Opening Statement by Matthew Elderfield, Head of Financial Regulation, to the Joint Committee on Economic Regulatory Affairs

06 October 2010 Speech
Good morning chairman and committee members.

I would like to start by thanking you for inviting me here today to talk about our banking supervision strategy and, in particular, our recently launched paper on this subject. I will also like to give you an update on the recapitalisation of the banks.

I am joined by my colleagues, Jonathan McMahon, Assistant Director General with responsibility for Financial Institutions Supervision; and Shane O’Neill, Head of Retail Banking Supervision. We are happy to take your questions following this brief opening statement.

In line with other regulators globally, we are changing the way we supervise banks and are reshaping our approach to banking supervision based on the lessons learned.

We have begun the process of restructuring and resourcing our organisation to deliver a more assertive, risk based and challenging approach to banking supervision. We are placing a greater focus on macro-prudential analysis to identify the risks and stresses for business models, sectors of the economy and the financial system. We are building our capability to enforce standards, rules and requirements and deliver a credible threat of enforcement to underpin the new approach. We want to be in a strong position to translate macro-prudential analysis and micro-prudential oversight into the supervisory actions necessary to address identified risks. We want to better influence and implement the regulatory legislation and requirements emanating from the EU.

In the paper we published earlier this year, we set out how we will manage our relationship with the banks we supervise. It is clear that in addition to our more intrusive supervision on a day to day basis, we expect the banks to reform themselves. We will supervise to ensure they are making progress with this. We have set out four important examinations – we call them supervisory themes – we are taking this year to scrutinise the progress banks have made in reforming themselves. We will publish the overall results, which will provide an insight into the nature and pace of change in banking practices in this market.

The first, and the most significant theme, involves in-depth reviews of governance and risk management arrangements. This year we are reviewing the two major retail banks. The areas we are covering include the effectiveness of bank board members and of risk management arrangements. We will examine the actions taken by management to correct the impact of the previous lending policy through their risk management practices. This year we are focusing on new lending to first-time home buyers and the SME sector.

In particular we want to assess the adequacy of the measures the banks have taken to address weaknesses in practices and processes exposed during the crisis. And we want to assess whether the banks have taken sufficient measures to address deficiencies in attitudes amongst staff at all levels towards risk management and compliance with internal policies and regulatory requirements. We will publish the headline findings of these reviews in January 2011.

The second theme concerns lending standards. In May we started a review of new mortgage lending to establish the soundness of credit risk practices. The initial focus of that work has been the market for first time buyers as this represents a significant portion of new lending. We have already published the results of this review. We concluded that more work is required across the banking sector to improve the quality and detail of mortgage lending strategies. These strategies must be rooted in detailed expressions of risk appetite, applying more sophisticated measures of risk. In some instances we had concerns that banks were not using robust and reliable risk measures when developing new mortgage lending strategies or mortgage products. The absence of such measures, for example, a risk adjusted return on capital, can undermine risk calculations and thus the quality of lending decisions. A particular concern is the absence of such measures in circumstances where a bank is adapting its strategy in response to its competitors’ actions. All banks must ground their lending in strategies appropriate to their risk appetite rather than the direction of the market as a whole. It is very clear that a ‘follow the leader’ approach to mortgage strategy has not served banks or their borrowers well in the past.

The third theme of our work announced in June, involves assessing the quality of banks’ strategies. The environment for banks is, and will remain, extremely challenging. We expect bank boards to have thought through, and then described in credible detail, what this will mean for their business models. A key area of focus for the Central Bank will be the steps banks are taking to broaden their lending capabilities. This year we are focusing on SME lending.

In the pre-crisis years, Irish banks became excessively reliant on property lending, and their earnings consequently were too concentrated. There is now an economic imperative to broaden lending to other areas of the economy. There is also a prudential imperative: banks will require diversity in their earnings to attract lower capital charges and higher credit ratings. But this will not be an easy or quick process and the risks of broadening lending activities in this way must be understood. We will report publicly on our findings in November.

Our fourth theme concerns remuneration practices. We know that the structure of compensation was a major factor in the financial crisis globally. Within Ireland, it would appear that remuneration arrangements over-emphasised asset acquisition and under-emphasised the effective stewardship of funding needs and risk management. The consequences of this skewed approach are clear today. To examine this we are drilling-down into two areas: first, the arrangements at board-level for setting and scrutinising remuneration priorities, including the nature, substance and frequency of board-level debate about remuneration practices; and, second, how banks, through their remuneration policies and practices, balance rewards and incentives between asset acquisition and funding and risk management. This work is underway and we will publish the results of our examination next month.

Our work on themes will continue through 2011 and beyond. The common thread running through all this work is a concern with how banks make money. We will spend time looking at the viability of individual business lines, the quality of certain loan portfolios, the maturity mismatches which arise from loan originations, and the adequacy of information sent to a board and the seriousness of the associated discussions.

I want to repeat that our approach is risk-based: where a bank identifies, manages and mitigates its risks, it can expect us to recognise this work, when we are satisfied, through testing. But we are very clear that “risk-based” is not a synonym for light-touch regulation. Where we don’t see risks being managed, we will intervene.

In preparing our discussion paper we have been careful to be cognisant of a number of points: We recognise, as the Honohan and the Regling-Watson reports have pointed out, that the banking crisis was not the result of just one factor but of a combination of many which must be considered in framing banking supervision strategy for the future. In an open economy, where monetary policy is under the ECB’s direction, supervision is arguably the most important tool available to policy makers to counter the accretion of risk in the banking system. But it is not the only one; and we have therefore described broader changes, for example the implementation of a Central Credit Register, which might assist in delivering a sound banking system. We have also sought to make sure our recommendations create incentives for good behaviour and discourage bad behaviour. The fixed cost of being regulated will be higher because we will be more intrusive. But the variable cost – measured in time and money – will reflect how individual banks conduct themselves. We will make life difficult and expensive for banks which fail to manage risk adequately.

We have been careful not to generalise when talking about banks in Ireland. There are many different banks operating here; and within the wholesale market there are banks doing very distinct types of business. We recognise these differences in our own structure, with supervision split along a wholesale and retail line, and in how we practice supervision. We do not have a one-size fits all regime of supervision. But I want to be clear that we are intensifying our supervisory approach for all banks. The difference I have described is one of emphasis.

As you can see we have a heavy agenda. It is of critical importance in carrying out our job of regulation that we have adequate resources and the right tools to do the job effectively. We have made some progress in building up our resources by hiring people with the experience and expertise to carry out the task and in developing and implementing suitable training for our staff. But it is clear from benchmarking against other regulators that we must continue to build up our numbers of frontline supervisory staff.

Having the right tools to do the job is equally important. By that I mean having an effective statutory framework to underpin effective regulation. In his introduction to the Central Bank Reform Bill in the Dáil in April, the Minister for Finance referred to bringing a second bill before the House to enhance the powers and functions of the restructured Central Bank regarding the prudential supervision of individual financial institutions; the protection of consumer interest; and the overall stability of the financial system. In due course we would appreciate the support of members of this Committee in expediting, in so far as possible, the introduction of enhancements to our supervisory powers.

One area where legislation could make an improvement, and which has been much discussed in recent days, is through the introduction of a Special Resolution Regime, as recommended by the IMF and others. I would encourage the introduction of such legislation covering all credit institutions. A Special Resolution Regime would provide the Central Bank with a full tool kit for the future and is best practice internationally. A Special Resolution Regime is designed to allow a regulator to take control of a failing financial institution at an early stage and to pursue resolution options other than straightforward corporate insolvency proceedings or the injection of public funds.

Early action, while still imposing losses on shareholders and other exposed stakeholders, minimises the disruption to the financial system and the economy that would arise in a full insolvency. Equally, if public funds were called upon, this would be to a much smaller extent than in the absence of a Special Resolution Regime. Such regimes also typically include provision for an accelerated bank insolvency process to minimise the disruption that would be caused by a prolonged insolvency. Such extensive and potent powers necessarily have to be balanced with the Constitutional protection of private property rights and this will be a key challenge in the design of any regime.

A comprehensive Special Resolution Regime would be a powerful tool for the future to deal with a crisis. In the short-term, I support the measures that have been announced to ensure burden sharing by holders of subordinated debt in Anglo and Irish Nationwide. I know that there is keen debate about the position of senior bond holders. The Government has made its position clear on this matter and it does not intend to impose losses on senior bond holders. However, this does not rule out the possibility of some negotiations or a liability management exercise agreed by consent. Reflecting on actions by other authorities during the crisis, using resolution powers to impose losses on senior bond holders has, as far as I am aware, taken place only extremely rarely. The current difficult funding position for both the Irish government and the banking system means one should be very cautious about contemplating such a step in the present crisis, never mind whatever legal and constitutional obstacles would need to be resolved.

Finally, I would like to say a few words about the developments last week concerning the cost of the recapitalisation of the banks.

As you are aware, last Thursday the Central Bank published its estimates for the capital requirements of the Anglo restructuring, including an estimate of additional losses under a hypothetical adverse stress scenario. Last week also saw the publication of estimated NAMA haircuts for the remaining AIB and Bank of Ireland portfolios to transfer to the agency. In light of the significant increase in NAMA haircuts for AIB, the Central Bank advised that the bank will need to raise an additional €3 billion by 31 December to meet its capital requirements. In his statement last week the Minister for Finance set out the process that has been agreed to put this capital in place. All of these actions now help to bring as much accuracy as possible to estimates of the cost of government support to the Irish banking sector and draw to a close the phase of government recapitalisation of the sector.

The natural question is whether this action by government is enough and what the future holds for the banks in terms of capital requirements and other measures of their strength. Now that the capital impact of the NAMA haircuts is known, the obvious area of continuing scrutiny by the Central Bank will be the non-NAMA portfolios of the banks. We have not seen grounds to revise our base and stress capital assessment, which included substantial buffers, for the non-NAMA portfolios of the principal banks. This is, however, an area of continuous scrutiny by the Central Bank and we will conduct a full repeat of our Prudential Capital Assessment Review (PCAR) next year. This will allow a comprehensive updated view of the loss experience and projections on the non-NAMA portfolio.

The other key variable for the banks is their cost of borrowing in the wholesale markets. The banks’ loan to deposit ratios continue to be far from what is desirable and will take some considerable time to normalise, leaving reliance on wholesale funding sources. This means that the banks will need to exit from forms of support such as the government guarantee in an orderly manner. It also means that the banks’ costs of funds are currently linked to the government’ s own funding costs and therefore the national fiscal position.

When we review the PCAR process next year we will also give guidance to the banks on the milestones they will need to achieve full compliance with the new Basel 3 capital framework. The capital standards the Central Bank set in March are very close to the Basel requirements, indeed exactly so in the case of the key measure of required equity, although to be sure there are some differences in the way capital will be measured for Basel 3. Despite the long transitional period provided by Basel we have decided to stick to our accelerated timetable for the Irish banks, in order to strengthen their capital position more quickly. This also means that the banks will have time to meet the remaining aspects of the Basel regime and continue to strengthen their capital position. In the meantime they are also better prepared for a stress situation.

The announcements last week therefore represent a very important milestone. By accelerating the NAMA process, there is now more certainty about the haircuts for the remaining tranches of loans to be transferred and therefore the losses that are imposed on the banks. NAMA’s actions in turn provided greater clarity to my team and I as to the capital position of the banks and the gap they needed to close in order to meet our new capital requirements. And by drawing a line under the costs to government from the recapitalisation process, there is now more certainty for taxpayers and markets.

The strategy is to strengthen the banks’ balance sheets as quickly as possible by recognising losses on NAMA loans, building up buffers for the non-NAMA losses to come and accelerating the move to new international standards. While this is a painful exercise, it is an essential foundation for economic recovery, for improving the funding position of the banks and government and providing clarity as to the costs to the taxpayer. While these costs are being identified now, they will be spread over time to make the impact more manageable.

While the Irish banking system deteriorated rapidly, it will only be rebuilt slowly. At the Central Bank, we are under no illusion about the work that still remains to be done. We are by no means near the end of this process, but we are coming to the end of the critical recapitalisation phase.

Thank you for your attention. I shall now be happy to answer your questions.