Irish Credit unions appear to be divided as to their freedom to undertake differential credit risk pricing as part of their normal business. The argument is offered by some credit unions that, as mutual organisations, they must, under section 38 of the 1997 Act, charge the same price for ‘The Same Class of Loan’. Critically, however, ‘Class of Loan’ is not defined and loan types are of course not internally homogeneous.
Take as an example, financing the common car. Some aspects which differentiate one car from another and arguably require differential pricing include:
- Is the car taken as security against the loan? Most credit union lending is unsecured, so arguably the ‘Class of Loan’ is an unhelpful term.
- And even where taken as security, the amortisation schedules of various cars can be very different, offering alternative levels of security for car loans, differentiating classes of loan
- What Loan to Value ratio is involved? 50 % or 80%. This also distinguishes the ‘Class of Loan’’
- What is the maturity of the loan? A car loan structured over, say, 6 years, as against over two years, represents a very different loan for the borrower (and in the arrear book of the lender)
- Loans on the popular executive cars e.g. BMW, Lexus Mercedes, etc are very different loans from the popular, more modest marques, with very large differences also in Loan values.
These differences in Classes of Loan apply equally to the very important and, for many credit unions, dominant Home Improvement loans.
Loans to consolidate other debts are transparently unique and should be distinguished for credit risk purposes.
If it is accepted that the Class of Loan is the loan itself, rather than the loan purpose, then pricing differentiation must be allowed equally and especially for the credit standing of the borrowers!
All these observations are already well understood by Irish Credit Unions, but many still consider themselves additionally constrained from Risk Pricing by their mutual status. Here we consider the operation of that important operating principle.
Principle of Mutuality
There is a very extensive literature on the principle of Mutuality. This writer found the definition of the Australian Tax office succinct and helpful and an excellent primer:
The mutuality principle is a legal principle established by case law. It is based on the proposition that an organisation cannot derive income from itself.
The principle provides that where a number of persons contribute to a common fund created and controlled by them for a common purpose, any surplus arising from the use of that fund for the common purpose is not income. The principle does not extend to include income that is derived from sources outside that group’, adding ‘.
The members of the organisation share a common purpose in which they all participate or are entitled to do so. The organisation is carried on for the benefit of its members collectively, not individually. The contributors to the common fund must be entitled to participate in any surplus of the common fund.
Uniform Pricing of Asset Types offends against the principle of Mutuality.
Extensive Credit risk analysis of credit union data illustrates that undifferentiated pricing of loans, based on the above simple categorisation of loans e.g. Cars, or Home Improvements is damaging to the credit union at large, is inefficient and, in its operation is unfair to individual members and even classes of members, as follows.
- It prefers Borrowers over Savers who currently and typically receive no return whatever for their savings.
- By uniform/average pricing credit unions prefers Higher-risk Members over Lower -risk members
- Invoking the principle of Mutuality, average pricing by Credit Unions inadvertently penalises lower risk borrowers by extracting price subsidies from them
- By undifferentiated average pricing they are exposing all members to an unnecessarily high level of credit risk
- Mutuality simply and primarily seeks to avoid dividends to external parties or to external shareholders. It does not require the inefficiency that uniform/ average pricing imposes, with consequent and serious under-pricing or overpricing of loans.
- A second serious inhibitor of the efficiency and growth of Irish Credit Unions is, of course, the 12 % p.a. cap on loans, unlike the 36% allowed in the UK. The lack of upward pricing flexibility confines credit unions to a limited segment of the marketplace, greatly restricting growth possibilities, to the general cost of all members. But that is another critical matter, considered separately.
- Irish Credit Unions are a celebrated social success, but they need to be encouraged to be fully efficient via differential loan pricing, which, contrary to some beliefs, promotes rather than offends against