Financial Regulation today and an insight to Asset Management Supervision – Michael Hodson, Director of Asset Management Supervision

Keynote address at Cork Financial Services Forum Briefing “Cork as an IFS location and the changing asset management landscape in Ireland”

Good afternoon ladies and gentlemen. I want to thank you for the invitation to speak at today’s event which has been kindly organised by the Cork Chamber and the Cork Financial Services Forum.

Today I will discuss the role of the Central Bank and highlight some recent changes that have been introduced. I will also provide you with a brief overview of the Asset Management Supervision directorate. Finally, I will address a number of important topics relevant to the Irish Asset Management industry today such as MiFID II and Brexit.

Financial Services Sector and Regional Growth

But first, I am cognisant that part of the mandate of the Cork Financial Services Forum is to drive the advancement of the financial services industry in the region. In this regard, it is interesting to note, as outlined in the IFS 2020 Action Plan for 2017, that there are now over 400 companies employing approximately 40,000 people directly in the financial services sector in Ireland. In this regard, one third of those employed are operating in companies outside the greater Dublin area.

If I can expand on this and provide you with an example of the national presence in the fund services space, a sector that is supervised within my directorate. At present, there are six fund service firms in Cork employing over 650¹ staff while 10 firms with operations in Kildare, Kilkenny, Limerick, Louth, Waterford and Wexford employ circa 2,400 staff. At the same time, these firms employ close to 4,000 in Dublin.

I believe that this growing presence outside of Dublin is evidence that other regions have the potential to attract firms, create employment and become a location of choice or hub for the financial services sector. I think that this viewpoint is reflected in the survey results published in the Cork Chamber’s Economic Bulletin last month with 49% of firms surveyed expecting an increase in employee numbers over the next 12 months and overall business confidence increasing from 91% in the previous quarter to 96% in quarter 2.

Central Bank: changes to note and regulatory role

If I may now take a few moments to speak about recent structural changes introduced in the Central Bank and also touch on our regulatory role.

From 1 September, the financial regulation pillar of the Central Bank has been split into two separate pillars, prudential regulation and financial conduct. Ed Sibley has been appointed the Deputy Governor of the Prudential Regulation pillar, which includes the credit institutions, insurance and asset management directorates. Meanwhile Derville Rowland has been appointed the Director General of the Financial Conduct pillar and has responsibility for consumer protection, securities and markets supervision and enforcement.

Why have these changes to financial regulation been introduced? The answer quite simply is that the scale of financial regulation activity has increased sharply in recent years and this is likely to continue to increase. In addition, the level of European engagement required by senior management has also increased dramatically.

As a result, in order to manage the workload in an efficient and effective manner, the decision was made to create a prudential regulation pillar and a conduct pillar. I think that the creation of the two new pillars is a reflection of the importance that the Central Bank places on supervising both conduct and prudential risk. It is critically important that both pillars work closely together and we in the Central Bank are adamant that we will continue with the strong collaborative culture we have built up over the last number of years. Regulated entities can expect intrusive conduct and prudential supervision to continue and the two new pillars working together will provide a strong platform for the Central Bank to achieve our regulatory mandate.

Regulatory Role of the Central Bank

Turning to the regulatory role of the Central Bank, our mandate is to safeguard stability and protect consumers. In order to fulfil this role as a competent authority we are committed, as outlined in our Strategic Plan 2016-2018, to being an independent, forthright and influential organisation while also being trusted by the public, respected by our peers and providing a fulfilling workplace for our people.

You may ask what a robust regulatory regime entails. A proactive engagement model is key and this is at the heart of the Central Bank’s supervision process. We engage with firms to understand what they are doing and their level of compliance with set rules, requirements and regulatory guidance. Such engagement also enables the Central Bank to determine if a firm poses a threat to financial stability or consumers.

Furthermore, to ensure a consistent approach to the supervision of firms across the various financial sectors, the Central Bank introduced the Probability Risk and Impact SysteM, commonly referred to as PRISM, in 2011. PRISM is the bedrock of our risk-based supervision, which starts with the premise that not all firms are equally important to the economy and that the Central Bank can deliver most value by focusing on firms that are most significant.

Our most thorough supervisory engagement comprises of a full risk assessment of a firm, whereby a desk based review of firm information is completed by supervisors before a series of engagement meetings are held with key personnel within a firm to obtain an overview on firm specific risks such as governance, strategy, market and conduct. The full risk assessment will also see supervisors undertake an in-depth onsite examination of key aspects of a firm. Should supervisors identify risks which if left unmitigated would be outside our risk appetite, a Risk Mitigation Programme will be issued and mitigation actions will need to be undertaken by the firm.

Thematic inspections are another important element of our proactive supervisory engagement model. Similar to a full risk assessment, thematic inspections comprise of desk based and onsite reviews. They are a tool which enable our inspectors to dig deeper on a specific industry theme by inspecting a sample of firms within scope for thematic inclusion. The end result of a thematic inspection will see the Central Bank issue Risk Mitigation Programmes if firm specific issues are identified. Furthermore, an industry letter will generally be issued to the wider industry segment on the key findings of the thematic and good practices observed. Once issued, the Central Bank expects that industry letters are actioned upon with board discussions and consideration of thematic findings against their own current practices.

If you consider the Irish financial services sector today, it is a dynamic and changing environment with an increasingly diverse array of firm types, business models and distribution channels falling under our regulatory remit. Moreover, in the last few years we have seen European developments such as the Single Supervisory Mechanism and the introduction of Solvency II. While in the near future, we will see the implementation of MiFID II and the potential changes that Brexit may deliver.

As a result, our regulatory approach is also forward-looking. As supervisors, we are committed to assessing regulatory compliance not just against current risks but also against those that could possibly arise in the future. This can take place in many forms including preparedness for legislation coming down the track such as MiFID II, a topic that I will address in the next section of my speech, and also by way of stress testing and reviewing recovery plans submitted to the Central Bank by firms that are in-scope of the Bank Recovery and Resolution Directive. This forward-looking strategy also extends to Central Bank staff participating at a European level on working groups, standing committees and task forces. Such participation enables the Central Bank to contribute on a wide range of matters on the horizon including selection of appropriate peer review topics and the drafting of industry guidance.

In speaking about the Central Bank’s regulatory role, enforcement has an integral part to play. Enforcement action is taken when firms and individuals fail to comply with their regulatory requirements. It enables the Central Bank to address bad practices, highlight the consequences of regulatory breaches and promote compliance.

To some culture is viewed as a buzzword with no core meaning; however, there is undoubted value in firms adopting a culture of compliance. As highlighted in a speech provided by Derville Rowland² earlier this year, it is about doing the right thing even when no-one is watching. It is therefore essential that senior management and boards influence from the top down in driving for compliance.

As you can see we do a lot, we spend a lot of time with firms, time considering current and future risks and understanding the changing regulatory landscape. We do this so we understand the firms we are responsible for authorising and supervising, that we are in a position to effectively challenge those firms and ensuring they play a positive role in providing suitable products, contribute towards efficient and effective markets and support the wider economy. It is important to note that it is not our role to decide on the business strategy or operational arrangements of a firm, but it is our role to question these and be prepared to ask the hard questions, and in doing so we play a crucial role in the financial services industry in Ireland.

If I can sum-up briefly the benefits of a proactive Central Bank and a robust regulatory model. Firstly, it enables us to protect consumers in their dealings with regulated entities to ensure that they are treated fairly, provided with appropriate information and that products they are sold are suitable. Secondly, it provides us with a platform for challenging firms, judging the risks they pose to the financial system and ultimately determining if they have sufficient financial resources, are effectively governed and have durable business models. Finally, it is key to ensuring that financial services and financial markets operate in such a way that they support the functioning of the economy and the achievement of sustainable growth. Ultimately, all our actions are driven to achieve such outcomes.

Asset Management Supervision Directorate

This leads me on to the next topic, the Central Bank’s Asset Management Supervision directorate is responsible for the supervision and authorisation of a diverse array of firms within the asset management sector. At present, we supervise 371 firms, across the MiFID investment services and fund services space.

• The MiFID firms we supervise have approximately €433³ billion assets under management and over 140,000 clients.
• In the fund services sector, there are close to 13,000 funds administered and nearly €4 trillion assets under administration.

In order to give you an insight to our supervisory work programme, I think it would be worthwhile to provide an overview of recent work that we have completed and also discuss areas that are currently requiring significant attention from my staff, namely MiFID II and Brexit.

Last year the Central Bank carried out a review of outsourcing arrangements concentrating on the following areas (i) the extent to which larger Fund Administrators outsource their activities and (ii) the relevant control environment (governance and oversight arrangements) in place within these Fund Administrators in Ireland. This year we have continued our focus on outsourcing, with our supervisors completing a review of the extent to which both (i) larger Irish Fund Administrators and (ii) Fund Administrators with a low impact PRISM rating, have outsourced activities to service providers. The Dear CEO letter issued following last year’s review has now been transposed into guidance and a Question and Answer document has been published. In light of this development, I encourage firms to consider completing a gap analysis against the recently issued guidance to ensure the expected standards are being met.

Following completion of the Central Bank’s CP86 work to examine and enhance fund management company effectiveness, there are a number of key obligations that regulated fund management companies must remain cognisant of. First off, the deadline to have the dedicated regulatory correspondence email address in place has passed as of 30 June 2017. There has been a strong response to this and going forward, the Central Bank will use this as the primary point of contact for all regulatory correspondence.

Looking forward, there are a number of key obligations to be mindful of, such as managerial functions, organisational effectiveness and retrievability of records. The deadlines applicable are dependent on when the relevant fund management company was established. I encourage fund management companies to refer to the Central Bank’s AIFMD⁴ and UCITS⁵ Q&As for further information on the upcoming deadlines applicable to them. Ultimately, fund management companies need to be mindful that all obligations introduced as a result of CP86 will be applicable to them from 1 July 2018.

Moving onto our thematic review work, earlier this year the Central Bank completed a review in relation to how investment firms holding client assets had implemented the new risk management requirements introduced in 2015. The review highlighted the important role of boards in challenging the content of the Client Asset Management Plan and in ensuring the Head of Client Asset Oversight role is allocated to an individual with adequate authority, resources and expertise. The protection of client assets is a strategic priority for the Central Bank, as it should be in all firms, and we expect boards to ensure that the firm has effective and robust client asset oversight structures in place. Firms must strive for the highest possible standards in relation to safeguarding client assets, in order to ensure risks to investor protection are effectively managed. The Central Bank will continue to conduct regular inspections of firms holding client assets, and we will insist on effective risk mitigation where we identify that firms have fallen below the required standards.

Another area of focus this year was our recent thematic review of Suitability, with the industry letter published on 29 August. The Suitability requirements are a key pillar of the consumer protection regulations and are there to ensure client investments align to investment objectives and personal circumstances. The review highlighted the need for firms to evaluate their suitability framework to ensure that they meet the relevant requirements and the Guidelines. The findings also underlined the importance of firms taking all necessary steps to ensure that the suitability policies and procedures are fully embedded within the firm. Firms should consider all good practices listed in the appendix of the industry letter. With the introduction of MiFID II in January, I encourage firms to incorporate this review of the suitability framework into their MiFID II project.

MiFID II

As we enter the final stages of preparation for MIFID II, it is timely that we take time to remind ourselves of the objectives, which necessitated its introduction. MIFID II seeks to neutralise some of the flaws, which were, exposed during the financial crisis by:

• Addressing the weaknesses in the functioning and transparency of financial markets.
• Rectifying limitations in prevailing corporate governance structures.
• Increasing the investor protection mandates.
• Increasing the level of harmonisation across financial markets, for example through the development of a single rulebook.

As clients, regulators and market participants, I think that we can all agree that these are credible and worthwhile objectives.

MiFID II seeks to strengthen investor protection as well as improving the regulation of the market and firms. Increased investor protection and transparency in financial markets will ultimately benefit all stakeholders involved in the sector and should help to safeguard the financial system against future crises.

It is important to reflect on these objectives, as I am mindful that industry is currently expending considerable time, energy and resources preparing for the fast approaching implementation date.

It would be remiss of me not to mention some of the aspects of the Central Bank’s preparation for MIFID II. As this is an issue, which I have spoken to on a number of occasions I will focus on the most salient points.

We have fundamentally reviewed the IT infrastructure, which has underpinned our supervisory approach to MIFID firms; we have carried out a comprehensive review of all the MIFID legal texts and guidance, we have run training workshops across the organisation. We have engaged with industry since 2015; through public engagements and roundtables; this exercise has been very useful for us in terms of gauging industry’s preparedness and has been instructive in terms of providing insights on issues, which may need further clarification. Additionally we have issued questionnaires and used heat mapping to guide our supervisory engagement with firms.

Finally, it is timely to reiterate some of the messages, which colleagues or I have raised previously.

• We expect firms to be in the final stages of their MIFID II implementation projects, with a view to ensuring compliance by the 3 January 2018.
• Any firm which is currently exempt form MIFID I and this particularly the case for proprietary traders and other businesses that deal in financial instruments on their own account in the course of an otherwise unregulated business model, may now as a result of MIFID II require authorisation. Firms ought to take the necessary steps to ensure that they comply with MIFID II by the implementation date.
• The Department of Finance has transposed MIFID II in Ireland; we encourage firms to review that legislation in addition to keeping abreast of any relevant European initiatives.

There is good news for those who have met the challenge and embraced MIFID II; the end is near and hopefully your projects are nearing completion, all critical decisions have been made and you can now endeavour to leverage off your MIFID II expertise and processes’ to augment your existing business lines.

To those who have not risen to the challenge, which MIFID II presents; time is of the essence.

Brexit

Before I conclude, I would like to say a few words on Brexit.

As highlighted in our annual report, Brexit is a key priority for the Central Bank. To date, we have had a significant amount of engagement with firms regarding potential relocation decisions and the resulting authorisation process. It is interesting to note, that at meetings held so far, I have found firms expecting and indeed wanting high quality and challenging supervision that is in line with the highest regulatory standards.

There is a wide breath of firm types making enquiries and requesting meetings with us, in some cases, these firms will be similar to those already operating here. However, we may also be presented with new firm types, new business models or new pieces of market infrastructure.

In this regard, potential applicants will find that the Central Bank is an open, engaging and constructive regulatory body that is committed to providing transparency, consistency and predictability in our regulatory decisions. The Central Bank has considerable experience in dealing with authorisations and to supplement our experienced staff, we have recruited and set up teams to deal with Brexit specific applications for authorisation.

When asked to consider the authorisation of a firm in Ireland, substance is paramount. We expect that that the board and management of an entity are located here such that the business is being run from here and can therefore be supervised by the Central Bank. We accept that there are different ways that substance can be achieved and that outsourcing is a part of many business models. However, it is important and the Central Bank will insist, that a firm does not outsource to the extent that it becomes an empty shell.

While on the subject of Brexit, I do not want to give the impression that the Central Bank is only concerned about Brexit from an authorisation perspective. Existing authorised entities should be planning and considering the possible impact that Brexit will have on their business models and revenue streams. This is also on our radar and over the coming months, as we edge closer to the UK leaving the EU, Central Bank supervisors will continue to engage with existing authorised entities on this subject.

In addition to the regulatory work we do, our colleagues in the Central Banking side of the house continue to analyse and publish research and papers on potential Brexit impacts on the economy.

Finally, at a European level, we have seen efforts made to ensure convergence in how NCAs respond to Brexit. Earlier this year for instance, the European Securities and Markets Authority published a number of opinion papers. These opinions set out principles aimed at fostering consistency in authorisation, supervision and enforcement in relation to the relocation of entities, activities and functions from the UK. I am of the view that these opinion papers will help progress supervisory convergence in the EU, which is something that the Central Bank strongly supports.

Conclusion

At this juncture, let me conclude by once again thanking the Cork Chamber and the Cork Financial Services Forum for the opportunity to address you today.

I would like to stress the importance of firms planning and devoting time and resources to meet the challenges ahead such as MiFID II and Brexit. By doing this, firms will be able to benefit in the long run and take advantage of opportunities presented in Ireland’s growing financial services sector.

In addressing the Cork Chamber back in February, Governor Lane referred to Cork’s vibrant IT sector and pharmaceuticals industry located here. I look forward to seeing Cork and other regions continue to grow their financial services industry. Perhaps one day, Cork’s financial services sector will even rival that of the IT and pharmaceuticals sectors.
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¹ Employment figures in this paragraph are based on Central Bank estimates
² https://www.centralbank.ie/news/article/'enforcement-insights-attitudes-and-behaviours'-derville-rowland
³ Figures in this paragraph are based on Central Bank estimates
⁴ https://www.centralbank.ie/docs/default-source/Regulation/industry-market-sectors/Funds/AIFS/Guidance/qa/aifmd-qa-version-25.pdf?sfvrsn=5 (PDF 1.32MB)
⁵ https://www.centralbank.ie/docs/default-source/Regulation/industry-market-sectors/Funds/UCITS/Guidance/170814_final-qa-edition-19.pdf?sfvrsn=2 (PDF 970.8KB)