Financial Regulation in support of the economy and economic wellbeing - Speech by Gerry Cross, Director Financial Regulation - Policy and Risk, at the Business and Finance FS Leaders Summit

Good morning. It is a pleasure to be with you. Many thanks to the FS Leaders summit for inviting me to speak today.

Financial regulation plays a significant role in the functioning of the economy and in the economic wellbeing of citizens. Today I want share some thoughts about how we should think about financial regulation. How we should consider its objectives. And how we should go about achieving them.

It is perhaps a good moment to think about this 10 years after the bank-driven economic crisis that hit Ireland at the start of the last decade. And at a moment when the financial system is changing significantly and financial regulation is evolving to respond to those changes. We are at a moment of rapid and significant technological innovation with all of the benefits that that can bring but also challenges. And we are facing the key challenge of funding the transition to a carbon neutral economy. It has never been more important to get financial regulation right.

I will make my comments under two headings. Firstly, the role of financial regulation; and secondly, the techniques of good financial regulation – that is the approach to financial regulation that supports the achievement of the best outcomes.

The role of financial regulation

A first important thing to say is that financial regulation is about supporting positive outcomes. It is there of course to prevent abusive behaviour by financial firms and to avoid crises and instability. More broadly however it is there to ensure that the financial system operates in a manner that supports the effective – and of course sustainable – functioning of the economy. And that contributes significantly to the economic wellbeing of citizens.

As Governor Makhlouf has set out in his foreword to the Central Bank’s recently published Strategy¹ and referring to our founding legislation, the Central Bank’s constant and predominant aim shall be the welfare of the people as a whole. This translates to our mission to serve the public interest by maintaining monetary and financial stability while ensuring that the financial system operates in the best interests of consumers and the wider economy.

Our Strategy

Indeed our Strategy, which lays the foundation for how we will prioritise our work over the next five years, contains much that is relevant to my topic today. It identifies four strategic themes for the Central Bank. Safeguarding: that is the fulfilment of our mandate to maintain price stability and financial stability and to ensure that the interests of consumers are secured. Future focused: in a world of rapid change we seek to understand the dynamics of change and to carry out our work in a manner that allows the benefits of such change to be realised while the risks are managed. Open and engaged: we will enhance our engagement with the full range of our stakeholders – citizens, consumers, and businesses including both those that we regulate and those that we do not. We want to improve the quality of our discussion with them so that can better understand their challenges, concerns and perspectives and better explain our approach and what we are doing. And, fourthly, Transforming. We will change the way we operate to keep up and be successful in a changing world. We will be focused on being more agile, enhancing our skills and capabilities, and making even better use of technology.

Market failure

In Ireland and Europe, as elsewhere, we operate a market based economy. The central benefit of a market based economic system is that it allows for the allocation of financial resources to those economic activities where they add the greatest (economic) value. However as we know only too well markets are also subject to very significant weaknesses and failings. And that is why they are subject to a significant overlay of rules and requirements designed to ensure that these weaknesses and flaws are managed and remedied and that final outcomes are in line with society’s expectations as determined by the legislature under the Constitution. The key role of financial regulation is to address the weaknesses and failings that markets exhibit and to ensure that requirements are applied which mitigate or even eliminate the effects of such failings.

Cost internalisation

Let me give two important examples of market failures that it is the role of financial regulation to address. The first is risk- or cost-externalisation. This occurs when economic actors can achieve benefits based on certain actions but where the risks or costs of those actions are borne by others. To take a simple example: where a financial firm takes on a lot of risk, say through the warehousing of large amounts of subprime mortgage securitisations. If all goes well, the firm will make a large profit on the transactions. If things go badly however, though the firm will take a loss and may even fail, the shareholders will at most suffer the loss of their capital investment. But society may suffer significant impact and loss through an event of financial instability.

Similarly, if a bank carries out too much maturity transformation – too much short term funding of long term exposures - then to avoid losses to depositors, the central bank may need, if things don’t work out, to step in to provide support, again at a cost to society.

What financial regulation seeks to do in these cases, by for example the imposition of capital and liquidity requirements, is to ensure that financial firms internalise the costs of the risks that they would otherwise be imposing on others. In other words, regulation seeks to ensure that in making their investment decisions, firms are forced to take into account not only the risks to themselves but also the risks they impose on others.

This is also a good example of the important synergies that come from the different aspects of our mandate. The cost internalisation achieved by capital and liquidity requirements serves both our “macroprudential” objective to ensure the ongoing stability and resilience of the system as a whole; and our “micro-prudential” objective to secure consumers interests by requiring individual firms to be well managed and run. You can also observe this complementarity in our approach to the non-bank sector where the traditional investor protection approach to funds regulation is being enhanced with a macroprudential approach which builds on the existing approach. For further insights on our approach to macroprudential regulation, see the speech of Governor Makhlouf of 8^th November on the topic.²

Addressing Asymmetries

A second example of market failure is to do with information asymmetries. Markets work effectively in deploying resources to where they are most useful on the basis of an assumption of full information. If the relevant parties are “fully” informed this role can be well fulfilled. If they are not, then overall outcomes are likely to be suboptimal. Where one party is better informed than another, and is able to take advantage of that imbalance, then the results will not only be suboptimal but they are likely to be unfair. And even more so where information asymmetries are compounded by power asymmetries – where one party has less stake, sees fewer relative risks and benefits associated with a transaction than the other. And if a system is seen to deliver unfair results systematically then it will become distrusted and ineffective in achieving its objectives.

So then, these are two very important market failures that financial regulation is designed to remedy – cost and risk externalisation and information asymmetry. And there are of course others – the tendency for credit cycles to veer towards boom and bust dynamics; the principal-agent relationship which can lead to the management function in financial firms operating the firm more for their own benefit that for the benefit of stakeholders; the risk of the financial sector being used to facilitate financial crime; etc.

In this regard, it is useful to mention the objectives of the Central Bank of Ireland in relation to financial regulation as they have been set out in our recently approved Supervisory Risk Appetite statement. These are:

• To maintain the stability of the financial system
• To promote high levels of trust and confidence in the financial system via proper and effective regulation of financial service providers, such that:
  • Inappropriate losses are not incurred by users of financial services (where “inappropriate losses” broadly means losses that could not reasonably have been anticipated as a risk that was being taken)
  • Customers are treated fairly and consumer and investor interests are protected
  • The system is not abused for money laundering or terrorist financing purposes
  • The system is governed and managed by individuals who behave in a manner consistent with our standards of fitness and probity
• To pursue the orderly and proper functioning of financial markets

Competition and innovation

For markets to be effective there is a need for there to be adequate levels of competition between firms operating within that market. Financial regulation is not competition regulation, which operates separately and with a different focus. Nonetheless financial regulation can be relevant to the functioning of competition within the regulated sphere. This is an aspect to which it is important to have regard in determining regulatory approaches and requirements.

This aspect comes to the fore in the context of technological innovation and the ongoing rapid change in the way in which financial services are provided to consumers and businesses. For many of these technologically innovative firms, regulation might be something that they perceive as inhibiting their efforts to transform aspects of financial services. So how should a financial regulator consider this aspect? In summary, I would say that the role of a regulator is to create the regulatory context in which the potential benefits innovation for consumers, businesses and society can be realised, while the risks are effectively managed.

It is in this spirit that we have for example operated our Innovation Hub over the past four years. The Hub is a facility whereby we can engage in an open and informal way with tech innovators and they with us. During this period, the Hub has allowed us to have a great deal of engagement with innovating firms and individuals. We have learned and gained a lot from these engagements. The feedback we have obtained indicates that those that we have met through the Innovation Hub have also found the process a valuable one.

In the area of payments we see clearly the dynamic of rapid innovation bringing significant potential benefits for consumers as a result of competition from “disruptive” new firms and business models. And we see also the challenges and risks associated with this dynamic of rapid growth - for example in the area of cryptoassets. It is our goal as financial regulators to strike the balance which allows the benefits to be realised while ensuring that the risks are managed and mitigated.

Differential pricing

A good example of how at the Central Bank of Ireland we have balanced competition considerations in the development of financial regulation can be found in our recent proposals on pricing practices by insurance firms set out in our Final Report and Consultation Paper on Differential Pricing.³

Under our proposals to eliminate price walking or stealth pricing in the insurance sector, we spent a long time looking at the practices of non-life insurance firms in relation to the pricing of policy renewals for existing customers. What we found was that to a material extent renewing customers are charged more year-on-year for their policies for reasons other than the cost of, or risks associated with, the provision of that insurance.

This seemed troubling to us. We were told however that this is the pricing that the market will bear; customers are always free to change insurers. However, the provision of financial services is a business, which depends heavily on trust. Customers need, and have a right, to expect that financial firms will act in their best interests. They often feel that they are dealing with complex, difficult to understand, risky matters. This makes it difficult for them to engage as fully informed, freely moving participants in the market. For this reason, our Consultation proposes to prohibit the practice of price walking in the areas of motor and home insurance.

However, we also noted the benefits of competition to consumers in the motor and home insurance markets. A valuable aspect of this, it seems to us, is the ability for insurers to attract new customers with appropriately managed, well-explained price discounts. Accordingly, we are proposing to maintain the ability of insurers to offer these new customer discounts – so long as they flag clearly that this is a first year discount and that the renewal premium can be expected to be materially higher, with the amount of the renewal premium on a like-for-like basis being indicated. So here, in relation to our price walking proposals, you see a good example of how our regulation seeks to correct for market failures while supporting high quality competition within the relevant market.

Techniques of good regulation

The second aspect that I want to focus on are what might be called the techniques of good regulation. What mechanisms should we use to maximise the likelihood that we will achieve our objectives? Let me mention a few of them.

Clear objectives

Firstly, clarity as to the objective(s) of any given piece of regulation. It is important to be clear about the objective of any particular proposed regulation. This may sound like it is rather straightforward, but it is not always the case that it is. While there may be a generally shared view that it is a good idea to regulate in a particular space, there may be much less commonality of view as to what precisely it is that is sought to be achieved. Moreover as regulation goes through development and negotiation, the compromises arrived at in order to maintain progress can also add to the lack of clarity as to what precisely it is that is sought to be achieved. And to be clear any piece of regulation may have a number of different aims. But the achieve the best outcomes it is valuable to be clear about what the aims are and what aspect of the regulation is designed to achieve which aim.

A good example of this perhaps is the bonus restrictions that were introduced for bankers’ pay under the capital requirements directive in the wake of the last financial crisis. From the legislative process, it can be seen that there were at least three complementary aims of this regulation:

One important objective was restricting the degree to which bonus payments in the financial industry gave rise to undue and potentially dangerous levels of risk taking.

A second was to foster change in the culture of the banking sector deriving from high levels of bonus that traditionally prevailed and which gave rise to behavioural, reputational and wider distributive concerns.

And a third objective was to address the wider problem that was perceived to arise from the fact that highly qualified professionals were disproportionately attracted to working in the financial sector at the cost of other sectors of potentially greater value add.

All of these are wholly legitimate aims. The point I want to make is that in deciding on and considering the content of such legislation there is great benefit in being clear about which aims one is targeting in order to arrive at the best regulatory solution.

Predictability

Such clarity is important in itself. But also so that the regulation can meet the other hallmarks of good regulation. These are firstly that it is coherent and consistent having regard to the general framework of regulation in which it is set. And that there is therefore appropriate levels of predictability as to its interpretation and implementation by regulators. This is important if market participants are able to internalise and implement these regulatory requirements in an orderly manner, to a reasonable timescale, and without undue disruption to their business activities.

Proportionality

Clarity as to the objectives is also necessary to ensure proportionality. Proportionality requires that any piece of regulation is effective to address the harm or failing to which it is addressed but is no more intrusive than is necessary to achieve the particular aim. If it does go further than is needed then it begins to have a distortive effect and can itself contribute to suboptimality of outcomes. In considering proportionality, 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 to is likely, in many cases, to be different from what is expected of a smaller, less risky, small firm or sole practitioner.

In order to achieve the goals of good regulation there are two further techniques that are important to be adopted in the development process.

Costs and benefits

The first is an effective consideration and weighing of the costs and benefits of the proposals. Understanding the likely costs that will follow from any given proposal so that that they can be weighed against the likely benefits is an important exercise in helping to achieve optimal outcomes. Cost benefit consideration is an important discipline – but it can also carry risks if it is not done well. It can carry the risk of regulation falling short of its mark if the quantitative measurability of costs against the less numerically calculable benefits is permitted to skew perspectives too much to the avoidance of those more calculable costs. And it can result in regulatory overreach if the wider and longer-term benefits of any particular proposal are considered to be somehow self-evidently valuable to achieve as they must surely be greater than any narrowly calculable cost. Cost benefit consideration should therefore be considered as a disciplining approach, not per se determining outcomes on some technical measurement, but as delivering a more clear-eyed perspective on the trade-offs involved in any particular proposed regulatory intervention.

I have mentioned already our current proposal on price walking in insurance. Behind this proposal lies a significant amount of analysis – including in relation to relevant market functioning, pricing practices, and consumer experiences – and including statistical and survey methodologies – to provide a significant cost benefit underpinning for these important proposals. Moreover, as this is an area of some dynamic complexity, it is proposed to maintain continuing analysis to verify how relevant parts of the non-life insurance market continue to evolve in the context of this proposed regulation.

An area where cost benefit consideration may be considered to have achieved a very high level of specificity is that of capital requirements for banks. Starting with the Quantitative Impact Studies of the Basel Committee in the context of the development of Basel II and continuing with, for example, the ongoing impact monitoring work of the EBA, proposed and implemented prudential requirements are subject to close and rigorous quantitative assessment to be set against the benefits of additional financial stability that they can be expected to deliver. So for example, the input provided by the European Banking Authority on the implementation of the final components of the Basel III framework was accompanied by a highly detailed impact study setting out the likely costs of the implementation. In this regard I would note that, while we are still considering the recent “Basel III final” proposed regulation by the European Commission, it seems that the overall costs to banks across Europe from this “Basel III final” proposal while not immaterial are outweighed by the important benefit of ensuring that required resilience is not undermined by banks’ relying on their own capital calculation models to excessively reduce capital levels. As far as the Irish domestic banks are concerned it appears that in absolute terms the impact will be quite proportionate, while in relative terms to other European banks it will be not unfavourable.

Stakeholder engagement

Finally, a further essential component of good regulation is high quality stakeholder engagement. The Central Bank’s new Strategy which I referred to earlier has as one of its four strategic themes that of being Open and Engaged. Understanding and engaging appropriately with the perspectives and concerns of the users and consumers of financial services, of those participants in the economy that financial services are there to support, and of the providers of financial services themselves is of great significance. It is important both when in it comes to understanding the current context and whether existing, regulation requires amendment or change and when it comes to development of new or amended regulation.

At the Central Bank, we place a lot of emphasis on high quality engagement with a wide range of relevant stakeholders. The ways we engage cover a very wide spectrum from the multi-year meetings of our Consumer Advisory Group, Civil Society Roundtables and Industry Roundtables, through meetings with trade bodies and with individuals and entities who seek to engage with us on one topic or another. Currently we are finalising and publishing our feedback statement on our analysis of the responses received to our recent consultation paper (CP136) on Stakeholder Engagement where we have set out a number of proposed enhancements to our engagement practices. This includes seeking to give enhancing our engagement with consumers, civil society and the business community. Broadening and deepening our engagement with these groups will add significant value. We will also put in place more structured arrangements for industry stakeholder engagement including an industry stakeholder forum, and a periodic Financial Services Conference to allow for all parties discussion of key financial system and regulation issues. In CP136 we also noted the intention in the Programme for Government to apply the Lobbying Act to engagements with the Central Bank. We welcome this proposal as high quality stakeholder engagement is materially enhanced by high levels of transparency.

An important aspect of stakeholder engagement is consultation on proposals for new regulatory developments. Such consultation is an integral part of our policy making process at the Central Bank, with proposals being submitted to generally a three month consultation period followed by a feedback statement setting out what we have heard and our response to the comments received.

Conclusion

In conclusion, let me return to where I started. That is to the fact that what financial regulation is about is achieving positive outcomes. Positive outcomes for the funding of a well-functioning, sustainable economy, positive outcomes for consumers and the users of financial services, and positive outcomes for the economic wellbeing of citizens. To achieve these goals financial regulation needs itself to meet the highest standards. Hopefully what I have set out here today gives you at least some idea of how we at the Central Bank of Ireland seek to meet those standards.

Thank you for your attention.