Deposit Insurance Reserve Fund Strategy

Deposit Insurance Reserve Fund Strategy September 2013

Table of Contents Executive Summary... 2 Introduction... 3 Background... 4 Purpose of the Reserve Fund... 5 Current State... 5 Increasing Size and Complexity of Insured Institutions... 5 Reserve Fund Size... 7 Improved Coverage for Failure Events... 7 Time to Achieve Reserve Fund Target... 8 Conclusion... 8 Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 1

Executive Summary This document sets out the Deposit Insurance Corporation of Ontario s ( DICO or the Corporation ) strategy for establishing a revised target for the size of the Deposit Insurance Reserve Fund ( reserve fund ) and the timeframe to achieve the proposed target. The target for the reserve fund was determined in 2002 through the use of an actuarial model and after consultation with the sector and set at 60 basis points ( bps ) of insured deposits. Through advice from DICO s auditors in 2005, this target was modified to reflect the current acceptable range of 56 to 68 bps. Compared to other provincial credit union and caisse populaire jurisdictions, Ontario has the smallest fund as measured in terms of a percentage of insured deposits. Since the establishment of the current fund target range, DICO has experienced a number of institutional failures with associated significant financial losses to its reserve fund. This has created challenges for the Corporation to sustain and build a reserve fund to provide adequate protection to the sector in the event of further institutional failures. There have also been significant changes in the size and complexity of the Ontario credit union and caisse populaire sector as well as in the economic environment. These factors have resulted in a change in the risk profile of the sector, which may affect the adequacy of the reserve fund to meet its obligations. In light of these factors, DICO is reassessing the current target to ensure that the reserve fund is adequate to protect depositors. In order to ensure ongoing confidence in the sector and to provide a high level of premium stability for insured institutions, DICO is proposing the following: the reserve fund target be increased to 100 bps of insured deposits compared to the current range of 56 to 68 bps; the revised target be reached by 2020; deposit insurance premium rates will remain relatively stable throughout this period unless material losses beyond those provided for in DICO s plan are experienced; and the continued review of the size of the fund and deposit insurance premium rates to ensure ongoing adequacy. A reserve fund of 100 bps will provide the Corporation with the financial resources to ensure an increased level of protection against potential losses or liquidity shortfalls in the event of the failure of a larger insured institution. It will also reduce the likelihood that a draw on DICO s credit facility with the government will be required. DICO s credit facility with the Ontario Financing Authority ( OFA ), currently under negotiation, ensures that the Corporation has access to funding in the event that the failure of an insured institution exceeds DICO s financial resources, thus further enhancing confidence in the sector. DICO invites all stakeholders to submit comments or views on this proposed reserve fund strategy. Comments may be forwarded to the attention of Suzanne Tucker, Manager, Policy & Research at DICO consultation@dico.com by November 15, 2013. Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 2

Introduction DICO is an agency of the Province of Ontario and is governed by the Credit Unions and Caisses Populaires Act, 1994 (the Act ). The Corporation functions within the legal framework established by the Act, Management Board of Cabinet Directive on Agency Establishment and Accountability and other applicable directives and laws. DICO is accountable to the Legislature through the Minister of Finance for the conduct of its affairs. The Corporation has a mandate to act as the prudential regulator of Ontario credit unions and caisses populaires and to insure eligible deposits in a manner that will minimize the exposure of DICO to loss. Over 1.6 million Ontarians are members of a credit union. As at June 30, 2013, 133 insured institutions held aggregate assets in excess of $37 billion, including insured deposits of approximately $23.5 billion. Among the objects of the Corporation set out in Section 261 of the Act are to: provide insurance against the loss of part or all of deposits with credit unions and caisses populaires; and promote and otherwise contribute to the stability of the credit union/caisse populaire sector with due regard to the need to allow credit unions to compete effectively while taking reasonable risks. Further, Section 276 of the Act requires DICO to maintain a deposit insurance reserve fund to be used to pay deposit insurance claims, costs associated with the continuance or orderly winding up of credit unions/caisses populaires in financial difficulty, financial assistance, and the costs of the Corporation. DICO receives no public funding. The annual premiums paid by insured institutions are credited to the reserve fund. As at June 30, 2013, the fund was $156.9 million and represented 66 bps of insured deposits. In addition to the reserve fund, there are two supplemental sources available in the unlikely event that the fund is not adequate to meet the obligations of DICO s regulatory responsibilities. The Corporation has access to a line of credit arrangement with the Ontario Financing Authority (the OFA ). To date, DICO has not had to draw upon this line of credit. DICO also has the ability, with approval from the Minister of Finance, to borrow money: on the credit of the Corporation; on bills of exchange or promissory notes drawn, made, accepted or endorsed by or on behalf of the Corporation; or by the issue of debentures, if necessary. In order to fulfill its mandate, the Corporation must maintain a state of readiness to quickly intervene in the affairs of a troubled insured institution of any size or type. The discussion and analysis in this paper are driven by a number of strategic objectives that assist DICO in achieving its mandate including: Building a financially strong Corporation that maintains confidence in and financial stability of the sector; Maintaining sufficient financial resources to enable quick and effective action to deal with problem insured institutions; Avoiding periods of deficit so confidence in the Corporation s financial capacity to fulfill its obligations when needed is maintained; Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 3

Providing sufficient premium revenue to build and maintain a reserve fund and reducing procyclicality 1 in the existing premium assessment process by allowing moderate, steady assessment rates throughout positive economic and credit cycles; and Avoiding excessive or undue regulatory or financial burden on the sector. Background During 1987 to 2001, the Corporation incurred insurance losses of over $170 million, which created a substantial deficit in the reserve fund. As a result, deposit insurance premium rates were increased significantly to eliminate this deficit. The amount borrowed during the period, which was guaranteed by the province, amounted to $70.4 million. In 2000, the deficit was eliminated and deposit insurance premium rates were reduced by about 50%. In 2002, DICO established a target size of the reserve fund of 60 bps of insured deposits and modified this to a target range of 56 to 68 bps in 2005. Further significant losses to the reserve fund totaling approximately $53 million occurred in 2008-2009, reducing the fund to 38 bps of insured deposits, or $81.8 million. To restore the reserve fund back into the acceptable target range of 56 to 68 bps, deposit insurance premiums were raised by an average of 15% in 2010. As at June 30, 2013, the reserve fund has recovered to almost $156.9 million, or 66 bps of insured deposits, through a combination of premium revenue and loss recoveries. Deposits insured by DICO currently amount to approximately $23.5 billion as at June 30, 2013. This represents a significant amount of savings entrusted by Ontarians to insured institutions and a significant source of financing, which contributes to the effective functioning of Ontario s economy. Sector stability is a key factor to maintain public confidence. In this context, stability means that depositors are assured of the safety of their insured deposits, and insured institutions are assured of a reliable, ongoing source of funding. During 2008 and 2009 the world s financial system encountered a period of extraordinary instability. While the financial crisis had an effect on DICO s insured institutions by reducing profit margins, the sector has performed steadily since then. However, the crisis highlighted the need for deposit insurers to have a viable source of financing to settle claims promptly and effectively, and the significant role the deposit insurer plays in ensuring the industry bears the cost to resolve the issue. Core Principle 11 in the International Association of Deposit Insurers ( IADI ) Core Principles for Effective Deposit Insurance Systems illustrates this point: A deposit insurance system should have available all funding mechanisms necessary 1 Pro-cyclicality arises if the deposit insurance system requires large premium rate increases following a period of failures to replenish the financial reserves. DICO s differential premium system reflects this pro-cyclical nature as current measures used to classify insured institutions into differential premiums categories are driven by financial results. When insured institutions report adverse financial results, these measures potentially result in higher risk classifications and premiums. The system was designed to motivate insured institutions to adopt lower risk-taking behaviours to reduce risk in the sector (DICO s differential premium system is the subject of a consultation and is not addressed in this document). Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 4

to ensure the prompt reimbursement of depositors claims, including a means of obtaining supplementary back-up funding for liquidity purposes when required. Primary responsibility for paying the cost of deposit insurance should be borne by the insured financial institutions since they and their clients directly benefit from having an effective deposit insurance system. 2 Purpose of the Reserve Fund The purpose of the reserve fund is to have sufficient financial resources to pay deposit insurance claims to insured depositors when an insured institution cannot meet its obligations. In defining the purpose of the reserve fund it is important to distinguish between funding of deposit insurance claims because of insolvency and funding of liquidity needs. In the event of the failure of an insured institution, the Corporation has a number of options. One option is to place the failed institution into liquidation or bankruptcy. Under this scenario, DICO pays depositors the amount of insured deposits immediately and then makes a claim against the estate of the institution for these amounts as a creditor. DICO also has the option to provide financial assistance to an insured institution for the purpose of allowing a credit union/caisse populaire to continue its operations and to correct any practices that have increased the risk of claims by depositors. Over the past twenty years, all the failures of insured institutions involved relatively small credit unions or caisses populaires the largest holding assets less than $100 million. This has enabled DICO to make the required payouts or financial assistance payments from the reserve fund. The average assets of an insured institution today is approximately $256 million with 17 institutions with assets in excess of $500 million. In the event of a failure of one of these larger institutions and if the Corporation did not have sufficient funds available to ensure a payout of insured deposits, DICO would need to borrow against its credit facility with the OFA. The shortfall between cash outlays (e.g., insured deposit payments) and asset recoveries is the loss incurred in the resolution. DICO would absorb these losses first with the fund and, if required, through additional borrowings against the credit facility. Borrowings are repaid and the reserve fund is recapitalized through the collection of deposit insurance premiums from the remaining insured institutions. Under the scenario of very large losses, the Corporation could, with the approval of the Minister, require the payment of special levies by credit unions. Current State Increasing Size and Complexity of Insured Institutions Insured institutions differ significantly in size and complexity. Asset sizes range from $1.2 million to almost $9 billion, with a widely diversified range of financial services and products offered. The average asset size of an insured institution increased from $12 million in 1988 to $47 million in 2002, when the reserve fund target was established. Average losses to the fund per institution 2 The BCBS and the International Association of Deposit Insurers Core Principles for Effective Deposit Insurance Systems, Core Principle 11. Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 5

during this period were $1 million per year. The average asset size of insured institutions has grown over five-fold since then to $256 million and the average losses to the fund have increased to $5 million. The five largest institutions each have assets exceeding $1 billion and combined hold assets of more than $16 billion, or almost 43% of total sector assets. In contrast, there are 13 institutions with assets under $10 million, which account for just over 1basis point of total sector assets. Number of Insured Institutions and Average Assets 1977 2013 $ Millions 300 250 200 150 100 50 0 1400 1200 1000 800 600 400 200 0 # of Instituions Average Assets Number of Institutions Since 2008, continued interest rate margin compression has led to significantly reduced earnings and associated profitability challenges for many credit unions and caisses populaires. In some instances, this has resulted in an increase in risk appetite in the search for increased revenues such as participating in banking services for money service businesses, white label Automatic Teller Machines, pre-paid debit cards and establishing investment dealership subsidiaries. These nontraditional sources of revenue have increased the risk to the insured institutions as, in many circumstances, they have not conducted an appropriate level of due diligence to identify the associated risks and often lack the needed expertise to manage them. In other instances, it has motivated some insured institutions to enter into commercial lending or, if already offering commercial loans, to seek to expand their portfolio as returns are higher but also riskier. To date, the reserve fund has been able to absorb losses arising from the failure of smaller institutions. Stress testing indicates the reserve fund could withstand the failure of several institutions with assets between $1 million to $250 million. However, in the unlikely event of the failure of one large and one mid-sized, or several mid-sized insured institutions, DICO would not have sufficient resources to pay depositor claims promptly, which would reduce public confidence. In these circumstances, reliance would have to be placed on the $250 million credit facility with the OFA. Repayment of such borrowings and the rebuilding of the reserve fund would likely be achieved by a combination of an increase in deposit insurance premiums (which would require an amendment to the regulations) or through a special levy (which would require the approval of the Minister of Finance). Since 2002, when the reserve fund target size was established, there has been an increasing potential risk in the sector due to the increased size of institutions, which in turn has elevated the exposure to Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 6

the reserve fund. This development has also highlighted the need for considering an increase in the target fund level. In developing its current funding strategy, the Corporation recognized the importance of having adequate financial resources for the proper functioning of a sound deposit insurance system. Its strategy reflects the need for a high degree of confidence the resources available will be sufficient to address the risks to which it is exposed. The reserve fund uses an actuarial model based on DICO s loss experience to predict the potential impacts of insured institution failures on the reserve fund over a 20 year period. The size of the fund is dependent on the level of insured deposits, premium revenue, interest rates, loss experience and the confidence level. Changes in one or all of these factors could affect the time for the fund to reach the top end of the range. Under current forecasts, the top of the target range of 56 to 68 bps of insured deposits should be achieved by the end of 2013. Reserve Fund Size Deposit insurers in other Canadian jurisdictions have larger target fund sizes, as shown in Table 1. These sectors have slightly different regulatory regimes and deposit insurance programs, are at a different stage in the sector development lifecycle and operate in a different competitive environment than the highly competitive financial centre of Ontario. As well, these targets are affected by factors such as the financial health of insured institutions, deposit insurance coverage, past experience of failures and losses as well as insurance rates. Table 1: Summary of Selected Provincial Fund Targets (December 2012) Total Sector Assets ($ billions) Deposit Insurance Coverage Fund Target/Range 2 (as a % of insured deposits) Fund Size ($millions) BC AB SK MB ON PQ (FSD) 0 CDIC 57.2 20.4 16.9 23.4 36.6 134.9 3,530.0 Unlimited Unlimited Unlimited Unlimited $100,000 $100,000 $100,000 0.88% 1.50% 1.40 to 1.60% 0.95% to 1.15% 0.56% to 0.68% 0.55% to 0.65% 1.00% $405.2 $204.7 $237 $208.3 $147.5 $815.1 2,440.8 Fund Size 0.81% 1.09% 1.52% 0.99% 0.64% 0.57% 0.39% 1 FSD refers to Fonds de sécurité Desjardins a stabilization fund operated by Groupe Desjardins. This fund is in addition to the Autorité des marchés financiers (AMF) deposit insurance fund. 2 Fund size target ranges differ between jurisdictions due to the use of differing confidence levels and deposit insurance coverage used in their models. Improved Coverage for Failure Events As noted in the executive summary, the proposal is to increase the reserve fund target to 100 bps of insured deposits. With a fund of this size DICO would be more capable of meeting its obligations to pay deposits in the event of the failure of an increased number and/or size of insured institution without the necessity of drawing on the credit facility with the OFA or borrowing with the approval of the Minister. An adequate reserve fund serves to increase the confidence of depositors and the public in the sector. Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 7

Time to Achieve Reserve Fund Target The time to achieve the 100 bps being proposed for the revised fund target is impacted by assumptions for factors such as deposit insurance premium rate levels, forecasted insurance losses, DICO operating expenses, investment returns and sector asset growth. By changing any one or more of these factors, the time to achieve the proposed reserve fund target can be shortened or extended. Based on DICO s analysis, the reserve fund would reach the 100 bps target in eight years or 2020 under the following assumptions: current premium rates are maintained; a conservative annual provision for losses of $5 million; 2% annual growth rate in DICO expenses; an investment yield of 0.5% earned on the reserve fund, increasing to 1.5% in 12 months and remaining at that level each year; and a 3% annual growth rate in insured deposits. Changes in the size, complexity and composition of the sector suggest an adjustment to the target range is needed in order to ensure the reserve fund continues to provide the comfort that it is adequate to protect depositors interests. Conclusion In light of foregoing discussion and analysis, DICO believes changes in the size, complexity and composition of the sector warrant an adjustment to the target in order to ensure the reserve fund continues to provide the comfort that it is adequate to protect depositors interests. In order to ensure ongoing member and public confidence in the sector and provide for deposit insurance premium rate stability, DICO believes the following changes to the reserve fund strategy are appropriate: the reserve fund target be increased to 100 bps of insured deposits compared to the current range of 56 to 68 bps; the revised target be reached by 2020; deposit insurance premium rates will remain relatively stable throughout this period unless material losses beyond those provided for in DICO s plan are experienced; and the continued review of the size of the fund and deposit insurance premium rates to ensure ongoing adequacy. DICO believes that this reserve fund strategy will enable the Corporation to cover an increased level of losses and/or liquidity shortfall in the event of the failure of a series of several or one or more large insured institutions. The strategy will also reduce the potential need for a draw on the credit facility with the OFA or DICO to borrow to meet regulatory demands. DICO invites all stakeholders to submit comments or views on this proposed reserve fund strategy. Comments may be forwarded to the attention of Suzanne Tucker, Manager, Policy & Research at DICO consultation@dico.com by November 15, 2013. Deposit Insurance Reserve Fund Strategy Draft September, 2013 Page 8