Prudential Regulation and Australian Credit Unions

Abstract

This paper examines the impact of recent changes in the prudential regulation of non-bank financial institutions in Australia, with a particular focus upon the implications for coöperative financial institutions, such as credit unions. Such institutions are unable to raise external capital to satisfy regulatory capital requirements, and are thus forced to rely upon retained surpluses to generate capital. This, it is argued, creates an incompatibility between the regulatory structure and institutional form, imposes an arbitrary constraint on coöperatives' growth and can induce a focus upon inappropriate financial targets by credit union management. A further impediment to the survival of coöperative financial institutions can be found in the risk weights applied for capital adequacy purposes. It is suggested that these constraints will hasten the on-going decline in the number of credit unions through mergers and conversions to alternative forms.

Accounting Window Dressing and Template Regulation: A Case Study of the Australian Credit Union Industry

“…It is well known that credit unions have a comparative advantage in managing personal loan debt. Because of their restrictive membership covenants, and relationship banking philosophy, they have lower agency costs and thus bad debts when compared to banks [Davis (1994)]. Therefore, why should credit unions be penalized if banks do not invest in lowering these agency costs?…”

“…As a group, and relative to similar positions in the financial sector, it may be argued that credit union managers have captured an influential power base and higher salaries and perquisites based on size [Davis (1994)], and therefore they have a strong incentive to minimise the risk of institutional failure in order to maintain this supernormal stream of salary and perquisites. Whilst these window dressings are risky, Bishop and Lys (2001) propose that the expected costs of regulatory violation are larger than the reputation costs of censure from the regulators.…”

“…As early as Berle and Means (1932) there was a recognition that, in the face of diffused member and board power, managers may further their own interests by hiding poor performance, diverting cashflow to preferred investments, giving themselves overly generous salary and perquisites, and in capitalising these benefits by job entrenchment. Davis (1994) and Frame, Karels and McClatchey (2003) suggest this may be the case for some credit union managers.…”

“…Davis (1994) documents that credit unions have unrefined corporate governance structures with policy and board agenda dominated by managers. As a result, there are moral hazard problems that results in weak bonding covenants between management, the membership, and the board of directors.…”

A review of research on regulation changes in the Asia‐Pacific region

“…Papers examining the impact of new regulation include Chong et al (1996) on the effect of the Financial System Reform Act (FSRA) of 1992 on the Japanese financial services industry; Davis (1994) on prudential regulation of non-bank financial institutions in Australia, specifically the effect on cooperative financial institutions, such as credit unions; and Yan et al (2014) on the consequence of the 2008 deposit and wholesale funding guarantee on depositor market discipline of Australian banks. Batiz-Lazo and Billings (2012) document some unintended consequences of regulatory change in a case study of a major British mutual financial organisation where accounting manipulation occurred to offset the unfavourable impact of new regulation.…”