The Evolving Regulatory Architecture: A Supervisory Perspective – Gerry Cross, Director of Policy and Risk

Speech delivered to the Banking & Payments Federation Ireland (BPFI) Conference on the Evolving Supervisory Architecture

Good morning ladies and gentlemen. I would like to thank the BPFI for the invitation to speak and for the opportunity to contribute a national supervisor’s perspective to today’s discussion.

The topic of supervisory architecture is an interesting and timely one, as there is a lot happening in this area at the current moment. Reflecting this, in my remarks this morning I will focus on a number of different aspects: the changing architecture within the Central Bank; developments in relation to Banking Union with a few comments about the risk reduction measures proposals; the effects of Brexit; and finally a few words about the ESAs reform proposals currently on the table.

Central Bank regulatory architecture

As you will be aware, just three months ago, on the 1 September, the Central Bank restructured our financial regulation and supervision functions. Whereas previously there was a single financial regulation pillar operating under a single Deputy Governor, the decision was taken to divide this into two pillars, a Prudential Regulation Pillar and a Financial Conduct Pillar, with the Deputy Governor Financial Regulation role now divided into two: a Deputy Governor Prudential Regulation and a Director General Financial Conduct. The titles are different only because of legislative constraints in this regard.

There were a number of reasons for moving to this new structure. The first was simply one of scale. This new structure better fits the scale of regulatory activity undertaken by the Central Bank as driven by post-Crisis and other developments. On the one hand the significantly increased levels of European engagement have been a major factor. The establishment of the Single Supervisory Mechanism (SSM) together with the expanded role of the European Supervisory Authorities (ESAs) - about which more later - means that the European dimension of the role – now roles – has become much greater than previously. At the same time, our move to a new model of assertive, risk-based supervision underpinned by strong enforcement means that the domestic aspect of the job has also become increasingly intensive. The change also reflects ongoing changes in the regulatory context in particular the need to enhance our focus in areas of conduct regulation over and above our longstanding focus on and commitment to consumer protection. This includes responding to the increased range of firms and activities that will be present in Ireland in the context of Brexit.

It is essential of course that these two pillars work seamlessly together in a highly integrated way. While prudential and conduct risks are different, they are both significantly interlinked. Conduct failings, for example, can give rise to fines which impact the financial position of a firm. And prudential weakness can provide a fertile ground for weak conduct controls. The relevance of governance issues and culture issues within firms to both aspects, prudential and conduct, and supervisory practicalities, all speak to the need for a very well joined-up approach. At the same time, both financial regulation pillars will be working very closely with the Financial Stability function which is located in the Central Banking pillar.

An important part of making sure that these objectives are achieved is the “One Bank” culture and approach that is now an embedded part of the Central Bank’s way of working. This is the approach which demands that, while we are organised into different pillars with a view to achieving a number of mandates, these pillars and mandates are complementary and co-dependent and as an organisation our structures and people need to reflect this joined-up concept. It is reflected in the behaviours and approaches we expect, and in the Bank’s governance structures, with key committees such as the Financial Stability Committee, the Financial Regulation Oversight Committee, the Policy Committee and the Supervisory Committee going across two or three of the pillars as the case may be.

As a further example, my own directorate, the Policy and Risk Directorate, supports both the Prudential Regulation and Financial Conduct Pillars and has dual reporting lines. This reflects the imperative that while we deploy sharp focus on both prudential and conduct supervision, we do so in a manner that is closely integrated and strongly coherent. Having a policy and risk function that goes across both areas contributes importantly to this outcome.

Banking Union – the evolving European architecture

It is now over three years since the commencement of the SSM and it is fair to say that we have come quite a long way. We in the Central Bank have noted with interest the recent European Commission stocktake Report to the European Parliament and the Council of the EU on the SSM. That report is, in the main, positive on the SSM’s performance to date, and we fully share that sentiment. We also tend to agree with most, if not all, of the Commission’s suggestions for improvements within the SSM in that report. This includes the Commission’s recommendation that intra-SSM networks populated by the ECB and the National Competent Authorities (NCAs) be afforded a clearer status to ensure their stability, influence and effective governance. This would be a valuable contribution as the SSM continues into the next phase in its development.

Evolution in the regulatory architecture also continues in the form of the new EU resolution framework. A key lesson learned from the last financial crisis was that banks were not resolvable without potential impact on financial stability or recourse to public funds. In order to enhance their resolvability banks needed to increase their levels of loss absorbing capacity (LAC) and, in many cases, make structural changes to their organisations – setting up holding companies for example. Significant progress has been made in Ireland and across the EU in this regard. However, a body of work remains to be completed. The resolution framework will continue to evolve through the risk reduction measures banking reform package and through the policy positions of the Single Resolution Board. The banking sector will need to keep pace and adapt accordingly.

The resolution framework was tested in the more recent Spanish and Italian resolution cases. Bail-in, which is seen as a key resolution tool underpinning the new framework was not used in these particular cases. It is important to move quickly to the completion of implementation of this aspect of the reolution framework. LAC needs to be brought to completion at banks to ensure that, should a resolution action be required, losses are absorbed by the shareholders and creditors of the bank. This concept is the foundation of the European resolution framework and, given its importance, it is critical that banks are informed of their minimum requirement for own funds and eligible liabilities (MREL) as soon as possible.

Turning to the third pillar of Banking Union, a European Deposit Insurance Scheme (EDIS), which has been buffeted by political headwinds since first proposed by the Commission in late 2015. Certain Member States have taken the view that a fully mutualised EDIS cannot be facilitated until further appropriate risk reduction measures have been executed within the EU regulatory framework and banking system generally. It was hoped that the November 2016 proposals to amend aspects of CRD IV and CRR would have gone some way to alleviating these concerns by, in particular, completing the implementation of Basel III in the EU. However, opposition to EDIS has persisted and is traceable to a broader array of concerns, not least legacy non-performing loans. It is against this backdrop that the Commission issued its October Communication on Completing the Banking Union wherein the Commission modified its approach on a fully mutualised EDIS. We in the Central Bank are currently reflecting on this. Our guiding principle remains the importance of the deposit insurance component to a completed Banking Union.

Risk reduction package

I have mentioned above the risk reduction package which the Commission put forward last year. We are pleased that an IFRS 9 capital transition will be available to institutions from 1 January 2018, and we look forward to political agreement being reached on the broader package as soon as possible. While timely progress is to be hoped for over the period ahead, there remain important and challenging issues to be resolved including MREL calibration, macro-prudential measures, FRTB implementation period and IPUs.

For its part, the Central Bank strongly supports EU implementation of the binding minimum Pillar 1 leverage ratio, with the aim of ensuring that institutions are not permitted to become excessively leveraged – a key learning from the global financial crisis. The Central Bank also strongly supports EU implementation of a binding net stable funding requirement, thereby establishing a harmonised standard for how much stable, long-term sources of funding institutions require; and of the Fundamental Review of the Trading Book (FRTB) proposals which are designed to address key weaknesses in the operation of banks’ trading books which were important contributors to the development of the financial crisis.

There are other elements of the Commission’s proposals where the Central Bank has some concerns. For example, the Central Bank is concerned that flexibility in Pillar 2 powers for competent authorities should not be undermined. Furthermore, the Central Bank does not consider that facilitating capital requirement waivers for subsidiaries of cross-border institutions is prudent, particularly given that Banking Union remains incomplete.

Separately, and as has been well reported, negotiations are ongoing at the Basel Committee on Banking Supervision to finalise the remaining prudential building blocks. This is aimed at finalising the prudential framework for our experiences during the financial crisis; including in terms of potential shortcomings in internal models.

While not directly represented at the Basel Committee on Banking Supervision, the Central Bank is strongly supportive of the efforts to reach an agreement. Having a completed international agreement in this area is of enormous value in terms of global financial stability and maintaining the benefits of cross-border banking activities. We very much hope that compromise can be achieved in the near future.

Brexit

Any discussion of evolution in the EU invariably leads to the topic of Brexit. I am conscious that the Central Bank’s position has been well articulated publicly at this point. Nevertheless, I would like to take the opportunity to address certain issues that I believe will be particularly meaningful for the audience today, first by continuing to discuss initiatives at the EU-level, and then turning to more Ireland-specific issues.

The Central Bank fully supports EU efforts to promote supervisory convergence in the context of Brexit-related decision-making. We continue to be actively engaged at the three European Supervisory Authorities (ESAs) and the SSM in relation to Brexit planning; and we are actively involved, via the ESA working groups and membership of the relevant Boards of Supervisors, in developing a common cross-sectoral approach to Brexit-related issues. We do this with the aim of ensuring that the Central Bank is both operating to European norms and influencing them – with respect to Brexit and otherwise.

All of the ESAs have now published opinions, and the SSM has issued FAQ guidance, on the approaches to be adopted in respect of firms relocating activities because of Brexit. In general, we are satisfied that these opinions articulate approaches which represent an appropriate combination of rigor and pragmatism. This is very important to us as it reflects the approach that we adopt in our dealings with the firms that we are engaging with in this regard.

As relocation activities continue, and such guidance is interpreted and implemented, I think that it is important to bear a number of principles in mind.

Amongst these I would mention the following: Although this particular work is taking place in the specific context of Brexit, actually what is being developed here in terms of approach will ultimately need to be more widely applicable. Assuming a hard Brexit, then the UK will become a third country. Therefore, the principles and how they are implemented and applied will need to be appropriate in the context of third countries generally. This is an important factor for all of us regulators to bear in mind.

Secondly, and let me be very clear about this: it is essential that any business authorised in Europe is subject to European norms and standards, is capable of being subject to effective supervision, and is capable of being resolved in the event of failure without losses being inappropriately or unfairly distributed. At the same time we should also be attentive to not unduly penalise the efficiencies and benefits that can be obtained from an entity being a part of an appropriately integrated international group. Diversification and risk management expertise, to mention two aspects, can bring important benefits both to local entities and to the economies that they serve. It is a question of getting the balance right. In doing so we should recognise that many of these issues are not new, even if they are being considered now in a new light.

Coming back to Ireland, from a regulatory and supervisory perspective, a primary concern is to ensure that regulated firms with direct or indirect exposures to the UK economy plan accordingly. We expect regulated firms across all sectors to consider, plan and adapt to the potential implications for their business models and revenue streams. Our engagement with firms to date shows that more work needs to be done to prepare for the very real potential scenario of a hard Brexit. 

It is difficult to overstate the importance of prudent preparation for the various foreseeable outcomes and, in particular for the risk of a hard Brexit. To this end, in November a number of in-scope banks received letters from the SSM Joint Supervision Teams in which the Central Bank participate, outlining the SSM Brexit Expectations and requesting detailed information on relevant aspects including activities in the UK, licensing, booking models, governance and risk management arrangements and outsourcing. The data is to be submitted for review in December. Similarly, on the LSI side, the Central Bank has been engaging with banks on Brexit preparedness and contingency plans. In October a letter was issued to the banks requesting up-to-date Brexit contingency plans which should include a Hard Brexit scenario and provide detail on potential Brexit impacts on business model and operations. LSI submissions have been received and are under review by supervision teams with the intention to revert to the banks in Q1 2018.

European Supervisory Authorities (ESA) Review

The European Commission has, as you know, recently put forward a legislative proposal for revision of the structure and mandate of the European Supervisory Authorities and the ESRB.

This is a proposal of much significance as you will all be aware. Time does not allow me to speak about this proposal in any detail today. So instead let me just set out a few principles or considerations that, from a regulatory perspective, I believe it would be helpful to apply when considering what changes should or should not be made in respect of the ESAs. And to be clear this is not an exhaustive list, rather a simply a number of important considerations.

Firstly: the European Supervisory architecture that was implemented post-crisis has been shown to be a good one. The ESAs have delivered strongly on their objectives on the basis of a good balance between centralised and local responsibilities. So, that should be the starting point: we currently have something in place that is working well.

Secondly: it is important to be very clear about the goals that we are seeking to achieve. That is done should be designed to enhance our achievement of financial stability, investor protection, and orderly, fair, and optimally functioning European financial markets - all in support of a sustainably growing economy. We need to be extremely clear about how any changes proposed will enhance these outcomes. If not, we risk that in respect of some areas where the current framework has delivered well we could see regress rather than progress.

Thirdly, while they have done some very good work in the area, not all of the ESAs currently have a consistent consumer protection mandate strongly embedded and clearly articulated in Level 1. There is need for a cross-sectoral approach in this regard. We are supportive of measures that would address this weakness.

We should be careful about easy but ultimately false comparisons in this area. For Banking Union a strongly centralised supervisory system is necessary in order to break the link between banks and sovereigns. In respect of capital markets union there is no similar imperative. It is important to bear this in mind when determining the best approach.

There are other important considerations, including the desirable balance between centralising powers and promoting convergence, which I do not deal with here. However, whatever the approach, it is very important that the integrity of the decision making process is strongly maintained in order to ensure effectiveness and appropriate accountability. It should be avoided to introduce fragmentation or uncertainty in this regard which leaves any doubt about the decision-making authority in the context of authorisations.

Conclusion

I will conclude here.

I would like to thank the BPFI again for the invitation to speak today and you for your attention.

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My thanks to Scott Hanson for his work on this speech.