PS11/23 – Credit Unions: Changes to the regulatory regime

1. Overview

1.1 This Prudential Regulation Authority (PRA) policy statement (PS) provides feedback on responses to consultation paper (CP) 7/22 – Credit Unions: changes to the regulatory regime It also contains the PRA’s final policy, as follows:

• amendments to the Credit Unions Part of the PRA Rulebook (Appendix 1); and
• a new Supervisory Statement (SS) 2/23 – ‘Supervising credit unions’ (Appendix 2) which supersedes SS2/16 – ‘The prudential regulation of credit unions’, which has been deleted

1.2 This PS is relevant to all UK credit unions. Certain amendments apply only to Great Britain credit unions.^{footnote [1]}

Background

1.3 In CP7/22 the PRA proposed to:

• provide more flexibility for credit unions when investing their surplus funds so long as they meet specified requirements and consider applicable guidance;
• set higher requirements and expectations for credit unions that pose greater risk to the PRA’s safety and soundness objective (either due to their size, or activities undertaken); and
• clarify the PRA’s existing expectations of credit unions in certain areas.

Summary of responses

1.4 The PRA received 36 responses to CP7/22. Respondents generally welcomed the PRA’s proposals, while some respondents raised concerns and/or requested clarification on a number of areas. This is set out in Chapter 2.

Changes to draft policy

1.5 Where the final rules differ from the draft in the CP in a way which is, in the opinion of the PRA, significant, the Financial Services and Markets Act 2000 (FSMA)^{footnote [2]} requires the PRA to publish:

• details of the difference together with a cost benefit analysis; and
• a statement setting out in the PRA’s opinion whether or not the impact of the final rule on mutuals is significantly different to (i) the impact that the draft rule would have had on mutuals; or (ii) the impact that the final rule will have on other PRA-authorised firms.

1.6 The PRA does not consider the rule changes from the draft CP to be significant. The most material changes to the draft policy as set out in CP7/22 include:

• In the Credit Unions Part of the PRA Rulebook:
  • changes to the categories of permissible credit union investments, including clarification of the application of the counterparty concentration limits;
• In SS2/23:
  • changes in presentation that make the SS easier to read;
  • changes to the investment counterparty concentration limits to provide that they would not apply to certain investments;
  • changes to the PRA’s expectations regarding the quality of credit unions’ capital base;
  • clarifications of the PRA’s expectations with respect to credit unions that provide mortgages; and
  • changes to the PRA’s expectations for large credit unions to carry out exit strategy planning.

1.7 The PRA has considered the costs and benefits of the changes made to the rules and SS. The changes to the rules and SS text that relate to credit union permissible investments continue to provide credit unions with additional scope to invest surplus funds with a wider range of products, however with more flexibility to enable credit unions to invest a larger proportion of funds with highly rated counterparties should they wish to do so. The PRA has removed Undertakings for Collective Investment in Transferable Securities (UCITs) from the category of permitted investments, but does not consider this to have a material impact given (i) it is unlikely any existing fund would have met the criteria proposed, and (ii) there is less need for this category of investments now as the PRA is proposing to allow credit unions to hold more funds with highly rated counterparties.

1.8 The PRA has provided additional detail on its expectations on the quality of capital held by a credit union, including, for example, details of capital arrangements that would raise particular concerns on longer term sustainability. The PRA has separated out and increased the limits of subordinated debt and interest-bearing deferred shares which should provide credit unions with additional flexibility to meet their capital requirements. The PRA has provided more details around its expectations for when a credit union exceeds these limits, which includes providing plans to the PRA to satisfy supervisors that, for example, the credit union has a robust and credible plan for reducing reliance on external funding. The PRA considers this to be justified and proportionate given the additional risks involved.

1.9 The remaining amendments are largely clarifications or areas where the PRA has provided additional flexibility, for example, in recognition of the limited resources of smaller credit unions and the importance of taking a proportionate approach.

1.10 When making rules, the PRA is required to comply with several legal obligations, including considering responses to consultation and publishing an explanation of the PRA’s reasons for believing that making the proposed rules is compatible with its objectives and with its duty to have regard to the regulatory principles.^{footnote [3]} In CP7/22, the PRA set out this explanation in Chapter 3 ‘The PRA’s statutory obligations’, and the PRA has provided an updated explanation to take into account consultation responses.

1.11 The PRA considers that these changes to the draft policy are particularly relevant to the regulatory principle that places emphasis on the desirability of recognising the differences in the nature and objectives of business models carried out by different persons. For example, the amendment to permit a greater proportion of credit union funds to be invested with highly rated counterparties recognises that this is the strong preference for a majority of smaller credit unions with a simple business model who do not have the desire, nor in some cases the resources or expertise, to invest their funds more widely. The PRA considers its amendments to include further detail around the PRA’s expectations with respect to quality of capital are consistent with the principle that the PRA should exercise its functions transparently.

Implementation and next steps

1.12 The new rules and SS will take effect on Tuesday 29 August 2023.

2. Feedback to responses

2.1 Before making any proposed rules, the PRA is required by FSMA to have regard to any representations made to it, and to publish an account, in general terms, of those representations and its feedback to them.^{footnote [4]}

2.2 The PRA has considered the responses received to the CP. This chapter sets out the PRA’s feedback to those responses, and its final decisions.

2.3 The sections below have been structured broadly along the same lines as the chapters of the CP. The responses have been grouped as follows:

• Changes to the Credit Unions Part of the PRA Rulebook
  • Extending the range of credit union permitted investments
• Credit Union SS and superseding of SS2/16
  • Presentation of the SS
  • Liquidity
  • Capital
  • Mortgages
  • Exit strategy planning

Changes to the Credit Unions Part of the PRA Rulebook

Extending the range of credit union permitted investments

2.4 The PRA proposed to extend the range of permitted investments to include a wider range of products, where a credit union is meeting certain requirements, as the existing Credit Unions Part of the PRA Rulebook provides credit unions with a limited range of options when investing their surplus funds, and some credit unions struggle to find sufficient highly-rated counterparties willing to accept their funds. The extended range proposed including corporate bonds, bank bonds, undertakings for collective investments in transferable securities (UCITS), qualifying money market funds (MMFs), and supranational bonds. This would move the emphasis away from capital protection which would be a step change and in order to minimise any corresponding risks, the PRA proposed to put in place a number of safeguards, for example, relating to the investment grading, counterparty concentration limits, and expectations around liquidity management (see Table A).

2.5 The PRA also proposed that credit unions with over £10 million in assets (as well as credit unions investing in the new investment products) should be expected to meet investment counterparty and concentration limits in relation to the existing investment products as well. This included an expectation that an amount equivalent to no more than 75% of a credit union’s total capital should be held with a single counterparty, and no more than 20% of total investments should be held with a single counterparty.

2.6 While most respondents welcomed the PRA’s intention of broadening the scope of investment products available to credit unions, some respondents opposed the proposed 75% counterparty concentration limits (referred to in paragraph 2.5). The respondents viewed the proposals as pushing them to move their funds to potentially riskier counterparties (with a greater risk that one of their counterparties will default – due to increased number of counterparties as well as lower credit quality of counterparties). Some respondents also referred to the administrative burden of opening accounts and maintaining a relationship with multiple counterparty banks.

2.7 The PRA recognises that the majority of credit unions have a strong preference for investing their surplus funds in low-risk counterparties (such as gilts or highly-rated credit institutions that are authorised in the UK to accept deposits) and do not have the desire, or in some cases the expertise, to invest their funds more widely. The PRA also recognises that while its proposals would have expanded the scope of products available, the attaching conditions proposed would have meant that, in practice, a number of the investments would not have been available to many credit unions. In light of this, the PRA has amended the concentration limits set out in paragraph 2.5 so that they would not apply to the following investments:^{footnote [5]}

• sterling denominated securities issued by the UK government, or a fixed interest sterling denominated security guaranteed by the UK government with a maturity of up to five years from the date on which the investment is made (under Rules 6.3.3, 6.3.4, 6.4.3, and 6.4.4 of the Credit Unions Part of the PRA Rulebook)^{footnote [6]};
• deposits placed with a credit institution which is authorised in the UK to accept deposits on terms that the deposit shall be repayable within at most 12 months from the date on which the investment is made (under Rule 6.3 (1) of the Credit Unions Part) and rated A-AAA by at least two credit rating agencies registered with the FCA; and
• UK bank bonds which have a maturity of up to five years from the date on which the investment is made (under Rule 6.4 (6) of the Credit Unions Part) and rated A-AAA by at least two credit rating agencies registered with the FCA.

2.8 The PRA has set out more information on this expectation in the SS, for example, the PRA’s expectations where a rating changes during the investment period. The PRA has also outlined in the SS that it remains good practice for credit unions to spread funds out where practicable. Before making investment decisions, credit unions should remain mindful of the importance of not creating excessive source concentrations in line with Rule 6.5(4) of the Credit Unions Part of the PRA Rulebook.

2.9 The PRA has also made a number of other changes to the investment rules in light of feedback received:

• UK bank bonds – to clarify that the 5% and 30% counterparty limits in Rule 6.4 (which provides that a credit union cannot directly invest more than 5% of its capital in corporate/non-UK bank bonds, and cannot invest more than 30% of its total capital in the new more complex investments), do not apply to bank bonds issued by credit institutions authorised in the UK to accept deposits.
• Supranational bonds – (a) to clarify that these must be sterling-denominated (avoiding currency risk); and (b) to remove the 5% counterparty limit for supranational bonds given that they are usually highly-rated institutions. The 30% limit (across all new investment products) would still apply.
• MMFs – The requirement for MMFs to be comprised of credit union permissible investments has been removed, as (a) these are generally low risk investments with close capital certainty; and (b) no MMFs would currently meet the requirements as currently worded (it would therefore require a bespoke solution which would be costly and likely take several years to deliver).
• UCITS – This category has been removed because (a) it is unlikely any funds would meet all of the criteria proposed;^{footnote [7]} and (b) there is less need for this category of investments when credit unions are able to hold more funds in certain highly rated counterparties (paragraph 2.7).

2.10 A number of credit unions also urged the PRA to consider a wider range of permitted credit union investments, such as Credit Union Service Organisations (CUSOs) and local authority sponsored projects. The PRA will continue to keep this area under review.

New credit union SS2/23 superseding SS2/16

Presentation of the SS

2.11 Following feedback that the draft SS was difficult to read, especially for smaller credit unions with a simple business model, the structure of the SS has been changed to make it more accessible and user-friendly. For example, the expectations that only apply to credit unions that invest in more complex investments, lend to corporate members, provide consumer credit, or provide mortgages, have been removed and separate chapters created for these. Separate chapters for credit unions that have more than £10 million, £50 million, or £100 million in total assets have been created.

2.12 This has resulted in a much shorter ‘core’ SS (Chapters 1-10) that applies to all credit unions and are the only chapters a credit union needs to read if it has less than £10 million in total assets and does not carry out complex activities.

2.13 The PRA’s expectations that relate only to larger credit unions (with more than £10 million, £50 million, or £100 million in total assets), or credit unions carrying out more complex activities (such as investing in more complex investments, lending to corporate members, providing consumer credit or mortgages) are set out in separate Chapters 11 to 17.

Liquidity

2.14 The PRA proposed additional liquidity expectations for credit unions with more than £50 million assets and/or credit unions that wish to undertake more sophisticated investment business as outlined above, and/or credit unions that provide mortgages, loans to corporate members, credit cards or hire purchase/ conditional sale agreements, to undertake basic liquidity stress testing in recognition of the additional risks they present.

2.15 The proposals were generally welcomed, although some respondents note that the proposed expectations for liquidity stress testing may be disproportionate for some of the proposed categories of products it would apply to (ie hire purchase, conditional sale, and corporate member loans) and could represent a barrier to credit unions wishing to provide these products. While the PRA acknowledges that the risks posed by some categories (ie hire purchase) are less than others (ie mortgages), they do nonetheless pose additional risks (eg in the case of hire purchase there is a risk of goods being returned that are potentially worth less than the outstanding loan) and credit unions wishing to provide these products should be able to demonstrate capability to manage associate risks. The PRA therefore does not intend to make any changes to the credit union liquidity expectations as proposed.

Capital / Quality of capital

2.16 The PRA proposed to clarify its expectations with respect to quality of capital. This included an expectation that, with the exception of credit unions that have been established for less than five years, no more than 50% of a credit union’s minimum capital requirement should be comprised of subordinated debt or interest-bearing deferred shares. The PRA proposed that where the capital base of a credit union (that has been established for more than five years) exceeds this level, the PRA would expect to be notified of this, and of the credit union’s plan to reduce their reliance on these sources of capital.

2.17 Respondents gave mixed feedback on this proposal. While many were supportive, a number of respondents who would be directly affected by the proposal were strongly opposed, citing the benefits of external investment to drive growth and long-term sustainability of credit unions. They noted that many credit unions seeking to grow are held back by high operating costs and customer acquisition costs, and that external finance can allow credit unions to meet capital requirements while investing in technology, marketing, and back-office services. Respondents also highlighted the distinctions between subordinated debt and interest-bearing deferred shares (which are perpetual and do not carry a refinancing risk) and requested that they are not subject to the proposed combined limit.

2.18 The PRA acknowledges that external capital investment can be an important tool in supporting a credit union’s growth, in particular in the early years when a credit union is first established, to help credit unions recover from financial shocks in the short term and to support growth plans or the expansion of services in a sustainable manner. However, the PRA considers that the use of material amounts of subordinated debt and interest-bearing deferred shares could have the potential to threaten the sustainability of a credit union if not used appropriately and prudently. Credit unions utilising such instruments are expected to demonstrate they are acting in the best interests of members, particularly if capital arrangements mean that operating profit is in a large part used to service the capital coupons rather than serving as returns to members. Credit unions should carefully plan their approach to such instruments with a view to operational sustainability and viability. 

2.19 The new SS sets out in more detail the PRA’s expectations on the quality of credit unions’ capital. There are separate limits for subordinated debt (no more than 50% of the minimum capital requirement) and interest-bearing deferred shares (no more than 75% of minimum capital requirement to be comprised of subordinated debt and interest-bearing shares), and we have set an asset limit on the application of these limits so smaller credit unions are unaffected (applies to credit unions with more than £50 million in total assets). There is also an expectation that credit unions should not be raising external capital in order to service existing capital coupon payments.

2.20 The SS sets out that there may be circumstances where the limits referred to in paragraph 2.19 may be exceeded, and in such instances the PRA would expect credit unions to provide details to satisfy supervisors before proceeding with their plan to raise such capital. The PRA would then review the credit union’s plan taking into account factors such as whether the arrangements provide investors with external influence over the credit union and whether the credit union has a robust and credible plan for reducing reliance on external capital investment (see SS2/23 paragraph 2.14).

Mortgages

2.21 The PRA proposed to set an expectation that credit unions that offer mortgages should, as evidence of good practice, consider relevant sections of SS20/15 – Supervising building societies’ treasury and lending activities.

2.22 While many welcomed the proposals, some respondents directly affected by the changes shared some concerns, noting that SS20/15 was written solely for the building society sector whose primary lending business is the underwriting of mortgages, whereas it is a secondary activity for credit unions whose main lending business is unsecured lending. Respondents highlighted that interest rate risk is different for credit unions. They noted that credit unions have a discretionary dividend declared at the end of the financial year (interest-bearing accounts are rare so most credit unions do not have contractual re-pricing risk), and credit unions’ loan books have relatively few low-margin mortgages as the majority of their loan book are unsecured personal loans at a higher APR reflecting the higher credit risk. It was also noted that due to the low mortgage volumes (eg, a credit union might only administer mortgage lending of up to £1 million over a 12-month period), adopting an administered or matched approach may prove difficult.

2.23 The PRA considers that a number of elements of SS20/15 may not apply directly or be practicable for credit unions to apply, and additional wording has been included in SS2/23 to acknowledge this, asking credit unions affected to discuss their intended approach with their supervisor. Credit unions that have a fixed-rate mortgage book would be expected to demonstrate that they are managing the interest rate risks adequately and follow, to the extent possible, the risk analysis elements of the financial risk management indicative control framework in SS20/15 for the ‘administered approach’ (the approach followed by small building societies that hold less than 10% of their balance sheet in fixed rate assets). The PRA expects such credit unions to discuss their approach for managing interest rate risk with their supervisor and share their plan.

Exit strategy planning

2.24 The PRA proposed to set an expectation that the largest credit unions (with more than £100 million in assets) consider the steps and resources needed to (i) wind down; and (ii) achieve a transfer of engagements, in an orderly manner, while minimising negative effects on members. Credit unions would be expected to evidence that they have evaluated the risks and impact of these actions and considered how best to mitigate them.

2.25 While the respondents generally supported the overall objective of exit strategy planning, it was noted that several of the potential barriers are legal, and common to all very large credit unions, rather than anything specific to an individual credit union (eg a credit union is not able to sell its loan book under the current legislation). Moreover, while transfer of engagement is a route used effectively by smaller credit unions that are no longer viable on their own, it is less clear whether credit unions with assets over £100 million could find any compatible partner (eg common bond requirements mean a credit union can only transfer to another credit union with the same or overlapping common bond; also legislative restrictions prohibit a credit union from transferring to a bank or building society).

2.26 The PRA has retained the expectation that credit unions with more than £100 million in assets undertake basic exit strategy planning. However, in light of the above, the PRA plans to work closely with the larger credit unions and trade bodies to facilitate some of the work in this area, for example to identify common obstacles to achieving an orderly wind down or transfer.

Other minor changes

2.27 The remaining amendments are largely clarifications or provide additional flexibility, for example in recognition of the limited resources of smaller credit unions and the importance of taking a proportionate approach.