Address by Director of Credit Institutions Supervision, Sharon Donnery to the Banking & Payments Federation Ireland National Conference

Introduction

It is clear from listening to your earlier speakers as they addressed your theme of innovation that this is a time of change for banks and your customers. It is also a time of change and challenge for regulators, so, I thought today would be a good opportunity to look back at the program of reform that has been underway in recent years and then to look ahead at the new regulatory landscape. It is, I think, important that we reflect on and understand our recent journey and continue to learn from the mistakes of the past so that we can, hopefully, avoid repeating them.

With the Comprehensive Assessment now completed, the new euro-area Single Supervisory Mechanism, the SSM, was launched on the fourth of November, creating a new system of banking supervision. As the Central Bank’s Alternate Member of the Supervisory Board of the SSM, I would like to give you some insight into how it operates. With this fundamental regulatory change now in place, it is important that you understand how it will impact on your business and your relationship with your regulator.

Finally, I will highlight some of the issues we are now facing. Among them is the need to ensure that new lending is prudent and sustainable, that provisions write-backs are balanced and appropriate, and, the importance of assessing business risks when you consider any business innovation.

The Past: The Programme

Ireland successfully exited the EU-IMF programme of financial support almost one year ago in December 2013. Following this, we are now subject to "post programme surveillance" and the next review mission takes place later this month. This monitoring is well established standard practice for all countries that exit a programme and will remain in place for some time.

During the Programme, the Central Bank’s Banking Supervision Divisions completed more than 100 specific actions, ranging from issuing provision guidelines to last year’s balance sheet assessment. All were agreed in order to improve or reform the financial sector and to strengthen supervision. This shows the level of change that was required both in the approach to supervision and also from the banking system itself. By driving and embedding these changes the quality and effectiveness of our supervision has increased considerably. Supported by the recent IMF ROSC review we enter the next chapter of regulatory change with confidence in our approach.

As you are all well aware, the Irish covered banks had to be recapitalised by taxpayers to the tune of €64 billion between 2009 and 2011. This recapitalisation was also supported by both restructuring and deleveraging which were aimed at “right-sizing” the banking sector.

Analyses of the causes of the crisis identified significant deficiencies in corporate governance in our institutions necessitating an overhaul of governance requirements. The Corporate Governance Code for Credit Institutions and Insurance Undertakings came into effect in January 2011 and was further updated last year. As a result, there are now core governance standards under which credit institutions licensed or authorised by the Bank must operate. Of course, we must not lose sight of the goal of good governance which is to support sound and effective oversight and a culture of ethical behaviour and challenge.

Analyses of the causes of the crisis also identified weaknesses in supervision which led to a comprehensive action plan to strengthen it. Among the actions we took was the roll-out, in November 2011, of our Probability Risk and Impact SysteM (PRISM), which introduced a more systematic risk-based framework for our supervisory actions. PRISM has been chosen by the ECB as the basis for their supervisory system, IMAS, and to support the roll-out of risk-based supervision across the euro area as part of the SSM. Another major initiative we have undertaken with the credit sector, is the development of a central credit register. When operational, this will provide valuable credit risk information to your sector as well as to other lenders including credit unions.

Together these steps, along with the many others taken over the last number of years, have delivered major changes in the regulatory and supervisory framework and in the structure of our banking sector. Indeed, many of you here today have been instrumental in the progress made in recent years to restore the sector itself.

The Present: Unresolved Issues

While we have made good headway to resolve the issues of the past, some remain unresolved and must now be tackled vigorously in order to move forward towards a healthy, competitive and innovative banking sector that can play its role in promoting economic growth.

The high level of mortgage arrears weighs on individual borrowers as well as on Ireland’s banking sector, adding to the capital needs of banks and acting as a drag on the economy and damaging market confidence.

Addressing mortgage arrears was never going to be short-term. We have always believed it was going to take time, effectively it will require a number of years to work out fully. We are now at a point where progress is evident and, notwithstanding some specific areas for improvement by banks, we are moving along the right path. The figures are now going in the right direction, but it remains too slow. The targets we have set need to be achieved and you must continue to make progress.

The latest Mortgage Arrears Statistics (published on 2 September) show that there have been successive declines in arrears over 90 days. However, there is cause for concern in the continuing increase in very long term arrears of over 720 days. These now constitute almost 30 per cent of all accounts in arrears, and just over 70 per cent of the value of arrears outstanding.

By contrast with the overall improvement in Primary Dwelling House (PDH) numbers, arrears on buy-to-let (BTL) mortgage accounts in the over 90 days category increased by 2.3 per cent during the second quarter of the year, though there was a marginal decline among the banks subject to the Central Bank’s Mortgage Arrears Resolution Targets (MART). BTL mortgages in arrears over 720 days increased by 9.4 per cent during the second quarter with some 14,500 accounts in arrears and outstanding balances of €4.5 billion.

We have pushed lenders to improve their systems and procedures to ensure that they resolve as many of their arrears cases as possible by implementing sustainable solutions for distressed borrowers in a fair manner. Lenders have responded with better policies and systems, better procedures and delivery, though some aspects still display weaknesses.

While we are maintaining our focus on the ‘workout’ of distressed PDH loans which has started to gather momentum, we are also re-focusing system-wide efforts on BTL distressed loans. Significant supervisory effort is being directed at this area and many of you here today will have been asked to complete further analysis which will help to inform our approach into 2015 and beyond. The BTL problem is significant. Many of the properties involved were bought late in the ‘boom era’ and are thus in deeper negative equity and need to be resolved with greater urgency.

We are also encouraging borrowers who are in arrears to meaningfully engage and co-operate with their lenders either directly or supported by a trusted third party. Lenders have now developed a range of options capable of resolving much of the problem through bilateral agreement.

Throughout all of this, lenders will, of course, remain subject to the Code of Conduct on Mortgage Arrears which offers key protections for PDH borrowers in vulnerable circumstances. Options which create a real improvement in affordability are the most effective in sustainably resolving arrears. It is important as banks work through the harder cases, that the treatments consider what adjustments to principal, time and interest rate achieve the best outcome for bank and borrower alike.

The focus on mortgage arrears is understandable given the sheer numbers of people who have experienced difficulties. However, in the context of distressed bank balance sheets, mortgage arrears make up one third of the value of all distressed loans. Commercial distressed loans represent the reminder.

In 2012, when the Bank reviewed your operations, very significant deficiencies were evident in relation to the handling of SME debt. Two years on, banks have addressed many of the gaps and are working through the problem, case-by-case. Resolving commercial loans will take time as many of the restructures involve a business plan spanning a number of years, often involving a mix of debt restructure, trading recovery and some element of asset sales. We want to see continued progress in this area as it is vital that the elevated levels of distressed loans in bank balance sheets continues to reduce in order to build confidence in individual banks and in the wider banking system.

Looking Ahead: Comprehensive Assessment, SSM, Emerging Risks

Looking ahead, with the Comprehensive Assessment now completed and the Single Supervisory Mechanism in place, we have moved into a new supervisory landscape.

As you know the CA was carried out over a roughly 10 month period. It included an asset quality review of at least half, as measured by risk weighting, of all the material portfolios of banks. This asset quality review itself was highly similar to the balance sheet assessment we conducted in 2013 as part of the Programme. Indeed, the similarities were strong enough to allow the Bank to re-use the outputs of certain of the file review results from the balance sheet assessment for the asset quality review.

The collective provision assessment was also consistent in design and approach for the two exercises and this was borne out by the lack of material outcomes for the mortgage portfolios of the significant Irish banks. In short, our balance sheet assessment exercise and resultant bank actions on provisions in certain portfolios helped to remediate the materiality of findings ahead of time. The CA also included the EU-wide European Banking Authority stress test of the forward looking capital position of banks as assessed under a standard methodology, constraints and macro-economic scenarios. The recently published results also reflect the join up of the two elements. The results now published will be a “floor” for capital decisions which will be taken in December by the SSM under the new legislative framework.

In all of the analysis of the CA, it is important not to lose sight of the overall objective to strengthen the balance sheets of the banks by repairing problems, to enhance transparency by improving the quality of the information on banks and thereby build confidence. I think it is fair to say that in this regard, the Assessment, building on the measures put in place in recent years, has been a success.

Single Supervisory Mechanism

The introduction of the SSM is one of the most significant developments in recent times and marks a fundamental change in how banking supervision will be conducted. The ECB now directly supervises so-called significant institutions (SIs) while less significant ones continue to be supervised by national competent authorities, such as in Ireland, the Central Bank. Here in Ireland, AIB, Bank of Ireland, Permanent tsb and Ulster Bank are on the SI list for direct supervision.

All euro-area credit institutions will now be supervised in line with the Supervisory Manual approved by the SSM. This is aimed at ensuring a consistent supervisory approach and that the strong supervisory standards introduced by the Capital Requirements Directive and Regulation will be applied in a consistent way, hence providing a level playing field.

So what changes can you expect under the new SSM? Details on how the SSM will work and the expected interaction between the ECB and the national competent authorities are set out in The Framework Regulation. Danièle Nouy, the chair of the Supervisory Board has committed that supervision will be “intrusive, tough and fair”. From our perspective that means you can expect to see some changes in the way decisions are made, the intensity of analysis and the nature of your engagement with us.

As the Central Bank’s Alternate Member of the SSM’s Supervisory Board, I attend regular Board meetings to examine, discuss and make decisions on supervisory issues. The draft decisions prepared by the Board are then considered, on a non-objection basis, by the Governing Council which is the ultimate decision making body of the SSM. While it is fair to say that decision making has changed fundamentally, it is important to emphasise that we are part of the SSM just as we are part of the Eurosystem. In light of that, our role in the various committees of the SSM, the Supervisory Board and the Governing Council are critical and full participation and contribution to those structures is a key priority for us in the Bank.

It will take time for the new supervisory approach to fully take shape. It is fair to say though that our own philosophy of assertive risk based supervision is at the heart of approach which will be taken. What is also very clear at this stage is the vital role that national competent authorities will continue to play in the supervision of banks in their jurisdictions and that the ECB will continue to rely on the knowledge and experience of the national competent authorities.

Day-to-day supervision of significant institutions will be conducted by Joint Supervisory Teams, comprising staff from both the ECB and the Central Bank. For less significant institutions, day-to-day supervision will conducted by us locally in the Bank, but subject to SSM oversight. Key issues will be brought to the Supervisory Board for discussion and approval which means that issues affecting banks in Ireland will be discussed at a European level, will more often be subject to comparison with European peers and decisions will be taken by regulators with no direct link with the Irish banking system. Moving oversight to the central SSM system is one of the key objectives of Banking Union and is aimed at achieving more consistent, dispassionate and cohesive decision making across Europe.

For many of you, your contact point in Ireland will remain the same while some of you will have new contacts at the Central Bank and the ECB and those of you who are SIs will already have met your Joint Supervisory Team co-ordinator. At the Central Bank, the Joint Supervisory Teams and the local Supervisory Teams are located in one division under Ed Sibley. Ed and his team are working closely with DG I and II in the ECB which are the directorates responsible for the direct supervision of significant institutions. They are also developing a close alignment with DG III which is the directorate providing oversight on the supervision of less significant institutions.

In addition to engaging with the team responsible for your on-going supervision, you can expect to have teams of inspectors on-site for significant periods conducting in-depth investigations of risks, controls and governance on a much more frequent basis. You can expect three main types of inspections:

• full-scope inspections covering a broad spectrum of risks and activities;
• targeted inspections focusing on a particular business area or on a specific issue or risk; and
• thematic inspections focusing on one issue across a group of peers.

All inspections will require certain support and co-operation from you while on-site. This separation of inspections from on-going supervision is a significant change to banking supervision in Ireland and a new division has been set up in the Bank, under Fiona McMahon, to support this. As part of the establishment of this new division, we are also building a team dedicated to conducting inspections on IT risk.

I mentioned that there will be a change in the intensity of analysis under the SSM. This will change across Europe but in Ireland, having come through the Programme, many of you will be familiar to some degree with the intensity you can expect. It is clear from our colleagues in the ECB that there will be a more granular evidenced-based approach to supervision with less emphasis on judgement. As a result there will be greater reliance on data, quantitative analysis, top down guidelines and centralised processes. We have established a third division, headed by Dwayne Price, to lead the analytical and cross-sectoral functions of banking supervision. This division will work closely with DG IV in the ECB in the development and use of analytical tools. We will write to each of you shortly to set out the roles and responsibilities of our new divisions and how they will interact with you.

While there has been significant change in the prudential supervision of credit institutions arising out of the lessons learned during the crisis, supervision is also required in the non-prudential areas that fall outside the remit of the ECB and the SSM. In this regard, we continue to focus on our overall strategic and statutory objectives - safeguarding stability, protecting consumers. We remain solely responsible for conduct supervision and anti-money laundering. Enforcing proper behaviour in these areas will continue to be a key focus for us.

Emerging Issues

Finally, I would like to raise some of the emerging issues on our supervisory radar.

Credit risk

As the economic recovery gathers pace, a prudent approach to new lending is essential to avoid repeating past mistakes. Banks must ensure they have the policies and procedures in place to properly assess applications for credit and apply appropriate and prudent lending standards.

We have recently published a consultation paper setting out the range of possible measures that we may implement specifically in relation to mortgage lending. The objectives of the proposed loan to value (LTV) and loan to income (LTI) regulations are to increase the resilience of the banking and household sectors to the property market and to reduce the risk of bank credit and housing price spirals developing in future. The measures introduce proportionate limits and specific exemptions which take into consideration that there are some cases which could fall outside strict limits.

Media commentary in recent weeks has focused on the potential negative impact of these measures on individual borrowers in certain circumstances. We would acknowledge that there is certainly some potential for such impacts. However, it is also important to balance the needs of these individual borrowers with the resilience of the banking and household sectors overall. In addition, I think we would all agree that, and indeed our analysis shows, there is a clear link between lending at a higher LTV and income limits and future difficulties.

I must emphasise that the proposed regulations are complementary to existing supervision and to lenders’ own risk management practices. They are not intended to capture all aspects of credit risk associated with the borrower, nor to replace or substitute for a bank’s existing internal credit assessment policies and procedures, but rather to reinforce and strengthen the existing suite of credit risk mitigation tools employed by prudent lenders. Therefore, you remain responsible for creditworthiness assessment of borrowers and for your own systems of internal control.

Appropriate Provisioning

We note that there is a consistent commentary amongst market observers that banks will start to write-back provisions in the coming year to reflect initial improvements in property prices. Banks in Ireland are now painfully aware that the recognition of appropriate levels of provisions is critical to stabilising and working out a non-performing loan portfolio. Provisions are effectively the financial raw material used to work out problem loans.

In the case of residential mortgages, provisions are estimated based on collective models which explicitly rely on assumptions and inputs. It is the role of regulators to ensure these assumptions remain an appropriately conservative reality. Whilst there have been improvements in certain key parameters such as house prices, there are still unreliably low levels of activity to have high levels of confidence in changing assumptions.

The ability to write back provisions must be reflective of a conservative view and therefore the timing and extent of any write-backs must be balanced extremely carefully. Demands to bolster profits, reserves and capital - including from regulators - cannot be allowed to destabilise the progress on debt resolution. It would be a significant backwards and destabilising step if a bank had to reverse course and re-recognise provisions in the coming years. We will continue to strongly challenge our banks to make sure that the appropriate balance is struck.

Payments

Banks and other payment service providers are operating in a sector which is changing. In the last few years the payments sector has been impacted by technological developments and changes in consumer behaviour. The internet is increasingly a commerce and payments platform and the greater ownership and use of smart mobile devices is giving rise to significant developments in mobile payments. Apps and internet platforms are now seen as more than just another means to manage finances as institutions begin to deliver features for engagement and revenue.

While there is an increase in these types of payments and improvements are to be welcomed, these changes must be introduced with necessary consideration of the risks to institutions and their customers. With each innovation the consumer must be at the centre of consideration – is the product something they understand, do they see a benefit for them, and will they use it. New and innovative payment products should not leave the consumer behind. Banks and other payment service providers should also consider market efficiency when developing new technologies to ensure the market is not fragmented with multiple systems and a lack of standardisation preventing compatibility between payment types or infrastructures.

Developing new payment products has also meant changes to the technologies and infrastructures of institutions. Integrating new systems and those of third parties is often necessary to produce new products. For many institutions, developing new technological capabilities on existing infrastructures can be challenging. In this context, there is a need for product development to be cognisant of existing legacy systems and the impact of new service offerings. Some of our banks have already experienced systems failures. Banks whose IT systems are already under strain will need to make significant investment in upgrading or replacing their systems if they want to migrate to doing more of their business electronically or undertaking new forms of business. New products should not increase the risk of technology failures in existing services. In addition, as with all systems, it is expected that areas such as security, availability and integrity in the development of these products are key considerations.

New payment methods are being used by more consumers and on a more regular basis. It is essential that the development and evolution of these products is completed within the confines of the appropriate governance and risk management processes that will ensure that we can trust in the future of payments.

As you plan any business innovation you are responsible for examining the risks attached. This will include ensuring that your IT systems are appropriate for the business planned. It is important to note that IT risk is high on the SSM agenda and, as I said earlier, we will have a new team working to assess such risk.

More broadly, proactively managing the risks associated with the national payment system is a priority for the Bank in recognition of the fact that payments are the lifeblood of the financial system and resilient payment systems are a key contributor to the maintenance of financial stability. Over the last two years the Bank, in consultation with your Federation, has put in place a more rigorous process to annually assess the risk profile and resilience of the national payment system.

Overall the common thread between new lending and new business opportunities and innovations is the need to build a sustainable business in the context of your overall risk appetite and where risks are identified, well understood, managed and mitigated.

Conclusion

Finally to sum up, we have all learned important lessons through the financial crisis and we are continuing to work through the problems caused by poor governance, bad lending decisions and inadequate supervision. The crisis has resulted in a new euro-area wide approach to the supervision of credit institutions. Supervision under SSM will be intensive and intrusive and will involve external oversight as well as peer comparison. Now, as you consider business innovations and new lending opportunities, I would urge you to remember the lessons of the recent past and to ensure you apply prudence and good governance principles in your assessment and decision- making processes. Thank you for your attention.