10 January 2019

BIS: Regulation and supervision of financial cooperatives

Based on a survey of regulators and supervisors from both emerging market and advanced economies, the paper outlines these challenges in the new regulatory and technological context and assesses how FCs and the relevant authorities are responding.

In many jurisdictions, financial cooperatives (FCs) are the most numerous financial institutions although their share in total banking assets is typically limited. As such, most FCs are small, with a simple business model based on deposit-taking and lending. However, in some European jurisdictions, FCs make up a larger share of the financial system, with some institutions considered to be systemically important.

How FCs do business and organise themselves differs significantly across jurisdictions. At one end of the spectrum, FCs are small, with a simple business model, and serve only their members. At the other end, FCs pool resources and form federations with internal solidarity schemes or even consolidated groups. These centrally coordinated networks may resemble those of large banking groups, conducting business with non-members and providing a wide variety of services.

FCs and commercial banks differ mainly in terms of their ownership structure and aims. In a traditional FC, each member has one vote, regardless of the number of shares held. In addition to being owners, members are also depositors and borrowers, with some participating in the FC’s governance bodies Furthermore, an FC’s main purpose is to serve its members by providing affordable financial services. Although FCs need to be profitable to sustain their activities, maximising profitability to distribute revenues to owners is not their sole or even primary aim.

FCs have certain competitive advantages. Funding is frequently cheaper and generally more stable than that of most commercial banks, as it is sourced mainly from members’ deposits and member shares. Also, thanks to their local focus, FCs traditionally have – or are perceived to have – closer client relationships and may be better able to customise services. Finally, FCs may be better placed to cooperate with each other to achieve scale economies than are rival commercial banks.

These characteristics also create challenges. FCs’ local focus of operations, common bond requirements and typically small size mean that they are more exposed to concentration risks in both their assets and liabilities. In addition, their capacity to increase resilience or expand their business is limited since capital growth relies mainly on accumulating retained earnings and expanding membership. Finally, the governance structure, in which members of the board of directors and of the senior management are also owners and customers, can give rise to a wider range of conflicts of interest than at commercial banks Moreover, the ownership structure and legal nature of those entities make some of the standard bank resolution approaches unsuitable for failing FCs.

Changes in technological developments may be eroding some of FCs’ competitive advantages. In particular, the use of technology such as online and mobile banking allows competitors to offer a wider variety of financial services in geographical areas where they have no physical branches, and at a lower cost.

To respond to these challenges, FCs may need additional human and financial resources. These pressures are particularly relevant for small and standalone FCs, given that they would need to invest heavily to improve processes, systems and staff skills.

In general, the new challenges strengthen the case for increased cooperation among FCs. Resources can be pooled in order to achieve economies of scale and for investment in strategic areas. Common services provided by central entities include capacity-building and support in compliance, risk management and other areas. Common structures may also provide central liquidity management and facilitate payments system access. Mergers between healthy FCs can also generate economies of scale.

Increased cooperation could also support business diversification and access to capital markets. This would help FCs offer a wider range of products, attracting new types of customers. Business diversification would reduce FCs’ concentration risks on the asset side and their reliance on interest margins. Larger cooperative networks could gain improved access to capital markets and help to reduce concentration risk on the liability side by diversifying funding sources.

More cooperation would help strengthen risk and crisis management. In networks where cooperation among FCs is more systematic, FCs have developed mutual guarantee systems. Failures of individual FCs in such networks tend to be rare because the central entity has the tools to provide liquidity and solvency assistance and, where necessary, to promote mergers or intervene at an early stage before a member FC’s viability is compromised. Timely intervention is desirable as contagion risk across different FCs can be significant.

Policy intervention might be necessary to deal with FCs’ challenges. Challenges in relation to risk concentrations, funding, governance and crisis management could be mitigated through increased cooperation, which could be promoted through regulatory incentives or requirements. National regulations could encourage the creation of networks, including the creation of consolidated groups, with sound governance, clear roles for the central body and effective solidarity mechanisms to facilitate crisis prevention and management.

Policy action may be also needed to strengthen the protection of buyers of member shares. FCs typically issue member shares, or other capital instruments that may qualify as regulatory capital, to their own customers in so-called self-placements. Buyers are typically retail customers, who may be investing their savings in instruments that are sold as alternatives to low-yielding savings accounts. This can result in mis-selling, as FC customers may be unaware of the loss-absorption characteristics of these instruments. To address these uncertainties, specific customer protection requirements related to issue documentation, marketing materials and disclosures may be necessary.

Regulators should promote a level playing field for different types of institution. Tailoring of some regulatory requirements may be justified, in cases where they are disproportionately high for entities that due to their size and complexity (proportionality), are less able to take advantage of economies of scale. At the same time, a cautious approach needs to be taken when establishing different sets of rules for different types of financial institution with similar size and risk profiles (differentiation) as this could create market distortions and tilt the playing field. Furthermore, applying the differentiation and proportionality concepts should not lead to overprotecting specific types of institution, thus creating competitive distortions.

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