SUMMARY - Cooperative Financial Institutions: Issues in Governance, Regulation and Supervision

By Carlos E. Cuevas and Klaus P. Fischer (November 2005)
http://publications.worldbank.org/ecommerce/catalog/product?item_id=5774683

Abstract

Cuevas and Fischer address the issue of regulation and supervision (R&S) for cooperative financial institutions (CFIs) in developing countries. Their goal is to arrive at consensus guidelines for R&S, suggesting that CFIs should be treated as a specific type of financial intermediary, distinct from NGO microfinance institutions and investor-owned commercial banks. The authors cover three main issues:

1. The fundamental structure of the CFI sector, including both intra-CFI and inter-CFI organization
2. Existing legal frameworks and implications for the functioning of CFIs
3. Regulatory frameworks under which CFIs operate and proposals for effective supervision of CFIs

They conclude by proposing six key principles of effective CFI supervision and highlighting areas for further research in each:

• Licensing standards - Should licenses be uniform across all CFIs?
• Capital standards - Should minimum capital requirements be implemented? Should there be solvency ratios similar to those in banks?
• Control of management expense preferences - What mechanisms can control expense preferences to prevent CFI failure?
• Supervisory authority - Who should supervise and should this be implemented as a unified or dual regime?
• Networking - What activities should be allowed? Should there be a tiered system?
• Delegated/auxiliary supervision - Should it be encouraged or discouraged?

Summary

CFIs - including credit unions, savings and credit cooperatives, and cooperative banks - collect deposits and do business solely with members, often serving poor communities. Generally speaking, CFIs serve larger numbers of poor people than MFIs, and do not rely on donor support. Cuevas and Fischer emphasize the need for a regulatory response to CFIs to ensure that contracts between stakeholders of these institutions are fair, efficient, and enforceable.

Cuevas and Fischer assert the following advantages of CFIs:

• "Natural solution" to the adverse selection problem - redresses the exclusion of poor individuals and small microenterprises from the financial services market. These segments are often left out from investor-owned banking systems.
• Allow contracting parties to govern relationship
• More efficient in promoting economic growth and reducing poverty

The authors also cite the following weaknesses:

• Supervisors and promoters may be inclined to shield CFIs from competition through preferential tax treatment, control of interest rates, and subsidized credit.
• Larger CFIs are less efficient than smaller ones--an increase in size may distort management incentives and impair corporate governance. This casts doubt on the idea of merging CFIs.

Member-manager conflict: The member-manager conflict is the most studied problem within CFIs. Agency theory explains the divergence in interests between members (owners) and managers. While members are interested in maximum effort and frugality, managers seek the opposite. Specifically, managers are said to have expense preferences (EP), or the propensity to make wasteful expenses as profits increase and to become more self-serving as ownership dilutes. As this is a principal source of CFI failure, control of EP should be a central theme of CFI supervision.

Alliances: CFIs often organize into complex strategic alliances which allow them to mitigate market risks which may face individual members and enable member CFIs to serve more people with a broader range of financial services. Inter-CFI alliances are hybrid organizations such as federations, leagues, and unions that allow CFIs to exploit economies of scale and manage uncertainty of input procurement efficiently.

Cuevas and Fischer identify two types of alliance networks:

1. Consensual network - looser in nature, operates on the basis of continued consensus of all or a subset of participants
2. Strategic network - make decisions based on agreed-upon governance mechanisms

Stress can result in networks because of the following reasons:

1. Difference in size of the CFI members
2. Basel II Standards and the increasingly powerful role played by the rating agencies are pushing for more centralized decision-making at the network level. The poor record of bureaucracies in CFIs does not indicate that this will be a successful path.
3. The increasing of integration and openness of financial markets causes CFIs to expand their focus, seeking collaboration across borders and abandoning the traditional domestic scope.

Legal & regulatory frameworks: In discussing the legal framework for CFIs, the authors caution against grouping CFIs together with NGO microfinance institutions because of the special characteristics of CFIs. Three distinct legal frameworks for CFIs are identified: 1) CFI-specialized law, 2) cooperative societies law and 3) banking law. Many combinations of these three types also exist.

The authors believe that either the growth of CFIs or the existence of crisis situations has influenced governments to update legal frameworks and shift away from cooperative societies laws. In a unified regime, the banking authorities govern all CFIs, whereas in a dual regime, smaller CFIs are still governed by cooperative societies law and the larger CFIs, which more closely resemble financial institutions, are governed by the banking authorities. In countries where CFIs are most integrated into the mainstream financial system, authorities have generally included the entire system under a unified legal regime. In contrast, in countries with less integration, more rural and closed CFIs remain under traditional cooperative law and cooperative authority supervision.

The pros and cons of a dual legal regime for the two main variants of CFIs (large and urban vs. small and rural) are weighed.

• Supporters argue that dual regimes may be a transition toward a unified regime and that larger CFIs are more similar to commercial banks and should be subject to banking laws.
• Opponents argue that CFIs and investor-owned banks have fundamental differences in governance rooting from differences in ownership. Furthermore, dual regimes would prevent the setup of a workable cooperative alliance and would promote inequality in that large, urban CFIs would be governed under strong banking law, whereas the most vulnerable smaller, rural CFIs would still be poorly supervised by cooperative authorities.

Cuevas and Fischer acknowledge that large CFIs have similarities to investor-owned banks but see disadvantages to applying identical standards to them. Investor-owned banks have a specific kind of agency conflict: between shareholders seeking risky assets and depositors seeking safe assets. CFIs do not have this problem, as shareholders are also depositors and therefore naturally prefer safe assets. Some have therefore questioned the need for R&S for CFIs.

The goal of CFI regulation is to have a specialized regulatory environment different from that of commercial banks and NGOs with banking-style rigor and expertise (unachievable through poorly managed cooperative authority regulation), adapted for CFIs. If an R&S framework is to be designed it must take three factors into consideration:

1. The different kind of agency conflict that affects CFIs (member-manager conflicts based on expense preferences, rather than shareholder-depositor conflicts as in investor-owned banks)
2. The typically layered structure of CFIs arising from alliances
3. CFIs' service to a specific market segment. A CFI that serves a poor rural community should not be expected to support the costs of meeting reporting standards similar to that of a commercial bank.

Supervision: Supervision of CFIs is discussed in the context of delegated/auxiliary monitoring, or indirect supervision. In indirect supervision, a specified agent performs certain supervisory tasks on behalf of the state authority. The authors cite reasons why indirect supervision might work, such as low transaction costs and built-in incentives of the members to cooperate with the regulators (because the system is designed to protect the members, not the managers). They cite as evidence the success of indirect supervision in Germany and evidence of failures of direct supervision during times of crisis in Argentina, Colombia, and Peru.

However, indirect supervision also suffers from the following shortcomings:

• Inherent lack of independence of regulatory/supervisory bodies that are run by those being supervised (as in coop-owned federations)
• In extreme cases with no intervention by banking authorities, the absence of an independent party to control quality, making supervision unreliable
• Federations' role in advocacy and promotion, which is inconsistent with supervision

Despite these flaws, the authors believe that indirect supervision is a powerful way to adapt supervision to the specific needs of CFIs and facilitate their integration into a supervision environment with financial sector standards. They counter the flaws by citing its history of achieving stability in CFI movements in many countries.

They further argue that funding the supervision of CFIs is a better way for governments to promote access to finance than direct credit programs. In countries where public finances cannot fully cover the cost of funding the regulatory environment, government budgets should be supplemented with donor funding.