Regulatory challenges in the “New Normal” - Gerry Cross, Director of Policy & Risk

Speech delivered at the FIBI International Banking Conference

Good morning. I would like to thank the Federation of International Banks in Ireland for the invitation to speak to you today.

This conference on the new normal of international banking is certainly timely. 

The ‘old normal’ was characterised by political stability, a long period of low macroeconomic volatility, sustained economic and productivity growth, and historically (and unsustainably) low risk premia. All this coming against a background of, and contributing to, a propensity for light-touch regulation. 

If we have left the ‘old normal’ behind us, then what may be said to characterise the ‘new normal’ is significantly elevated levels of uncertainty. Uncertainty which gives rise to challenges across a range of key features of the financial services and international banking landscape.

The role of regulation

Against this backdrop uncertainty let me start with a question that we get asked from time to time: “what is the role of regulation in all of this? Is there a point at which regulation becomes part of the problem rather than the solution?”

It is important to be clear about the purpose and objective of financial regulation. If we lack clarity about this then at best we will be talking across purposes. At worst we will be arriving at suboptimal outcomes.

At the Central Bank of Ireland, we have three objectives in respect of our financial regulatory work: financial stability, consumer protection, and "the proper and effective regulation of financial service providers and markets"¹.  Quite a bit has been said about the first two of these three objectives. Maybe a little less about the third. I did discuss the latter in a recent public talk at the University of Limerick. Let me pick up again now here some of the threads of that discussion. What does it mean to deliver "proper and effective regulation of financial service providers and markets” and how should we recognise that? 

Unfortunately, the Central Bank Act 1942 does not provide a description of what “proper and effective” means in practical terms. 

What it does not mean is regulating so tightly and conservatively that no firm ever fails and no investor ever suffers losses. Therefore, it must mean something like regulating financial firms and markets effectively and well so that they can fulfil their role in supporting an effectively functioning economy.

As we have a market-based system of financial services provision, it is important that that market functions well. This means that the pricing of risk must be effective. It was the mis-pricing of risk that was at the heart of the financial crisis. 

For financial firms and markets to function effectively, it is important that regulatory requirements are well-calibrated. If they are too lax then risk will be mis-priced and somewhere along the way problems will emerge. If they are too conservatively calibrated, then while the risk of failure may be further reduced this will be at the cost of pricing financial services at such a level that the market no longer functions as effectively as it should. This is an important factor. Increased safety comes at a price; it is the job of the regulatory authorities to make sure that this price is not so high that we get a very, very safe system but at the price of a reduction in economic activity that taken as a whole is sub-optimal. 

Finalising the post-crisis framework

At the Central Bank we consider that taken as a whole, and as a set of individual measures, the regulatory reform that has been developed after the global financial crisis is very much in line with this objective. In November the European Commission put forward its proposals for a directive and regulation amending CRD IV and CRR. We are pleased to see that progress has already been made in the Council of the EU negotiations, not least in relation to IFRS 9²,  and we look forward to political agreement being reached on the broader package as soon as possible. 

In particular, the Central Bank strongly supports EU implementation of a binding minimum Pillar 1 leverage ratio of 3%, 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. 

There are other elements of the 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 is not convinced that facilitating capital requirement waivers for subsidiaries of cross-border institutions is prudent, particularly given that Banking Union remains incomplete. 

Looking forward, 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 in this area. 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 so that at least this one element of uncertainty can be removed.

Fintech

Independent of regulatory and political forces, the shape and operation of the financial system will continue to change. Technological innovation is one of the most prominent of these disruptive forces in the “New Normal” environment. Governor Lane has recently spoken about this.³

With disruptive innovations coming from a host of different areas such as distributed ledger technologies; peer to peer lending; robo advisors; innovative trading platforms; digital wallets; amongst others, financial services firms business models – how they interact with their customers and the products and services they offer - could change significantly in the coming years.

Such innovation poses challenges both for regulated firms and for supervisors. We don’t yet know whether such innovation will at one point or other give rise to a paradigm shift, or whether it will rather manifest as a context of accelerating but incremental change. Either way, it requires financial firms to pay close attention to their business models and to their manner of functioning to ensure that both remain relevant both for now and for the period immediately ahead.

For regulators, fast evolving financial technology presents a range of challenges. These challenges go across all of our mandates. Take our consumer protection mandate: we need to ensure that rapidly evolving technology does not undermine, and potentially enhances consumer protection. To take a simple example, many of us “press accept” for new terms and conditions with such speed and lack of attention to what we are agreeing to, that there may be increased challenges in ensuring that consumers fully understand financial products that they are purchasing. The Central Bank will in the coming period issue a Discussion Paper on the implications of technological innovation for consumer protection.

We also have the challenge in seeking to ensure that regulated firms remain well run and financially sound as they grapple with rapidly changing technology. This means that we want to understand what the introduction of new technologies means for the risk profile of a firm and how that is managed and what competition flowing from new developments means for the sustainability of firms’ business models.

Innovation in financial technology also poses other challenges for us. On the one hand we have a mandate to ensure that financial services that require to be regulated are not being carried out by unregulated persons and firms. This is a challenge because it is possible the innovative service providers, coming from a different context than we have seen in the past, may not even know that they are required to be regulated. At the same time, innovation is a key part of a well-functioning market. Heavy handed requirements or the not-well-calibrated application of those requirements can act as a restriction on such innovation. So for regulators, getting the balance right between an approach which ensures that consumers are appropriately protected and at the same time is well-judged and proportionate is an important challenge. 

To help us address these challenges, as well as the many actions that are being taken day to day and week to week across our different divisions and teams, within the Central Bank we have set up a fintech working group. This brings together people from across our different areas which seeks to ensure that we are joined up across the organisation in our thinking on these matters. This will help us to maintain a good sighting on the developing landscape, to engage with stakeholders, and to ensure that we have a joined up, consistent, and well-considered approach.

Brexit

Finally, let me say a few words about Brexit. Time is short and we can discuss this further during the panel session. So let me just focus on one important question here. That is the issue of relocation of activities from the UK and in particular what has been happening across Europe to ensure that decisions are not made on the basis of regulatory or supervisory divergences, also known as regulatory arbitrage.

By way of background, let me say that at the Central Bank we continue to see significant levels of engagement from firms who are considering relocating some of their activities from the UK in the context of Brexit. Firms have rightly been adopting the approach of planning for the worst even while hoping for the best. We expect to see firms making their decisions on this matter in the coming period. 

One of the major issues that has come to the fore over the recent period is the question of “substantive presence”. This is the question of how much of its activities a firm needs to carry on from a particular jurisdiction in order to be able to ask to be authorised there. 

There have been considerable concerns that different jurisdictions would take different approaches to this very difficult question with the result that firms would make their decisions based on regulatory differences rather than for the reasons that they should be focusing on – questions such as best fit with business model, accessibility, cultural and legal fit, workforce preferences, etc. 

At the Central Bank we have been very actively engaged with European Authorities – the ECB / SSM and the European Supervisory Authorities – encouraging them to, and then closely engaging with them as they, address this issue. 

Very good progress has been made. The SSM has issued guidelines on a range of issues. ESMA has issued guidance in the form of a General Opinion. EIOPA has carried out site visits to different national authorities. In the coming period we can expect to see further developments, in particular further guidance from the different authorities. This is very good news. Combined with approaches seeking to ensure that the guidance is well implemented it should significantly reduce the risk of regulatory arbitrage.

As this work is taken forward, the Central Bank considers it important that a number of aspects are adhered to.

Firstly, the authorities should continue to adopt an approach which combines pragmatism with appropriate rigour. Brexit is an exogenous occurrence that financial firms have to deal with. Worst-case time constraints present significant practical challenges for all us – for firms, for regulators, and for the wider economy. It is important therefore that we regulators adopt an approach which incorporates a degree of pragmatism and outcomes focus to the extent that that is appropriate and in line with our mandates. At the same time there must be no lowering of standards. That would lead us down a road of regret.

Secondly, in developing guidance, it is important that the authorities do not stray beyond the framework currently established in Level 1 legislation. The single market and how it functions and the rules around its interactions with third countries have been established by the Co-Legislators – the European Commission, the European Parliament and the Council. In the highly valuable work to drive convergence in this area, we should be careful to stay within that dispensation. 

Conclusion

Let me finish here. A well-functioning financial system is a prerequisite for sustainable economic growth. High-quality regulation and supervision are essential to achieving this. 

In an overall context of significant uncertainty, the Central Bank of Ireland remains committed to providing as much clarity, consistency, and predictability as possible in respect of our regulatory and supervisory approach, including our approach to such issues as Brexit, financial innovation, and regulatory reform.

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¹ Article 6A of the Central Bank Act 1942.

² http://www.consilium.europa.eu/en/press/press-releases/2017/06/16-banking-creditor-hierarchy-ifrs9-proposals/

³ https://www.centralbank.ie/news/article/drivers-of-change-in-the-banking-sector-speech-by-governor-philip-r-lane