New rules permitting Canadian credit unions to operate outside their home province raise the credit negative prospect of rapid geographic and product expansion, according to a Moody’s analyst, but will allow the institutions to gain economies of scale and reduce geographic concentration that would support covered bond programmes.

Under a new framework unveiled on 7 July credit unions will no longer be prohibited from offering core banking services outside their home province, according to Moody’s analyst William Burn, with new rules giving them the option of being incorporated and regulated at the federal level.

He said the changes are credit negative because of the execution risk entailed in rapid geographic and product expansion, and drew parallels with the US, where increased competition among credit unions following the removal of regional barriers contributed to greater risk taking and ultimately the failure of several corporate credit unions during the credit crisis.

“In the US, competition for deposits between corporate credit unions (the equivalent of centrals) drove a search for yield that led to sizable concentrations in mortgage backed securities, and ultimately losses,” he said.

He noted that while the largest Canadian credit central, Caisse centrale Desjardins (CCDJ), is bound to its members by group affiliation, the new rules creating a federal option for credit unions could have a negative effect on Central 1 Credit Union and other centrals, which are not so closely tied to their member credit unions. This is because the new framework allows members to opt out of provincial regulations that require them to maintain deposits with the central.

Cross-province amalgamations are a likely to follow the opting for federal regulation by credit unions, according to Burn, as they will be able to operate more easily across provinces. This will extend a consolidation trend that is already underway within provinces, he said, with the 10 largest credit unions holding 45% of all credit union assets, excluding Quebec, up from 39% in 2007.

“Expansion beyond provincial borders will allow credit unions to gain economies of scale and reduce geographical concentration,” said Burn. “In principle, these characteristics would lead to stronger credit profiles over time, but rapid expansion into new regions and products is a high-risk strategy, particularly for institutions built on deep local franchises.”

Consolidation will allow more credit union centrals to attain the same level of funding diversification as Caisse centrale Desjardins, he added, which has good access to wholesale markets through commercial paper, medium-term note and covered bond programmes.

CCDJ issued its first covered bond in March 2011, a US$1bn five year issue, returning to the US market in February this year. Officials at Central 1 Credit Union, which provides services to independent credit unions in British Columbia and Ontario, have previously told The Covered Bond Report that it has also been considering covered bonds.

Asked about the implications of the federal option for covered bond issuance by credit unions, Burn said that the main point is scale.

“As credit unions expand outside their home province they will gain the kind of scale to support covered bond programmes,” he said. “A second benefit is greater geographic diversification.”

He noted that funding diversification is credit positive if a credit union has an adequate alternative liquidity plan in place, but that firms have a tendency to use new funding sources to grow the balance sheet, often by expanding into new products or asset classes.

“As such, incremental market funding may lead to a heightened risk profile, which, in turn, can lead to a sudden reduction in the market’s appetite to lend,” he said. “Managing such risks will be important for the credit quality of credit unions that expand beyond their home provinces.”