“The spirit in the machine: considering evolving financial regulation” – Remarks by Gerry Cross, Director of Financial Regulation – Policy Risk, at the Compliance Institute

Speech delivered at Compliance Institute

Introduction

Good afternoon. I am very pleased to be here at the Compliance Institute today. Thank you for the invitation to speak with you.

Financial regulation and compliance are close siblings which have much in common; they are both about achieving the best outcomes by implementing – through design, engagement, oversight and enforcement - a framework of rules and guidance; they are both about doing so as efficiently as possible so that interference with the underlying enterprise is kept to the minimum; and, unfortunately, they both share the feature that they are at times misunderstood.

One of the ways they are misunderstood is that it is often thought that they are inevitably at odds with or running counter to the activities to which they apply. That they are a costly overlay on those activities, very often more burdensome than beneficial. In fact, done well, the function of both is to support those activities in an efficient way and render them fit and sustainably successful over the medium and longer term.

Effective regulation supporting economic activity

The role of financial regulation is to help ensure that the financial system works well. That it works effectively to support a sustainable, well performing economy and the economic wellbeing of citizens. At the Central Bank of Ireland, we do this in three main ways: by securing financial stability; by ensuring that the financial system operates in the interests of the consumers and users of financial services and of investors, including through the orderly functioning of markets; and by requiring firms to address the risk that their services are used for money laundering or other criminal purposes.

Importantly, these three components of our mandate contribute to the effective functioning of the financial system not simply by the fact that they are delivered upon, but also by the manner in which they are delivered upon. In other words, success for a regulator depends not just on what we do, but also on how we do it. For example, regulation brings with it costs – both direct and indirect – which can reduce the overall efficiency of the market if misjudged, therefore we need to make every effort to ensure that the benefits of our regulatory interventions clearly outweigh the costs.

One of our regulatory objectives at the Central Bank is the orderly and proper functioning of financial markets. Well-functioning competition, innovation, and a flow of new entrants are important for the effective functioning of financial markets and beneficial and necessary to delivering the best outcomes for consumers and users. So our regulatory activities and processes should strive to be consistent with these features.

Proportionality is a further important feature of high quality regulation. In developing our frameworks, and in implementing them, it is important that our actions are aligned with, but do not go further than is necessary to address, the goal that is being targeted. Moreover, it is important to take account of the scale and complexity of the different types of firm or individual who will be subject to the regulation. What is required of a large systemic financial firm is likely, in many cases, to be different from what is expected of a smaller, less risky, small firm or sole practitioner.

Achieving a positive regulatory dynamic

It is often suggested that regulation and compliance are focused on the letter of the law and the punctilious application of precise normative strictures, rather than on the substance and achieving the right outcomes. Less frequently, it is suggested that they are too much about the spirit of the rules, and that this provides insufficient certainty and predictability. The truth, and the optimal approach, of course lies somewhere between these two perspectives.

A letter-of-the-law approach, without having ongoing regard to the intention or spirit of the rules, can lead to dry and artificial outcomes that are likely to be both inefficient and ultimately leading to disrepute.

As the title of my comments today – “the spirit in the machine” – suggests, regulation, and I believe compliance, are about the positive dynamic, inherent in any body of rules and regulations, between the spirit and the letter. Regulatory rules derive from an intention to deliver some public interest benefit - their sprit if you like. In order to give effect to this intention, we seek to capture it in a clear articulation of language as to what should be done, or should not be done, and how. This normative articulation is as important as the intention itself. Good regulation requires both an equilibrium and a productive tension between the letter and the spirit of the law. Each should inform and constrain the other.

Regulation is continually evolving. Success in a changing and competitive world requires that it evolves steadily and well to respond to a changing environment to deliver positive outcomes for consumers, for businesses, and for the economy. A significant contribution to success in this regard – combining stability and progressive change - is the creation of a positive feedback loop between regulatory intention and its normative articulation, the ongoing iteration between the spirit and the letter of the law.

As you know, the Central Bank has recently published our new multi-year Strategy designed to ensure we can meet the challenges of a rapidly changing financial system and deliver on our mission and vision. The Strategy has four connected themes: safeguarding; future-focus; open & engaged; transforming. We will continue our central role to safeguard the public interest in line with our mandate. We will do this while being future-focused so that the benefits of change and innovation for consumers and the economy can be realised; and open and engaged so that what we do is both fully informed and better understood. Like all successful organisations we will be focused on continuing to transform ourselves to be better at what we do and how we do it.

Individual Accountability

In July 2021 the Department of Finance published the General Scheme of the Central Bank (Individual Accountability Framework) Bill 2021. This proposed legislation is aligned with the behavioural, cultural and regulatory objectives put forward in the Central Bank’s Report into the Behaviour and Culture of the Irish Retail Banks.¹

Subject to the legislative process, it can be expected that the Bill will be enacted into law during the course of the months ahead. At the Central Bank we have been working in parallel on the regulations and guidance which will complete the new framework. It is our intention to publish the proposed Central Bank regulations for consultation very shortly after the finalisation of the legislation.

The Framework is fundamentally about underpinning good conduct and high quality governance and culture within firms. It is about being clear who is responsible for what and ensuring that reasonable steps are taken to fulfil those responsibilities. It is aligned with what will already be sound practices at well-governed and organised firms. The framework is, and our approach to implementation of it will be, firmly founded in proportionality and what is reasonable.

Similar to my earlier comments on the spirit and letter of regulation, an interesting feature of the proposed IAF is the dynamic that exists within it between substance and form. On the one hand the requirements for responsibility maps; the application of different responsibilities to different senior roles (CEO, CRO, CFO etc.) appear to involve a considerable degree of formalism. On one level it appears to be about a focus on the form of things. On the other hand, we know that at the heart of the framework are very important substantive goals.

During the consultation exercise undertaken by the Department of Finance, this interface between substance and form gave rise to a number of questions. It was asked, for example, what will happen when one Senior Executive (PCF role-holder) under the regime reports to another. It has also been asked whether there is risk of so-called “juniorisation” – where a formal title is applied to a less senior executive while the more senior person seeks to stay out of the regulatory picture – and if so how the regime will cope with this? In a similar vein we have been asked about the outsourcing of senior executive roles.

The answer to all of these questions is that while the new framework does have its heart the responsibilities of different senior manager roles, it is focused on the substance of those roles and not their titles. Fundamentally, it is about substance, not form.

Take the case of so-called “juniorisation”, where a more senior executive attempts to hide behind a less senior executive by the latter being given the formal role title, with the more senior person actually making the relevant decisions. In this case, the more senior executive will be identified as the person actually carrying out the role, and therefore deemed to be the role-holder and to hold the relevant responsibilities under the framework.

Let’s take the question of one PCF role holder reporting to another. Again there is no difficulty with this under the regime – provided one takes a substance-based approach. Take for example the CEO and the COO: both will be individually accountable - the COO for the inherent and prescribed responsibilities of their role including their reporting responsibilities to the CEO; and the CEO for the broader responsibilities of their role including how they discharge their management and oversight responsibility towards the COO. The fact that the COO reports to the CEO would not absolve the COO from their role specific responsibilities and the related individual accountability.

Or again on the question of outsourcing. The Bank of course recognises the value well-managed outsourcing can bring to the effective and efficient functioning of financial firms and the market. Indeed we have recently finalised our Cross Industry Guidance on Outsourcing² following a detailed consultation process.

In the context of SEAR, to ensure transparency and accountability, the Bank expects that where outsourcing arrangements are in place then there will be a Senior Executive Function in the regulated firm with responsibility for outsourcing arrangements. Moreover, the outsourced role-holder will fall under the oversight of a PCF role holder within the entity. This will need to be reflected in the relevant Statement of Responsibilities and Responsibility Maps. This will ensure that the overall responsibility and related individual accountability is retained within the regulated firm.

One final area where the importance of the substance-based approach of the Individual Accountability Framework is very important is in the question of the interaction between individual and collective responsibilities within a firm. In developing the IAF, we have been focused on enhancing the quality of overall governance, accountability, and decision-making within firms. One challenge has been to ensure that in enhancing individual accountability, the framework does not undercut collective responsibility and decision making within the firm. Collective and individual responsibility should be complementary, mutually reinforcing aspects in the high quality governance of firms. The new framework is designed to ensure that they are.

The proposed framework therefore retains the existing accountability requirements for the collective actions of firms and includes effective participation in collective decision-making as a component of individual accountability. In terms of expectations of individuals, and their role in collective decision making, these have been reinforced. The continued expectation that they participate appropriately in collective decision making, actively challenge and exercise sound judgement, ensuring that all such decisions are robust and properly informed, is now integrated in the framework of individual accountability.

Consumer protection

During 2022 we are planning to publish a Discussion paper on our review of the Consumer Protection Code. It is now fifteen years since the Consumer Protection Code was originally introduced. It has been a central pillar of the protection of consumers during this time. The Code sets out the general principles that are at the heart of ensuring that the interests of the consumers and users of financial services are properly served and protected.

They include acting honestly, fairly and professionally in the best interests of its customers and acting with due skill, care and diligence; ensuring that the customer has high quality information as to the product or service that they are being offered; avoiding conflicts of interest; etc.

These general principles are then further filled out in the detailed sections that make up the body of the code. Importantly however, these general principles stand on their own merits. They do not require for application and enforcement the details contained in the subsequent chapters of the Code.

In our review of the Code, we will consider the evolution of the code since it was introduced. We will reflect on the significant impact of developments in EU consumer protection legislation in this period. We will examine the current context of rapid technological change and innovation and consider how consumer protection needs to adapt to these changes.

We intend to use the opportunity of the Code review to engage in a wide-ranging dialogue with stakeholders – including both the consumers and users of financial services and the financial industry which is subject to these requirements – on the state of play in financial services consumer protection in Ireland at this point in time.

As part of our multi-annual strategy, we indicated that we intended to enhance our openness and engagement on the wide range of issues that falls within our mandate. As a first step we propose to issue a Discussion Paper on a range of key aspects of consumer protection towards mid-year. This will also form a central topic at our first Financial Services Conference which we will hold in the second half of the year.

Differential Pricing

Let me say something now about differential pricing. In July we published our final report on our investigation into the practice of differential pricing in the home and private motor insurance market. We also published a Consultation Paper on our proposed response to the practices that we identified in this area. What we found were widespread practices whereby insurers have been increasing the cost of customers’ premiums simply by virtue of the fact that they are customers who have been with them for a number of years. Counter to what might be the legitimate expectation of a customer that by proving themselves to be a good customer, a loyal customer, their premiums would reduce taking due account of their overall riskiness, in fact the reverse has been happening. Insurers have noted this loyalty and taken covert advantage of it to charge the customer more on renewal.

In our final report and consultation paper we made clear that this practice – the practice of price walking – because it takes undue advantage of customers’ behaviours or habits - is unacceptable. We indicated that we planned to ban the practice and that this ban would be introduced from July this year. To support positive competition in the market, beneficial to consumers, we have proposed that new customer discounts should continue to be permitted subject to clear and informative disclosure to the customer.

We received a significant number of responses to our consultation – for which we are grateful. Largely these responses were supportive of our proposals. We will be publishing our Feedback Statement and final draft regulations in March very much in line with our original proposals.

Amongst the comments that we received were requests for the implementation date to be postponed by a further 6 or 9 months. We were also asked for clarification as to the scope of application of the proposed ban.

It is important to state that in the context of our proposed prohibition on price walking we have identified behaviour which is inconsistent with the interests of firms’ customers. It goes against their interests. It is a practice which firms should not be engaged in. This is different from other areas of regulation where we might propose changes to enhance the performance of the system, to increase resilience, to provide for enhanced disclosure etc. Here the proposed measures are designed to bring an end to harmful practices.

There is accordingly a degree of urgency about it. We made clear in our consultation paper that we planned to introduce the prohibition from July this year. For the reasons I have outlined, relating to the importance of stopping this harmful behaviour as an urgent priority, we will be sticking to this timetable. Firms should accordingly continue with their work to complete the necessary adjustment to their pricing models by the July deadline.

In our consultation paper, we indicated that the prohibition on price walking would apply to personal consumers in the area of house and private motor insurance. We do not intend to extend this more widely at this stage to other forms of insurance. This is because the harm that we have identified manifests predominantly in areas of insurance activity which are based on high-volume business models with pricing driven largely by model outcome rather than commercial negotiation.

We want to ensure no consumers of motor and home insurance are unprotected. For instance we will clarify that the ban will include will include coverage for personal vehicles such as motorbikes, and campervans; motor products sold to a sole trader, such as a plumber or florist, where they use a van or ‘light commercial vehicle’; and home insurance that relates to a holiday home, a buy to let property or a mobile home - as distinct from commercial property.

Mindful of the need to ensure proportionality and predictability, we will also provide guidance making clear that where a policy is offered by a firm only through a commercial negotiation – as distinct from the context of a high volume, model-based output - and where price walking is therefore not embedded in its approach, it will be reasonable for the firm to consider that no further action is required.

Finally, as regards automatic renewals of insurance policies, we will be confirming our proposal to require enhanced information and more effective opportunity to switch providers. On the question of moving from and “opt-out” approach to an “opt-in” approach, we are proposing not to include this requirement now, but to consider the issue further in the overall context of the Consumer Protection Code Review.

Conclusion

Ladies and gentlemen, let me conclude here. My theme has been “the spirit in the machine”; that is the fact that financial regulation, like compliance, is always a dynamic interaction of intended outcome and textual elaboration, of substance and form. The challenge for good regulation is to keep these aspects in strong equilibrium and to create a positive feedback dynamic so that regulation evolves in a timely and high quality way to change and innovation and to lived experience. I have discussed the areas of Individual Accountability, Consumer Protection, and Differential Pricing as examples of areas where this dynamic can be seen.

Thank you for your attention and I look forward to your questions.

Thank you for your attention.

¹ Central Bank’s Report into the Behaviour and Culture of the Irish Retail Banks

² Cross Industry Guidance on Outsourcing (PDF 1.4MB)