Financial Regulation in a Time of Uncertainty - Gerry Cross, Director of Policy & Risk

Kemmy Business School, University of Limerick

Thank you to Professor Eoin Reeves for the introduction and the invitation to speak at the Kemmy Business School this afternoon.

I know that my topics this afternoon will be of interest to those involved in the KBS MSc course in Financial Services. But I hope to cover matters also of interest to the broader community. In the first part of my comments I will speak about the role of financial regulation in supporting economic activity. In the second part, I will discuss issues arising from Brexit.

One thing is sure: we are living in uncertain times. We only have to take a look back over the past 12 months to understand how much this is the case.

It is clear that we live in a world that is rather more unknowable than we previously assumed and that we face a future that is, both in its short and medium term aspects, rather more unpredictable.

Against this backdrop, I am grateful to have the opportunity to talk to you today about the role of financial regulation in a time of uncertainty.

Financial regulation is, of course, only one part of the picture in terms of the public policy measures and instruments that have a significant role to play in such a context. Economic policy – fiscal, structural, and monetary; social policy, including its protective, supportive and distributive aspects; and international and regional arrangements, to mention a few, are all key to addressing the challenges that arise.

But financial regulation also has an important role to play. It plays an important positive role in the effective functioning of the economy. And I wish to say a little bit about this this afternoon.

Objectives of financial regulation

Under Article 6A of the Central Bank Act 1942, the Bank has three objectives relevant to financial regulation:

(a) The stability of the financial system overall;

(b) The proper and effective regulation of financial service providers and markets; and

(c) Ensuring that the best interests of the consumers of financial services are protected.

We also have a mandate to seek to achieve the efficient and effective operation of payment and settlement systems. But this is not something I will elaborate on further today.

Financial stability

A central objective in the area of financial regulation is to maintain financial stability. We seek to avoid systemic crises so that we do not experience disruptions to the normal functioning of the economy because of failures in the financial system. 

One of the mistakes that was made in the run-up to the financial crisis was to think that if individual firms were properly regulated and supervised then the system as a whole would also be resilient. This proved to be a textbook example of wishful thinking leading to major error and enormous damage. So, post crisis, as well as financial regulation generally being re-oriented so that it is significantly informed by a systemic as opposed to simply a firm-by-firm perspective, a whole array of systemically-focused developments have taken place.

New institutions have been developed – the Financial Stability Board; the European Systemic Risk Board; and the national macroprudential authorities to mention a few. We have had to reconceive our approach to data creation, collection and utilisation. And we have had to develop a whole suite of new instruments. These include additional requirements for systemically important financial firms, capital buffers that operate countercyclically, and various powers of intervention by macroprudential authorities.

In Ireland, the Central Bank that has been vested with marcroprudential powers. Falling within our powers is that for setting macroprudential requirements relating to the property market.

As you will be aware the Central Bank introduced measures on residential mortgage lending in February 2015. These include an 80% loan-to-value limit (90% for first time buyers) and a 3.5 times loan to income limit for primary dwelling house loans. These are required to be complied with by banks for a specified percentage of mortgage lending.¹ The aim of these measures is to curb the risk of house price-credit spirals, and increase the resilience of both banks and households in the event of a downturn. It is worth noting that it is not the aim of the measures to limit house price-increases per se; the focus is stability and resilience not prices taken separately. The Central Bank carries out an annual evaluation of the mortgage measures. As Governor Lane recently told the Joint Oireachtas Committee on Finance, more frequent evaluations would be counter-productive²

Regulating a well-functioning financial system

After financial stability, the 1942 Act talks about the proper and effective regulation of financial firms and markets. What exactly is meant by this proper and effective regulation? We must assume that it does not mean regulating so tightly and conservatively that no firm ever fails and no investor ever suffers losses. This would be relatively easy to do, but it would have the effect of more or less shutting down risk taking in the economy, and therefore the economy itself. Therefore, it must mean something like regulating financial firms and markets effectively and well so that they can fulfil their role in supporting an effectively functioning economy.

Whether it be making loans, facilitating funding, providing instruments that allow risks to be hedged, or helping individuals and businesses manage their financial affairs, the essential role of financial services is to support the activities of other actors in the economy. The role of financial regulation is to provide the framework of rules, requirements, supervision and enforcement that allow this function to be carried out to optimal effect. It requires a system of measures which support safety and reliability, deliver rule-based effectiveness and efficiency, and promote the confidence without which the system will not work.

At the same time if we accept that the goal is the optimal functioning of the system, then the things to be careful about are not just those things which under-secure but also those things which, by going too far, themselves inhibit the good-working of the system. That is the essential challenge of financial regulation. And that, put frankly, is why it is difficult.

Soundness of individual firms

A key aspect of financial regulation is to ensure that financial firms are sound – soundly financed and soundly run. This is prudential regulation. It is why we have capital requirements and liquidity requirements, why we require strong governance and effective risk management, why we worry about and inspect for sound business models and IT vulnerabilities. For bank regulation of course we carry out our responsibilities now as part of the Single Supervisory Mechanism led by the ECB. So called “significant banks” are directly supervised by the SSM, with the supervision of “less significant banks” overseen by it.

We are seeking to achieve two things here: the first is that taken both collectively and individually financial firms do not pose a threat to the system. This does not mean trying to make sure that such firms never fail. But rather that where firms do fail, (a) that does not happen on an unduly frequent basis; (b) it doesn’t happen in a way that the system as a whole comes under pressure, and (c) it does not come at the expense of the public purse.

And the second thing is related. We are seeking to ensure that customers, and potential customers, of financial firms have the necessary confidence to do business with those firms and participate in the system as a whole. If everyone decides to keep their money in a safe, then the system as a whole, the economy, fails to meet the needs of society. It is important that financial services customers have a high degree of confidence in the soundness of the firms with which they are dealing. This is of course also why we have depositor, investor and policy-holder protection schemes.

Levels of required capital have been increased dramatically since the crisis. Banks are now required to hold common equity capital at levels that would not have been imagined prior to the crisis. The ability of banks to absorb losses is also being materially enhanced under the requirements of the Bank Recovery and Resolution Directive.

As for liquidity, the EU requirements for prudent liquidity management have also significantly increased since the crisis. Now banks are required to hold significant levels of liquid assets. They will soon also be required to comply with stable funding requirements which will limit the risks of undue levels of maturity transformation

And capital and liquidity are just the headline items. Governance, risk management, remuneration, all of these have been transformed by post-crisis regulation. With all of this reform having taken place why do we continue to hear so much about ongoing regulatory change – about “Basel IV’ for example; or “CRD 5”. In fact, there is no Basel IV and there is no CRDV 5. What is happening is that the final components of the post-crisis regulatory reforms are being put in place – including a required leverage ratio and a binding Net Stable Funding Ratio.

And in Basel the important work to address undue variability in banks’ risk modules is being finalised. The Central Bank is very supportive of these and other finalising elements. While we do not have strong views in favour of output floors for risk models, we think it is of great importance that Basel III is now brought to finalisation and the necessary compromises made to get the deal finalised without undue further delay.

Beyond this, while it will of course be necessary to continue to assess the reforms that have been introduced to ensure that they are working as they should, we do not consider that major further changes should be envisaged at this stage beyond what is already in train. In this context, I would note that current European Commission proposals to limit the flexibility of supervisory responses are in our view unhelpful and contrary to some of the key lessons of the financial crisis.

Effective functioning of the financial system

In a market-based system of financial services provision, it is important that that market functions well. This means that the pricing of instruments and risk must be effective. The Markets in Financial Instruments Legislation (MiFIR/MiFID2) that is currently being brought into force to replace the original MiFID legislation is a good example of regulation in this context.

The MiFID legislation seeks amongst other things both to put in place the rules that ensure that price formation works effectively – in particular a strong set of rules around the transparency that is required in relation to trading in financial instruments; and it seeks to ensure that the opportunities for gains to be made as a result of undue opacities and complexities are reduced to the extent possible.

The new, enhanced MiFID regime will be brought into force in Ireland and throughout Europe on 3 January 2018. For a detailed discussion of the implementation of this legislation in Ireland, I refer you to a speech last week by my colleague Michael Hodson, Director of Asset Management Supervision at the Central Bank³.

Consumer protection

Governor Lane recently spoke comprehensively about the role of the Central Bank in consumer protection in a speech given at University College Cork⁴. 

I do not intend to reprise here what Governor Lane said there. But let me mention a couple of aspects.

The first is to note how all of our financial regulatory mandates – financial stability, prudential and market functioning regulation, and consumer protection – have as a core feature ensuring that the financial system works in such a way that the interests of consumers are appropriately protected so that they in turn have confidence in how the system operates and in the firms and entities who make it up.

Governor Lane also noted that in this area there are a number of bodies with different roles to play. There is the Central Bank, with our responsibilities for seeking to ensure that financial firms deal fairly with consumers. There is the Competition and Consumer Protection Commission whose responsibility includes the provision of personal financial information and education, including a web helpline and comparison of financial products, and there is the Financial Services Ombudsman who assesses complaints of individual consumers and can direct redress where he finds against a firm.

All three of these bodies have their distinctive roles in respect of consumer protection. And we work cooperatively for the protection of consumers.

Here again there is virtuous cycle to be achieved. For while consumer protection is at the heart of financial regulation and is essential to its success, it is also the case that a well-functioning financial system is essential to the success of the economy and, in turn, to the financial well-being of our citizens.

What we seek to do in the area of consumer protection is to ensure fair treatment for consumers in how financial firms conduct their business – the suitability of products, the quality of advice, the clarity and effectiveness of information provided. At the moment to take one example we have a significant focus on culture within regulated firms where we are seeking improvements. For example, we have been directing firms to look at and restructure where necessary their incentive payments for sales staff.

Fintech

An important emerging challenge for supervisory authorities is the extent of innovation taking place through greater use of modern technology (fintech). Technological development can have a very positive impact (new products, reduce costs, increase competition, improve service delivery) but it also brings risks and challenges.

Rapid innovation represents a test for our regulatory approach: (a) when we authorise a firm to enter the financial system, we need to strike the right balance between ensuring the firm meets our expectations, while at the same time being to open to new ideas and innovation; (b) for regulated firms, we need vigilance about shifting business models and emerging risks – including ensuring that prudential and consumer protection requirements are appropriate for new business models; (c) resolution regimes need to be such that they enable the financial system to absorb the failure of individual firms as others grow and prosper; and (d) we are strengthening international cooperation arrangements necessary to be able to effectively regulate in a digital environment that may have little regard for national borders or jurisdictional reach. 

Enforcement

A credible threat of enforcement is crucial to ensuring effective regulatory and supervisory outcomes. Our approach in this regard is clear: we rely on high-quality rules and assertive supervision underpinned by a rigorous approach to enforcement.

Since the financial crisis, our enforcement and redress powers have been significantly expanded and strengthened by legislation. During which time we have concluded some 80 enforcement cases, half of which dealt with consumer issues and imposed fines totalling over €46 million⁵. In 2016 alone, the Central Bank imposed fines of just over €12 million, the largest figure for fines imposed by the Bank in a single year to date. 

Europe

I have spoken so far about the key areas of financial regulation as they are carried out by the Central Bank. I have not made a great deal of mention of Europe in all of this – though you will have noted of course that when I have spoken of legislation – CRDIV, MiFID2, BRRD – it is of course European regulation that I have been referring to. While not all of our financial regulation comes from Europe, a great deal of it – I would say roughly 75% - does.

As well as being very active participants in the work of the three European Supervisory Authorities (ESAs), the Central Bank has also been, like other Eurozone bank regulators, since 2014 a member of the Single Supervisory Mechanism led by the ECB, with responsibility for the direct supervision of Significant Banks and for oversight of how less significant banks are supervised by national authorities.

As you are all very much aware, the European system is now undergoing a significant challenge with the forthcoming UK exit from the Union. This is something with significant consequences for financial regulation. So let me take the time to say some things about this now.

Brexit

As part of the European Union, the UK like all other EU / EEA countries, currently enjoys the full benefits of financial services passporting rights. This means that UK financial firms are able to provide services anywhere in Europe without having to be authorised in the local jurisdiction. Similarly, firms authorised anywhere in the EU can do business in the UK without needing a UK license.

Given the UK’s intention to leave the single market and to no longer be subject to the jurisdiction of the European Court of Justice, it seems likely that such passporting will come to an end.

Now, it is possible that other arrangements can be found that in one way or another mimic the current situation and therefore allow financial services passporting to be retained. This could be on a permanent basis or, possibly more likely, as some kind of transitional arrangement. As it has not yet been identified what such arrangements might look like, and because the negotiations are likely to be so difficult and fraught, for now, most people are making the appropriate assumption that for UK firms passporting is likely to end and there is a materially high possibility of it doing so in April 2019, 2 years after the triggering of Article 50.

So at the Central Bank, we have seen over recent months a large number of enquiries from UK headquartered financial groups and firms thinking about potentially setting up a subsidiary entity – be it a bank, or an insurance firm, or an investment firm, or a fund manager, or a payment entity, or an infrastructure provider, or something else entirely – in order to maintain their presence in the EU after Brexit and, crucially, the ability to passport throughout the remaining 27 EU (30 EEA) countries.

At the Central Bank, in line with our stated approach of being transparent, active and engaged, we have had many discussions with such firms to explain to them how the Central Bank approaches regulation and supervision and to discuss with them their potential plans to deal with the significant challenge that Brexit presents for them. It is worth mentioning, because people often ask us about this, that we have engaged with the Department of Finance, the IDA and others to ensure that the approach of the Central Bank to regulation and supervision can be effectively communicated to interested parties. This of course requires respect at all times for the mandate and role of the Central Bank which for financial regulation is as described above and nothing else.

What we are finding is that there are a range of matters that such firms are weighing up in their decision-making. These include such matters as the availability of commercial office space, the ease of access to housing for their staff, the travel infrastructure, the educational offering, tax rates, both corporate and personal, ease of access to their parent entity in the UK, and of course the approach to regulation and supervision. I will say more about the latter in a moment. A big factor for such firms is also the question of timing. If they are planning for the worst (even if hoping for the best) they realise that they will have to have at least the minimum necessary structures in place and operating by the end of Q1 2019.

In terms of what we are likely to see in Ireland, whether through the extension of existing activities or through the presence of new ones, the IDA has said that it expects Ireland to achieve a meaningful share of the business that is re-located from the UK. This is consistent with what we are seeing in the Central Bank. UK firms have a choice of many countries to potentially move business to and a wide range of factors to weigh up. Decisions are in the process of being made. At the Central Bank we expect to see a meaningful increase in applications for authorisation or for extension of existing business. We have already seen a number of these either come through or be indicated as being intended. And of course this is a matter of important interest here in Limerick, particularly in light of the Limerick 2030 Vision with its important financial services aspect. But as I said, the full picture will not be known for a little while yet.

The degree of continued integration.

One question that UK-based firms are thinking about, and which is also very much on the mind of policy makers, is the extent to which the City of London will remain an important component of the EU financial services landscape. Will it continue to be closely integrated with the EU economy? Or will we see a move to something like two parallel ecosystems? This matters, not only for the European economy as a whole, but also for individual firms for whom the more closely London remains integrated the less disruptive Brexit will be for them and for their business and structures.

The recent months have seen increased articulation of the extent to which the European economy is currently supported by financial services activities originating in London. One recent report suggests, for example, that 78% of European FX trading and 74% of European interest rate derivatives trading, and 50% of European fund management activities (by assets) takes place in the UK.⁶

What this might mean is that while the issue of financial services will still be the focus of significant political bargaining as part of the overall Brexit / future relations negotiations, it can be hoped that both sides have a lot to gain from achieving as low as possible levels of disruption to the degree of integration of UK and European financial services. It must be remembered that great financial centres grow organically over a very long period and create highly beneficial cluster effects; and that while such centres can fade and give way to others (see recent speech at Chatham House by Deputy Governor Sharon Donnery; 23 March 2017 centralbank.ie) and modern IT potentially makes physical clustering a little less key than previously, nonetheless the challenges in recreating the London effect, even in a dispersed way, within the EU-27 would be significant.

So from a regulatory perspective my hope would be that the political negotiations on the financial services aspects would result in a situation whereby disruption and change, while to some extent inevitable, would be kept to the minimum possible. This could be achieved if negotiations were to focus on requiring only those changes which are necessary (a) in order to ensure the financial stability of both areas; and (b) to ensure that firms carrying on business in the EU (or UK) do so on the basis of the same standards and requirements that apply in the other area. The system cannot work if firms located in one area are able to undercut firms in the other because the rules are looser or substantially different.

These two imperatives – financial stability and avoiding regulatory mismatch – are of course in themselves very demanding. They will require a lot of work and effort to achieve. Achieving them, at least at a reasonable cost to all concerned, will require some imaginative thinking and the development of new approaches and solutions. For example, we may need to develop a new concept of enhanced ‘equivalence’ or some similar concept, new forms of third country oversight and supervision, agree on dispute resolution, and further develop arrangements for binding cross-border resolution agreements. Each of these in itself will be highly challenging. And taken together even more so. And time is tight. So the best minds need to be addressing themselves to these matters now. (The good news is that this is underway.)

Transition

From a financial regulator’s perspective, the other feature that we worry about is the tightness of the potential timetable. Whether it be ensuring that there does not take place a major disruption to flow of financial services through the arteries and veins of Europe’s economy or simply ensuring that individual firms have as much time as possible to make their appropriate arrangements, the availability of a transitional period is highly desirable. It is recognised of course that this is something for the political authorities as part of the overall negotiations, but I welcome the recent indications that discussions about the future relationship between the parties will take place on the basis of appropriate progress in the “divorce” negotiations and therefore we should not have to wait until the end of those negotiations for progress to be made on this question.

The role of the European authorities

For the final part of my talk here today, and still very much in the context of Brexit, I would like to say a few words about the European authorities in the area of financial services and the very significant contribution that they can make, and are making, to optimal outcomes in respect of Brexit as it relates to financial services.

A major risk, given the circumstances, is that regulatory differences could emerge between different countries in the context of Brexit-related decision making. This could have serious negative consequences. Take for example, the so-called question of “substance”. This is the question as to how much presence a firm needs to have in place in a EU jurisdiction in order to be allowed to be authorised there. Can it just have a small group of administrators who are not really on top of the business decisions that need to be made to run the entity safely and well but who, for example, simply allow business to be booked into the entity before being re-booked in the UK parent. Would that be acceptable? And, if that is not sufficient, then what do we mean by substance? What actually has to be in place for the entity to be authorised by a EU authority?

Why does this matter? Well it matters in particular because, unless a firm is actually running the authorised business from the EU jurisdiction where it is authorised, then the business must be being run elsewhere. And if it is being run elsewhere then in fact it is the rules and requirements of that other place, and the supervision of those other authorities, that are governing the business, not the EU rules and supervision. And that of course is one of the things, as mentioned above, that we wish to avoid – that firms doing business in the EU are not in fact subject to EU rules and requirements.

The risk of divergence on this question has been a real one. This is why we have been very pleased to see the SSM in the last couple of weeks come out with a set of guidelines on the matter⁷. We have been working very closely and very actively on this as part of the SSM. And we are pleased to see that the guidelines that they have issued reflect in many respects similar thinking to our own in terms of an appropriate balance of robustness and pragmatism. We will continue to work closely with our colleagues in the ECB and SSM as the situation and thinking evolves.

Amongst the SSM guidance is the following:

• There needs to be appropriate substance. Establishing an “empty shell” company will not be acceptable. Banks in the Euro area should be capable of managing material risks potentially affecting them independently and at the local level, and should have control over the balance sheet and all exposures.
• While all the requirements for a well-functioning bank must be in place from the start, to the extent that the European entity is building up its activities over time, it may be possible that some of the additional local capabilities and arrangements are also built up in parallel, to be decided on a case by case basis, grounded on an appropriate and credible business plan. We will of course want to see consistency between the governance, management and controls and the business that is carried on.
• In respect of the approval of models already authorised by the UK authorities, there will be a limited period when, subject to certain requirements and any appropriate checks, such models may continue to be used by the Euro area entity in advance of them being fully considered and approved by the EU regulators.
• For back-to-back booking, there could be temporary transitional arrangements on a case-by-case basis. Thereafter there needs to be sufficient capabilities to manage material risks locally and after any transitional period a part of all risks should be managed locally.
• In respect of outsourcing (or insourcing), there should be robust risk control mechanisms in place so that outsouring arrangements are properly monitored and fully compliant with regulatory requirements.

This guidance will ensure the avoidance of supervisory divergences in respect of both Significant and Less Significant Banks in the Euro area. While the SSM does not have direct supervisory responsibility for the latter, it does have the final say on the authorisation of any bank, significant or less significant.

In so far as other types of financial firms are concerned - investment firms, asset managers, insurance companies – of course the SSM’s guidance does not apply directly to the approach to these firms. However, we would expect that the same or similar standards will apply. And the good news, is that here too the European authorities are closely engaged.

ESMA, for example, is developing guidance which will set out the approach that it would expect to see adopted by national authorities when dealing with Brexit-related, and other, authorisation applications. EIOPA is likely to follow a similar approach. Peer review and scrutiny of the authorisation approaches of national authorities is also being undertaken by the European Supervisory Authorities. This is also very welcome.

Finally, it is worth mentioning that the role and functioning of the ESAs is itself the subject of a consultation currently being undertaken by the European Commission. While this is topic which can be the subject of a whole separate speech, it is worth mentioning now for this reason. The departure of the UK from the EU changes the landscape significantly. At the Central Bank we think that this may be a good moment to look again at the ESAs’ role and capacity in driving supervisory convergence and to consider whether these might be further enhanced.

Conclusion

Let me finish there.

You will see from what I am saying that there is a great deal going on at the moment. And all of it with significant relevance and importance to Ireland, its economy, and its citizens.

During all this change, one might take a mental solace in the constant presence of the River Shannon, the great unifying focus point on this impressive 133-hectare campus. But even there we have to bear in mind the words of Heraclitus: “No man ever steps in the same river twice, for it's not the same river and he's not the same man.”

Amid all this change, it is important that the Central Bank is open, transparent, engaged, and responsive to ongoing developments . Hopefully my comments today will contribute a little bit to this.

I look forward to hearing your questions.