Address by Matthew Elderfield, Head of Financial Regulation to the Association of Compliance Officers in Ireland

The Regulation Agenda: Update on Bank Recapitalisation and New Corporate Governance requirements

Good afternoon ladies and gentlemen.

Thank you for inviting me to speak at your annual conference.

Today, in the context of recent market developments, I would like to start by giving you an update on the ongoing recapitalising of our banking sector and some possible options for the future. Then, against the background of the huge losses that have been incurred by the banks, I would like to set out the new Corporate Governance requirements we have recently announced.

The process of recapitalising our credit institutions and restructuring the regulation of our financial services sector has been underway for some time. The Central Bank assessed the banks' capital position in March, leading to a significant re-capitalisation of the sector. The most recent data on loan losses does not suggest that existing capital is inadequate. It is clear, however, that market expectations on bank capitalisation have risen globally. Equally, concerns about government finances, the current macroeconomic environment and the future prospects for growth and employment in Ireland have impacted confidence in Irish banks. As such, it is desirable that additional measures are now taken covering both capital and balance sheet size. I will return to this shortly but first let me remind you about the work that has been done so far.

Earlier this year the Central Bank carried out the first round of a Prudential Capital Assessment Review (PCAR) exercise to determine the forward-looking prudential capital requirements of the Irish credit institutions covered by the government guarantee. The PCAR assessed the recapitalisation required at each credit institution to satisfy both a base case and a stressed target capital requirement over a 3 year time horizon.

We required the banks to meet a PCAR standard of 8% core tier 1 and 7% equity by the end of 2010, taking account of both NAMA losses and of projected expected losses on non-NAMA portfolios, including mortgage portfolios, through 2012. We also set a stress capital requirement of 4% of core tier 1. Specific PCAR target capital levels were set for each institution and we required that the institutions put this amount of capital in place by the end of 2010.

Let me explain our PCAR requirements in some more detail. Our methodology involved a series of steps including the following:

• Assessing the provisioning estimates of each credit institution, their Basel capital model outputs, expected loss forecasts, funding costs and projected operating income;
• Reviewing independent third party estimates of provisions and expected losses conducted on specific credit institutions’ portfolios;
• Reviewing likely and stressed loan loss projections by credit rating agencies and other sources;
• Reviewing the outcome of modelled base and stress macro-economic scenarios; and,
• Applying prudent buffers to estimates of expected loan losses; and,
• Also applying prudent adjustments to base case and stress scenario funding costs and treasury asset losses.

The next step was putting a process in place to ensure the banks meet their new capital targets. We required each credit institution to prepare a recapitalisation plan to show how they would comply with the additional capital specified by the PCAR. This plan had to show how the institution would ensure that capital would be in place by the end of 2010 to a level calculated by reference to the capital target, after taking account of projected expected losses, including bank-specific and other adjustments.

At the end of September we announced that we had advised the Irish banks that have been subject to PCAR assessments that the year-end deadline for meeting the PCAR standards remains in place despite developments in international capital standards. At that time we also advised the banks about the capital treatment of any adverse development in NAMA haircuts since the PCAR calculations were conducted on 30 March.

We are already taking steps to prepare for the next PCAR exercise in early 2011. Our goal will be to repeat our assessment with a more granular review of base and stress expected losses at the banks in the light of updated macroeconomic scenarios and loss rates. But we plan to enhance the process in a number of respects, by providing more transparency around the assessment calculations and involving third party validation of the data provided by the banks to provide greater assurance to ourselves and to market observers.

The natural question is whether this action by government is enough and what the future holds for the banks in terms of capital requirements and other measures of their strength. Now that the capital impact of the NAMA haircuts is known, the obvious area of continuing scrutiny by the Central Bank will be the non-NAMA portfolios of the banks. We have not yet seen hard evidence to revise our capital assessment, which included substantial buffers, for the non-NAMA portfolios of the principal banks. For example, the recent data on mortgage arrears, while showing an anticipated increase, are still inside the base capital assessment and well below the stress level.

However, it is clear that while there has been a significant investment of taxpayer funds to recapitalise the banking system these measures have not been sufficient to restore market confidence. The sovereign debt crisis, deteriorating government finances, and increased NAMA haircuts have combined to heighten market uncertainty about the banking system and mean that the existing policy measures have been insufficient to reassure the market. Indeed, from our perspective as a Central Bank, the prospect of slower economic growth and the anticipated impact of further fiscal consolidation need to be taken into account in the next PCAR.

In light of this continuing market uncertainty additional policy measures are under active consideration some of which might be categorised under the heading of “overcapitalizing” the Irish banks. For example, as a principal source of concern relates to the possibility of further losses beyond those assessed by the PCAR process, then a standby contingent capital facility could be considered to provide a backstop to the banks. Given the current budgetary position, this facility would need to be provided by external sources. Such a facility could also provide a resource to allow bank capital to be topped up to meet current or future target capital levels as base loss estimates are periodically revised, as will occur according to our existing plans. In addition, immediate additional capital injections could also be made to make faster progress to full compliance with new international standards. The exact balance between these different options needs to be carefully considered in light of the implications for taxpayers and long-term government finances.

The Government application for assistance from the IMF and the EU means that the capability to take these additional measures will soon be in place. It also means that progress can be made to restructure the Irish banking sector to a smaller size with more sustainable funding ratios. In this context, restructuring is a term of art in EU competition policy: thus all banks in receipt of state aid have been required to take restructuring measures. This restructuring would ideally involve further deleveraging over time through asset disposals like the core/non-core approach undertaken by the UK banks.

What does this mean for the customers who use the Irish banking system? The protection of both a deposit insurance scheme and the government guarantee are already in place, and a considerable investment of taxpayer funds has also already taken place to strengthen the banks. Depositors have the reassurance that the financial resources and firepower of the European and international financial institutions will be in place to further support the Irish banking system.

It is clear from all this that the cost of the banking crisis in Ireland will be considerable. The Irish people are now paying a heavy price for the failures at the heart of banking. We have to try to ensure, as best we can, that we make the changes required to address the shortcomings identified as contributing to the crisis. The analyses of the factors and failures that lead to the banking crisis clearly pointed to weak, or in some cases, absent corporate governance as a contributory factor.

We have now introduced strong corporate governance requirements for banks and insurance companies to tackle this shortcoming. In our new Corporate Governance Code we have set out statutory requirements aimed at improving the performance of boards and directors and at ensuring appropriate independence and challenge at board level.

As compliance officers working at the coalface in the financial services industry you will appreciate the importance of sound and strong corporate governance standards and of a culture that promotes and encourages best practice in this area.

Why did corporate governance fail? There are several possible reasons. Were the existing and well meaning principles of the past too general in nature? Did they encourage a box ticking approach to compliance rather than developing a good corporate governance culture? Was it too easy for strong individuals to override principles that had no statutory backing and no enforceability? There was no statutory obligation on enterprises to comply with the corporate governance recommendations which were generally issued by international organisations unable to enforce them. It is evident that boards were unwilling or unable to curtail excessive risk taking. And the same boards were unwilling or unable to exercise sufficient control over senior management.

It is easy to be wise in hindsight but it is important to take on board the lessons from the past as we try to shape a better future. Looking back now we can identify instances of unacceptable corporate governance, such as CEO’s with apparently unfettered powers carrying out their roles with insufficient challenge. We can see that many boards were either too complacent, or, perhaps lacked the strength or industry knowledge to challenge high powered executives. Sometimes they failed to comprehend the risks associated with their business and the potential for disaster in not knowing or confronting these risks. Some non-executive directors, and indeed possibly executive directors, did not understand the complex and technical nature of the businesses over which they had charge. And some boards appear to have been in the dark about what was happening on the ground in their organisations.

The need to reform Corporate Governance within the local financial sector was highlighted in the findings of the two reports commissioned to understand the sources of Ireland’s banking crisis. These reports, one by Klaus Regling and Max Watson and the other by the Governor of the Central Bank, were published in June of this year. They both emphasised the need to reform Corporate Governance. Regling and Watson commented that “... Ireland was one of those cases where there were at least some instances of extremely serious breaches of corporate governance, going well beyond poor risk assessment, and eventually having a systemic impact”.

This experience of poor or absent corporate governance is of course not unique to Ireland. Many international organisations and national regulators have taken action to put in place or revisit their Corporate Governance standards and requirements. Here in Ireland our new Corporate Governance Code for credit institutions and insurance undertakings is part of a wider strategy to update the domestic regulatory framework. We will also develop Corporate Governance frameworks for the other sectors of the financial services industry we regulate. We have asked the funds industry to devise an appropriate code for its sector. We will also devise a code for investment firms. The question of the appropriate governance framework for credit unions will be considered in the context of the forthcoming Strategic Review of the Credit Union Sector. We will carve out captive insurers from our proposals and develop bespoke standards with the assistance of the industry. Last month we issued our Code of Practice for Lending to Related Parties. We will soon issue requirements on other related matters such as remuneration policies within the financial services sector and a revised fitness and probity framework. Next year we will also develop requirements in respect of internal governance and risk management informed by international initiatives in these areas.

I would now like to talk to you in some more detail about our new Corporate Governance Code. As you know, this was the subject of a well publicised consultation process over the summer. We received over 130 responses to the consultation paper - an unprecedented volume compared to any other consultation with a wide range of respondents - which we welcomed. The topic clearly seized the imagination of many interested parties. Respondents generally welcomed the proposals in broad terms. As you would expect, some respondents felt we went too far and some felt we did not go far enough.

We gave considerable thought to all of the responses. I believe the Code, in its final form, combines the best of what was contained in the consultation paper and the responses to the consultation. I know it will not please everyone - as with the consultation paper some will think that it goes too far, others will complain that it does not go far enough. But I am confident that it represents a balanced and proportionate approach to strengthening the governance of our banks and insurance companies.

We have made a conscious decision to set more demanding corporate governance standards here 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 in financial institutions. We have acknowledged some of the concerns regarding the possible international competitive impact of our earlier proposals by adjusting the standards we are setting out for IFSC companies, or more specifically for Irish subsidiaries of companies regulated in other jurisdictions. But we have consciously decided that we do not want to simply match best practice internationally. We want to set a higher standard because Ireland has suffered more than most countries in the financial crisis and now needs to get to grips with the home grown elements of that crisis.

In Ireland poor governance may well have been exacerbated by the concentrated nature of corporate life where challenge and assertiveness in the Board room was perhaps blunted by the social constraints of working and living in a small business community in a small country. For this reason stronger remedies are needed here to shake up prevailing corporate governance practices. New blood needs to be introduced and exacting standards need to be set. This will improve the reputation of Ireland as an international financial centre by knocking on the head concerns about too cosy corporate governance practices.

We have taken a proportionate approach in our new Code as we are doing elsewhere. We are imposing minimum core requirements on all institutions covered by the Code and also imposing additional requirements upon those firms which we deem to be major institutions. We will make our own judgements with regard to what constitutes a major institution. We are doing it this way very deliberately because we consider black line definitions to be too inflexible for this important area. We will operate this Code in line with our risk based system of regulation and our one size does not fit all approach. We are likely to align major institution status with the structure of our forthcoming risk model to cover higher impact firms. Some large IFSC firms could therefore be designated major institutions. But we will give firms an opportunity to make representations to us as to whether they are major or not – we are open to dialogue. In coming months we will advise institutions of their “major institution” status. Clearly, all banks with a significant retail presence in Ireland should fall within this category. But I would add that there is no bar on non-major institutions deciding to implement the additional requirements and indeed I would encourage such firms to consider doing just that.

In our consultation some respondents expressed concern about the proposal that each board should have a majority of independent non-executive directors. We have decided to retain this requirement for domestic major institutions. But for banks and insurers that are subsidiaries, we will now require that they have a significant presence of INEDs on their boards rather than a majority. This is in recognition of the need of the parent company to be able to direct and control its Irish subsidiary - the presence of the independent non-executive directors is to provide an independent voice that will challenge and question both the parent and the group executives within that subsidiary.

One of the most contentious issues in the consultation was the limits we proposed on the numbers of directorships an individual could hold. There was a wide divergence of views. The majority of the 99 submissions on this issue were concerned that our approach was too restrictive and would put stress on the limited pool of talent and overall quality of directors in companies. They favoured the abolition of any set limits preferring instead that we should adopt a case by case approach. We had proposed that directors of all credit institutions and insurance companies should be limited in the number of directorships which they could hold to 3 directorships in a bank or insurer and no more than 5 directorships in companies outside of those financial institutions.

We disagree with these concerns. We decided to retain the limits proposed in relation to directors of major institutions. But we have given some leeway to non major institutions, by increasing the limits to 5 financial directorships and 8 non financial directorships. These are important requirements that should help to ensure that independent non-executive directors devote sufficient time to their oversight responsibilities and should encourage more focus and attention on the board role and crucially, improve challenge in the board room.

We also think that this restriction on the number of directorships should help to improve challenge in financial board rooms by broadening the gene pool in Irish corporate life. The current very limited breadth of board membership here was set out very clearly in the TASC Report - “Mapping the Golden Circle” - published in May. We disagreed with the argument that a limit on board directorships should be dropped because there were not enough existing directors to go around. We believe that it is possible to bring more directors into the financial services sector in Ireland by looking beyond the existing pool of directors.

We need to bring more outsiders into the board room. More diversity in the boardroom will help to avoid the dangers of “groupthink” which contributed to the crisis. Bringing fresh voices and perspectives into the boardroom both from outside Ireland and from new people within Ireland should offset the social ties and connections that have blunted challenge in the past, as well as promote an understanding of standards and practices elsewhere.

The EU Internal Market Commissioner Michel Barnier put it succinctly when he said recently “I also think more effort needs to be made for a more diverse boardroom. It is always difficult to take good decisions. But debate and different views help us to get there. And diversity in all forms creates the right conditions for a real exchange of views.”

Training for appointed directors is an important element in ensuring good boardroom performance. We believe that greater investment in training, both in general board skills and in technical risk skills is required. To encourage this, we have invited the Institute of Directors (IOD), the insurance and banking institutes, corporate governance experts and other stakeholders to a Roundtable early next month to see what action they can take to improve corporate governance standards, to prepare more people to be more challenging in the board room and to assist the industry to implement our new standards. This Roundtable will be chaired by our new Commission member Blanaid Clarke.

You will have seen that we are maintaining our proposed restrictions and requirements with regard to the positions of chairmen and CEOs. This recognises the importance of the proper functioning of these roles in ensuring strong corporate governance. Under the new Code:

• the chairman is required to lead the board, encourage critical discussions and challenge mindsets;
• the Chairman and the CEO are required to have the necessary personal qualities, professionalism and integrity to carry out his or her obligations;
• the Chairman and the CEO are prohibited from holding such a position for more than one institution at any one time; and,
• an individual who has been CEO, executive director or member of senior management of an institution during the previous 5 years is prohibited from progressing to Chairman of that institution.

These requirements and restrictions underpin the general requirement that no one individual may have unfettered powers of decision. It is clear that we need to put better controls in place to protect against the terrible damage that has been caused by over-dominant CEOs or directors in some of our leading banks and insurance companies. Colourful and dynamic entrepreneurs are always a welcome source of innovation and economic success, but it is essential that this is matched by strong corporate governance checks and balances. It is especially important in the financial services sector to ensure that a dominant personality is not allowed to ride roughshod over the board in pursuit of unacceptable risk-taking when depositor and policyholder money can be at risk.

As you know we decided to adjust our proposals in the light of what we considered to be reasonable concerns among IFSC firms about the impact on the ability of a parent to exert control over a subsidiary. This is not to suggest for a moment that it is any less important for IFSC firms to have high standards of corporate governance. We know that Irish subsidiaries of overseas companies can be subject to their parents seeking them to take on too much risk and they need to be willing and able to push back. Or sometimes subsidiaries can become too remote and drift into weak practices due to a lack of local scrutiny.

But we listened to the concerns expressed and in our new Code we have sought to strike a balance. Particular concerns were the proposal that the chairman of the IFSC subsidiary should be an independent non-executive director, as companies often appoint a group executive to this role, and, also related to the number of independent non-executive directors required on the subsidiary board. In our Code we amended our proposals to allow the chairman of a subsidiary to be a group director and we have modified the board membership requirement.

The issue of compliance statements raised some objections but we have maintained the requirement that regulated banks and insurers submit compliance statements in respect of adherence to the Code. As compliance officers you would no doubt welcome guidelines specifying what we will require here. We will develop guidelines and we will consider industry input in the process. I would welcome your contributions to this process – your experience in this area would help to ensure that the guidelines provide us with an effective monitoring tool as well being practical for industry to compile.

Our Corporate Governance Code becomes effective on 1 January 2011 and institutions will be given until 30 June next year to introduce the necessary changes. Where changes to board membership are necessary this period will be extended to 31 December 2011 in order to allow institutions to identify and assess candidates prior to making appointments.

We are well aware that rules alone are not sufficient to ensure that a Corporate Governance Code will be effective and will achieve the change required. It is relatively easy to set quantitative requirements and to monitor adherence to them. It is much more difficult to monitor qualitative requirements and to achieve the change in culture necessary to ensure the spirit of the Code becomes the norm in corporate governance. We have to ensure that those directors, senior managers and others in senior roles within institutions have the integrity, professionalism, skills and experience necessary to fulfil their tasks.

We have already commenced an interview process as part of our “fitness and probity” assessments for appointments at senior management levels within institutions. Initially, our focus is on the domestic retail banks but we do intend to roll this out across a number of institutions on a risk-based approach and consistent with the resources available to us.

We have also started to look at board performance and how individual directors conduct themselves at the largest institutions. We’re doing this in two ways. We are conducting interviews with the directors to assess their grasp of their institution’s strategy and key risks, and, our supervisors now attend at selected board and other committee meetings, for example the risk committee or the asset and liability committee. In this way we are not focusing solely on individuals but we’re also getting a good handle on the overall quality of boards, including the skill sets, management oversight and adherence to the requirements proposed for corporate governance.

The recently passed Central Bank Reform Act provides for a statutory Fitness and Probity Regime for directors and senior management of financial institutions. The Act provides that the Central Bank may issue standards of fitness and probity with which firms must comply regarding officers and employees performing “controlled functions”. These “controlled functions” may include, for example, the CFO, the head of risk, head of credit, Money Laundering Reporting Officer and compliance officer and so forth. We are currently working on a draft Code on Standards of Fitness and Probity and we intend to consult publicly on this code in December.

We know the importance of having a governance code at board level. But to ensure it is effective it must be supplemented by sound requirements for internal governance. Companies must have systems and controls in place that allow the board and the executive to work together to deliver on the strategy within the risk appetite set by the board. We have therefore promised also to bring forward proposals on internal governance early next year.

As Compliance Officers you have an important role to play in helping to bring about change for the better. You can help improve the corporate governance culture in your organisations by ensuring you are well versed in the new Code and in the other regulatory requirements and, crucially, by adopting a questioning approach.

We need to learn the lessons of the financial crisis by improving corporate governance practices in the financial services sector in Ireland. These new rules from the Central Bank deliver stronger standards for banks and insurance companies operating in Ireland. It is time to bring fresh blood into the board room, which brings more challenge, asks more awkward questions and devotes more time to assessing risk.

Thank you for your attention.