Speech by Head of Financial Regulation, Matthew Elderfield, to Fintel Third Annual Global Financial Services Centres Conference

Regulatory Risk Management Structures and their impact on Financial Centre Brands

Good afternoon Ladies and gentlemen.

I welcome this opportunity to be with you to discuss the new regulatory framework we are building in Ireland, and I would like to focus on three main areas today.

First, I would like to outline briefly our recent bank recapitalisation exercise which has set the capital standards for the Irish banks going forward.

Second, I would like to talk about the new emerging international standards for financial services regulation and the implications of some of these standards for the International Financial Services Centre in Ireland.

And, third, I would like to set out our views on the very important area of corporate governance and announce to you today some new developments in this area.

Bank recapitalisation

It is a useful starting point to explain the recent work that the Central Bank and Financial Regulator has carried out on the recapitalisation of the Irish banks – in conjunction with the Government and NAMA. I think it is important that the international financial services community is fully informed about the significant progress that has been made to put the Irish banking sector on sounder footing as our recent actions have helped draw a line under the banking crisis in Ireland.

The recapitalisation requirements have laid the foundation for a strongly capitalised banking sector. Purged of their most toxic loans and with full account taken of potential losses on the loans that remain, the Irish banks can better withstand severe stress and are ready to face the tough new international capital regime that is around the corner. Because this recapitalisation process is such a critical step in restoring market confidence in our banking system, I would like to take a little time to explain the process we undertook.

We carried out a Prudential Capital Assessment Review, or PCAR, of each bank and then used the findings to decide on the recapitalization requirements of that bank.

The valuations put by the National Asset Management Agency on the property and development loans it is acquiring from the Irish banks was our starting point. The NAMA valuation process was rigorous, as demonstrated by the tougher than expected “haircuts” on the first tranche of transferring loans. These haircuts have crystallised a loss to the participating banks on the assets transferring to NAMA.

In our process, we have projected these first round haircuts across the full NAMA portfolios in the banks to establish the likely losses that will arise when the process is finished.

In addition to the NAMA losses, there are still significant sources of loan impairment in the bank’s non-NAMA assets and we sought to ensure these losses were fully recognized and accounted for in our PCAR process. We closely scrutinised the banks’ projected loan loss forecasts for the next three years and rigorously challenged the accuracy of projections for losses on smaller property and development loans, mortgage portfolios, on unsecured lending and indeed on all the other non-NAMA portfolios.

Based on these and other factors – including a stress analysis of funding costs - we applied our supervisory judgment to set bank-specific add-ons to the forecasts. These add-ons recognise the difficulty in forecasting losses and the need to take a prudent approach. They provide an additional source of comfort to us as prudential regulators.

The next step was setting the target capital level for the banks and the time period they would have to reach that target. After careful debate, the Governor and I decided that we should establish a requirement of 8% core tier 1 capital and 7% equity capital, and that this should be reached by the end of this year.

In setting this target level, we were informed by a number of factors including current market expectations of appropriate bank capital levels and the need to ensure Irish banks were well positioned for the further changes that are expected in international capital standards. We felt strongly – and still do – that the recapitalisation process should proceed as swiftly as practicable. In our judgment, decisive action is needed to draw a line under the banking crisis and to avoid the risks and uncertainty of a long drawn out process. As a result, the banks have until the end of this month to submit their recapitalisation plans and until the end of this year to execute them.

One of the outcomes of the PCAR process is a banking system that can withstand severe stress. Using stress tests to help determine capital requirements has become a best practice feature of international banking regulation. It has, for example, been adopted by the various US agencies, the EU and the UK Financial Services Authority. Our approach was similar to that applied by these regulators. We prescribed a stress test on the banks’ portfolios and required the banks to hold sufficient capital to withstand that stress and still remain above 4% core tier 1 capital. This requirement must be met as well as the base capital requirements I have described just now. Our target level of 4% core tier 1 is the same as that prescribed by the FSA and similar to that used by the US authorities.

The key question, obviously, is the severity of the stress that we used. We did a few things to construct the stress simulation. We prescribed a macroeconomic scenario based on a delayed recovery. We also applied a portfolio level simulation derived principally from credit rating stress losses, which were adjusted based on our prudential judgment. For particular portfolios, such as non-NAMA property and development loans and for mortgages, we applied very severe stress levels to ensure the banks could withstand particularly adverse developments. There stresses were very extreme and details can be found in our PCAR statement.

If this all sounds like a rigorous process and a demanding standard, it is.

The PCAR forces the banks to face up to both their NAMA and non-NAMA losses now, and, in a way that commands market confidence. It means that the banks are prudently capitalised to withstand a severe stress scenario. It means that the banks will be able to stand on their own feet in terms of funding more quickly than would otherwise be the case. It also means that the banks are well on the path to being ready for the new Basel regulatory capital regime which will impose tougher requirements in a number of areas.

The PCAR also means that there is now certainty about the maximum costs to the public debt as a result of the banking crisis and international capital markets now have certainty about the impact on Irish public finances and public sector debt.

In this respect, the process has made a few points clear to international investors.

It is clear, for instance, that the costs of recapitalisation for the two largest Irish banks can be achieved without adding to public sector debt, principally by converting existing preference share investments into equity holdings.

It is clear that a very rigorous process has been undertaken and that it would take an extraordinary amount of stress before there was prospect of the need for further support for the banking sector.

And, it is clear that while there are significant costs associated with the recapitalisation process, these costs are manageable and will be spread out over time.

The fact that private investors have just this week shown their willingness to support the Bank of Ireland capital raising process is very encouraging.

Ireland has already demonstrated to the capital markets that it is determined to tackle fiscal consolidation in a responsible manner and is now showing that it is prepared to take decisive action on the recapitalization of its banks. The result is a clear, credible and swift path to a strongly capitalised banking system, certainty about the costs to Irish public finances and a stronger economic recovery.

New international standards for regulation and the implications for the IFSC

If I may I would now like to turn to the topic of international regulation, highlighting changes in prospect for the insurance and funds industries and discuss the resulting implications and opportunities for the International Financial Services Centre in Ireland.

It is a busy time in the international arena where regulators and firms are facing a number of challenges. The G20, Financial Stability Board, ECB, CEBS, CESR, CEIOPS, Basel Committee, IAIS and IOSCO are collectively driving through a major agenda of regulatory change that will have a significant impact on the IFSC and the domestic Irish market. Given the considerable disruption caused by the global financial crisis, and the contributing role caused by weaknesses in regulation, it is right and proper that such change is being proposed and implemented.

It is important that the Irish public authorities and industry have an active voice in that debate. I would like to see us punch above our weight and influence the debates that are emerging in Europe, leveraging the clear expertise that we have in various centres of excellence in the IFSC.

There are significant challenges ahead, not least for international financial services companies but also for offshore operators who will have to make major changes in their operating models if they want to do business in Europe.

As a regulator we are committed to meeting the challenges of this new international regulatory framework. We want to be ready to implement the regulatory changes required and able to deal with the challenges ahead. We are re-organizing internally to create a central policy capability and expand our international policy resources. This will enable stronger advocacy and influencing in policy debates of key interest. It will also allow us better capacity to work with industry to assist with the implementation of directives and other EU changes.

In the insurance sector we have recognised that being ready for Solvency II is a key project both for us as regulators and for the industry, over the coming few years. Therefore we have been gearing up the level of resources we commit to Solvency II implementation. We have added to our existing complement of actuaries and are setting up a dedicated policy team dealing with prudential insurance matters. We are already very heavily committed to the work of CEIOPS and this will continue and be enhanced over time, as CEIOPS transforms itself into one of the new European Supervisory Authorities.

In addition to these strictly Solvency II-driven changes, we are also adding to our supervisory staff to provide better coverage for our highest impact firms, so that we are better resourced for the supervisory tasks that will arise from the Directive.

This means that Ireland is on track for Solvency II implementation. We recognize that insurance companies around the world, both within the EU and outside, are measuring up their options as to their optimal structure to be ready for the Directive. Solvency II provides important passporting benefits for insurance companies from whatever base they chose in the EU and it is already clear that firms are re-organizing their corporate structures to take advantage of these privileges.

We are also therefore taking the opportunity to look at our authorisation processes so that we will be able to handle applications from firms from within the EU or from third country jurisdictions more efficiently. We have transferred insurance authorisation activity into the insurance supervision department to ensure that applications can be handled by expert staff from day one. Processing of applications will receive high priority, the demands of Solvency II notwithstanding, and resources will be made available as required. If insurance companies decide to re-domicile to Ireland or to re-organize their EU operations to use Ireland as the hub of their activities, we will have an efficient process that can ensure high prudential standards are maintained when firms seek to act swiftly on the commercial choices thrown up by the Directive.

As a regulator, our challenge or is to ensure that we tackle the implementation of Solvency II in a risk-based way, but, at the same time, we must ensure we have the resources, market understanding and improved processes to respond efficiently to the commercial changes that are just around the corner.

These imminent changes in regulatory standards therefore provide opportunities for the IFSC. Ireland is well positioned to gain from these changes in insurance regulation. I also think this is the case in funds regulation.

In the Funds sector, the move to introduce standards for hedge funds through the Alternative Investment Fund Management (AIFM) Directive has provoked considerable debate and is still subject to negotiation. It is natural to review the regulatory framework for this sector as part of the post mortem following the global financial crisis. But it is important that the right lessons are drawn and that the new framework is balanced and appropriate. The proposals for stricter liability standards for service providers could usefully be revisited for example.

But it seems pretty clear that new EU standards of some sort will emerge, sooner or later, and that the EU is setting the pace internationally in terms of developing such standards. This creates an important dynamic for financial services centres and throws down a challenge for the major offshore fund centres.

In line with other EU directives, the AIFMD will almost certainly have so-called equivalency provisions. This will require operators from non EU jurisdictions to match European standards in order to compete with EU firms on a level playing field. As a result, offshore jurisdictions will face a requirement to match EU standards. This may impact the balance of judgement about choice of domicile or, where these jurisdictions fail to make the grade, funds, fund managers and services providers may look to re-domicile or explore new structures. Indeed, we are already seeing the process of alternative investment funds employing a UCITS structure.

Ireland has an established position as a centre of excellence for the funds industry, with a strong regulatory framework matched by a strong commitment to efficient service delivery on authorisations. As I will explain in a moment with respect to corporate governance, our risk-based framework will continue to provide an approach that allows appropriate differentiation of regulatory standards for funds. And the Government has recently introduced legislation to facilitate the easy re-domiciliation of funds. As a result, the IFSC is well positioned for the new regulatory framework and the changes that lie ahead.

Corporate governance

I would now like to set out our views on the very important area of corporate governance and want to announce some new initiatives from the Financial Regulator in this area. We are publishing today a consultation paper on new corporate governance standards for banks and insurance companies.

There have been serious failures of corporate governance at a number of financial institutions in recent years. Over-dominant CEOs have gone unchecked resulting in unacceptable costs to shareholders and the taxpayer. Risk management standards and controls have eroded on the watch of less than vigilant boards.

It is clear that regulatory standards in this area must therefore be reassessed. The proposals we have published today set exacting standards for Boards of Directors of banks and insurers and include requirements relating to Board composition and impose restrictions on the number of directorships that can be held at one time. Breaches of these standards will be sanctionable under the administrative sanctions framework.

The consultation paper sets new standards in a number of areas including the composition of boards, with a requirement for a minimum of five directors. There are requirements regarding the role and number of independent non executive directors on a board, and, limits on the number of directorships an individual can hold to eight, subject to certain conditions, in order to ensure they can comply with the expected demands of Board membership of a regulated institution. Another requirement is that Board membership is reviewed at a minimum every three years.

The new standards require clear separation of the roles of Chairman and CEO and a prohibition on an individual who has been CEO, director or senior manager during the previous five years from becoming Chairman of that institution. Criteria are set out to ensure the independence of directors and to deal with conflicts of interest.

Boards will be required to set the risk appetite for their institution and to monitor adherence to this on an ongoing basis. Standards are being set to ensure the effectiveness of board committees, including that the remuneration committee must comprise a majority of independent non executive directors.

However, in line with our risk-based approach to regulation, we recognise the need for a proportionate application of corporate governance standards depending on the size and risk profile of the firm and that a one size fits all approach is not appropriate for all sectors.

On this basis, we consider that the rigorous corporate governance standards we are now proposing for banks and insurance companies may not be appropriate for the funds sector. The funds sector poses a different risk profile than that of the banks and insurance companies, without the same sort of prudential risks and compensation scheme framework, and with important differences in governance arrangements.

Therefore, I have proposed to the Irish Funds Industry Association that it undertakes to develop a corporate governance code for financial services firms in the funds industry in Ireland. This code would then set the corporate governance standards for the funds sector and as a result the statutory standards we are proposing for banks and insurance companies would then not apply. The IFIA has agreed to undertake this work and we will act as observers in this process.

When we reach agreement on appropriate standards for the funds industry, IFIA will promulgate these standards among its members and encourage early implementation. The Financial Regulator will defer to the industry to operate the agreed corporate governance standards for a trial period but will reserve the right to take action if we deem this necessary. It is important to be clear that if new EU standards emerge in this area they will, of course, have to be adopted.

The standards we are publishing today are consultative proposals and we are looking forward to input from the industry and other stakeholders before they are finalised. We want to understand better the cost implications of the proposals. There are also some important questions around scope. For example, we propose to carve out most captive insurers from our proposals due to their special nature. And we are asking the question as to whether or not these standards should apply to investment firms. We also include provisions ensuring that the requirements can be calibrated in a proportionate manner based on the size, complexity and structure of the firm in question.

But the main direction of our proposals is clear. The buck stops with the board. But many boards of directors still need to raise their game. The proposals we are publishing today will set exacting new standards for boards, designed to improve corporate governance in the banking and insurance sectors.

Conclusion

The corporate governance standards I have described are a key milestone in reforming the regulatory framework in Ireland. I hope I have demonstrated why the work we have done on banking recapitalisation is another very important mark of progress in Ireland. And I hope I have shown that while there is a busy international agenda ahead, the Irish framework is ready for the challenges to come and the IFSC can continue to prosper.

Thank you.