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ture has risks. Credit unions have been operating without any form of government regulation or supervision, with excessive risk-taking by the boards of directors and management constrained by the threat of depositor withdrawal. The formal supervision of credit unions and their incorporation into the public sector safety net (lender of last resort, deposit insurance, and government bailouts) could lead to a relaxation of this market discipline and result in severe moral hazard problems. The supervisory authorities must exercise great care in the timing and sequencing of these changes in order to minimize these moral hazard problems; for example, formal supervision must be reasonably well advanced before access to the safety net is granted. Credit unions are multipurpose financial intermediaries, mobilizing deposits and using these resources to fund a highly diversified loan portfolio, which includes loans to micro and small enterprises in virtually all sectors of the economy. In addition, credit unions provide consumer and housing finance to households in their target markets. Although their financial transactions are typically simple, they are quite similar in nature to those of other financial intermediaries, and so many of the prudential regulations can be similar as well. However, credit unions differ in important ways from banks in their ownership/governance structures and in certain key operational characteristics such as the greater geographic concentration of their loan portfolios and the nature of their clientele (which includes many micro and small entrepreneurs), all of which necessitates special additional regulations or different regulatory treatment. The principal difference between credit unions and stockholder-owned financial intermediaries relates to the incentives for member participation in the governance of each type of institution. The complicating factor in the case of credit unions is that members have differing incentives for participation (which may in fact put members into conflict with each other), depending upon whether they are primarily net debtors or net savers. The most important regulatory instrument designed to constrain excess risk-taking by any financial intermediary is the capital adequacy requirement. Although the legal framework for credit unions defines shares as risk capital, the characteristics of this instrument and general practice require that shares be considered a liability. The recommended policy for the regulatory authorities would be to make this instrument in fact conform to the definition of true risk capital. Shares should be priced at their net asset value by the institution, transacted exclusively in a secondary market, and not repurchased directly by the credit union itself. This practice would strengthen the capital structure of these institutions and contribute toward improving the incentives for the general membership to actively participate in credit union governance. The practice of allowing credit unions to mobilize deposits from nonmembers should be prohibited because it tends to undermine the most effective mechanism to promote greater
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REGULATION AND SUPERVISION