Matthew Elderfield: Central Bank of Ireland's strategy for the next few
years to come
Address by Mr Matthew Elderfield, Deputy Governor of the Central Bank of Ireland, to the
Institute of Directors in Ireland Spring Lunch, Dublin, 22 February 2013.
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Introduction
I'd like to start by thanking the Institute of Directors for giving me this opportunity to speak to
today. I would like to express my support for the important work that the Institute does in
promoting high standards of corporate governance in Ireland. Ireland is lucky to have a
number of strong organisations in place which support corporate governance and encourage
professional development at the board level in the financial services industry. I was very
pleased to receive a Christmas present from Maura at the end of last year in the form of a
copy of the Institute's Handbook for directors of regulated financial services companies. I
thought this provided an accessible and helpful summary of the evolving Irish corporate
governance framework. I'm also grateful to the Institute for its continuing training work for
directors in the financial services sector, which helps complement the activities of the
Insurance Institute of Ireland and the Institute of Bankers (with its new bank director
programme) for example. Members of boards of directors of Irish financial companies have a
strong institutional support framework to assist them undertaking their roles.
With the audience here, there are of course a wide range of possible topics to discuss. I
thought it might be helpful to take this opportunity to provide an overview of the progress and
future direction of some of the most important components of the Central Bank of Ireland's
strategic plan. We have in fact just finished a three-year cycle in strategic planning which
corresponded to Patrick Honohan's and my tenure in post to date. We are now starting a
new three-year cycle and set out an updated strategic plan at the end of last year. This
covers a wide range of issues, such as the increasingly international regulatory policy
agenda, our continuing work on consumer protection and some more prosaic but important
internal organisational challenges around, for example, improved cost efficiency. But I think
by any measure, our most pressing strategic priority is the continuing process of restoring the
banking sector so that it can contribute to economic recovery. So, I'll take a bit of time today
to discuss progress and what lies ahead. No doubt this will be of some general interest, not
just to those of you who are directors at banks. Also high on our list of priorities is the again
continuing process of reforming regulation and supervision in Ireland, to provide an assertive
risk-based approach underpinned by enforcement. So, let me take this as my second topic in
order to provide an update on where things stand and are heading. And, as is natural with
this audience, I would like to conclude by giving you an update of our thinking on continued
enhancements to the corporate governance framework for financial services firms. In doing
so, I would like to suggest a few areas of priority interest for financial services directors in the
year ahead.
Banking sector strategy
Let me begin with a brief update on the elements of the Central Bank's strategy to restore the
functioning of the banking sector. This strategy has had a number of interconnected
elements over the past few years.
One important strand has involved restructuring of both the banks' individual balance sheets
and the sector more generally. The first wave of balance sheet restructuring involved the
transfer of hard to value and poorly performing commercial property assets out of the
banking system into NAMA. The second phase of this exercise, which is now well
progressed, has involved identification and disposal of so-called non-core assets. This is less
directly to do with improving asset quality but is rather an exercise in reducing the leverage of
the banking system and therefore the reliance of the banks on central bank funding. This
process of rightsizing the bank's balance sheets has made good progress with most banks
hitting or exceeding their targets, but there is still further to go.
In addition to balance sheet restructuring, there have been some broader steps to restructure
the banking system as a whole. Action has been taken to support the continuing operation of
the three remaining principal domestic Irish banks, namely AIB, Bank of Ireland and
Permanent TSB, while the three other domestic banks that were taken over by government
have either been absorbed by one of these players (in the case of EBS) or liquidated (in the
cases of Anglo and INBS forming IBRC).
Looking ahead, our focus will be on ensuring continuing progress in the deleveraging of
non-core assets. It also makes sense to continue assessing the case for the possible transfer
of poor performing or hard to value core assets out of the banking system, although this
depends upon providing a solution for an appropriate structure for this, in terms of funding
and cost more generally.
In addition to balance sheet and sectoral restructuring, a second key stream of activity has
involved assessing the embedded credit losses in the banks to ensure they are robustly
recapitalised. Our principal regulatory tool for this has been the use of stress testing, to
project forward credit losses that are likely to arise in a stress scenario and require a capital
injection to make up the shortfall against a predefined hurdle rate. In the Central Bank's
Prudential Capital Assessment Review of 2011, the stress test was calibrated to ensure a
high degree of conservatism by using projected loan losses assessed by an independent
third party, Blackrock Solutions, rather than the banks themselves and by having a higher
threshold target, a longer assessment period and an additional capital buffer compared to
similar international exercises. As a result of the capital injection that followed, current capital
ratios of the leading domestic banks include a healthy buffer above minimum requirements.
Towards the end of 2013, the Central Bank is planning to conduct a further stress test on the
domestic banks at the same time as a pan-European exercise by the European Banking
Authority. This will provide an update on the financial resilience and capital adequacy of the
domestic banks. There are a clearly a wide number of factors at play that will determine the
outcome of this exercise. The methodology and severity of the stress has yet to be agreed at
a European level, for example. On the positive side, the Irish banks start with a stronger
capital position, have suffered fewer losses than projected from the non-core asset disposals
and perhaps will benefit from early signs of stability in the housing market. However,
conversely, the macroeconomic picture still remains in stress, mortgage arrears levels
continue to rise (although so far within stress levels and more recently at a slower rate) and
the introduction of insolvency legislation adds to the picture of uncertainty. In addition, even
without these factors, new international standards under Basel 3 will require additional capital
over time for the Irish banks. These various factors will require close and detailed
examination in a new stress test, where we will again be taking an independent view of
projected loan losses in reaching our conclusions.
A crucial input into the stress test exercise is the treatment of troubled loan portfolios, and
this is the third key stream of the banking strategy. In the area of mortgage arrears we have
been encouraging the banks to develop detailed strategies to improve their operational
capacity for handling this portfolio. We've also pressed for a case-by-case re-underwriting of
existing arrears cases involving, where possible, recovery and, when necessary,
restructuring of troubled loans. We have also encouraged development of specialist
strategies for buy-to-let portfolios. And we have pressed the banks to develop a broader
range of techniques to deal with loans in arrears, particularly unsustainable mortgages, such
as loan modification arrangements like split mortgages.
Our assessment of the banks' operational capacity for arrears handling over a year ago
showed significant weaknesses. As a result, since then, we have had an intense programme
of supervisory engagement with the banks involving multiple detailed reviews of their
distressed credit operations, guidance on required improvements and suggested best
practices, and a continuing work stream on improving metrics around performance. While the
situation is still short of ideal, this has led to significant improvements from where the system
was 15 months ago and so now is the time to see real delivery. It is important that this
involves a more realistic mix of solutions for borrowers. It is encouraging to hear more than
one bank CEO acknowledge that while repossessions will inevitably rise significantly, for
cooperating owner occupier borrowers there will also be a step up in the volume of cases of
long term loan modification - carefully targeted debt relief if you like. Wider industry
recognition of this balanced approach is important: recovery of loans in full wherever
possible, repossession, voluntary surrender or trade down if necessary, but for cooperating
homeowners who are insolvent and at the threshold of repossession having already cut back
their living expenses, that there will be more use of long term loan modification where they
are willing to repay what debt they can but also want to remain in their home.
For customers the key message is one of full engagement with their bank, meaning being
available for contact, making a full disclosure of your affairs and actively working with the
bank to discuss possible solutions. This is especially important because customers who do
not cooperate with their bank are liable to immediate commencement of legal proceedings
and rule themselves out of possible participation in the new personal insolvency
arrangement.
We will continue to have a high level of engagement with the banks on their mortgage
portfolios and further efforts in this area are underway. We are also publishing more detailed
key performance indicators so that there is transparency around the degree of progress on
this key issue. It is important that this work on mortgages is matched by the banks' efforts on
their small business portfolios. This will be a major area of focus for the Central Bank in
2013. Here too, we will encourage a clear strategy, better specialist skills and operational
capabilities and a more determined effort to work through the existing stock of troubled loans
to try to recover or resolve individual cases.
Broadly speaking, these three work streams - balance sheet and sectoral restructuring,
capital assessment and troubled loan workout - remain core elements of the strategy to
improve the functioning of the banking system. A fully functioning and revived banking sector
is essential to the economic recovery of Ireland in order to provide credit to individuals and
businesses. It is in Ireland's interest to see a profitable banking sector returning to full health.
There have been some encouraging signs, such as the willingness of private investors to
take stakes in Bank of Ireland and the ability of the banks to make a limited return to the debt
capital markets. However, a key goal must be sustained profitability for the sector. In this
respect, the outlook remains difficult, with low levels of domestic economic activity and
compressed net interest margins. An early exit from the guarantee will help to normalise the
sector and reduce a drain on profitability. Continuing efforts are also needed on cost control.
Clearly the path ahead remains a difficult one and progress will inevitably continue to be slow
given the significant dislocation that has occurred to the banking sector and the economy as
a whole.
Supervisory and regulatory reform
If banking sector recovery is perhaps the Central Bank's top strategic objective, close behind
it is the process of continuing to reform regulation and supervision. Significant progress has
been made on this front since I first set out my thoughts on this subject in March 2010. At
that time, I drew the analogy that you can't referee a Premier league match with one
linesman and no red card in your pocket. In other words, that it's important that the Central
Bank has the resources and powers needed to do the job.
I'm pleased to say the good progress has been made on both fronts. The Central Bank was
significantly under-resourced in terms of front-line supervisors, enforcement professionals
and policy staff. We have now completed a phase of significant growth and in fact have
revised downwards our target staffing numbers from 735 to approximately 685, with some
further reductions planned in future years as a result of efficiency improvements and
completion of some key responsibilities. We also continue to encourage improvement in staff
quality, through rigorous hiring and probation procedures, in-house training and various
quality assurance mechanisms.
Ireland is also making good progress in developing a set of robust powers. The Central Bank
Reform Act 2010 provided for the introduction of fitness and probity standards. These are an
important strengthening of the regulatory framework and have now been largely
implemented. However, the principal legislation to reform and strengthen the regulatory and
supervisory framework is the Central Bank Supervision and Enforcement Bill which is
nearing adoption. This important legislation strengthens regulation in a number of ways,
providing better tools for risk assessment (such as skilled persons reports), increasing
enforcement sanctions against firms and individuals, setting clearer regulatory and policy
making powers, providing a new best practice whistleblowing standard and making various
other changes. This is a welcome set of improvements and I am grateful to the support which
successive governments have provided to this legislation.
While the resourcing and powers available for regulation and supervision are important, our
reforms have also touched on a number of other essential elements. In particular, it has been
important to learn the lessons of the financial crisis to reset the supervisory philosophy for
engagement with regulated firms. Our strategy is one of assertive risk-based supervision
underpinned by the credible threat of enforcement. This is designed to put a few concepts
front and centre: that we operate a risk-based approach, differentiating based on impact and
probability; that there are consequences and accountability for non-compliance; and that our
supervisors are empowered to insist upon actions to mitigate risk where we are not satisfied
by the explanation from a firm's management. To support this approach, we have
significantly geared up our enforcement activities to ensure that an effective deterrent does
indeed work in practice.
And in terms of supervision, we have implemented a new Central Bank-wide risk assessment
framework, which we call PRISM for probability risk and impact system. This framework sets
out a prescribed level of engagement with different types of institutions based on their impact
in terms of potential prudential and consumer detriment. For higher impact firms, it requires a
periodic systematic assessment of risks around a range of criteria, resulting in a clear
communication to the firm as to those issues we believe require mitigation - in other words,
action by the firm to sort out the issue. This framework, which we are still embedding, to my
mind is already beginning to show strong benefits by prompting a critical assessment of the
position in the firms we assess and flushing out problems that require action. As Board
Directors, our PRISM assessment provides an insight to you into what we think about your
institution and what action we think needs to be taken. For well-run firms, with strong internal
risk management and a strong compliance culture, much of this assessment should hold no
surprises and should ideally already have been identified and escalated to the Board. Where
this is not the case, as a Board member I would suggest you should find that revealing in and
of itself and indicative of an area for Board discussion and challenge of management.
Looking ahead, our continuing strategy is to build on the progress that has been made in
these various areas. We are planning the implementation of the new powers that are close to
adoption and will be engaging stakeholders in close consultation on these. We will continue
to strengthen our supervisory capacity, even though our period of significant growth is
concluded, by working to improve supervisory quality through training and quality assurance.
And we will continue to embed PRISM as we roll out the process of doing assessments for a
growing number of firms. We will also take stock at the end of the year as to PRISM's
implementation to allow any necessary fine-tuning.
Corporate governance standards and the role of the director
One of the important regulatory changes that has taken place in the past three years has
been the introduction of corporate governance standards for banks and insurance
companies. These were a domestic initiative by the Central Bank in response to our
assessment of the need to raise standards of corporate governance in financial services
companies in Ireland and ensure that boards of directors play a stronger role in challenging
management over strategy, risk appetite, compliance and other important matters. Rather
than a 'comply or explain' approach, our corporate governance framework has sharper teeth
by being enforceable. It also includes restrictions on the number of board directorships that
could be held simultaneously, with the goal of encouraging more diversity of background and
robustness of challenge by broadening the gene pool of corporate life.
We want to take an opportunity to revisit the code during the course of this year to see what
refinements are needed and to reassess the scope of the framework. For example, we want
to take the opportunity to assess subsequent European developments in this area. We also
plan to examine the merits of extending the code to investment firms governed by the MIFID
Directive, which is itself subject to changes. The diversity of types and sizes of investment
firm operating in Ireland is a particular aspect that will need careful consideration when
reflecting on the structure and content of a possible code for the sector, as well as
consideration of timing in light of European developments.
Separately, we would also like to see how well the funds sector is progressing with the
implementation of its own voluntary code of corporate governance. I'm pleased that IFIA
showed such leadership in developing this code and I think it will soon be time to assess the
extent of take up and compliance in the sector.
More generally, this will be a good opportunity to take stock about what has worked well -
and what has not - with the corporate governance code and regulatory framework in this
area. Strong corporate governance is such a crucially important foundation for a prudently
run and compliant financial services sector that it's essential we get the regulatory framework
right and be prepared to update it periodically. There will be a lot of interest in this exercise
and I'm sure that the Institute of Directors will again be a sensible voice in the consultation
process and a source of useful input.
In the meantime, however, the current code remains in force as is and those of you in this
room who are directors at financial services companies continue to have the challenging task
of overseeing your firms in a period of seemingly never-ending financial uncertainty and
regulatory change. There are a huge range of issues you will need to stay on top of, but I'm
sure you know that already. As I mentioned earlier, where we provide a risk assessment
under PRISM, this will hopefully assist you with your work. But taking a step back, let me
suggest a few areas that all directors in all financial services firms might reasonably take a
strong interest in during the year ahead. There are obviously some sector-specific issues that
should be worrying some of you. I hope the boards of the domestic banks are pressing their
management teams to make real progress in the workout of those troubled mortgage and
small business portfolios I mentioned, for example. However, let me draw out three areas of
broad applicability across all sectors.
Firstly, I would suggest that boards of directors should take a close interest in ensuring that
their financial services firm has in place a high quality risk appetite statement that is well
understood and implemented throughout the firm in practice. A clear articulation of the
acceptable level of risk undertaken by a firm, for example in terms of potential lending,
investment portfolio or insurance underwriting losses expressed in terms of P&L or balance
sheet events at different confidence intervals, is an important discipline and an essential
complement to a well-articulated business strategy. Indeed, our corporate governance code
requires that such a statement be in place. However, the quality of what we see, in a range
of sectors, is uneven and even at some of the larger and apparently more sophisticated firms
we have been surprised by the lack of rigour and quantification in some cases. This applies
to the international sector as well as the domestic one. Directors of subsidiaries of
international financial services firms still have important regulatory responsibilities and need
to satisfy themselves as to the risk profile of the legal entity and balance sheet which is under
their particular charge. Risk appetite is an area where we would think boards themselves
would want to set a very high standard. It is certainly an area of increasing interest on our
part and where we are debating the best approach to encouraging improvements.
Secondly, I would encourage you as directors to provide broad, challenging scrutiny of your
firms' culture regarding regulatory compliance and internal challenge and that you ensure
you are approaching this strategically and with suitable vigour. There are a number of
elements to this, but I will highlight a few and give you a very specific tip to help you.
Appropriately resourced and well-qualified risk management and compliance functions are
an obvious starting point for a board seeking to satisfy itself in this area. But I would
challenge you to think more fundamentally and strategically about the culture in the institution
you oversee and to consider whether a strong approach to compliance, encouraging internal
challenge, and maintaining high standards of conduct is truly embedded. This is a difficult
task that merits regular reassessment by a board, with a willingness to get right to the heart
of the incentives provided by the current design of a firm's remuneration structure and by
holding business leaders to account for poor compliance records, persistently weak audits,
suppression of challenging opinions and any actions inconsistent with standards of conduct.
In terms of the specific areas of supervisory interest by the Central Bank - and potential
areas of enforcement action - my tip to you as board directors would be to read closely the
Central Banks planned programme of thematic supervisory reviews and our announced
enforcement priorities for 2013. These have been published recently and are a very
transparent roadmap of our areas of particular interest in the year ahead and where
regulatory transgressions are more likely than not to lead to enforcement action. They
provide a very obvious checklist for boards of directors who want to stay away from any
problems with their regulator.
Thirdly, I would encourage you as part of your board assessment process to take a
hard-nosed view on board composition with a view to improving performance. Our corporate
governance code is designed in part to prompt this process of board renewal: adding to the
gene pool through new directors with new skills and different backgrounds. Part of this
process should involve a rigorous assessment of the skill mix of the board as a whole, so
there is both sufficient technical knowledge of finance, sectoral issues, risk management and
regulation, as well as broader skill sets. But also important is ensuring that the mix of
backgrounds and personalities provides a safeguard against group think by self-perpetuation
of the same "type" of board member. Is your current board composition providing the right
degree of management challenge and a willingness to ask the awkward questions? Do you
have the right gender diversity? Do you have the right international experience? If you look
around the board table and you are all the same sex, ethnicity, nationality and educational
background, well, the answer is probably no! Board effectiveness reviews with these goals in
mind are essential and need to be tackled in a structured and determined way, ideally with
facilitation on these key points, to help offset the inertia that comes from incumbency.
Conclusion
I hope these brief remarks have given you a good sense of our strategy at the Central Bank
for the next few years to come. The challenges facing Ireland and its financial services sector
are considerable. Returning the banking sector to full health so that it can support economic
recovery must be the most central of these challenges and therefore, as I've explained, is at
the forefront of our strategy. Ensuring that our regulatory and supervisory framework is
adequately resourced, with robust powers, and able to deliver assertive risk-based
supervision with a credible enforcement deterrent, remains a key strategic priority where
good progress has been made but further work remains to be done.
And central to the success of Ireland recovering from the financial crisis and its financial
sector supporting businesses, consumers and the economy as a whole, will continue to be
the crucial role of the board director. Supported by the good work of the Institute of Directors,
I encourage you to challenge your management team, your fellow board directors and indeed
yourself to not only meet the minimum requirements of our corporate governance framework
as it continues to evolve, but to set the bar as high as you can in striving for a robust risk
management framework with a clear articulation of risk appetite, to be relentless about
embedding a culture which is serious about compliance, challenge and high standards and to
take the tough decisions to rebalance board composition to improve diversity, quality of
oversight and performance.
Thank You.