Address by Matthew Elderfield, Head of Financial Regulation, to the Foresight Business Group, Trinity College

22 March 2011 Speech

Raising Standards in Banking

Good morning ladies and gentlemen. I am delighted to be here in Trinity College today to talk to you. I appreciate your attendance here this morning at what I remember as a very early hour when I was a student.

For this morning’s remarks I have proposed the topic of raising standards in banking. I would like to take the opportunity to explain the new corporate governance standards for banks and insurance companies that have been issued by the Central Bank, but my main purpose here today is to announce proposals governing the fitness and probity of individuals working in the Irish financial services industry. We are publishing a consultation paper on this subject later today so I want to outline our new proposals. In doing so I want to announce what these standards mean for current or past Board members at the banks which have received government support, a topic about which I anticipate there will be some considerable interest.

However, before I get to fitness and probity standards I expect that there is also interest in the forthcoming bank stress tests, the results of which will be published next week. I am going to disappoint those of you who are hoping for an early announcement of these results but let me take an opportunity very briefly to explain the approach we are taking in the exercise.

Stress tests have become a crucial regulatory tool in assessing the required capital for credit institutions. The importance of these latest stress tests is perhaps greater in Ireland given the context in which this latest exercise is taking place. These tests take place in the context of a severe crisis in the euro sovereign debt markets, a weaker Irish economy subject to further fiscal consolidation, as part of a formal EU-IMF programme for Ireland and against the backdrop of a lack of market confidence in the Irish banking system, reflected in the stressed wholesale funding position of the banks and concerns about future loan losses under adverse scenarios. At the Central Bank our objective is therefore to approach the stress tests with more conservatism, more transparency and stronger validation.

In terms of validation, for example, the stress tests will be informed not only by the banks’ own views, but by a third party assurance process about the quality of loan data, a fully independent assessment of portfolio loan losses conducted by Black Rock Solutions, peer review by other supervisors, quality assurance over the capital calculation and loan loss methodology by Boston Consulting and close discussion with the IMF, European Commission and European Central Bank.

In terms of transparency, we have already published the details of our macroeconomic scenario to be used under the stress test but we will also publish detailed portfolio level loan loss data under various assumptions. This will allow market participants to take an independent view of the rigour of the analysis.

The context in which these stress tests are taking place clearly argues for a conservative approach as well. Rather than focusing on the embedded losses in the portfolios of the banks in base conditions, our emphasis will be on assessing losses in future stress scenarios. With the assistance of Black Rock we will be able to develop, independently from the banks’ own analysis, an assessment of stress loan losses that is less calibrated for exceptional Irish factors which might mitigate losses and is therefore on the more conservative end of the spectrum. There will be a strong focus on exposures in the banks’ residential mortgage books. (The banks’ commercial property exposures have now mostly transferred to NAMA, which also means that the risk of further adverse haircuts from NAMA, which did so much damage to the stress tests last year, has now passed.)

Loan losses and credit quality, is only half the story in the resuscitation of the Irish banking system. The other half of the story is the funding position of the banks which in turn is linked to their structure.

In Ireland, the critical structural problem we are dealing with is the huge build-up in the pre-crisis period of reliance by the banks on funding from the wholesale markets. The net foreign liabilities of the Irish retail banks had grown to just under €140 billion by late 2008 while the pre crisis loan-to-deposit ratio for the system as a whole was as high as 170% in 2007. By January 2009 banks were relying on €193 billion of funding from the wholesale markets. The sovereign debt crisis has meant that these wholesale sources of funds are no longer available to the banks and have been replaced by funding from the Central Bank and the euro system. To reduce the dependence of our banks on this form of exceptional liquidity funding and to enable them to meet the required international metrics of liquidity, the Irish banking system will have to be slimmed down and right-sized over time.

Our aim is to bring the banks to eventual compliance with Basel III liquidity ratios and to target loan-to-deposit ratios. It is a key step in the transition to a banking system with lower leverage. As part of this process, the banks have submitted detailed funding plans which include significant deleveraging, or sales of assets. We are currently reviewing these plans. At the end of the process, the banks will be given target loan to deposit ratios and other target ratios that must be achieved by 2013.

To achieve these targets, some fundamental decisions will need to be made about the future structure of the banking system and, crucially, the timescale within which it must be accomplished. It is important that clear direction is provided on the desirable end structure of the banks.

The issues must be weighed carefully. Forced deleveraging at an unrealistic pace would crystallise huge losses by selling assets into depressed markets. But it is also critical that the deleveraging process moves ahead as swiftly as practicable. There are no easy choices or no overnight solutions. The process of deleveraging and of reducing reliance on central bank funding will take time.

Corporate Governance

The terrible costs of the banking crisis highlight the need to ensure that we make progress on other parts of the new supervisory agenda. We are in the process of building up the staff resources we need to carry out effective supervision of regulated financial services firms. We have been given some new powers and look forward to forthcoming legislation to further strengthen our position as regulator. Stronger legislation and better staffing levels improve our capacity to act. Equally important is our will to act in difficult situations. I am determined to ensure that the Central Bank is an assertive regulator operating within a risk-based framework.

Improving corporate governance is also high up on our supervisory agenda and is critical to raising standards. We have made very necessary progress in this area by introducing a new statutory Corporate Governance Code for banks and insurance companies.

One of the lessons we have learned from the banking crisis is the importance of good corporate governance and sound risk management. The need to reform corporate governance within the financial sector was highlighted in the findings of the two reports commissioned to understand the sources of Ireland’s banking crisis. These reports, by Klaus Regling and Max Watson, and by the Central Bank Governor Patrick Honohan, a former professor of economics at this distinguished university, were published last June. Regling and Watson found in Ireland “at least some instances of extremely serious breaches of corporate governance, going well beyond poor risk assessment, and eventually having a systemic impact”. Governor Honohan noted that ... “the major responsibility lies with the directors and senior management of the banks that got into trouble. They are the first line of defence to protect those who have entrusted them with their funds”.

Last November we took steps to raise corporate governance standards by setting out clear requirements in our Statutory Code for the directors and boards of banks and insurance companies. Boards of directors and senior management are the first line of defence in ensuring that their bank is well managed. They must ensure that they have in place the systems and controls appropriate to the nature, scale, complexity and risk of their operations.

While our new Code has not pleased everyone - some may think that it goes too far, others may complain that it does not go far enough - I am confident that it represents a balanced and proportionate approach to strengthening the governance of our banks and insurance companies. It is an important milestone in the drive to ensure high standards in the board rooms of regulated financial firms. We know that our new Corporate Governance standards are more demanding than those in place in other jurisdictions. For example, our standards are on a statutory basis – rather than a “comply or explain” Code, and, we have included restrictions on the number of Board directorships that can be held in financial institutions. The decision to impose more demanding standards is a conscious one. We have decided that in the area of corporate governance we do not want to simply match best practice internationally but wish to set a higher standard. Ireland has suffered more than most countries in the financial crisis and needs to get to grips with the home grown elements of that crisis.

Poor governance has been exacerbated by the concentrated nature of corporate life in Ireland, with challenge and awkwardness in the Board room perhaps blunted by the social constraints of working and living in a small business community in a small country. Stronger remedies are needed here to shake up prevailing corporate governance practices by injecting some fresh blood and setting more exacting standards. This will improve the reputation of Ireland as an international financial centre.

Having clear rules in place is important, but, of course, I recognise that rules alone are not always sufficient to ensure the desired result. Setting quantitative requirements and monitoring adherence to them in the relatively easy part of the job. The real challenge lies in monitoring qualitative requirements and achieving the all important change in culture necessary to ensure that the spirit of the Code becomes the norm in corporate governance.

Fitness and Probity

In addition to introducing these new corporate governance standards, we are today publishing a Consultation Paper on our proposed new Fitness and Probity Standards. This sets out the framework to ensure that the people operating at senior levels in regulated firms are fit and proper.

What do I mean by fit and proper? Fitness and probity are the broad headings for applying standards to individuals who work – or wish to work – in the financial services industry in Ireland. They relate to an individual’s ethics, integrity and financial position but also their competence and capability.

When I arrived in Ireland just over a year ago, I was surprised to find gaps in the regulators’ powers in this area and no clear statutory framework. There were some powers but they were very uneven. For example, in the banking and insurance sectors the Regulator could only consider an individual’s fitness and probity on the way into the industry. Once someone was in, if an issue subsequently came to our attention that we considered would justify their removal, we had no statutory power to take action. The only statutory tool available was the nuclear option of revoking a licence or authorisation – hardly a proportionate or realistic response. In practice, the only real option was moral suasion.

Last year we looked for new statutory powers to allow us to apply an enhanced fitness and probity regime to individuals and entities across the financial services industry. Once the new powers are in place, we will be able both to act as gate-keepers for individuals entering the industry and to remove individuals from their posts.

This means we will be able to act on fitness and probity issues that arise in a regulated firm. Where an issue arises we will have the power to carry out a full investigation. And now, with our new powers, we will be able, where appropriate, to suspend or remove an individual from a senior position in a regulated firm.

These Fitness and Probity standards will apply to all financial services companies in line with practices in other jurisdictions. I know there is sometimes concern expressed about applying the lessons of the banking crisis to other sectors, but in the area of fitness and probity it is clear that the standards need to apply to all sectors. However, as I will explain shortly, we do have particular plans for the bank boards.

How will we assess whether people meet the standards? The requirement to act honestly, ethically and with integrity needs little explanation. I would say that our proposed standards will enable greater clarity and robustness in dealing with individuals who have been removed from other positions or otherwise have been subject to civil or criminal sanction, in this jurisdiction or elsewhere. The requirement for financial soundness will mean that individuals who wish to carry out senior functions in the financial services industry will have to demonstrate an ability to manage their affairs in a sound and prudent manner.

In assessing competence and capability we will not just consider professional qualifications and experience, we will also look for capabilities such as an understanding of governance and risk management standards and a firm’s particular business model. Common standards of probity will apply regardless of the size or activity of the entity, but competency requirements will vary according to the position involved and the size and activity of the entity in line with our risk-based approach to supervision.

A firm proposing an appointee should ensure that the candidate fulfils the Central Bank’s minimum competency requirements where these apply. Firms will need to show us that they have satisfied themselves with regard to the proposed appointees’ awareness of the responsibilities of the position, their knowledge of the business and their understanding of the regulatory and legal environment. Firms will also have to take account of any existing responsibilities the individual has, including for example the number of existing directorships they hold.

We will also take account of the track record of the individual in the jobs they held previously, and particularly in the financial services industry. What do I mean by track record? By track record I mean, that we will look at the competence and proficiency that a person has demonstrated in a previous or current role. We will assess each case individually.

We have been given these new powers under the Central Bank Reform Act 2010. But before we can use them we must identify those people who should be captured within the regime. In our Consultation we identified the roles we consider appropriate to classify as Pre-approval Controlled Functions, that is roles requiring our approval before people can take up those positions. We also identify Controlled Functions, or roles which we can remove people from where they fall short of the appropriate benchmark for fitness and probity. We welcome industry views on our proposals for defining the scope of pre-approved controlled functions. We also welcome comments on our proposed standards of fitness and probity which provide more detail on our approach to issues such as competence, track record and so on.

It is our intention that the new regime will, following consultation, come into effect on 1 September 2011. Individuals who hold positions classified as pre-approved controlled functions and controlled functions at that date will continue in those positions. Any new appointments to pre-approved controlled functions from September 1st will have to be processed through the new regime.

We propose to require firms to identify and maintain a record of the individuals who are carrying out pre-approved controlled functions and controlled functions at the transition to the new regime. Each firm will also be required to give us a list of those individuals who are carrying out pre-approved controlled functions in their firm when the Regulations come into effect. We will allow firms until 31 December 2011 to supply the list of pre-approved controlled functions to the Central Bank.

Boards of regulated firms will be required to confirm that they are satisfied that the individuals in pre-approved controlled functions are fit and proper according to the new Standards. If they are not satisfied they should discuss their proposed actions with their Central Bank supervisory team.

Let me conclude on fitness and probity, and the theme of standards more generally, by saying a few words about what this means for the Irish banks. I mentioned earlier that we can perform an assessment of an individual’s track record in the industry in assessing his or her competence and fitness. I draw your attention to proposed wording in our Standards that specifies that we will pay particular regard to the actions of individuals who may have contributed to a financial institution being forced to seek government financial assistance. It is only right that this is something we will consider carefully in assessing the competence of senior managers or board members from banks which required government assistance who wish to re-enter or remain in the industry – and that we send a clear signal on this point.

Where does this leave the existing boards and senior management of the Irish banks? The drafting of the new statutory regime means that all incumbent directors will continue in their positions and do not have to reapply under the new law. My preference would be for the Central Bank to be able to determine which classes of pre-approved controlled functions are grandfathered and, on a risk based assessment, to require reapplication for certain roles. Even in the absence of such an explicit requirement, however, I believe it is important that we initiate a process to assess the fitness and probity of existing bank boards.

The Central Bank therefore plans to conduct a review of the fitness and probity of all existing executive and non-executive directors at the Irish banks which have received government support. We will assess the incumbent directors against the new statutory Fitness and Probity Standards, including, where it is relevant, their competence and track record in the period leading up to the financial crisis. We will use our new investigative powers, where appropriate, to ensure that the people in those positions meet the required level of fitness and probity. Where they fall short of the required Standards, we will not just remove individuals, but we will also, where appropriate, issue notices to prohibit individuals from continuing as directors. I don’t underestimate the legal challenges that we might have in using our new powers, but we must be prepared to make difficult judgments on fitness and probity and it is right that we should start with this group. We will be writing to all bank directors to advise them that this process will apply to anyone that plans to be in office as of 1 January 2012 to allow them an opportunity to make their plans accordingly.


Raising standards in and reforming the Irish banking system is going to take time. The measures that have already been adopted on corporate governance are an important first step and the new standards announced today will continue this process by setting clearer enforceable requirements for fitness and probity.

Next week will see another important milestone in this process. Deleveraging the Irish banks to meet new liquidity standards will be a multi-year process to slim down and restructure the banking system. It will take time for market confidence to return following the extraordinary events of the past year. Our objective is to provide a conservative and transparent assessment of the banks’ loan losses and capital requirements subject to rigorous external validation. This will provide a clearer picture of the financial position of the banks to market participants and Irish taxpayers. It is an essential precondition for rebuilding the banking system and supporting the Irish economy.

Thank you for your attention.