Introductory Statement by the Head of Financial Regulation, Matthew Elderfield to the Public Accounts Committee

13 May 2010 Speech
Good morning deputies.

Thank you for inviting me today to discuss with you the Special Report of the Comptroller and Auditor General on the response of the Financial Regulator to the financial market crisis. Special Report 72 was published shortly after I arrived in Ireland to take up the position of Head of Financial Regulation. It set out the background to the financial crisis and the actions taken by the Financial Regulator. We have studied the Comptroller and Auditor General‟s report and have paid particular attention to the issues it raised, as I will outline in more detail later.

Today I am accompanied by two of my colleagues, Patrick Brady, who is our newly appointed Assistant Director General for Risk and Policy, and, Bernard Sheridan, our newly appointed Assistant Director General for Consumer Protection.

At the outset, it is important to acknowledge that weaknesses in regulation contributed to the financial crisis in Ireland. As outlined in the Financial Regulator‟s own analysis of the financial crisis published in it‟s 2008 Annual Report, it was caught off guard by the force and the severity of the crisis. In response to accelerating credit growth, steps had been taken in 2005 and 2006 to slow bank lending in Ireland, but, with the benefit of hindsight, these 2 measures were insufficient given the severity of the problems that have emerged.

With hindsight, it is now clear that stronger measures should have been taken and these should have been taken much earlier. Regulation in Ireland was not robust enough to prevent the asset bubble and the Financial Regulator‟s reliance on some boards and management to meet their corporate governance responsibilities was misplaced.

Although international pressures contributed to the timing, intensity and depth of the Irish banking crisis, the underlying cause of the problem was domestic and classic - too much commercial property and mortgage lending, financed by heavy foreign borrowing by the banks, which led to an unsustainable housing price and construction boom. This occurred against a background of low interest rates and protracted expansion in output, employment and population especially from the mid-1990s.

The devastating impact of the financial crisis on Ireland‟s economy, finances and citizens is clear. As you know, the Government decided to establish a Commission of Investigation into the crisis. The first phase involved commissioning two independent preliminary reports into the regulatory and banking aspects of the crisis to be carried out by the Governor of the Central Bank, Patrick Honohan, and, Klaus Regling and Max Watson respectively. These independent reports are imminent and their findings will help the Government and the Oireachtas as they prepare the terms of reference for the second stage of the investigation.

But it is not necessary to wait until this investigation is fully completed to begin a fundamental overhaul of the regulatory model for financial services in Ireland. Indeed, that work was already underway when I arrived here in January, lead by my predecessor, Mary O‟Dea, as acting chief executive of the Financial Regulator. 3

Today, if I may, I would like to comment on three main areas. First, I would like to outline briefly the changes we have made and are making in the supervision of financial institutions. Second, I will comment on the main regulatory issues the Comptroller and Auditor General raised for consideration in Special Report 72. Finally, I wish to set out important changes we are publishing today in the area of related party lending.

Let me turn now, if I may, to the changes that have been made in how regulated financial services firms are supervised.

The first phase of improving the supervisory system, introduced by my predecessor Mary O‟Dea, involved changing to a more intensive approach to the regulation of banks, with particular focus on monitoring liquidity and solvency issues and monitoring banks‟ compliance with the Government Guarantee scheme. New codes relating to mortgage arrears and business lending to SMEs were introduced. The reporting obligations of regulated firms were increased so that the Financial Regulator could obtain more comprehensive information on a more timely basis. Supervisory staff were placed on site in the banks so that they could attend regular meetings with senior executives, including those responsible for compliance, internal audit, risk management and credit, and could attend certain board, board committee and other management meetings on a sample basis to assess corporate governance in action.

Internal supervisory procedures at the Financial Regulator were also strengthened with the introduction of „challenge meetings‟, where examination teams produce a monthly supervisory report and engage with management and the senior executives on serious prudential issues. Policies for escalation and information sharing were also introduced so as to improve internal communications. A number of investigations were also initiated into issues at Anglo and in this regard we are supporting the Garda and Director 4 of Corporate Enforcement. This more intensive approach to supervision included reassigning staff from other areas and the recruitment of specialists.

This was a very important first phase in changing the system of financial regulation in Ireland and paved the way for the second phase we are now entering. We are now developing an assertive risk-based system of regulation underpinned by the credible threat of enforcement. This involves calibrating the intensity of our regulatory standards and day-to-day supervisory approach to the risk profile of the firms and sectors we supervise. We will concentrate our efforts and resources where the greatest risks lie. It means we will insist that the biggest and riskiest firms manage themselves better and that firms and their management are questioned and probed by their supervisor and held more accountable for their actions. We will focus on risk mitigation and challenge, assessing business risk, not just controls and rules, and, developing and using the risk model to systematically assess firms and set the supervisory agenda.

While many of the required changes in regulation are occurring at European level, there is also a need to improve the domestic regulatory framework in a number of areas. In this regard, the Central Bank Reform Bill will, when enacted, provide us with new statutory powers to ensure that those responsible for managing financial service providers continue to be fit and proper to do so. A new enforcement division will be resourced at a level sufficient to apply a credible threat of action where that is necessary. The entire approach to enforcement, including the current Administrative Sanctions Procedures, will be reviewed at an early stage and we therefore plan to consult on our enforcement strategy later this year.

It is clear that to operate such a supervision system effectively a significant increase in front line regulatory staff will be required. It was clear to me when I arrived here that the level and skill-mix of supervision staffing at the Financial Regulator was inadequate to implement a risk-based model of supervision. This model requires significantly more intensive supervision of 5 high risk firms at this critical time in financial markets. Our supervision model also needs to take on major new tasks such as the supervision of large complex groups, new risk assessment and enforcement capabilities, the implementation of new EU Directives and regulations and the unwinding of delegations from the Irish Stock Exchange.

In addition to adding more resources we are working to improve our internal processes and procedures to ensure we are operating effectively and efficiently. We need to upgrade our information technology and have recently appointed a chief information officer who will spearhead this important development process.

More resources means, of course, additional costs, and, as we move towards a full-funding model we are examining our fee structure. We plan to retune this structure to ensure that the appropriate proportion of the increased costs of regulation will be borne by the entities that require the highest levels of supervision. The cost of regulation will undoubtedly rise. But judged in the context of the huge cost of a financial crisis, the increase in the cost of regulation must be seen as a price worth paying.

It is important to be clear today that these are major changes and they will not happen overnight. This is a multi -year and multi-faceted project, not a quick fix. We have to recruit and train staff, to put in place information technology systems, to develop risk assessment models and to develop and implement our enforcement capability. It will take some time to fully develop our new system of regulation. But we have started the process.

Even with all these changes, we can never guarantee a zero failure rate. But I think regulated firms are already very clear that the bar has been set high and they need to adjust to the new world of financial regulation in Ireland. 6

I would now like to turn to the four major issues the Comptroller and Auditor General raised for consideration in Special Report No. 72.

He said that consideration should be given to requiring that the Financial Regulator make an annual statement about supervisory matters. This measure, as well some other accountability measures, is included in Central Bank Reform Bill 2010. Under this legislation the Financial Regulator will be required to produce an Annual Performance Statement comprising a regulatory performance plan for current year and a review of regulatory performance for the preceding year. In addition, the Bill provides for other accountability measures, including a requirement to arrange, at least every four years, an international peer review of our regulatory performance

The Comptroller and Auditor General also suggested that the auditors of financial institutions should provide annual positive assurance about the functioning of the internal corporate governance regime in each institution, including the risk management function. We broadly welcome this suggestion. While its implementation will require considerable further work by accounting bodies, a strengthening of audit review and assurance would be a helpful improvement in the regulatory framework.

But this needs careful consideration. Ireland needs to be wary of the Sarbanes Oxley experience. It is important to be cautious about new measures which could significantly increase costs, especially if the standards being audited are too vague or extensive. We have, however, recently published a consultation paper on Corporate Governance which sets out a standard that could be assessed and we will be developing other standards. In addition, it is not clear if the auditor‟s report is to be made to the Financial Regulator or to the public: the latter could raise liability concerns that would have to be addressed by the accountancy bodies. Nevertheless, we feel this suggestion merits further consideration and would be prepared to contribute 7 to an initiative in this area from the appropriate accounting regulatory authorities.

The third major issue raised in the Report referred to the Financial Regulator‟s systems, procedures and practices. The Comptroller and Auditor General suggested that the Financial Regulator should consider incorporating a greater emphasis on testing of transactions and balances into its inspection work to improve on-the-ground evidence, and, that this be balanced with a top-down analysis of the sustainability and of the business models and associated strategies of individual institutions. We are in the process of enhancing our supervisory approach and engagement with financial institutions. We agree about the importance of the top-down analysis and analysing the business models and strategies of individual institutions to add value to the supervisory process. Greater emphasis in inspection work on testing the implementation and application of policies, procedures and practices could add value but we have concerns about the cost/benefit implications of this approach. Given the sheer scale of each individual bank‟s transactions and the limited resources available to us, we believe that it is unlikely that it would be possible to test a „statistically significant‟ sample of transactions. Nevertheless, we will consider how best to meet this recommendation as part of the development of our risk and supervisory models.

The fourth major suggestion from the Comptroller and Auditor General was that the Central Bank, the Financial Regulator and the Department of Finance carry out a review of the lessons learned from the financial crisis for future policy formation. This suggestion was made prior to the Government decision to establish the Commission of Investigation, that is currently underway, and I think it is clear that the investigation is the appropriate place for such a review. 8

I would also like to briefly address today some recommendations made by this Committee in your annual report last year following on from a previous special report prepared by the Comptroller and Auditor General.

You recommended that financial regulation should be based on a thorough assessment of the risks associated with individual financial institutions, taking account of sector-level risk. We fully agree with this recommendation and will be taking it into account in the development of our new risk model. Your recommendation that the Financial Regulator should report publicly each year on the extent to which it achieves its supervision targets is now covered by the Central Bank Reform Bill 2010 which will require us to produce the Annual Performance Statement, that I have already mentioned.

You recommended that supervision regimes for each sector should be benchmarked against international good practice, and subject to periodic independent evaluation. We agree with you on this too. In 2009, Mazars completed such an analysis of the Financial Regulator, which is available on our website. The Central Bank Reform Bill 2010 which was published recently requires that we undergo a review of our performance by our peers, or a suitability qualified person, at least once every four years.

You also recommended that the Financial Regulator should change the culture in the provision of financial services to give greater customer protection by imposing fines where we find that vulnerable customers were sold an inappropriate product or service. Consumer protection is a high priority for me. The Financial Regulator is adamant that regulated firms meet the requirements of the statutory Consumer Protection Code which requires them to treat consumers fairly. Firms need to be aware of their responsibilities. We are building up our enforcement capabilities to ensure that we have a credible deterrent in place.

Bernard Sheridan, who is here with me today and has recently been appointed Assistant Director General for Consumer Protection, will lead our 9 initiatives in the very important area. With his team he is examining how best to achieve this change as part of our consumer protection strategy. We are carrying out a review of the Consumer Protection Code and the Minimum Competency Requirements which have been in place since 2007.

Finally, I would like to take just a few minutes to tell you about a new initiative we are announcing today. We are launching a consultation paper to bring in new rules to cover related party lending.

One of the lessons we have learned from the banking crisis is the need to have clear and enforceable rules in the area of lending by banks and bank officers to related or connected persons or individuals. In the case of a bank, a related party would be a director, a shadow director or a senior manager as well as persons connected to these individuals. Related party lending also covers lending to significant shareholders or to entities in which the credit institution has a significant shareholding.

Lending to related parties is a form of lending that has a special potential to give rise to conflicts of interest and abuse. There is in particular the case where large sums are concerned. Unfortunately, Ireland has witnessed some of this lending at irresponsible levels, and, in one notorious case, in a manner that was apparently designed to avoid detection.

We want to take action to protect against abuses in this area and to address possible conflicts of interest. We intend to impose a statutory Code of Practice concerning lending by banks and building societies to related parties that aims to ensure that such lending is on an arm‟s length basis and subject to appropriate and effective management oversight and limits. In addition we will introduce a requirement for periodic reporting to us to enable us to monitor and enforce compliance with the Code. 10

Loans to bank directors and senior management have been subject to abuse and excess, if not outright subterfuge. Our proposals establish better checks and balances, tougher limits and clearer reporting to clean up these practices.

This latest Consultation Paper is part of a wider strategy to update the domestic regulatory framework applying to credit institutions. Just recently we issued a consultation paper on Corporate Governance Requirements for Credit Institutions and Insurance Companies. We will issue further requirements, including remuneration statements and a revised fitness and probity framework, in the coming months. And we will also consider the need for additional requirements in respect of internal governance and risk management as international initiatives in these areas are published.

Let me conclude by repeating that the programme of change required to improve Irish financial regulation is a multi-faceted and multi-year project. There is an enormous task ahead of us: increasing resources, improving skill levels, enhancing powers, implementing a new risk model, building an enforcement capacity, making domestic rules to fill the gaps on corporate governance, directors loans and credit risk management, implementing complex international rules on bank capital and liquidity, insurance solvency and funds regulation, tackling the problems of mortgage arrears and mis-selling, fundamentally reengineering our processes and investing in IT, to name just the top ten obvious categories.

And we need to accomplish this while doing the day job of processing transactions, doing on-site assessments of firms and engaging in supervisory fire-fighting at a time of continuing uncertainty in the financial markets. It is important that the members of this committee and the public are under no illusion about the scale of the task before us. This is going to take time and there will be bumps in the road ahead. But the process of change has 11 started and the Governor, my team and I are determined to make progress on this "to-do" list over the years to come.

I want to thank the members of the Public Accounts Committee for inviting me here today and would be happy to answer any questions you may want to ask.