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Banking Conduct Supervision: importance and key challenges

1. Please allow me to start by thanking you for the invitation to take part in
the CIRSF Annual International Conference, which, as a testament to the
excellence of its past editions, has established itself as a showcase event to

reflect on the most important issues in the financial sector.

I would like to salute all speakers and participants and, particularly,
Professor Luis Morais, whom I congratulate most sincerely for yet another

remarkable CIRSF initiative.

It is important that banking conduct supervision in the financial sector be

analysed and discussed even further.

During my speech, I will focus on banking conduct supervision. It will centre
around the reasons why it is so important to the pursuit of financial stability,
the emergence of what has come to be called the 'new paradigm' of
banking conduct supervision and in some of the main challenges it now
faces, more specifically due to the digital transformation of financial

services.

2. In Portugal, a specialised (or tripartite) supervisory system is in place,
which means that each of the three regulatory and supervisory authorities
of the financial system performs banking conduct supervisory duties within

their area of competence.

Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

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EUROSISTEMA

As I have stated on other occasions, and as generally agreed, there are no
ideal supervisory models. During the financial crisis, no model was immune

to serious problems.

The causes of the crisis were of a different nature and affected the different
models. This does not mean that it is not possible to identify more suitable
solutions than others, not so much due to the patent superiority of a model
over the others, but, mostly, by considering whether that model is the best
fit for the country's financial system and, in the case of the European Union

Member States, whether it is in line with the European architecture.

For my part, I unequivocally support the maintenance of a tripartite
institutional model. However, I emphatically acknowledge that various
legislative improvements are in order, so as to reap the full potential of the

present system.

3. Banco de Portugal is the national regulatory and banking conduct
supervisory authority. As such, it exercises regulatory, oversight and
sanctioning powers over the conduct of entities subject to its supervision as
regards the offering of retail banking products and services, more
specifically: bank deposits and bank accounts, housing loans, consumer
credit, and payment instruments (including cards, transfers, cheques and
direct debits). The offering of other financial products, even if by credit
institutions, is not subject to banking conduct supervision by Banco de

Portugal.

Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

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BANCO DE PORTUGAL

EUROSISTEMA

Banking conduct supervision aims at guaranteeing the transparency of the
information provided by supervised entities to their customers when
offering banking products and services and at ensuring compliance with the
regulatory framework governing these products and services.

However, the banking conduct supervision's goals cannot be effectively
pursued only on the supply side: it is also necessary to act on the demand

side.

The way people deal with money, how they make their consumption
decisions, what drives them to save or borrow depends on their knowledge,
attitude and financial behaviour, and these are vital, not only for their well-
being, but also for the allocation of resources in the financial markets and,

ultimately, the stability of the financial system.

Now, international studies, and most notably the surveys on this topic,
bringing to light financial literacy deficits in all countries where they are

conducted.

Nevertheless, increasing the population's financial knowledge is a
demanding task. Initiatives in this field do not produce immediate effects
and, therefore, it is important to develop structured, long-lasting and
diversified projects in view of the goals and target groups. This is what
Banco de Portugal has been doing, in cooperation with other supervisory
authorities, within the scope of the National Council of Financial
Supervisors, under the National Plan for Financial Education, and by running

its own initiatives.

Luis Maximo dos Santos
CIRSF ~ Annual International Conference
Lisbon, July 4, 2019

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BANCO DE PORTUGAL

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Schools play a key, irreplaceable role. Still, central banks now acknowledge
that it is also their mission to pursue financial education policies, especially

when they are also in charge of supervision.

In fact, a state-of-the-art strategy for banking conduct supervision must
necessarily rest on three pillars: setting out a proper regulatory framework,
monitoring compliance therewith through intrusive action, based on
innovative methodologies and instruments, and a policy promoting
financial literacy, which is referred by some - particularly in Brazil - as

'financial citizenship'.

And it is precisely on the basis of this three-pronged approach that Banco
de Portugal has interpreted and carried out its mandate conferred by the

legislator in the field of banking conduct supervision.

4. In the wake of the financial crisis, there has been an intensification and
refinement of prudential and banking conduct supervision. Lending for
house purchase and consumption, for instance, have become much more
regulated as a result of the measures taken by European and national

legislators.

The changes, however, are not only quantitative: they also impact on the
nature of the regulations. Regulation has indeed increased, but it has also
changed.

In fact, banking conduct supervision is now empowered to intervene in new

areas, with an impact on the institutions' business model. For instance, it is

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CIRSF - Annual International Conference
Lisbon, July 4, 2019

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empowered to act upstream in the contracting process, by assessing the
conformity of internal procedures adopted by institutions when creating
and distributing banking products and services, and must ensure that these
products and services and the channels selected for their distribution are

suited to the features, needs and goals of the respective target groups'.

As such, it is fair to state that a new regulatory and banking supervisory
paradigm has emerged. With greater empowerment and complexity comes

increased responsibility at various levels.

The European Banking Authority's Guidelines on governance and control
arrangements for retail banking products (which have already been

adopted in Portugal) have brought us to a vastly demanding realm.

A series of new obligations of relevance for banking conduct supervision
now applies to the institutions' employee compensation policy. Institutions
are required to put in place mechanisms for the approval and monitoring of
compensation policies applicable to their employees involved in the

drafting, sale and granting of mortgage credit.

There are rules on the training and knowledge requirements of employees

dealing with customers.

This new banking conduct supervision paradigm, which resulted from

extensive European legislation, has resulted in stringency levels that are

1See the 2017 Banking Conduct Supervision Report , pp. 28-29.

Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

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BANCO DE PORTUGAL

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difficult to meet both by institutions and supervisory authorities, as well as
to a degree of intrusion that is not always easily manageable, most notably
as when it comes to drawing the line between regulation and management.
However, in light of what transpired during the financial crisis, it was
imperative to strengthen banking conduct supervision for the benefit of the

banking sector.

5. Very often we hear about conflicts of interest between prudential
supervision and banking conduct supervision. Is it less common, however,
to point out that both converge towards the same ultimate purpose: to

ensure financial stability.

Indeed, the disregard for conduct of business obligations, particularly when
it becomes intense and lasting, directly undermines the pursuit of financial
stability to the extent that it jeopardises the core value where the financial

sector is founded: confidence.

If institutions fail to internalise a culture of compliance with conduct of
business obligations to their customers, is it reasonable to expect that they

do so in other regards?

A compliance-oriented culture is not partitioned: either it exists globally or

it is merely a facade that crumbles as soon as any difficulties arise.

Strictly speaking, even if on the basis of other instruments, the main issues
related to prudential supervision also focus on conduct of business issues:

what is, after all, sound and prudent management but the sum of many
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CIRSF - Annual International Conference
Lisbon, July 4, 2019

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attitudes and decisions? What is the basis for corporate governance rules if
not the prevention of improper behaviour? What is the basis for monitoring
the suitability of the management and supervisory bodies if not the

prevention of improper behaviour, either deliberate or accidental?

As Mark Carney,2 the Governor of the Bank of England, has rightly stated,
over the past decade banking has suffered "twin crises of solvency and
legitimacy". Unfortunately, improper behaviour in the financial sector
continued even after the crisis, of which the Libor manipulation case is

merely a very serious example.

Mark Carney added: "an industry the scale and importance of finance needs
social capital as well as economic capital" and gave the following bleak
numbers: in the United Kingdom, 2017, only 20% of citizens considered that

banks were being well administered, against 90% at the end of the 1980s.°

And we all know, from our own experience in our countries, that the United
Kingdom is not alone along this path. Are citizens wrong? Is it just an
unjustified perception?

Many lessons have been learned from the crisis. But it is undeniable that

there is still a long way to bring confidence back to the levels that the sector

needs and deserves, given its key role in economic development.

2 https://www.bankofengland.co.uk/-/media/boe/files/speech/2017/banking-standards-board-worthy-
of-trust-law-ethics-and-culture-in-banking.
Idem.

Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

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However, the best managers have long realised that, in the medium and
long term, a compliance-oriented culture is a source of long-lasting gains
and a sustainability basis. And this is a perspective that could even be
enhanced if, for example, among the criteria for managers' variable
remuneration there were indicators on regulatory compliance and
sanctions applied to the institution. Aligning incentives in favour of good

practice is a path that should be further explored.

Aclimate of confidence in the institutions makes the managers' work easier
and is, in fact, a very important advantage in scenarios of change and

uncertainty, as these we are experiencing.

The belief in Adam Smith's 'invisible hand' has been hastily and superficially
invoked for too long, forgetting that to correctly interpret his economic
thinking we would need to summon his entire philosophical thinking,

notably that expressed in The Theory of Moral Sentiments.

Any system of ideas put into practice while neglecting the ethical aspects of
behaviour is doomed to become a caricature of itself and, unfortunately,

historical examples of this abound.

Economics is a social science and not an experimental one. Proper
consideration of its behavioural dimension is therefore fundamental. Thus,
the Nobel Prize awarded in 2017 to Richard Thaler was an important sign
given at a timely moment. As the financial crisis has shown, many decisions

were driven not by economic rationale but by goals of a different nature.

Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

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EUROSISTEMA

6. The sale of non-performing !oans (NPLs) by banking institutions is a major
priority of the European strategy for the pursuit of financial stability.
However, it must be ensured that this is achieved without undermining the
legitimate protection of the borrowers' rights, due to the fact that the
claims are held by entities outside the scope of banking conduct

supervision.

The solution to this problem must be found on a European scale. Work on
the proposal for a Directive, known as the 'Credit Servicers Directive", has
made some positive progress towards that objective. But we will see how
the situation in the European political cycle that has just started will evolve,
since it was not possible to approve the Directive in the previous European

legislative term.

This is a problem with deep social repercussions and one that needs to be

given full attention.

On a different level - which already goes far beyond the area of banking
conduct supervision given the nature of the products concerned - it is also
essential to ensure adequate levels of transparency when it comes to

placing MREL eligible debt securities with retail customers.

7. The most important challenge currently posed to banking conduct
supervision is that of digital transformation. Recent technological

innovation has redefined the way in which financial products and services

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Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

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EUROSISTEMA

are offered. This innovation brings opportunities and benefits to consumers

whilst expanding the existing risks and creating new problems.

Some of the risks and disadvantages are already known, but others may
emerge as financial institutions embrace new technologies. The impact of
the technological revolution in financial markets affects not only the
functioning of the markets, but also changes the behaviour of the
consumers participating in these markets (which are increasingly digital and

demand greater convenience and speed).

To this end, the banking conduct supervisor faces a complex situation: to
ensure the balance between innovation, consumer protection, security and

financial stability.

For this purpose, banking conduct supervision should act dynamically, in
particular by promoting the necessary regulatory changes. The massive use
of consumer data by financial institutions may require the creation of
specific rules targeting the use of non-traditional data sources, the
promotion of greater transparency in the use of algorithms, or even the
need to adopt robust algorithms that are tailored to the consumers'

interests, and thus leading necessarily to their regular review.

In the Joint Committee Final Report on Big Data, the European supervisory
authorities reinforced the need for regulators and supervisors to monitor
the Big Data phenomenon and communicated a set of best practices to

financial institutions on the use of Big Data.

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Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019

BANCO bE PORTUGAL

EUROSISTEMA

Even the banking conduct supervisors are faced with the absolute need to
adopt new supervisory methods and tools, in line with technological

developments.

In Portugal, the strategy of banking conduct supervision vis-a-vis

technological developments is based on the following vectors:
© To keep abreast of technological innovation;
© To monitor the offering of financial products and services;
© Toremove regulatory barriers;
© Toensure technological neutrality;
© To promote digital financial education.

In developing economies, the digital context has the advantage of being
able to increase the levels of financial inclusion. In contrast, the more
developed economies should take into account the risk of excluding
segments of the population with low levels of digital literacy, which is

particularly relevant in societies with ageing population.

First, the supervisor must guarantee the same rights to consumers
regardless of the channel they use when acquiring banking products and
services, ensuring the principle of technological neutrality - 'same

business, same risks, same rules, same supervision'.

The European Commission is reviewing the Consumer Credit Directive and

the Directive concerning the distance marketing of consumer financial

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CIRSF - Annual International Conference
Lisbon, July 4, 2019

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BANCO DE PORTUGAL

EUROSISTEMA

services, showing concerns precisely about information transparency and

insights from behavioural economics in the digital context.

In the European Union, cross-border offering of financial services is further
enhanced by the possibility of providing services under the freedom to
provide services ('FPS') regime. This reality calls into question the banking

conduct supervisor's scope of action, a problem that needs to be addressed.

The European supervisory authorities have paid special attention to this
topic, and the report on 'cross-border supervision of retail financial
services' has recently been approved and is pending publication.

8. There are very different views on the economic and social impact of the
new digital technologies. But everyone agrees that it is both structural and
profound.

As at all times, problems do not reside in the technologies themselves but
in the use we make of them. A new world has already arrived and is
developing under our eyes. Whether or not it will be a 'brave new world' in
the sense given by. Aldous Huxley in his famous novel, it is up to each one

of us to contribute to the answer.

Thank you very much for your attention.

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Luis Maximo dos Santos
CIRSF - Annual International Conference
Lisbon, July 4, 2019