Deposit insurance and credit unions: an international perspective

Published date27 February 2007
DOIhttps://doi.org/10.1108/13581980710726787
Pages42-62
Date27 February 2007
AuthorKevin M.G. Hannafin,Donal G. McKillop
Subject MatterAccounting & finance
Deposit insurance and credit
unions: an international
perspective
Kevin M.G. Hannafin
Phoenix Natural Gas Ltd, Belfast, Northern Ireland, and
Donal G. McKillop
School of Management and Economics, Queens University Belfast,
Belfast, Northern Ireland
Abstract
Purpose – The purpose of this paper is to explore why credit unions might need deposit insurance,
how they might respond to its introduction and how this protection mechanism should be designed.
The objective is to determine how successful the deposit insurance scheme has been in the context of
Northern Ireland and whether it offers an alternative to the public provision of deposit insurance
which appears to have been the model adopted by credit union movements elsewhere.
Design/methodology/approach – As part of this analysis the paper considers the Northern Ireland
experience where a subset of credit unions has been members of a private insurance arrangement since
1989.
Findings – The deposit insurance mechanism did not cause a propensity for member credit unions to
engage in risk shifting behaviour. The analysis suggests that at present a universal blueprint in
deposit insurance design may well be unnecessary in combating risk shifting behaviour.
Originality/value – This paper helps to fill a gap in the banking and finance literature where the
study of deposit insurance in the context of credit unions has been given little attention.
Keywords Credit unions, Insurance, Northern Ireland
Paper type Research paper
1. Introduction
The standard view of economists is that a deposit insurance scheme primarily serves
to ensure financial stability through the prevention of depositor runs. In fulfilling this
objective, it invariably assures depositors of the safety of their funds which, therefore,
reduces their incentives to monitor and police the behaviour of insured institutions.
Thus, providing depositor vigilance is effective, the introduction of deposit insurance
has undesirable consequences in that insured institutions can now attract deposits in
the absence of this pre-existing discipline and fund high-risk, high-return investments
knowing that downside losses can be shifted onto the owners of the insurance scheme.
Owing to this moral hazard problem, deposit insurance can be viewed as a paradox
because it potentially weakens the health of financial institutions even though its
primary goal is to promote their stability. Over the past two decades the number of
countries with deposit insurance has grown exponentially. Coinciding with this growth
several countries around the world have experienced severe banking crises (Mishkin
and Eakins, 2003). These trends have led to a growing perception tha t deposit
insurance may not be stability-enhancing. This concern has contributed to a recent
flurry of interest in deposit insurance issues, with most of this work emphasising
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1358-1988.htm
JFRC
15,1
42
Journal of Financial Regulation and
Compliance
Vol. 15 No. 1, 2007
pp. 42-62
qEmerald Group Publishing Limited
1358-1988
DOI 10.1108/13581980710726787
banks. This paper shifts attention away from banks and considers credit unions as
they too are increasingly protected by deposit insurance.
Canadian credit unions in the province of Manitoba were the first to benefit from
this protection mechanism in 1970 and this soon became a province-wide phenomenon.
The US subsequently emulated the Canadian precedent with the establishment of the
National Credit Union Share Insurance Fund (NCUSIF) in 1971. Much of the recent
growth of deposit insurance has been concentrated in Europe. For example, Irish credit
unions voluntarily established their in-house savings protection scheme (SPS) in 1989.
In Poland, the Czech Republic and Lithuania, credit unions have been legally required
to adopt deposit insurance since 1996, 2000 and 2001, respectively. More recently,
British credit unions joined the Financial Services Compensation Scheme in July 2002
and Latvian credit unions were included within their state deposit guarantee system in
January 2003. Beyond Europe and North America, only a few credit union systems
currently have deposit insurance in place, however, we predict this will soon become a
global phenomenon in line with banking trends[1]. Fuelling this momentum, the World
Council of Credit Unions is openly encouraging credit unions to adopt some form of
deposit insurance.
Credit unions are like banks in the sense they accept deposits (or shares) and make
loans. Unlike banks, however, credit unions are mutually-owned institutions that
operate according to cooperative principles; they have a democratic structure with
a policy of one-member one-vote; they do not issue capital stocks; they are not
constituted to make profits; their directors are unpaid volunteers; and they deal
exclusively with their (borrowing and saving) members who are united by a common
bond. Recognising these unique characteristics, we set out the following questions
to be addressed: do credit unions need deposit insurance, and, if so, why? What are its
behavioural consequences, particularly in terms of moral hazard? And on the latter
note, is the contractual design of the insurance scheme important, and are there any
indications of an optimal worldwide blueprint? To help answers these question we
undertake a case investigation of credit unions in Northern Ireland where some credit
unions are not part of a deposit insurance mechanism and where others have been part
of a scheme since 1989. In addition, the scheme investigated is quite unusual by
international standards because it is entirely privately managed and funded, volun tary
in nature, and largely free from governmental supervision.
The remainder of the paper is structured as follows. Section 2 presents qualitative
research identifying deposit insurance design features observable internationally.
In this section, we also explain the circumstances under which credit unions might
need deposit insurance. Section 3 documents the experience in Northern Ireland,
beginning with a profile of the institutional setting and followed by a comparative
analysis of the risk and performance of insured versus uninsured credit unions over the
period 1991-2005. Section 4 provides some concluding comments.
2. Deposit insurance for credit unions: theory, practice and design
Risk taking behaviour in banks and credit unions
From a contractual perspective, conventional banks are designed such that depositors
stand to banks as bondholders stand to ordinary firms. This creates a risk-shifting
(moral hazard) problem in that shareholders can fully capitalise on large upside gains
when risky ventures are successful, but as their liability is limited, the consequences of
Deposit
insurance and
credit unions
43

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