Address by Director of Credit Institutions, Jonathan McMahon, to the Fifth Association of Compliance Officers Ireland,Compliance in Finance Conference

A New Risk and Compliance Challenge: The Credit Institutions Resolution Regime in Ireland

One of the results of the crisis globally has been significant reform both to the rules which govern financial systems and the rules of engagement regulators and central banks employ.

Some of this has been eye-catching: for example, the Basel III regime has provoked a very significant debate about the correct level of capital for banks, and has certainly influenced national and pan-national stress tests, in turn leading to major recapitalisation exercises.

Other changes have received less attention, yet cumulatively will be as important as these initiatives. Matthew Elderfield has spoken of the reforms to culture and practice within the Central Bank, including the introduction of our new risk model, PRISM. We have also detailed at some length, and publicly, the changes we are making to our supervision of banks. We set an ambitious agenda for ourselves and we are intent on pursuing it energetically.

The Central Bank’s new role as a resolution authority

Today I want to focus on one of the most significant new responsibilities granted to the Central Bank in the recent reforms to the regulatory regime in Ireland, namely the Bank’s new role as the resolution authority in the State.

It is accepted internationally that adequate resolution arrangements are essential if those involved in dealing with distressed financial institutions are to do so successfully. As such, the decision of the last Irish government to initiate legislation in this important area marked something of a change in the relationship of the State to the financial sector, with the State in effect deciding that securing the orderly failure of a financial institution can be a legitimate policy outcome in certain circumstances.¹  Moreover, the State has decided that interference in property rights can be a legitimate consequence of a resolution intervention. These are notable measures in a free market economy.

Such are the lessons of the crisis that it perhaps strikes us as incontestable that the State should want a broader range of tools to deal with stress in the financial sector. It is, however, important to remind ourselves that resolution of a financial institution – securing its orderly failure – is inherently different from supervision. The latter does not seek to eliminate the failure of an institution, but it does seek to minimise the instances of failure. As such, the Central Bank’s new responsibilities under the Act give it a role that is distinct from, and indeed one that creates a constructive tension with, its existing role as a supervisor.

Scope of and powers available under the Act

The new Act applies to deposit takers regulated by the Central Bank only, so essentially all banks, Building Societies, and Credit Unions, although the Covered Banks, namely AIB, Bank of Ireland and Irish Life & Permanent, will continue to be dealt with under the Credit Institutions Stabilisation Act while that Act remains in place, which is expected to be until the end of 2012. Branches of Foreign institutions operating in the State are not included. In addition the Act does not apply to investment firms, insurance companies or other financial services companies.

There are a number of new concepts which the Act introduces which are worth highlighting.

These are:

• The Credit Institutions Resolution Fund: The purpose of this fund is to provide a source of monies for the resolution of a financially unstable credit institution. The fund will be financed by contributions from authorised credit institutions. The Minister for Finance may also contribute to the fund. The Minister has already announced such monies in connection with credit unions.
• The power to establish a ‘bridge bank’:  A bridge bank is a limited company, owned by the Central Bank, created for the purposes of holding assets or liabilities transferred from a distressed institution. The arrangement is temporary in nature, with the intention that some or all of a business is transferred to a third party as soon as practical, such as when a buyer is sourced or the market recovers. Any residual entities can then be liquidated.

There are two further powers given to the Central Bank which can only be invoked if certain Intervention Conditions are met. These are:

• Transfer Order:  The Central Bank may apply to the High Court for a Transfer Order under which it can compel a distressed credit institution to transfer its assets and liabilities to another entity.
• Special Manager:  The Central Bank may apply to the High Court to appoint a Special Manager to a credit institution. A special manager takes over the management of the business, and runs it in accordance with pre-defined terms. This may include preparation for a transfer, a wind-up, or in some cases, an attempt to restore the institution to viability.

Furthermore the Central Bank can apply to the High Court to appoint a liquidator to a credit institution, albeit such powers exist already for certain financial institutions. The change the Act brings about is to equip the Central Bank to act pre-emptively and seek the order to liquidate for other than financial reasons, where those reasons are in the public interest.

Finally, the Central Bank may direct a credit institution to prepare a Recovery Plan and, on the back of that, the Central Bank may prepare a Resolution Plan. These two separate types of plans are sometimes loosely called a Resolution and Recovery Plan or, colloquially, a ‘Living Will’.

Resolution and Recovery Plans

The Resolution and Recovery Plan is the most obvious manifestation of the philosophical and practical differences between supervision and resolution.

A financial institution ought to plan to survive multiple business cycles and act accordingly. We know that this is not always the case. We also know that markets do not necessarily impose disciplines on participants such that this planning occurs. Supervisors therefore seek to address these gaps through interventions in management decisions, requirements on governance, barriers to entry for appointments to senior management positions etc.

A financial institution ought to survive multiple business cycles. But this does not always happen either, as we know. Supervisors seek to reinforce prudent behaviour so as to minimise instances of failure. We also maintain rules on how a financial institution can construct and use its balance sheet. Hence rules on capital, liquidity and asset weights to create “shock absorbers” within the financial system.

This does not always happen either. In such a situation the resolution powers give us the ability to secure an orderly failure.

But long before a financial institution reaches a point of needing to be resolved, the resolution authority will have asked itself the What if? question and planned accordingly.

Equally, we expect each financial institution the Act covers to have prepared its answer to the very same question. International experience suggests the very act of posing this question will introduce new disciplines for financial institutions. A board of an institution will need to identify credible actions to restore the firm’s viability in the event of a crisis. It will need to have eliminated obstacles to a successful resolution should a recovery not be possible.

Our expectation is that a board of an institution should consider What if? scenarios reasonably regularly (at least once a year), and identify credible actions to restore the firm’s viability in the event of a crisis. This should benefit the regulated institution, the resolution authority and the supervisor.

The very act of considering potential failure ought to mean that a business gains a better understanding of its commercial drivers and operational dependencies.

Key to this process is the reverse stress test.

The best definition of a reverse stress test is to be found in the Basel Committee’s 2009 paper on stress testing.²  It says:

“Reverse stress tests start from a known stress test outcome (such as breaching regulatory capital ratios, illiquidity or insolvency) and then asking what events could lead to such an outcome for the bank.”

It goes on to say:

“A reverse stress test induces firms to consider scenarios beyond normal business settings and leads to events with contagion and systemic implications.”

This technique can thus be used to understand those risk factors to which a firm is most exposed, and where corrective action now might avoid future problems. It is sometimes said that this is a hard thing to do. We do not accept this argument. It is common for all sorts of enterprises in all sorts of industries – pharmaceutical, defence, government – to complete similar exercises. The financial sector is no less capable of completing such exercises, and no less requiring of doing so.

This has to be more than a theoretical exercise – it must lead to different business decisions. It also has to be practical because the Central Bank will review the completeness of an institution’s plan. As a result of this review an institution may, for example, be required to restructure. We would expect that, in addition to evaluating a current set-up, procedures will be developed to ensure that resolution is considered as part of the process of establishing new functions. This is, as it has to be, a real world discipline. It should be approached accordingly.

The key to successful engagement will be appropriate leadership from the top of an institution.

A Board will be expected to produce a recovery plan, and to have in place a process to review the continued suitability of this plan. Ownership of this plan will need to reside with a named official in the institution, and the institution will need to consider where this function best resides.

Where an entity is part of a larger international group, it will need to consider how its own recovery plan fits within the recovery plan for the wider group.

The oversight of the recovery and resolution plan within a financial institution is thus a key issue.

Testing is also an important matter: you need to make sure you can execute a plan. You also need to make sure you deal with obstacles identified during testing.

Most important, though, is that the process of preparing and testing a plan leads you to consider whether there are aspects of your business model or control environment which lead to risks outside your stated tolerance.

In short, the arrival of this Act gives financial institutions another reason to look afresh at their risks.

Operational arrangements

In considering our operational process to implement the new regime, the Central Bank has considered equivalent regimes in other jurisdictions. Two important examples for the design of our own regime have been in the US and UK respectively.

In the US, the FDIC is the resolution authority. Other regulatory and supervisory authorities, such as the Comptroller of the Currency or the Federal Reserve, may fail a bank for which they are responsible and appoint the FDIC as Receiver. The authority to fail an institution does not require court approval to undertake action. The law permits a regulatory authority to fail an institution when it is judged as likely to fail and indeed requires that resolution be triggered for an entity when a certain capital ratio is reached. In all instances of failure, it is mandated by law that the FDIC resolves the entity at the least cost to the Deposit Insurance Fund. The FDIC has resolved over 1,600 entities since its inception in 1933.

In the UK, legislation for a Special Resolution Regime was introduced in 2009, and there the Bank of England is the resolution authority. The powers available are similar to those available in Ireland, and we can expect that court decisions in the UK will carry some weight here. The Bank of England, of course, has already undertaken resolution actions.

To implement the powers under the Act, we have created a new team called the Special Resolution Unit. The team includes specialists with legal, accounting, corporate finance and supervision expertise. The team will be augmented with resources from within the Central Bank and professional services firms, if required.

Changes to the EU regime

At the same time as these important changes are occurring in Ireland, the EU is working on a new directive in this area. The purpose is to ensure that all member states have a resolution regime which is broadly similar, and which removes or reduces the burden of bank failure on taxpayers.

As you would expect, we are engaged in the development of the directive. The draft includes consideration of bail-in clauses, the establishment of resolution colleges and co-operation with non-EU countries. The actual powers are broadly similar to those contained in the existing Irish regime, but include bail in, and at the moment ensure independence by removing any impediments to resolution such as the requirement for government or court approval.

Concluding remarks on new resolution arrangements

The Central Bank has for some months been preparing for the new regime. Now that it has arrived there is an immediate need to focus on certain credit unions. Our second priority is to produce guidelines for the production of recovery plans for credit institutions.

The creation of a Special Resolution Regime marks a major step forward in the Irish State’s ability to prepare for and manage crises. It provides the powers, complemented by an established operational capability, to effect resolution. It will be important for a financial institution the Act covers to develop its own capabilities to comply with its provisions.

Provisions and disclosure

In June this year we published our Banking Supervision Strategy paper. In it we explained the steps we would be taking, and asking the domestic banks to recognise provisions more closely to the reality of the actual losses incurred in their loan books and, separately, to enhance the quantity and quality of their disclosures. We explained then that our aim is “to ensure that financial statements are prepared on a more conservative, prudent and consistent basis that, over time, will enhance trust in Irish banks’ financial statements”.

In the intervening period, the banks concerned have engaged with the Central bank in an exemplary manner to progress this work, such that we expect to achieve the objective we set in June in good time for the publication of annual results for the 2011 financial year.

The consequence for banks’ will be a change in their provisioning methodologies reflecting more conservative impairment triggers being adopted which will result in earlier completion of impairment reviews and a more conservative and realistic approach to the measurement of provisions across all portfolios.

This will occur within existing accounting standards. While we are satisfied that we have achieved the best results possible within the limitation of these standards, it is important to state that we consider the existing standards an imperfect substitute for an expected loss approach. The absence of an expected loss standard under International Financial Reporting Standards remains a somewhat troubling omission from the post-crisis reforms announced to date.

Significant progress has also been made to improve Irish banks’ disclosures. Again working with the banks, we have taken the best examples internationally of high quality disclosure and imported into our own reporting requirements for banks.

Examples include:

• Forbearance strategies and metrics for residential portfolios
• Outlining the Impairment Triggers for the different portfolios;
• Mortgage Loan origination;
• Average LTV across the mortgage portfolios; and
• Analysis of LTV of the 90 day past due.

 As an objective underpinning the Financial Measures Programme was to foster investor confidence through enhanced disclosure, these new requirements for our banks are an important further step towards this goal.

We will publish our detailed proposals in this area in time for Christmas.

Closing remarks

The changes which have occurred, are occurring, and indeed are likely to occur in the domestic and international regulatory regime are, naturally, of particular interest to this audience.

Complying with the new requirements is a major operational challenge; and I am sure that many of you do not currently consider your jobs to be undemanding.

It is very much the Central Bank’s expectation, of course, that the steps financial institutions take go beyond compliance with the letter of our requirements. How financial institutions behave is, now more than ever, a matter of public interest.

For the industry and its regulator the task now is to create a lasting culture of compliance – in the broadest sense of that term – in Ireland. At the Central Bank we recognise the efforts you make in this regard, even if at times it perhaps might feel otherwise.

Events such as this one afford us all the opportunity to discuss that challenge. But what matters, of course, is what happens outside this room. Ultimately all of us involved in this industry exist to serve others, and it is towards their protection that our work is properly directed. This makes our respective work demanding yet rewarding. The challenge now is to rise to meet the ambitious agenda we have set ourselves. We look forward to working with you to this end.

Thank you.

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¹ The tests for legitimacy are, of course, set out in the Act.

² http://www.bis.org/publ/bcbs147.pdf