Taking stock of the past and insights on the future of the asset management sector - Michael Hodson, Director of Asset Management Supervision

Remarks delivered at IDA Event, New York

Good morning ladies and gentlemen.

It is a pleasure to join you at this breakfast briefing, which has been kindly organised by IDA Ireland.

Today I will give you an insight into the Irish asset management industry; touching on a number of important topics such as Brexit, culture and Fund Management Company Effectiveness, otherwise known as CP86. These, among others feed into the evolution of the sector in Ireland, more on this later.  As the regulator, we in the Central Bank are very much aware of the challenges facing the industry and the critical role we play, along with our fellow EU National Competent Authorities in ensuring a robust regulatory and supervisory model.

Financial crisis – 10 years on and the Central Bank’s response

Since we are in New York and not far from Wall Street, perhaps I can begin by touching on the financial crisis of 2008.

There has been much press coverage, articles and speeches written this month on the 10-year anniversary of the 2008 financial crisis. This should serve as no surprise to industry and regulators as it is incumbent on all of us to remember the mistakes of the past and look to learn from them. For many of us here, we were involved in the industry then, but as time progresses and we have new entrants, the risk exists that some of these lessons maybe lost.

In 2008 and 2009, I was working in industry and my abiding memory is one of the sheer level of uncertainty, we did not know what was going to happen next, if trades would continue to settle or if the market would continue to fall. I also recall the widespread fear that the financial system, that underpinned the global and local economies, may fail. As we sit here today and that financial system remains, a multi-year bull market continues in most asset classes and the global economy continues to grow, it would be easy to become complacent and all of us should guard against this.

There have been many books and articles written by experts about the cause of the crises and it is clear that there were complicated and numerous causes. In Ireland, we had our own banking crisis and the previous governor of the Central Bank, Patrick Honohan produced the Honohan Report¹ n 2010 in which he identified five causes, among them were two aimed at the Regulator:

• A regulatory approach which was too deferential and accommodating, insufficiently challenging and not persistent enough; and

• An under-resourced approach to bank supervision that, by relying on governance and risk-management procedures, neglected quantitative assessment and the need to ensure there was sufficient capital to absorb the growing property-related risks.

It was clear from this that the Central Bank needed to change and in a recent keynote address², the Central Bank’s Deputy Governor, Prudential Regulation, Ed Sibley highlighted that the Central Bank, has “undergone significant organisational change in terms of culture, structure and process”. The Deputy Governor also noted that, following the onset of the crisis, the Central Bank “introduced significant changes to the regulatory framework and our supervisory culture and approach”.

If I may expand on this. Today, our regulatory approach is underpinned by the Probability Risk and Impact SysteM, commonly referred to as PRISM.  Introduced in 2011, PRISM is at the core of our risk-based supervision. It delivers not only an IT system and approach to regulation but more importantly a guiding philosophy. This being that we are risk based supervisors and we are prepared to ask the hard questions to ensure we understand the business models we are supervising or authorising and the risks that they pose.

We carry out this work in multiple fashions through regular engagement meetings, full risk assessments, thematic reviews, targeted inspections, data analytics, board interviews and many more. The goal being our supervisors get a deep understanding of the business in front of us.

We take our role extremely serious and it is guided by our overarching mission of ‘Safeguarding Stability and Protecting Consumers’.

The sector today and significant developments (CP86 and Brexit)

So, I pose the question, rather rhetorically, where is the Irish asset management sector at today?

Firstly, it continues to grow. For example in the funds services space, back in 2008 the funds under administration were estimated to be €1,398bn and now this stands at €4,944bn³ (as at June 2018). Moreover, many of the firms operating in Ireland at present have US parents and the US asset management industry has and continues to be a significant part of the growth in Ireland.

The sector is evolving in many ways, not just in size, and both industry and regulators need to be mindful of this and ensure that they remain alert to the necessary changes required to keep the industry fit for purpose both at a policy level and at an individual firm level.

A key part of this evolution in Ireland is the work carried out by the Central Bank to enhance fund management company effectiveness and improve investor protection. This body of work commenced in 2014 and entailed the Central Bank issuing three consultation papers to industry and also engaging with stakeholders to inform our considerations.

In what has been a considerable journey for both industry and the Central Bank, this work culminated with CP86 coming into full effect on 1 July 2018. It has introduced important changes to how fund management companies should structure themselves with a heavy emphasis on the critical managerial roles (designated persons).

Prior to 1 July, our supervisory focus centred on firm preparedness and now, in line with other rule changes introduced, the Central Bank will turn its attention to assessing how firms implemented and embedded the key CP86 requirements into their arrangements.  We will do this via individual firm engagements and our supervisors will carry out a bigger piece of work across the industry in 2019.

However, even before this body of work commences, we have already gathered a significant amount of knowledge through our engagement at European level and from reviewing new authorisation applications received. These insights reinforce our strongly held view of the significance of the designated person roles (DPs).

They are the management who ensure that the strategies, policies and directions of the board are implemented. They also monitor and oversee a fund management company’s compliance with regulatory obligations. In addition, DPs report to the board on a regular basis and escalate matters as appropriate.

In my view, it is undoubtedly self-evident that these roles require experienced and knowledgeable people to discharge them and that people in these roles must be dedicating a considerable amount of time to them.

If I expand on this further, why is this so important?  We should not forget that fund management companies play a critical role in the EU funds industry. They allow, investment managers from outside the EU, to gain access to EU fund products, UCITs, AIFs and EU investors.

However, this access comes with responsibilities and management companies authorised in Ireland, or in other EU member states, must demonstrate that they are independent and make their own decisions. They are EU regulated entities and we expect them to ensure the proper implementation of EU rules and the protection of the underlying investors in the funds.

The EU, National Competent Authorities, ESMA and EU citizens rightly expect that the provision of key financial services will be provided, managed and controlled by regulated entities that comply with EU rules and regulations. The UK is part of that EU regulatory landscape but will not be post Brexit and so it is clear that activities and responsibilities will need to shift from the UK to the EU27.

We in Ireland, due to our position as a large fund domicile and with a strong fund ecosystem, are seeing a sizeable number of fund management companies seeking to relocate to our jurisdiction. However, I must emphasise the point that relocate means relocate, it does not mean create a structure that allows the previous arrangements to continue as if nothing has changed.

One mechanism that ESMA has set up to foster convergence on the various applications across the EU27 is the Supervisory Coordination Network and I represent the Central Bank on this committee.  The main objective of this Network is to ensure a high level of consistency in supervision across the EU27 and protection of the integrity of the EU single market. We have found it extremely useful and beneficial and it has resulted in strong debate on the appropriate level of substance for different types of firms.  ESMA should be commended for this initiative and it is a real practical example of delivering convergence.

Since the Brexit referendum, a number of fund management companies have approached us with the objective of also providing individual portfolio management (IPM). In engaging with such firms, we have been very clear regarding our expectations of greater substance from any firm requesting to carry out such activities, as IPM is different and carries different risks than collective portfolio management.

While we understand the ‘nature, scale and complexity’ element and our staff will assess each case on its own merit, all firms relocating must demonstrate that they have the staff necessary to carry out their functions and this, in the main, means full time staff dedicated to the management company.

We have significant experience in dealing with the authorisation of firms and we know what is required for a firm to demonstrate that it has a substantial presence.  We have a zero appetite for authorising firms that are not setting up real business in Ireland with the appropriate level of substance.  We have six months to go to March 2019 and you can expect to see a significant increase in the firms authorised by the Central Bank over the coming weeks.  For those firms who have not yet made their plans and are coming to us late with an expectation of being authorised by March 2019, I would say that this will be a challenge for you, as you will have multiple tasks to complete, with the regulatory approval just being one.

As we head towards 29 March 2019, considerable uncertainties still remain and while we can hope for the best, we all must plan for the worst-case scenario – that being a hard Brexit and no transitional period, with the UK becoming a third country from this date.

Brexit presents many risks to the financial services system. Therefore, financial services firms, operating in Ireland or intending to do so, need to understand these risks, prepare for all plausible scenarios and ensure that they have effective mitigation plans in place.

I think you can all appreciate how important it is to be mindful of the cliff effects that may occur in the event of a hard Brexit. The loss of the EU passport is one example of the seriousness of this, particularly in the case of fund management companies. This would mean that UK UCITS management companies and UK AIF managers will no longer be able to manage and market funds in the EU on the basis of their current authorisations.

Every firm should be considering these possibilities and putting in place the necessary plans to guard and protect their clients/business.

Other Key Topics

At this juncture, let me say a little bit on a number of topics that are important to us in our on-going supervision of the wider asset management sector.

The protection of client assets is a key strategic priority for the Central Bank, as it should be in all firms, and we expect boards to ensure that each firm has effective and robust client asset oversight structures in place.

This year we have expanded our focus with a thematic review on the Investor Money Requirements (“IMR”).  This review was undertaken to determine how a number of fund service providers holding investor money had implemented the IMR which was introduced in July 2016. Our assessment showed that the implications of the IMR appear to have been well considered in advance of the implementation date.

Nevertheless, in terms of embedding the IMR, it is clear that operational issues were encountered.  We noticed less operational issues in those firms with formal investor money committees and working groups in situ. The thematic review identified that Investor Money Management Plans (“IMMPs”) require enhancement, particularly in relation to the inclusion of a detailed insolvency section with a clear “roadmap” as to how it would be executed, particularly in the event of an insolvency.

Where issues were identified during the IMR thematic review, the Central Bank engaged with the entities by way of post-inspection letters, containing recommendations and/or risk mitigation programmes, where relevant.

In line with our supervisory priorities for 2018, the Central Bank recently issued a FinTech survey to all fund service providers in Ireland.  This survey extended to 189 firms, including fund administrators, depositories and fund managers. It was undertaken to assist us in identifying the extent of FinTech activity in Ireland and it was pleasing to have received a response rate of 98%.

In order to get a complete picture, the survey not only focused on how FinTech is affecting the Funds Service Providers industry today, but also had a forward looking element to consider what perceived impact it may have going forward into the next three to five years.

Some of the key statistics we took from the survey are as follows:

• 53% of firms are of the view that FinTech will fundamentally change the funds' industry in Ireland within 5 years.
• 55% of firms have a FinTech strategy in place, or under development.
  The activities most likely to benefit from FinTech are Transfer Agency and Investment Management.
• 94% of firms claim to have an appropriate level of IT / Tech expertise on their Board.
• 63% expect to see a new technologically innovative business enter their sector within 5 years
• Only 26% are prepared from a skills and budgetary point of view.

These statistics evidence an evolving industry taking advantage and driving financial technology. All of this FinTech must be wrapped in regulatory compliance whilst it enhances operational efficiencies.

In addition to this body of work, the Central Bank recently launched its Innovation Hub which serves as our point of contact to engage with industry and gather intelligence on FinTech firms and new innovations.  While still a relatively new initiative, the Innovation Hub is proving to function as intended, providing innovative firms with a regulatory sounding board and an opportunity to engage with the Central Bank outside of the existing formal channels.

This allows innovators to learn from the Central Bank, and the Central Bank to learn about forthcoming innovation. The Central Bank also continues to engage with key domestic and international stakeholders as we all look to best position ourselves to adapt to new technologies.

Another area of interest concerns the Product Intervention Powers, introduced as part of MiFID II. In this regard, ESMA have already utilised their powers to introduce intervention measures regarding the sale of CFDs and binary options to retail investors. Both can be considered as useful financial instruments, but only where the client fully understands the risks. They are certainly not designed for mass market retail clients with limited financial means and experience. Through ESMA, common concerns were raised in relation to the promotion of these investment products to retail clients, with thematic reviews indicating that approximately 75% of clients lose money when trading CFDs.

ESMA’s intervention measures came into effect in July 2018 and are directly applicable in all member states. However, as these measures are only temporary in nature, and having been renewed for a further three months, member states are now encouraged to start to consider the adoption of national product intervention measures, in an effort for permanence.

In my view, it is important to ensure that such speculative products are not mis-sold and the Central Bank is focused on ensuring investor protection concerns are identified with a view to addressing this on a more permanent and European wide level.

Turning to investment policy matters. The Central Bank’s Feedback Statement on Exchange Traded Funds (ETFs)⁴  was published on the 14 of September, in response to the Central Bank’s Discussion Paper 6⁵  that was published in May last year.

The Central Bank focus on ETFs is to ensure that this fund type and any inherent risks are comprehensively understood. The Central Bank undertook this initiative in order to highlight areas where further regulatory consideration and discussion are warranted. This is important for two reasons, firstly ETFs are the fastest growing type of investment fund globally and secondly, Ireland is the largest European domicile for ETFs.

The feedback statement provides valuable insight into the design features, dealing mechanisms and operating models that exist in the global ETF environment today, and what implications these may have for ETFs, particularly in stressed market conditions. The feedback received during the process will inform the Central Bank’s approach in international engagements. It is important to say that the Central Bank is very supportive of the international work underway and believes that a consistent approach internationally to ETFs would be the optimum outcome.

In addition to extensive feedback in relation to other areas, there are a number of regulatory outcomes for Irish ETFs arising from the review, which are summarised as follows:

1. Different dealing times will be permitted for hedged and unhedged share classes within the same ETF; and
2. Investment funds can establish both listed and unlisted share classes within a single fund structure, subject to disclosure requirements

However, there will be no change in the requirement to have daily portfolio disclosure at this time. The Central Bank’s work in relation to ETFs is not concluding with the publication of this feedback statement, instead ETFs will remain an area of focus and continued dialogue with industry for the foreseeable future. 

Supervision of culture

Before I conclude, I must speak about culture.

Earlier this year the Central Bank completed a substantial behaviour and culture review⁶  of the five domestic Irish banks. This body of work stemmed from the Central Bank’s Tracker Mortgage Examination which found that cultural failings, coupled with poor systems, weak internal controls and poor governance caused detrimental impacts on consumers.

The review, undertaken in collaboration with our Dutch counterparts in the DNB, who are experts in this field, identified that all five banks have recently taken steps to reinforce the consideration of the consumer interest in strategy, decision-making and procedures. However, the review also demonstrated that, although some banks are at a more advanced stage than others are, all five still have a distance to travel in their transformation towards a consumer-focused organisational culture.

You may ask why culture continues to be so important to regulatory authorities today. I think that the FED’s President, John C Williams7, summed it up best when he remarked recently that “culture shapes every conversation, every decision, and every action; it is at the root of whether an organisation performs in a manner consistent with its mission, or not”.

Looking at the 2008 crisis, one of the lessons learned is that an ineffective culture can be the source of multiple supervisory issues. In my opinion, both industry and regulatory authorities must learn from the past and this means ensuring that the right culture is in place across all firms, including those operating in the fund service providers sector.

For example, in the case of a fund management company operating a delegating model, how can the board satisfy themselves that its staff really are operating at all times for the benefit of the management company and the underlying investors of the funds they have. It is also imperative that firms put in place robust structures to ensure that the best interests of investors are being protected on important cultural topics such as fees and incentives, as evidenced in the findings of our recent review of performance fees in UCITS⁸.

Looking forward, you can expect regulatory authorities to be completing cultural assessments on your firms on a more regular basis.

Conclusion

I will leave it there and summarise with my final thoughts.

The crisis severely dented the financial services sector and its reputation on a global scale. We must not lose sight of the mistakes of the past as they can drive us to make sure they are not repeated.

There is no doubt in my mind that future storms will be met with a more robust regulatory system. However, as Mark Carney, Governor of the Bank of England, said at a recent event in Dublin, every time we have a financial crisis, quite often it starts with a false belief that “this time it is different”.

The work each of you will do today, after this breakfast, and the work you do each and every day is continuously shaping this global industry. An industry that follows the sun continuously, and that draws on us to contribute positively, making lasting impressions.  As this industry grows globally and continues to grow and evolve in Ireland it is incumbent on all of us, regulator, industry and advisers to ensure that it is well resourced within the EU, remains fit for purpose and continues to serve the ever growing needs of end investors.

Thank you for your attention.

With thanks to Adrian O’Mahony, Andy Cheetham, Conor Pierce, Joseph Marrinan, Mairead McGuinness, Paul Delaney and  Ruth Hogan-Davis  for their contribution to these remarks.

¹ The Irish Banking Crisis: Regulatory and Financial Stability Policy 2003-2008 (PDF 1.93MB)
² Deputy Governor Ed Sibley: The Banking Crisis – A Decade On.
³ Irish Funds Industry Statistics
⁴ Central Bank: Feedback Statement on DP6 - Exchange Traded Funds (PDF 1.16MB)
⁵ Central Bank: Discussion Paper 6 - Exchange Traded Funds
⁶ Central Bank: Behaviour and Culture of the Irish Retail Banks
⁷ John C Williams: Now Is the Time for Banking Culture Reform
⁸ Central Bank: Letter to Industry (PDF 188.91KB)