Resilience in the face of changing winds - Michael Hodson, Director of Asset Management and Investment Banking

Speech delivered at EY Funds Forum 2019

Good morning ladies and gentlemen.

It is a pleasure to be here at this morning’s Funds Forum and I would like to thank EY for inviting me to speak to you all today.

In my remarks I will cover:

1. The changing landscape of the asset management sector;
2. The evolution of supervision;
3. Supervisory convergence; and
4. Our supervisory priorities for 2020.

The year that was 2019:

But first, I want to set the scene by reflecting on the year that was 2019.

Brexit has not only continued to dominate the media headlines this past year, it has also remained a key area of focus for you in industry and indeed us as regulators in the Central Bank.

It has and still does take up a considerable amount of time in our working lives, but we should not forget what has been achieved this past year.

From a Central Bank point of view, we have remained committed to a robust and effective authorisation process which has ensured that those firms seeking authorisation, both BAU and Brexit related, were authorised where appropriate and in advance of a potential hard Brexit scenario.

We have also been proactive in participating at EU fora and in working internally to mitigate the risks posed to the economy, consumers and the financial system. A case in point is our collaboration with the Department of Finance and European stakeholders to ensure that there was no immediate disruption to the securities settlement in Ireland due to Brexit.

Further positive developments to note this year includes: (i) the agreement of the MOUs which facilitated the continued cooperation between the UK and European authorities and also tackled the risk that Irish AIFMs, UCITS management companies and Irish funds would no longer be able to delegate their portfolio management to UK investment managers in the event of a hard Brexit; (ii) the FCA opening the window for notifications under their temporary permissions regime to enable EEA-based firms currently passporting into the UK to continue regulated business within the scope of their current permissions in the UK for a limited period; and (iii) the efforts made by supervised firms in preparing for Brexit – it is true to say that some firms were better prepared than others and where planning was not deemed to be sufficient, increased supervisory engagement was necessary. For firms that put Brexit as a standing item on Board agendas it is clear that better preparation ensued.  

Notwithstanding the above, as we head into the Christmas season and more than three years on from the Brexit referendum, it would be very easy for us to let Brexit fatigue get the better of us. However, we are still in the realm of uncertainty and that means we all have a duty to remain alive to developments over the coming weeks. In this context, the efforts we have all made to date will stand to us as we approach the latest Brexit hurdle.

In parallel to Brexit, this year we have maintained our programme of on-going supervision across the cohort of existing supervised firms. And, to be brief, this has entailed driving firms to a high standard of regulatory compliance, most notably through engagement meetings, full risk assessments and also thematic inspections across the realms of fund management company effectiveness, corporate governance, cybersecurity risk management, UCITS performance fees, closet indexing and wholesale market conduct risk.

And, given the audience present, perhaps I can hone in on fund management company effectiveness. The Central Bank’s thematic review is progressing well with the questionnaire phase achieving a 100% response rate from all firms in scope.

What's more, the desk-based phase is now complete and onsite engagements are due to commence this month which will allow us to dig deeper and obtain a greater understanding of the information we have gleaned from the questionnaire. 

There are already some useful messages we can take from the questionnaire:

• All firms have in place the organisational effectiveness role, although there appears to be quite a wide range of time being dedicated to the role for similar type firms.
• In terms of Directors’ time commitments, while we have noted some improvement regarding the number of directorships held at Fund Management Company level, there are still some outliers and directors should remain cognisant of the number of Fund Directorships they hold and consider whether they can commit the requisite time to fully discharge each of their roles.

Some other messages are clear:

• The level of resources currently dedicated to key tasks varies considerably across firms and while nature scale and complexity may explain some of this it is clear that this is not the only reason.
• There also continues to be a reliance by firms on group policies and procedures.

However, with the review still ongoing it is important to note that we have not reached any conclusions on the information we have gathered so far and are very conscious that we need to test some of the messages from the questionnaire, this is why the desk based and on-site work are critical parts of this review.

As I have said in the past, we envisage this body of work concluding sometime in the second half of next year, whether it results in a change to the rules, further guidance, and/or ongoing engagement with individual firms, it is too early to say at this stage.    

Myself and my colleagues have spoken consistently over the last two years on the importance of the Irish regulated entity being able to demonstrate that it is fully in control of all aspects of the business it is responsible for, irrespective of the level of outsourcing or its relationship with group companies.

As a gateway into the EU market Irish fund management companies benefit from the passport, being permitted to sell their funds across the EU.  With this comes the responsibility to protect EU investors.

EU institutions and citizens rightly expect the Irish entity to take this responsibility seriously and to have in place all the necessary resources, both human and technical, within the EU to deliver on this.

For those firms authorised since June 2018 they have got and understood this message and all have staff based in Ireland, it is important that all firms understand these expectations.

The winds are changing:

Moving on, one of the panels that follows this address is titled “The winds are changing” and with that in mind, let me say a few words about the changes that are afoot.

The Capital Markets Union (CMU) for instance, is an extremely important project and one that has the potential to deliver real benefits in terms of improved financing for businesses; more diversified sources of funding; and greater opportunities for investors. The Central Bank fully supports the aim of the CMU and while much has already been achieved, it is clear that progress needs to be accelerated to ensure that it can be fully realised across the EU27.   

FinTech continues to demand an elevated level of focus. Innovation and advancements in technology mean that firms can benefit from increased efficiencies and new ways of engaging with clients. But on the other hand, such advancements also present new risks most notably in relation to IT strategies, governance and risk management. It is for this reason that we in the Central Bank continue to engage with innovators through our innovation hub. It provides a platform for us to engage with firms in the FinTech space and it is also a source of vital information to enable us to build on our existing intelligence of changes across the financial services landscape.   

Sustainable finance is another key evolving theme.

While ESG was previously an optional add-on for firms to consider, it is increasingly being embedded into the regulatory framework. As the various strands of legislation, arising from the Commission’s Action Plan on Sustainable Finance, comes into force over the coming years, firms will have to have policies and procedures in place around the assessment of risks arising from ESG factors and to disclose these to their end-investors.

Moreover, firms who offer ‘green’ financial products will also soon have to disclose the extent of their products ‘greenness’ against a defined EU taxonomy of environmentally sustainable economic activities.

Based in part on this taxonomy, an EU-Ecolabel for green financial products will also be developed. This will be a voluntary award scheme intended to promote financial products with a reduced environmental impact during their entire life cycle. In this way, the intention is that investors will have greater transparency and information about the environmental credentials of the financial products being offered. These are just a few of the many legislative changes underway at EU level and I think it is safe to say, that this is just the beginning as sustainable finance shifts our thinking to an economic model focussed on long-term value creation.

Structural Changes:

It is against this backdrop of change that regulators, including the Central Bank, continue to adapt and evolve to keep pace with industry and to ensure we can continue to fulfil our mandate of investor protection, market integrity and financial stability.

For example, to meet the needs of supervising both prudential and conduct risk, we have introduced a number of structural changes. This commenced in 2017 when we split the financial regulation pillar into two separate pillars, prudential regulation and financial conduct.

More recently, we launched a new Directorate, the Prudential Analysis and Inspections Directorate, to enhance and support the day-to-day supervisory efforts in analytics and inspections.

While in 2020, my Directorate will move from three divisions to a two divisional structure. A move that is designed to facilitate the supervision of existing firms and new entrants into the Irish market while also ensuring a continued focus on authorisations and the protection of clients assets.

Evolution of Supervision:

The Central Bank’s approach to supervision is also evolving.

By way of background, you may recall that in 2011 we introduced the risk-based Supervisory Framework, known as the Probability Risk and Impact SysteM (PRISM).

The adoption of a risk-based approach to supervision has meant that our supervisory efforts have primarily focused on those financial service providers that pose the highest risks to consumers, investors, the economy and financial stability.

And as I reflect on PRISM now, eight years on from its roll-out, it is safe to say that the supervision framework that we have in place today has ensured that our approach to supervision is effective, intrusive, analytical, evidence-based and outcome focused.

However, since its introduction, the breadth of the Central Bank’s mandate has increased and the financial services landscape has changed, grown and become more complex. As a result we have introduced and updated sector specific frameworks and as I mentioned earlier, we have restructured ourselves internally.

We have also learned from our supervisory engagements with regulated entities and we are currently conducting two large internal reviews – one on our Impact models which is focused on determining the optimal approach to describing and quantifying Impact for certain prudential Impact models and the other (which is intrinsically linked) is on our engagement models; this work is assessing our approach to supervisory engagement and enhancing our supervisory risk appetite framework.

The objective is to ensure that the Central Bank remains live in its approach to supervision and has a risk and outcomes-focussed supervisory framework that fully leverages our capabilities. All of this work is part of the evolution of supervision, and of course it is being completed in the context of broader European developments and considerations also.

The Central Bank intends to communicate with industry on the first phase of this work in the coming weeks giving context to the changes to prudential impact models for Fund Service Providers and the Asset Management sector amongst others. We will then communicate with the relevant firms regarding any changes to their impact categorisations and firms should expect to see changes take effect in early 2020.

Certainly, the redefined and more bespoke impact metrics, coupled with a refined risk and outcomes approach to supervision means that changes in supervisory engagement and in some cases, impact models and impact categories are afoot.

Supervisory Convergence:

In addition, I would say that this changing landscape, along with Brexit and the new supervisory risks presented, have all played a part in enhancing the need for supervisory convergence across the EU27.

In the past, concerted efforts have included ESMA launching the Senior Supervisors’ Forum and the Supervisory Co-ordination Network. We have also seen regulators become more proactive in engaging with each other by means of secondment opportunities, participation at supervisory colleges and also by way of periodic meetings. 

On that note, I am pleased to see that new convergence measures continue to be introduced. For example in January, the Central Bank will host the first Voluntary Supervisory College – an important initiative by ESMA that will see supervisors from different NCAs come together to discuss a particular supervised entity that has separate group entities authorised in multiple EU member states.

Furthermore, as Ireland is the home to a large funds population, I am certain it will come as no surprise for you to hear that the Central Bank will be participating in ESMA’s 2020 common supervisory action on liquidity management by UCITS. As highlighted by ESMA’s chair, Steven Maijoor, in a recent address (Maijoor, 2019), this body of work and the related sharing of practices across NCAs “is expected to help ensuring consistent application of EU rules on UCITS liquidity management and ultimately enhance the protection of investors across the EU”.

In short, let me be clear when I say that it is not our role as a financial regulator to inhibit the growth of the sector. The changes we are presented with today bring about enormous opportunities for you in industry and as regulators we understand that but we also appreciate that such opportunities bring new risks. It is therefore imperative that we keep pace with industry and that we take the steps necessary to ensure our approaches to supervision, authorisation and policy-making remain fit for purpose and underpin our strategic focus in the years to come. 

Supervision priorities for 2020:

So, with change in mind, let me briefly discuss some of our key supervision priorities for 2020.

Firstly, I think it would be remiss of me not to refer to the new bespoke prudential regime for investment firms, the Investment Firms Regulation and Investment Firms Directive (the IFR).

Currently, investment firms’ prudential requirements are derived from the credit institution centric CRD/CRR framework. This framework is based on international standards which were developed by the Basel Committee on Banking Supervision for large credit institutions and does not necessarily reflect the business and risk profiles of investment firms. 

Accordingly, the new bespoke IFR regime aims to be an appropriate, tailored and proportionate prudential regime that will categorise investment firms based on their nature, scale and complexity. Critically each category of investment firm will have a differing set of requirements in respect of reporting, capital, liquidity, remuneration etc.    

The Central Bank very much welcomes the extensive work which the European Commission, European Parliament and European Supervisory Authorities have undertaken over the last number of years to support the development of the IFR.

Looking into 2020 and beyond, the successful implementation of the IFR, from a supervisory perspective, will be a key part of our work in the Asset Management and Investment Banking Directorate.

A second key priority for next year is the review of the Irish Client Asset Regime.

Earlier this year, the Central Bank commenced a review of existing regime, including the Central Bank’s Client Asset Requirements¹ (the CAR), as well as our supervisory toolkit. This review has come about as a result of a changing client asset landscape in Ireland, and an increase in the value of holdings by Irish regulated entities.

Developments in the last few years, mainly due to MiFID II and Brexit authorisation work, have identified client assets holdings in new and emerging business lines and entity types, with a significant increase in wholesale client asset activities, primarily within credit institutions.

As many of you may be aware, while credit institutions are subject to the MIFID safeguarding of client asset rules, they are not subject to the more prescriptive requirements in the Central Bank’s CAR. Our review is looking at this, that is to say, we are actively considering broadening the scope of the CAR to include credit institutions, thereby refining our supervisory lens further to include client asset arrangements within credit institutions.

In terms of work undertaken so far, this has included participation in a secondment with our client asset counterparts in the FCA earlier this year and more recently, the Central Bank has increased its level of engagement with credit institutions. Such engagement is assisting our review in several areas, including our supervisory tools, such as the Monthly Client Asset Report (MCAR) and the annual assurance report prepared by auditors in respect of firms’ client asset arrangements.

As the project progresses into 2020, we intend to engage with industry through consultation, particularly on any revisions to the CAR. Credit institutions can therefore expect further engagement from the Client Asset Specialist Team (CAST), as the team seeks clarity around the governance and operational arrangements that impact on client assets.

As I’ve said many times before, the protection of client assets is a key priority for the Central Bank, as it should be in all firms. Therefore, while this review advances, we will continue our day-to-day supervision work of conducting 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.

A third key priority in 2020 will be our continued focus on the market based finance sector domiciled here in Ireland.

Since the crisis, the growth in this sector has been significant, and Ireland has become an international hub for non-bank financial intermediation. To put this in perspective, Ireland is now the sixth largest jurisdiction for non-bank financial intermediation according to the FSB (FSB, 2019). The size of the sector in Ireland has more than doubled from approximately €1.8 trillion at the end of 2009 to more than €4.4 trillion in the first quarter of 2019.

Nonetheless, the resilience of market-based finance in the current scale – both in Ireland and internationally - remains untested in times of stress. That is why we have been engaged actively in the international regulatory debate on non-bank financial intermediation for some years and we will continue to be in the coming period.

Non-bank financing is a valuable alternative to bank financing for many firms and households, fostering competition in the supply of financing and supporting economic activity. It has its benefits, as evidenced by the fact that the European Commission is seeking to boost the proportion of non-bank financing in the EU from current levels as part of the capital markets union initiative.

However, it also has the potential to become a source of systemic risk, both directly and through its interconnectedness with the banking system. In particular, activities such as liquidity transformation and the build-up of leverage warrant continued close monitoring.  

We will therefore continue to work towards ensuring that the market-based finance is monitored appropriately and that the actual risks from non-banks are understood.

This will mean a focus on reducing data gaps, continuing to strengthen our supervisory and analytical capabilities internally and playing a leading role in the policy discussions at a European and global level.

And finally, there is our on-going supervision work.

Perhaps it does not get the headlines it deserves but I would argue that it is the single most important body of work that we undertake as regulators.

If you bear with me, I would like to provide some context as to why I place such high importance on supervision.

In his autobiography, the founder of Nike, Phil Knight, reminisces on his running days back in college. Mr Knight mentions that running track gave him a fierce respect for numbers “because you are what your numbers say you are, nothing more, nothing less” and that his numbers in the end “were all that anyone would remember”.

Of course, this may be true in athletics but there is a difference between sport and our work in the asset management sector. To be brief, your raison d'etre should never solely revolve around your numbers – on your bottom-line figure for the year, on the growth in AUM achieved and so on.

In this regard, our role as regulators is not simply to look for compliance with regulation. It goes beyond that, it extends to challenging firms on their business models, asking the hard questions on the risks presented, assessing the underlying culture within your firm and seeking appropriate mitigation action where we identify risks that are above our threshold.

Ultimately it is our role to drive you to do better, not for my sake as a regulator, but for the sake of the clients you serve, the sector you operate in and the wider economy that you actively contribute to.

In summary, our supervision work will continue in 2020 across a number of areas including but not limited to:

• the conclusion of the thematic review on fund management company effectiveness;
• further consultation work on errors in investment funds;
• a focus on liquidity risk and leverage in the non-banking sector both of which remain important issues on our agenda; and
• the engagement meetings and full risk assessments that supervised entities have come to expect in line with our risk-based approach to supervision.

Conclusion:

I will stop there.

Over 10 years on from the financial crisis, year on year it seems as though new challenges are presented that we must rise to.  The last few years it has been Brexit and what will be next? Market fragmentation? Sustainable Finance? Non-banking finance? FinTech?

Yes, all these are hot topics but for us, as regulators our supervision work will continue and for you, serving your clients will continue. There may be new risks presented and new trends or advancements made by industry – but as highlighted in a recent address (Dombrovskis 2019) by the vice-president of the European Commission, Valdis Dombrovskis – “resilience will remain the name of the game for the financial sector”.

Today, the European financial system is on a much stronger footing than it was 10 years ago. I challenge each and every one of you here today, myself included, to take up the baton and take on the task of ensuring that the financial system remains on a strong footing for the years to come.

Thank you for your attention.

______________________

With thanks to Adrian O’Mahony, Lorna Bowles, Luke McInerney, Lydia Healy, Mairead McGuinness, Sean O’Sullivan, Suzanne Power and Steuart Alexander for their assistance in preparing these remarks.

Maijoor, Steven 2019. “Keynote address: EFAMA Investment Management Forum” Speech on 22 November 2019.

[1] The Client Asset Requirements are contained in Part 6 of the Central Bank (Supervision and Enforcement) Act 2013 (Section 48(1)) (Investment Firms) Regulations 2017 (S.I. No. 604 of 2017).

Financial Stability Board 2019. “Global monitoring report on Non-Bank Financial Intermediation 2018" 4 February 2019.

Dombrovskis, Valdis 2019. “Priorities of the new European Commission for Sustainability and green Finance” Speech delivered at the Guildhall, London on 15 November 2019.