Address to the IFIA/NICSA Global Funds Conference 2010 by Matthew Elderfield, Head of Financial Regulation

09 June 2010 Speech

The Future of Financial Regulation and How it will impact the Investment Funds Industry

Good morning, ladies and gentlemen. Thank you for inviting me to speak at your annual conference and for giving me the opportunity to visit this impressive new Aviva stadium.

Today, if I may, I would like to talk to you about the future of financial regulation and the important changes that are now underway and coming down the track. And I will try to focus, in particular, on the implications of all these changes for the funds industry.

Change in the way the financial services industry is regulated is inevitable given the significant and continuing social and economic costs of the global financial crisis. Much of this change will be driven by developments by international standard setters. But there will be changes too at domestic level here in Ireland, targeted at tackling some home-grown issues that have contributed to the financial crisis.

Change has already started. It will continue and it will be significant. The scale of this change should not be a surprise to anyone here today, given the extent of the financial crisis and its impact on Ireland’s economy and public finances, its banking system and on the lives of ordinary people. The international reform agenda will drive much of the change that will shape the future of financial regulation in Ireland. But, as I said, we are introducing our own changes to deal with specific shortcomings we have identified in the Irish market. The introduction of demanding corporate governance standards for financial services companies is one such initiative.

New Corporate Governance Standards

It is clear that there have been serious failures of corporate governance at a number of Irish 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.

We recently published a consultation paper on new corporate governance standards for the banking and insurance sectors. The new standards propose 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. Criteria are proposed to ensure the independence of directors, to deal with conflicts of interest, to ensure directors set and monitor the risk appetite for their institution, and to ensure the effectiveness of board committees, including the remuneration committee. When agreed, these will be statutory requirements and will be an important safeguard to ensuring the appropriate governance of financial institutions going forward.

These are standards we are proposing for the banking and insurance sectors. But what does all this mean for the funds industry? It is clear that appropriate corporate governance standards must be put in place in every sector. But in line with our risk-based approach to regulation, we recognise the need for a proportionate application of corporate governance standards. We know that “a one size fits all” approach is not appropriate. We consider that the particular 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.

For this reason, I have proposed to the Irish Funds Industry Association that it undertakes to develop a corporate governance code for firms in the funds industry in Ireland. I am pleased to say that the association has accepted the invitation and has initiated work in this regard. This code will apply strong standards of corporate governance to the boards of investment funds, management companies and other service providers including administrators and trustees.

The development of the Irish funds industry over the years in both scale and complexity has inevitably increased the demands on boards and on individual directors. It is important therefore that a minimum set of standards be developed setting out the roles and responsibilities of boards while taking into account the unique features and risks associated with the funds industry. Developing appropriate guidelines for your sector will require a wide ranging review of existing standards and of recent developments, as well as consideration of the particular issues that arise for funds industry participants. While in no way attempting to pre-empt the outcome of this initiative, we would particularly welcome the views of the industry on the enhanced role envisaged for funds’ managers under the new UCITS IV Directive and on the optimum number of directorships which anyone individual should hold.

I would like to suggest, if I may, a few issues that could be considered in arriving at an appropriate standard for the number of non-executive directorships that could be held by anyone director. These would include the nature, scale and complexity of the funds concerned, whether the director is a full time independent director and what, if any, other commitments the director may have. Other issues that will also require debate include possible conflicts of interest between funds appointments and appointments to management or administration companies or to other directorships.

Other areas which should be reviewed include the processes by which directors are selected and due diligence or vetting by promoters when setting up the first board. What about standards with regard to attendance at board meetings? Should boards have to declare in their annual accounts the meetings held and those who attended them? Should the standards require a minimum number of independent non-executive directors in order to have robust challenge to the points of view being put forward by the promoter or investment manager? Should boards have more directors with investment management experience and know-how so that they can challenge the investment manager’s views? Should there be standards on the documentation that should be presented and considered at board meetings to ensure best practice?

I hope you will not mind me setting out these questions – unanswered for now – as food for thought!

We look forward to working with the different parts of the funds industry as we consider these issues together. We have asked that the IFIA open the standard-setting process to involve a good cross section of industry participants and we will be sitting in on the deliberations to give a clear steer about the topics that we feel need to be covered.

We accept that developing the funds governance standards will take a little time, but, on the banking and insurance front, we are targeting final rules for the autumn. We appreciate that our proposed standards are more rigorous than those in many jurisdictions, although it was interesting to see that the European Commission has just recently floated the idea of limits on the number of bank directorships held. We believe it is right to push ahead with our own work and that action in this space will benefit Ireland’s reputation as an international financial centre by tackling head on the issue of weak corporate governance which has been at the heart of so many problems.

Change Driven By International Reform

As I said earlier, change in the way that the financial services industry is regulated is inevitable. The financial crisis has brought to centre stage serious shortcomings in both the underlying regulatory framework and the implementation of financial supervision. It has caused a fundamental reassessment of the philosophy and principles underpinning regulation and has resulted in an extensive international agenda of regulatory reform. It is clear that this reform agenda is very wide ranging with a vast range of initiatives, proposals and recommendations coming from bodies such as the Group of 20, the Financial Stability Board, the Basel Committee, IAIS, IOSCO, European Commission, ECB, CEBS, CESR and CEIOPS, as well as the regulatory reform proposals currently being finalised in the US.

Much of this regulatory agenda relates to the banking industry. But it also extends to insurance, investment firms, OTC derivatives, credit rating agencies and, yes, the funds industry. I will say a few words in a moment about the principal items on the funds agenda.

However, change can also be seen in the way individual institutions will be supervised. Here in Ireland, we are taking an assertive and risk-based approach to financial supervision. I am asking my front–line supervisors to be more challenging and sceptical. Supervisors need to have open and frank dialogue with senior management about the risks at their firms. But the burden of proof has shifted. Where the stakes are sufficiently high, supervisors must be prepared to insist on a course of action to mitigate risk even if this is resisted by the firm. As supervisors, we need to be strong enough to insist that our prudential judgment is substituted for the firm’s commercial one where we consider this is necessary.

I want to emphasise the risk-based nature of the new supervision model and to stress that this is not a “one size fits all” approach. Supervision will be calibrated depending on the size and risk profile of the firm or the characteristics of the sector. We need to be balanced and proportionate. While we need to improve our level of engagement across the board, a systemically important bank should expect a much more intrusive approach than a fund or wholesale insurance company with a lower risk profile.

New International Measures: Implications for Funds sector

As I have said, international reform is driving much of the change that will largely shape the future of financial regulation in Ireland. For your own sector there are a number of important developments at European level which I will touch on briefly:

As you all know, the UCITS IV Directive which I referred to earlier introduces a number of important changes to UCITS and their management companies. The most significant change is the introduction of a management company passport, whereby a management company located in one jurisdiction within the EU can establish a UCITS in another Member State. The amendments to the UCITS Directive in relation to the management company passport have the clear potential to enhance the UCITS framework. However, the introduction of the management company passport for UCITS has also brought into question our ability to continue to impose minimum activity requirements on UCITS, which I will come back to later. It is imperative that these and other operational issues are satisfactorily resolved to ensure that the potential benefits of this legislative initiative are achieved with minimal risk to investors. We will continue to work with industry in this regard.

Another Directive, the Alternative Investment Fund Management Directive, proposed by the EU Commission in April 2009 is aimed at reforming the financial regulatory environment in Europe for hedge funds. It is generally accepted, including in the de Laroisiere Report on financial regulation and supervision, that hedge funds were not a major factor leading to the global financial crisis. But the crisis has had a very significant impact on the asset management sector, especially on hedge funds. Some of the actions that hedge fund managers had to take once the crisis unfolded, such as the abrupt unwinding of leveraged positions in the wake of tightening credit conditions and investor redemption requests, had a systemic impact.

What is the position of the Financial Regulator on the AIFM Directive? We agree that information in relation to the activity of hedge funds must be available to authorities. We support proposals designed to ensure appropriate transparency in relation to their operations including their exposures to counterparties. However, we have concerns regarding a number of key provisions in the draft Directive.

I will comment again later on the liability issues in relation to depositaries, which I know is a key concern for many industry participants. But I can say briefly now that our position is that rules in this area should not exceed the standard of liability well established in the UCITS model.

With regard to valuation of assets, we are concerned about proposals that would move the responsibility for this valuation from the fund manager to an external valuer. We feel that responsibility for valuation must rest with the board of a corporate fund or the fund manager rather than a third party who is not subject to prudential regulation.

Proposals that would limit the extent to which the AIFM can delegate the activities of investment management to entities located outside the EU are not consistent with the regulatory regime which applies to UCITS and would not reflect market practice. It is also unreasonable to prohibit sub-delegation.

There have been many discussions in relation to leverage employed by the hedge fund sector. In Ireland, Qualifying Investor Funds are not subject to any investment restrictions or leverage limits imposed by the Financial Regulator. The Irish QIF regime works well and QIFs are recognised as having avoided many of the problems associated with hedge funds worldwide, due in part to the requirement to have an independent depositary and to use the services of an Irish fund administrator. It is reasonable for authorities to have the power to intervene in relation to the activity of particular managers and impose restrictions where relevant. But we feel that proposals which would require a regulator to make a judgement on the reasonableness of the leverage to be employed in the context of each fund would be difficult to apply in practice.

The treatment of fund managers established outside the EU, so-called "third country managers", is one of the most difficult issues that arises with this draft Directive. On the one hand, there was a view that third country managers should be allowed to operate within the EU without restriction. On the other hand, there were concerns that such an approach would not be consistent with the objectives of the Directive and would leave EU fund managers at a competitive disadvantage in relation to non-EU managers.

While the various proposals of the Spanish presidency and the European Parliament remain under consideration, it is likely that operators from non EU jurisdictions will be required to match European standards in order to compete on a level playing field with EU firms. As a result, third country jurisdictions, including the US and Cayman, 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, a development which could provide opportunities for countries such as Ireland with well developed regulatory regimes and ancillary services structures. Indeed, we are already seeing the process of alternative investment funds employing a UCITS structure.

The AIFM Directive process has now entered into a new stage where representatives from Council, Parliament and the Commission will negotiate a mutually acceptable compromise directive. We will continue to assist the Department of Finance in assessing the revisions to the text. We hope that these concerns will be addressed in that process.

At European level there have also been a number of welcome developments at the Committee of European Securities Regulators (CESR). Last month, CESR finalised its guidelines on a common definition of European money market funds. The key purpose behind a harmonised definition of ‘money market fund’ is improved investor protection, which is driven from the market events in 2008, where money market funds incurred significant liquidity issues. Because of the important role played by such funds as significant investors in short term paper, it is important that regulators and monetary authorities have a common understanding of the distinction between those funds which operate in a very restricted fashion, and can be labelled money market funds, and those which follow a more “enhanced” approach which places yield ahead of capital preservation.

The CESR paper creates two categories of money market funds, ‘Short-Term Money Market Funds’ and simply ‘Money Market Funds’. For each category, CESR has established a list of criteria with which funds must comply. Similar rules apply to both categories except that the second category is permitted to invest in instruments with a longer duration. Also, only short term money market funds are permitted to have a constant or stable net asset value. The second category of “Money Market Fund” must have a fluctuating Net Asset Value. More importantly, a third category of so called enhanced funds will no longer be able to include reference to “money market fund” in their title.

This is an important development for the money market fund sector, many of which have established their funds as Irish UCITS. However, Irish money market funds will, for the most part, fall within the category of “Short Term Money Market Fund”. These funds currently meet the CESR guidelines and accordingly our implementation of the guidelines will likely not have any significant impact on the Irish industry.

In April, CESR issued a consultation paper on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS. We welcome the work of CESR in fostering a level playing field among Member States in the area of risk measurement and, as you may know, we chaired the working group which produced this consultation paper. Our input into this group was important because Ireland was one of the first European Member States to develop detailed rules and guidelines on risk management and measurement for UCITS funds. We encourage you to respond to this consultation exercise.

Depositary Liability

Let me now return to the issue of depositary liability. On the world stage, regulators have learned important lessons from the failure of Lehman, the Madoff fraud and their affect on the European funds industry. Discussions have taken place between European regulators on the role of the depositary for authorised investment funds, including UCITS. In July 2009 the European Commission launched a wide-ranging public consultation to get views from industry participants, including regulatory authorities, on issues relating to the functions of the UCITS depositary. These questions covered, among other things, the types of entity that should be eligible to act as depositary, their organisational structure and the liability of the depositary in the event of loss of UCITS assets. In January 2010, CESR published the results of a mapping exercise it carried out on the way Member States have applied the rules in the UCITS Directive dealing with depositaries. How the Commission will proceed in relation to UCITS is, however, not clear at this time.

Meanwhile, the Alternative Investment Fund Managers Directive contains detailed rules in relation to depositaries for non-UCITS investment funds. It requires that a depositary is appointed to each alternative investment fund and the Directive also contains provisions governing the duties and liability of depositaries. Unfortunately the provisions dealing with depositary liability are not consistent with the UCITS rules and are in some instances very unclear and this is a cause for concern for both industry participants and regulators.

That said, the Financial Regulator would support any proposals to clarify the safekeeping and oversight duties of depositaries and we consider that it would also be useful to set minimum due diligence requirements for the appointment of sub-custodians. Whatever the outcome of the current legislative proposals we consider that it is very important that the same rules apply to depositaries of UCITS and non-UCITS particularly given that depositaries in Ireland and across Europe provide services to all types of funds.

As I mentioned earlier, we are engaged in a review of the minimum activity requirements which apply to Irish authorised funds. These minimum activity requirements, which require that certain key administrative functions including Net Asset Value calculation be carried out in Ireland, were first introduced in 1995. Over time the development of new technologies has allowed administration firms to operate on a global basis and provide services to clients around the clock while ensuring that responsibility, review and control of the activities remains with the Irish firm. The introduction of the management company passport for UCITS has also brought into question our ability to continue to impose these conditions. We will be working closely with industry to replace these minimum activities with a regime which will accommodate the models operating within administration companies while continuing to allow us to effectively supervise these companies and the funds they service.

Our aim is to publish proposals in the third quarter of this year with a view to finalising guidelines by the end of the year. This will mean our framework can be changed some six months before UCITS IV comes into force, giving industry the opportunity to act early. Standard guidelines will also allow us to progress matters more quickly than our current case-by case approach.

Ideally, our intention is to move to a framework that allows greater delegation and outsourcing to both EU and non-EU entities, by both management companies and fund administrators, subject to effective controls and oversight of delegated functions. However, the exact final shape of the AIFM will influence our ability to achieve this.

New Structure at Financial Regulator

Turning from international developments, let me take a few moments to discuss some organisational changes at the Financial Regulator.

We have initiated a process of reorganising the regulatory departments to better respond to the new demands of the international regulatory agenda and our domestic reform programme. As part of this process, we have decided to merge together the areas responsible for funds authorisation and post authorisation transactions with those responsible for prudential supervision of funds and fund service providers. The objective here is to have a single department with a joined up approach to all aspects of funds regulation. This area will be led by Patricia Moloney, whom you know well. It will take a few months to complete the merger process.

We are also investing into our policy capability for funds. I get very positive feedback about the capability of our funds policy team, in terms of their leadership in international policy discussions and their handling of complex authorisation inquiries. But it is clear that the demands on this area are growing. As a result, we have recently advertised for additional resources in the Policy and Derivatives & Risk Management areas and are now close to filling these positions. These additional resources will enhance the productivity of both units, which are heavily involved in European fund legislation and working groups. This will allow us to punch above our weight in the EU debates that are to come and to work closely with industry on the inevitable issues that are thrown up by implementation.

More generally, we are centralising our prudential insurance and banking policy teams in a new Policy & Risk Division. This division will include a dedicated and expanded international policy team, which will look across all sectors including funds and markets. The plan is to enhance our level of engagement at EU level given the advent of the new European Supervisory Authorities which will replace the co-ordinating EU supervisory committee early next year.

This increased level of resources will involve additional costs. However, the level of increase for the funds area is likely to be lower than that for other departments, where the intensity of on-site supervision needs to be greater, so the cost impact should be proportionate. And I am sensitive to the fact that costs has an important impact in where to domicile a fund, given the ease of routing business to competing jurisdictions. However, I believe that the additional investment in policy resources will have benefits to industry while advancing our regulatory agenda.

Statistics Initiative

Finally, I know you are keen that reliable and useful statistics for the funds sector are readily available. Your association raised this issue with me shortly after I arrived in Ireland. I think the new investment funds data series recently launched by the Central Bank, following consultation with the industry, is a welcome development. Produced quarterly, with the second series released at the end of May, this new data series on the assets and liabilities of investment funds will assist the analysis of the funds industry and its role in financial intermediation. For the first time, individual fund types are identified including hedge funds. The Central Bank also provides monthly statistical updates to the Association.

I feel this new statistical information goes a long way towards meeting the data requirements you outlined to me at the beginning of the year. But, of course, my door is always open if you feel we can further usefully enhance the statistical information available on your industry.

I hope I have given you a good overview of the many regulatory challenges facing the funds industry in Ireland, from the need to reassess corporate governance standards to the importance of tackling the busy international agenda. These challenges come in the context of a broader appraisal of the performance of the Financial Regulator and the Central Bank that has been conducted by Patrick Honohan, the Governor of the Bank. Patrick’s conclusions are due to be published shortly and will show the scale of the challenges that lie ahead in reforming the financial regulatory framework in Ireland. Patrick’s conclusions are frank and direct and he pulls no punches about the weaknesses that need to be addressed. I’ve mentioned a few of them today, such as more challenging and better resourced supervision. But that is only the start of a long to do list that we will be working through in the years to come.

As we tackle this agenda, I believe it is important to approach the regulatory issues of the funds industry in a risk-based way, avoiding a one size fits all approach and allowing appropriate differentiation of standards. Ireland has an established position as a centre of excellence for the funds industry, with a strong regulatory framework matched by a strong commitment for efficient service delivery on authorisations. I’m committed to maintaining that framework and to ensuring that Ireland has an active voice in shaping the international agenda that will be setting the pace of change in the years to come.