Why do Credit Unions fail?
The recent failure of the Castle & Crystal Credit Union brought into sharp focus the vulnerability of these community institutions to both micro and macro challenges. Coming so soon after the failures of 6 Towns Credit Union and the Birmingham Inner Circle Community Credit Union, and the failure of some 85 other Credit Unions in period between 2002 and 2015, it’s clear there’s a problem that’s not going away any time soon.
That Credit Unions are under pressure is not in dispute. Legal restrictions around the composition of a Credit Union means they are more dependent on depositors and exposed to borrowers with common risk profiles, making it difficult for them to diversify. Capital adequacy, asset quality, earnings performance, and liquidity are all factors that can ultimately feature in their demise.
Credits Unions can trace their history to the 1840s, when a group of weavers in Rochdale created their own society and sold shares to members to raise the capital necessary to buy goods at lower than retail prices, and the sold those goods at a saving to members. The idea caught on, and the concept of a ‘Credit Union’ spread across the world. Its mission then, as it is today, is to promote the financial wellbeing of its members, which it does by providing a broad range of financial products, predominantly loans, but also venturing into mortgages, bank accounts and ISAs.
Unlike the banks, they are not subject to market pressures for growth, earnings and performance, which begs the question: why do they fail? It is also interesting to consider why they are failing now, whether it is a trend, and whether there are any common reasons as to why?
A review of Credit Union failures five years ago by the Bank of England highlighted many of the challenges that Credit Union’s face. The biggest single pressure was one of regulation, and the onus placed on reporting. To monitor their performance, every Credit Union is obliged to submit details of assets, liabilities, profit and loss and liquidity. The regulator requires them to maintain a minimum level of capital and liquidity, and a liquidity ratio (taking into account risk adjusted capital and provision of bad debt) of 10%.
In very simple terms, Credit Unions fail because their capital and liquidity fall below the minimum levels required, and because lower capital ratios make them more vulnerable to shocks. The most vulnerable of all tend to be the smaller, less well capitalised and less profitable Credit Unions which are less able to withstand macro-economic factors such as increasing national unemployment rates and inflation.
This shouldn’t be a surprise. As far back as 2010, Liverpool John Moores University (LJM) wrote a paper that summarised the principal reasons for failure as being loan delinquency and bad debt, invariably in the context of a poor economic environment. Credit Unions simply ran out of cash because they had insufficient income to meet expenditure. Losses were eroding their capital base, and situations were being exacerbated by an end to local authority grants and government subsidies that they once used to rely on.
While those are the technical reasons for failure, they only go some way to explaining the ‘why’. LJM was quite brutal in its assessment. It cited a lack of financial discipline, a lack of financial control, and a paucity of financial information at Board level. It called into question the Boards’ ability to think strategically and adapt to changing environments, and the inability to accurately and meaningfully analyse financial results.
It went further, highlighting poor lending decisions that stemmed from poor credit administration, and the poor management of the loan portfolio leading to the Credit Unions being financially overexposed. It also cited an inability for the Credit Unions to diversify their risk, thus increasing their vulnerability, and a lack of formal systems and controls which prevented potential problems or deficiencies from being highlighted sooner.
Macro issues were, of course, also a factor, as well as ‘regionality’. If a membership was reliant on a small number of regional employers, then the failure of any one of those employers would negatively impact loan book collections. Poor economic conditions bordering on recession also led to a reluctance upon borrowers to take on credit.
Perhaps the elephant in the room as regards why Credit Unions fail, but LJM was bold enough to address, was the competence of the management, and whether they had the right skill sets to analyse financial data, ask challenging questions and hold employees and indeed other Board members to account.
Many Board members were and still are willing members of the local community who want to do right by their community, but lack the commercial culture and business instinct to make it work. A lack of succession planning and single points of failure (i.e an over-reliance on one or two key individuals) also led to difficulties, as did gatekeeper founder members refusing to allow the Credit Union to evolve.
LJM’s assessment, and the more recent Bank of England review, in many ways match our own experience in working with Credit Unions in Administration. It is therefore interesting to contrast a regulatory and academic view with the experiences of the directors themselves when they are struggling with a potentially failing entity, and the lessons that other Credit Unions could learn as a result.
A common issue Credit Unions have prior to going into Administration, based on our experience, includes significant and recurring issues with their IT and operating systems. To that end, investment in new technology, and better training for those tasked with using it would certainly help with ensuring access to more accurate and timely information about loan book provisions and losses which would in turn prevent them from falling in breach of regulatory requirements. Focused investment to update operating software will also ensure that current platforms remain compatible with regulatory standards.
While not to understate the investment required, technology is a comparatively easy fix. Perhaps more of a challenge is ensuring that the Credit Unions receive appropriate professional advice and support at the appropriate times. The quality of your choice of auditor, for example, will help in identifying issues and shortfalls early, and ensuring the Board has a correct view of the actual financial position and underlying trends.
Procuring well is also important. Good outsourcing decisions can prevent a Credit Union from entering a contract (into the provision of new office equipment or third-party credit control, for example) that it cannot afford. Similarly, recruiting well, and making sure those employees are fully supported prevent critical members of staff from being overwhelmed and mistakes from occurring.
Marketing to attract new members is critical, as is ensuring the right products are being made available to the right people. Encouraging new talent to join the Board is also critical, but increasingly difficult in an age where many are time-poor, and balancing a voluntary role with their everyday working responsibilities can be a challenge. The future success of Credit Unions, however, is dependent on having a new generation of executive-level Board representatives with current industry knowledge working with existing Board members with time served to deliver the optimum blend of age and experience. It is also important to ensure the Board remains focused, energised and engaged, since fatigue can inevitably lead to poor decision making, however well intentioned.
Some of the challenges Credit Unions face are not of their own making: pressure to offer ‘free’ services and apps, like the banks; difficulties with mergers to achieve economies of scale; ongoing decline in the grants, reliefs and financial support available from local councils. The cost-of-living crisis and inflation, as mentioned earlier, have meant that many borrowers have been unable to keep up with their repayments which, combined with falling memberships, make a difficult situation more difficult still. This difficulty is further heightened by an industry feeling that legislation makes it too easy for individuals to escape unsecured borrowing through a multitude of easily accessed debt management offerings.
There are a number of issues common to any failing business, and any failing Credit Union. Not surprisingly, Credit Union Boards recognise they are becoming increasingly vulnerable in an increasingly uncertain economic environment. The successful Credit Unions of the future will probably be those who are quickest to adapt to a changing economic and political landscape. They will recognise that the old model of providing cheap finance to a narrow demographic only works if the Credit Union is adequately funded. And since public sector funding is drying up, they will need to become more profitable through increased efficiency and an investment in technology.
This transition to a new state is not going to be easy, but it is essential. Credit Unions have a vital role to play in communities and their survival is important. They are not simply symbols of ‘fair’ finance but rather deliver tangible support to the people who need it most in a space that the government does not currently support. Notwithstanding they are not for profit in structure, they will need to adapt their business model and that means a potential shift in mindset. To prosper and grow, they will need to look and act like other commercial entities and diversify the products available to members where the business risk is reduced.
James Sleight is a Partner at PKF Littlejohn Advisory. He works in the restructuring team and head of its Leeds Office. He specialises in restructuring and financial distress solutions for company directors, lenders and regulatory institutions. James works with clients throughout Yorkshire and the North East, and also in London, where he spent over 15 years of his earlier career.