Differential Premium System Review
Consultation Paper
April 15, 2013
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DPS Consultation Paper
April 15, 2013Page 1
TABLE OF CONTENTS
Subject
/Page #
Foreword
/1
Overview
/2
Proposed Differential Premium System (DPS)
/3
Measures and Criteria
/3
Premium Calculation
/7
Impact on Institutions
/8
Conclusion and Next Steps
/9
Appendix 1 – Comparison of Measures and Criteria between the Proposed DPS and the current DPS
/10
Appendix 2 – Examination Assessment Criteria
/12
In this document,when we refer to credit unions we are also referring to caisses populaires.
DPS Consultation Paper
April 15, 2013Page 1
Foreword
Deposit insurance provides protection to the members who deposit their money in Ontario’s credit unions and caisses populaires. The Deposit Insurance Corporation of Ontario (“DICO” or the “Corporation”) is the Ontario government agency that oversees and operates the deposit insurance system for these insured institutions,in accordance with the Credit Unions and Caisses Populaires Act, 1994 (the “Act”).
One of the Corporation’s roles is to recommend to the government for consideration how the methodology for determining deposit insurance premiums should be set out in the regulation under the Act. This paper outlines revisions to the July 2012 paper that are being considered to address the comments and suggestions raised by stakeholders during the consultation process completed September 2012. Thisproposal continues to reflectrecent regulatory changes and revisions to DICO By-Law No. 5: Sound Business and Financial Practices (“By-law No. 5”) and provides additional information with respect to how corporate governance will be assessed.
Credit unions and caisses populaires, their associations, leagues and federations, and other interested parties are invited to provide feedback on the proposed changes by Friday, June 14, 2013by mail to the following address:
Deposit Insurance Corporation of Ontario
4711 Yonge Street, Suite 700
Toronto, ON M2N 6K8
Attention: Suzanne Tucker,Manager, Policy & Research
Alternatively, comments may be provided either by e-mail to r by completing an on-line survey. The link to the survey is available on the Corporation’s website and included in the broadcast e-mail with this consultation paper. Following the stakeholder consultation period, staff will evaluate feedback and make final recommendations to DICO’s board prior to submission to the government for consideration.
A webinar will be scheduled in Juneto review the proposals and provide an opportunity to ask questions. Information regarding that webinar will be provided well in advance. Also, asummary of the comments received and responses to any suggestions or issues raisedwill be published following the webinar.
This consultation document is intended to facilitate constructive dialogue concerning its contents. Please note that the proposals in this document are subject to change as a result of the consultation process and as a result of review by the government. The proposals will only become law if the Lieutenant Governor in Council makes an amending regulation under the Credit Unions and Caisses Populaires Act, 1994.
Copies of this document and other related materials may be obtained by calling Suzanne Tucker, Manager, Policy & Research at 1-800-268-6653, and then dial 416-325-9067 or by downloading them from DICO’s Internet website at
Overview
This document outlines the key elements of the proposed revisions to the Differential Premium System (DPS) and seeks to elicit additional stakeholder comments from the previous consultation in 2012. The following provides an overview of the most recent proposal:
The DPS will be based on two measures: Capital and Corporate Governance;
- These measures will be assessed based on a continuous scoring methodology, eliminating the current tiered structure;
- A credit union’s score will be determined by adding together the points attained in each of the two measures;
- The weighting in the scoring for each measure will be approximately two-thirds for Capital and one-third for Corporate Governance;
- The Capital measure will be based on the amount of regulatory capital:
- Class 1 credit unions will be awarded points for the amount of regulatory capital as a percentage of total assets (leverage test) that exceed theminimum amount of required capital of 5%;
- Class 2 credit unions will be awarded points for the amount of regulatory capital as a percentage of its risk-weighted assets (BIS test) that exceeds the minimum required BIS capital of 8%,however, must still maintain a leverage ratio of 4% or more;
- The Corporate Governance measure will be based on compliance with the corporate governance standards in By-Law No. 5 related to the responsibilities of the Board of Directors, Audit Committee, and Management; and
- DICO’s on-site examinations will continue to assess compliance with the criteria set out in By-law No.5 and provisions in the Act and Regulation 237/09 (consolidated January 1, 2011). There will be three possible examination assessment levels for each of the corporate governance standards based on the results of the examination: Adequate, Needs Improvement, and Inadequate.
The benefits of the new approach include:
- Elimination of premium “cliffs” whereby a small change in capital or governance can have a significant impact on the premium rate;
- Increased transparency and fairness in DPS scoring, which also eliminates the duplication of the effects of some conditions and performance measures in the current ‘CAMEL’ model;
- Updated structure reflecting changes to the Act and Regulation that increases the importance of capital to the on-going viability of institutions and protection of members’ deposits and puts heightened emphasis on corporate governance;
- A simpler approach to assessing relative risk, based on the two measures of Capital and Corporate Governance; and
- Improved fairness and flexibility for examination assessments.
After considering comments arising from the consultation process, the Corporation will recommend that the government consider amending the Regulation accordingly, based on credit unions’ financial year ends, commencing with fiscal year ends of December 31, 2014. This timeframewill provideinsured institutions with the opportunity,prior to implementation of the new regime,to optionally increase capital levels and strengthen Corporate Governance practices to improve their overall score and thereby reduce deposit insurance premiums.
Proposed Differential Premium System (DPS)
This section sets out the scoring for both of the proposed DPS measures. It also provides additional information regardingthe assessment criteria for Corporate Governance and assessment ratings for measuring governance for the revised DPS. A comparison of the current DPS and the proposed DPS is provided in Appendix 1.
Measures and Criteria
The proposed DPS would be based on only two measures: Capital and Corporate Governance, with Capital weighted approximately two-thirds (64%) and Corporate Governance weighted one-third (36%).
1. Capital Adequacy
Class 1 credit unions will receive one point where they hold the minimum legislated capital requirement of 5% using the leverage ratio. Class 1 insured institutions can receive up to a maximum of 64 points where capital is 8.75%or more. Where a credit union has less than 5% capital, they will receive no points.
Class 2 credit unions will receive one point where they hold the minimum legislated capital requirementof 8% of risk weighted assets (the BIS ratio). Class 2 insured institutions can receive up to a maximum of 64 points where risk weighted capital is 14% or more. Where a credit union has less than 8% risk weighted capital, or less than 4% capital as measured by the leverage ratio, itwill receive no points.
At the time of writing of this document, the Ministry of Finance has not made a decision regarding the adoption of Basel III for the credit union/caisses populaires sector.
Points for capital will be measured on a continuous basis. That is, as capital increases over the required minimum legislated limit, a higher score is possible and, thereby, potentially lower deposit insurance premiums.
Table 1: Capital Measure Criteria
Points / Class 1 / Class 2Leverage / BIS / Leverage
64 / ≥ 8.75% / ≥ 14.00% / > 4.00%
< 64 to 1 / Continuous / Continuous
0 / < 5.00% / < 8.00% / < 4.00%
Range / 3.75% / 6.00% / n/a
The upper limits of the capital measure were established based on a review of current capital levels. As at 4Q 2012, the average regulatory capital for Class 1 insured institutions is 8.98% (the median is 8.19%),based on leverage. The average risk-weighted capital for Class 2 institutions is 16.33%(the median is 15.85%).
The capital score is calculated based on the amount of excess capital the insured institution holds over the required minimum capital level for its class. The calculation for each class is shown below:
CLASS 1 Capital Score Calculation / CLASS 2 Capital Score CalculationCapital – Regulatory Minimum Capital (Leverage Basis)
3.75% / Capital – Regulatory Minimum Capital (BIS Ratio)
6.00%
EXAMPLES:
CLASS 1 Institution that has 8.25% Capital / CLASS 2 Institution that has 12.50% CapitalStep 1- Calculate Capital Excess Ratio: / Step 1- Calculate Capital Excess Ratio:
(8.25 – 5%)/3.75% = 86.67% / (12.50 – 8%)/6.00% = 75.00%
Step 2 - Calculate Capital Points: / Step 2 - Calculate Capital Points:
86.67% x 64 points = 55.47 points / 75% x 64 points = 48 points
Capital Score would be 55.47 out of 64 points / Capital Score would be 48 out of 64 points
This methodology results in a near-continuous score, which is depicted graphically below:
2. Corporate Governance
The Corporate Governance measure will be revised to align with the three Corporate Governance standards set out in By-law No. 5, namely Board of Directors, Audit Committee, and Management. Each standard has been allocated a maximum number of pointsthat can be obtained during the examination process as follows:
Governance Standard / Maximum ScoreBoard of Directors / 30
Audit Committee / 20
Management / 50
Points will be awarded based on ratings determined during the examination process. Each standard has been broken down further into components and each component will be assessed during the examination as Adequate, Needs Improvement or Inadequate.
A maximum score of 100 will be assigned as outlined in the following three tables. The points obtained in each component of each standard are totaled, and then converted to an equivalent point value out of 36 points.
GOVERNANCE: BOARD OF DIRECTORS
EXAMINATION SCOREADEQUATE / NEEDS
IMPROVEMENT / INADEQUATE
PRACTICES & EXPERTISE / 12 / 6 / 0
HUMAN RESOURCES / 4 / 2 / 0
RISK MANAGEMENT / 9 / 4.5 / 0
BUSINESS STRATEGY & BUSINESS PLANS / 5 / 2.5 / 0
MAXIMUM/MINIMUM SCORE / 30 / 0
GOVERNANCE: AUDIT COMMITTEE
EXAMINATION SCOREADEQUATE / NEEDS
IMPROVEMENT / INADEQUATE
PRACTICES & EXPERTISE / 6 / 3 / 0
INTERNAL AUDIT / 6 / 3 / 0
EXTERNAL AUDIT / 4 / 2 / 0
RISK MANAGEMENT & COMPLIANCE / 4 / 2 / 0
MAXIMUM/MINIMUM SCORE / 20 / 0
GOVERNANCE: MANAGEMENT
EXAMINATION SCOREADEQUATE / NEEDS
IMPROVEMENT / INADEQUATE
RISK MANAGEMENT / 30 / 15 / 0
BUSINESS PLANS & BUSINESS STRATEGY / 8 / 4 / 0
OPERATIONAL & FINANCIAL RESULTS / 7 / 3.5 / 0
BOARD REPORTS / 5 / 2.5 / 0
MAXIMUM/MINIMUM SCORE / 50 / 0
The definitions of these three assessment levels are provided below:
Adequate
This assessment level will apply to a standard when the risk management practices are found by DICO through its examination process to be adequate in controlling the risks of the institution relative to the size, complexity and risk profile of the insured institution. The risk management practices materially meet all the requirements of By-law No. 5.
Needs Improvement
This assessment level will apply to a standard when the risk management practices are found by DICO through its examination process to be less than adequate in controlling the risks relative to the size, complexity and risk profile of the insured institution. The risk management practices satisfy most of the requirements of By-law No. 5 for a particular standard and anyidentified deficiencies are not expected to harm the interests of members or depositors or increase the risk of claims against DICO.
Inadequate
This assessment level will apply to a standard where the risk management practices are found by DICO through its examination process to be inadequate in controlling the risks relative to the size complexity and risk profile of the insured institution. The risk management practices materially do not meet the minimum requirements of By-law No. 5 for a particular standard and identified deficiencies could be expected to harm the interests of members or depositors or increase the risk of claims against DICO.
Appendix 2 describes the characteristics that would likely be exhibited at each assessment level for each of the Corporate Governance standards (Board of Directors, Audit Committee, and Management).
Until a credit union is examined based on this approach beginning in January 2015, existing scores for Governance will be converted to an equivalent score under the new DPS. The chart below illustrates the conversion:
Current Governance Score / TransitionalGovernance Score / Governance Score from examinations conducted after Jan. 1, 2015
20 / 36 / 36
15 / 27 / Continuous scale
10 / 18
5 / 9
0 / 0 / 0
Premium Calculation
The minimum and maximum premium rates will remain the same at $1.00 and $3.00 respectively, per $1,000 of insured deposits. The points obtained for capital and corporate governance will be totaled to determine an insured institution’s score.
Where a credit union receives points totaling 90 or more a premium rate of $1.00 will apply. Where the points received are 0, a premium rate of $3.00 will apply.
Scores between 0 and 90 points will be calculated using the following formula:
Continuous Premium Calculation Rate = $1.75 - [(DPS Score ÷ 90) x $0.75]
Premium rates will be continuous between scores of 0 and 90 points. All scores will be calculated to two decimal places.
Impact on Institutions
Based on latest information and projections, these changes are expected to be revenue neutral to DICO. However, some insured institutions may pay higher premiums while others may pay lower premiums due to the scoring and premium being calculated on a continuous basis. To determine the impact on insured institutions, the most recent premium paid by the credit union was compared to what they would pay under the proposed continuous premium structure. Governance was converted from each insured institution’s current score out of 20 to a score out of 36 under the proposed DPS.
Under this scenario, 53 institutions would experience no change to their premium, 55 would pay a lower premium and 35 would pay a higher premium.
These changes will not become effective until January 1, 2015,based on credit unions’ financial year ends, commencing with fiscal year ends of December 31, 2014. As such, institutions will have time to increase their DPS points and, thereby, lower deposit insurance premiums, by optionally increasing their capital levels and/orimproving governance practices, as they may deem appropriate,prior to the introduction of the revised DPS scheme.
Class 2 institutions have the added flexibility to modify risk capital levels and thereby achieve a lower risk rating tier by changing their asset mix since the BIS capital measure is based on risk weighted assets. Some smaller institutions, with weak capital levels and poor governance practices, could see an increase in overall premiums although the extent of any increase is not expected to be material.
Conclusion and Next Steps
The DPS has achieved its original dual objectives of encouraging institutions to adopt less risky behaviours and establishing an appropriate base for managing insurance risks. The proposed changes will recognize the regulatory changes arising following the promulgation of the Act in 2009 and provide an increased focus on updated governance oversight and risk management practices outlined in revised By-law No. 5. The revised structure will be more equitableandeffective in differentiating risk, and simpler to calculate.
DICO will ask the government to consider approving the proposed rules for establishing an institution’s deposit insurance premium rate that will come into effect for financial years starting on or after January 1, 2015,based on credit unions’ financial year ends, commencing with fiscal year ends of December 31, 2014.
Appendix 1
This appendix provides a comparison of the measures and criteria of the proposed DPS versus the current DPS scheme in place.
Weight of Risk Measures
Risk Measure / Current / ProposedCapital / 35% / 64%
Asset Quality / 10% / 0%
Management (Governance) / 20% / 36%
Earnings / 25% / 0%
Asset Liability Management (Interest Rate Risk) / 10% / 0%
Total / 100% / 100%
Capital Criteria
Current DPS / Proposed DPSPremium Class / Points / Regulatory Capital
Leverage Basis
All Classes / Regulatory Capital
Points / Leverage Basis Class 1 / BIS Basis Class 2
1 / 35 / ≥ 7.5% / 64 / ≥ 8.75% / ≥ 14.00%
2 / 26.3 / ≥ 6.25% and ≤ 7.49% / Continuous / ≤ 8.74%
≥ 5.00% / ≤ 13.99%
≥ 8.00%
3 / 17.5 / ≥ 5.00% and ≤ 6.24%
4 / 8.8 / ≥ 3.75% and ≤ 4.99%
5 / 0 / < 3.75% / 0 / < 5.00% / < 8.00% and/or
< 4.00% leverage
Management (Governance) Criteria
Current DPS / Proposed DPSPremium Class / Points / Examination Findings / Points / By-law No. 5 Compliance
1 / 20 / No weaknesses / 36 / Full compliance. Adequate ratings in ALL standards
2 / 15 / 1 weakness / Continuous / Various ratings
(see Appendix 2 for examination assessment criteria and scoring)
3 / 10 / 2 weaknesses; or
1 critical weakness
4 / 5 / 3 weaknesses; or
1 critical weakness + 1 weakness
5 / 0 / 4 or more weaknesses; or
1 critical weakness + 2 weaknesses; or
2 critical weaknesses / 0 / Non-compliance. Inadequate ratings in ALL standards
Premium Tiers/Rate versus Risk Rating
Current DPS / Proposed DPSPremium Class / Risk Rating (Current) / Premium Rate / Risk Rating (Proposed) / Premium Rate
(per $1,000 of insured deposits)
1 / ≥85 points / $1.00 / 90 or more points / $1.00
2 / 70 to < 85 points / $1.15 / Between 0 and 90
points / Continuous
3 / 55 to < 70 points / $1.40
4 / 40 to < 55 points / $1.75
5 / < 40 points / $3.00 / 0 / $3.00
DPS Consultation Paper
April 15, 2013Page 1
Appendix 2 – Examination Assessment Criteria
GOVERNANCE: BOARD OF DIRECTORSROLE OF THE BOARD OF DIRECTORS
The board of directors is ultimately responsible for ensuring that the credit union is operated in a safe and prudent manner, and for ensuring adherence to standards of sound business and financial practices.
In fulfilling its responsibilities, the board should ensure that the credit union is consistently operating in accordance with co-operative principles.