensure that proposed developments are carefully assessed. Where credit unions set out a clear path on how they wish to develop, we will consider any amendments to the regulations that may be appropriate.

With that as context, there are opportunities for sector representatives and the Registry to engage, in a beneficial way, to advance the business model development agenda. As you know, we are undertaking stakeholder meetings on business development, aimed at discussing our business model transformation expectations and providing credit unions with a well-grounded basis to develop risk-based and feasible transformation initiatives.

Three meetings have been held and the priorities identified for 2016 include

  • Review of longer term lending limits;
  • Clarity on additional services framework, and
  • Publication of sectoral data and analysis.

With regard to longer term lending limits, we at the Registry are reviewing the existing conditions and will assess whether the limits are impacting in any meaningful way on business model development proposals. On the additional services framework, we will provide information to credit unions to help clarify how the application process works in practice. The next meeting of this forum takes place on 13 April and will provide an opportunity to update on developments.

5. New Regulations

As you aware, we are continuing to work on the development of the application process for the retention and acceptance of new savings over €100,000. We will continue to engage with sector bodies – including CUMA – as we finalise these processes. Our objective is to ensure that the approvals are consistent with the adequate protection of the savings of members and are effective and proportionate. When the application processes are finalised, the Central Bank will provide credit unions with application forms accompanied with explanatory notes for each application process. We are also committed to review the savings limit three years from commencement of the regulations.

6: Conclusion

We have spoken before about the challenges facing your sector and the efforts which you and your Boards and colleagues have taken, in difficult circumstances, to achieve the best outcomes for your credit unions. The greater momentum towards restructuring has provided the basis on which to build significant improvements in the outlook for the sector, and we will work with ReBo to complete the proposals in the pipeline where they best protect members’ funds and sector stability.

Mergers are not an end in themselves, and I urge you to continue the work required to reap the potential financial and operational benefits of mergers, with the aim of putting the combined operation on a sounder footing to make progress into the future. You must decide the form that your sector’s future will take and satisfy yourselves that you will continue to be able to meet your members’ and community objectives, as well as your regulatory requirements, as you move forward in a multistep approach to develop sustainable business models for the credit unions of the future. I wish you success in the vital role you play as front line managers of credit unions, as you work to secure the future of your credit union and the overall sector.


Thank you for your attention.