Matthew Elderfield: The future of Irish banking
Address by Mr Matthew Elderfield, Deputy Governor of the Central Bank of Ireland, to the
31st Annual MacGill Summer School, Glenties, 25 July 2011.
* * *
Good afternoon ladies and gentlemen and thank you for inviting me here today to address
this prestigious gathering. Your invitation has encouraged me to spend a very healthy
weekend sampling Donegal's excellent hill walking and has allowed me to see a little more of
Ireland, now that I have been in post for some 18 months.
The top priority during that time has been the Irish banking system. So, this afternoon I would
like to set out for you in some detail the work that is underway at the Central Bank to ensure
we remain on track to meet the targets for the banking system under our regulatory strategy
and under the Financial Measures Programme of the International Monetary Fund, the ECB
and the European Commission. In particular, I want to make reference to the update on our
banking supervision strategy, published at the end of June, which set out some new thinking
in a few areas in particular, such as provisioning policy and credit standards.
To best explain our work in this short presentation, I will set it out under five main themes:

the capital story, or, what is being done to strengthen the banks;

the deleveraging story, or, how the banks are being restructured;

our new rules for corporate governance and fitness and probity aimed at refreshing
boards and senior management;

some recent thoughts on new standards to improve the management of credit risk;
and, finally,

the work underway to improve supervisory practices at the Central Bank through the
implementation of a new risk-based assessment framework.
That is a big agenda and a lot of ground to cover in twenty minutes - so I will have to be
brief, but I want to try to give you a flavour of the interconnected nature of the work
programme. I think we are making good progress on all these fronts, but each area has its
own timeline for completion and seeing results.
Capital adequacy - strengthening the banks
The immediate challenge of rebuilding the banking system involves a number of
interconnected exercises under the Financial Measures Programme aimed at strengthening
the capital position of the banks. These exercises include the independent loan loss
forecasting and stress testing exercises carried out earlier this year to help establish the
capital needs of the banks under the Prudential Capital Assessment Review (PCAR).
Our PCAR took place against the very difficult background of a severe crisis in the euro
sovereign debt markets, a weak Irish economy, a formal EU-IMF programme for Ireland, and,
a lack of market confidence in the Irish banking system, reflected in the stressed wholesale
funding position of the banks, and concerns about future loan losses. Against this
background we took a conservative approach, making conservative hard-nosed
assessments of loan losses and adding an additional capital buffer, and, we built in
transparency and strong external validation into the exercises.
In terms of validation, the stress tests were informed not only by views of the banks, but also
by the fully independent assessment of portfolio loan losses conducted by consultants
BlackRock Solutions. The data inputs for this exercise were themselves subject to an
external assurance process to make sure that the information was reliable and we used
Boston Consulting to provide quality assurance over the capital calculation and loan loss
methodology. And, our detailed findings were subject to close scrutiny by large teams from
the IMF, ECB and European Commission. By any measure, this has been a very thorough
process with very extensive external validation.
In terms of transparency, our detailed 80 page Financial Measures Programme report is
published on our website. The goal of this transparency is straightforward: we wanted to
address market scepticism of the banks' financial position by being completely open about
the results of this process so that market participants can make an independent judgement
about the conclusions of our exercise.
An important issue we exposed in our recently published Banking Supervision update, and
which is closely related to capital, concerns the banks' provisioning for loan losses. Our
PCAR exercise was focused on ensuring adequate regulatory capital is in place to provide
for anticipated loan losses. It does not directly relate to the banks' accounting for such loan
losses, which should normally occur under their provisions in line with IFRS international
accounting standards. We feel it is important that further measures are put in place to ensure
that bank balance sheets reflect more accurately their current underlying risks. We have
therefore decided to require banks to make a number of new disclosures designed to align
the provisions they make with the underlying realities of their portfolios. We will require banks
to ensure that any potential impairment from future disposals is recognised as fully and as
early as possible.
In determining the banks' capital needs we assessed their residential mortgage portfolios
and I would now like to take a brief opportunity to refer to the difficult issue of mortgage
arrears. I recognise the stress and anxiety that mortgage arrears, or even the imminent
threat of mortgage arrears, is having on the day-to-day lives of many people. On 1 January
this year, we introduced our revised Code of Conduct on Mortgage Arrears (CCMA) - the
Code and a consumer guide to the Code is published on our website. The revised Code
changes the way all mortgage lenders must treat customers who are in arrears or
prearrears, and, by setting rules, aims to take away the fear factor for troubled borrowers when
they are dealing with their lenders. At the heart of the revised Code is a requirement for
mortgage lenders to establish a Mortgage Arrears Resolution Process (MARP) containing
five key elements: every mortgage lenders' process must include better communication with
borrowers, a standard financial statement to gather financial information, an assessment
process which considers the borrowers full circumstances and which is managed through a
centralised Arrears Support Unit, a resolution process where the lender must explore
alternative repayment schedules, and, an appeals process so the borrower can seek a
review of a lenders decision.
This MARP framework is aimed at ensuring a more consistent and transparent approach by
lenders when dealing with arrears cases. Additional protections introduced by the Code
include a requirement that legal action cannot be taken against borrowers as long as they
adhere to an arrangement agreed with their lender. Often referred to as "the moratorium",
this is a key measure which allows time and space for borrowers to deal with their difficulties.
The Code also ensures that borrowers in financial difficulties cannot be required to change
from an existing tracker mortgage to another type of mortgage as part of a move to a new
payment schedule. We have also put a limit on the number of unsolicited communications
that a lender can make to a borrower which can only add to the pressures a customer in
arrears already feels. From January this year, we have also required lenders not to apply
certain charges to mortgage accounts that fall within the CCMA.
Now that the banks are being conservatively capitalised they will have more capacity to
restructure the debts of their mortgage or small business customers. But there are a couple
of caveats. The PCAR exercise has , by some measures, been to overcapitalise the banks,
so the expectation is that at some point, when banking conditions have settled down
sufficiently, the taxpayer will wish to recover some of that capital, for example to assist the
overall government debt position in due course. Also, any approach to restructuring needs to
take account of the risk that it creates incentives for borrowers to cease meeting their
obligations. But despite these considerations there is now more scope for the banks to take
individual decisions, based on the particular circumstances of the borrower, to restructure
debt. And I am encouraged by the Government's commitment to reform the antiquated
bankruptcy laws. Allowing a statutory but non-judicial debt settlement mechanism would be a
welcome reform and allow borrowers to earn a fresh start by discharging their debt after a
reasonable period.
Mortgage arrears continue to be a focus for the Central Bank. The treatment of customers in
mortgage arrears and compliance by mortgage lenders with the CCMA form a key part of our
consumer protection agenda. But it is important to point out that our focus on arrears is not
confined to mortgage arrears. In our review of the Consumer Protection Code we have
proposed new requirements for arrears on other types of non-mortgage debt. These will
similarly prevent harassing behaviour. We plan to finalise the revised Code in the autumn
following a consultation over the summer. We are also considering what additional
protections need to be put in place to help small companies who may be viable but who
currently have arrears on existing loans. To facilitate arrears resolution between SME
borrowers and their lenders we have brought forward the review of two specific provisions of
the Code of Conduct for Business Lending to Small and Medium Enterprises to examine how
they are operating in practice. Broadly, provisions 16 and 17 of the Code are aimed at
protecting borrowers facing financial difficulties or in arrears, and require regulated lenders to
have procedures in place to handle arrears cases, to give borrowers reasonable time to
resolve an arrears problem and to try to agree an approach with the borrower to resolve the
problem.
Deleveraging and restructuring the banks
Another work stream underway at the Central Bank is aimed at correcting the funding
positions of the banks which in turn involves their restructuring: this is in large part a story of
beginning a steady process of deleveraging the system. Loan losses and credit quality is
only half the problem in the resuscitation of the Irish banking system. The other half of that
problem is the funding position of the banks which in turn is linked to their structure.
Our Prudential Liquidity Assessment Review or PLAR is aimed at repairing the balance sheet
funding mix of each bank through a combination of agreed deleveraging transactions or
asset disposals, and a set of liquidity metrics to be achieved by December 2013. Four
institutions, AIB, BOI, EBS and ILP, are currently executing the PLAR plans agreed with the
Central Bank. Under the PLAR we have set three key target funding ratios:
 a loan to deposit ratio;

a Net Stable Funding Ratio: and

a Liquidity Coverage Ratio.
We are monitoring progress towards achieving all these three key targets. Banks must
submit a detailed point-in-time quarterly liquidity profile to us. We will examine funding ratios
and compare them against the interim targets established as part of PLAR 2011. In addition,
the Central Bank and other public authorities are interacting more regularly with banks to
monitor progress towards the disposal of non-core assets.
Deleveraging at individual banks is a critical part of the necessary restructuring process. By
the end of 2013 the core components of the banks will focus on supporting the Irish
economy. In the meantime, assets for disposal and deleveraging will be managed though
non-core divisions. We have ensured that capital is set aside to support this deleveraging
process. But there is common cause between the Central Bank, the Government and the
banks that deleveraging should not come at any price and that fire sales should not be
adopted for the deleveraging process. We are therefore monitoring this process closely.
This deleveraging process will be a long slog but it is now starting in earnest. It will require
close monitoring and perseverance, with some difficult judgement calls around transaction
prices. The banks themselves have the lead responsibility for ensuring progress with this
process while responsibility for ensuring value for money lies with the bank's principal
shareholder, namely the government. It will be important that the non-core management
teams and governance arrangements are put in place swiftly to ensure momentum with the
deleveraging process.
Refreshing boards and management
A third key work stream involves improving standards of governance and fitness and probity
for the financial services sector generally, and continuing the process of refreshing the
boards and management teams of the banks.
We have learned from the banking crisis the importance of good corporate governance. As a
result, we are working to develop effective corporate governance codes for the different
financial services sectors. We have introduced a Statutory Code of Corporate Governance
which sets out clear requirements that the directors and boards of banks and insurance
companies must meet and have set Fitness and Probity standards for those who work in
regulated financial institutions.
Our new statutory Code is a balanced and proportionate approach to strengthening the
governance of our banks and insurance companies and is an important milestone in the drive
to ensuring high standards in the board rooms of regulated financial firms. We made a
conscious decision to impose more demanding Corporate Governance standards than those
in place in other jurisdictions because Ireland has suffered more than most countries in the
financial crisis and we need to get to grips with the home grown elements of that crisis.
Stronger remedies are needed here to shake up prevailing corporate governance practices
and to improve the reputation of Ireland as an international financial centre.
Putting a framework in place to ensure that the people operating at senior levels in regulated
firms are fit and proper is also an important part of our work. Fitness and probity are the
broad headings for applying standards to individuals who work - or wish to work - in the
financial services industry in Ireland. They relate to an individual's ethics, integrity and
financial soundness but also their competence and capability. Last year we sought new
statutory powers to allow us to raise the bar in this area. We wanted to be able to take action
where we have concerns about someone's fitness and probity to do the job. We wanted to a
consistent legislative methodology, applicable to all industries, that would allow us to prevent
individuals from entering into senior positions in regulated firms, in our gatekeeper role.
When our new powers are in place later this year, we will be able to act on fitness and
probity issues. We will have the power to carry out a full investigation and, where
appropriate, we will be able to suspend or remove an individual from a senior position in a
regulated firm. We will have the power to prohibit individuals from holding senior positions in
the financial services industry.
The drafting of the new statutory regime means that all incumbent directors will continue in
their positions and do not have to reapply under the new law. As you know the Central Bank
plans to conduct a review of the fitness and probity of all existing executive and
nonexecutive directors at the Irish banks which have received government support. We will
assess the incumbent directors against the new statutory Fitness and Probity Standards,
including, where it is relevant, their competence and track record in the period leading up to
the financial crisis. We will use our new investigative powers, where appropriate, to ensure
that the people in those positions meet the required level of fitness and probity. I don't
underestimate the legal challenges that we might have in using our new powers, but we must
be prepared to make difficult judgments on fitness and probity and it is right that we should
start with this group.
In the meantime the Minister for Finance has announced that he is seeking Board and
Management renewal plans from all the banks. He has also said that he would expect all
board members (both executive and non-executive) who were in place at the time of the
guarantee to step down from their posts by early next year. It is important to distinguish
between the Minister's initiative and our own. Ours is a regulatory process under statutory
powers to determine fitness and probity of individuals based on their track record during the
period leading up to the crisis. In contrast, as I understand it, the Minister is basically saying
to a class of all directors that it is in the public interest that they stand aside to refresh and
renew the Boards and management teams of the banks, to make it easier to move the
banking system forward, and that this does not in itself reflect on their individual commercial
or regulatory performance. This is an understandable initiative and will help provide a clean
break with the past. If all those involved take up the Minister's request to act in the public
interest then there will be a smooth succession process and obviously there should be no
need to conduct our regulatory reviews. But we are gearing up to consider initiating statutory
investigations if they are in fact required, in order to establish the necessary facts to make
individual judgements. And going forward, the new fitness and probity framework provides a
mechanism to assess the suitability of individuals who wish to re-enter the financial services
system, taking account not just of track record at the banks but also the type of role they are
seeking.
Credit risk management standards
Poor credit risk management practices were at the heart of the problems in the Irish banking
sector and seeking improved standards is another important work stream. We set out our
most recent thinking in June in our Banking Supervision update. While the international
regulatory agenda is acting to close gaps in this area through tougher regulatory capital (as
well as liquidity) standards, there was an "Irish dimension" to the banking crisis here that
requires Irish remedies.
We are therefore contemplating a few initiatives in this area.
First, we believe that there is scope to expand and develop the role of credit bureaux to
assist banks, borrowers and public authorities in managing credit risk. The absence of robust
credit intelligence has lead to poor credit decisions by lenders, and, has limited the ability of
the Central Bank to monitor risk levels in the banking system. How can a bank make a good
lending decision when it does not have a complete picture of the exposure profile of the loan
applicant?
To address this risk we are actively participating in an inter agency working group which will
soon make recommendations to the Minister for Finance aimed at ensuring more robust
lending practices around credit approval decisions, better supervision of both institution and
system wide risk, improved consumer awareness and increased access to credit. To give
you a brief preview - the Central Bank wants to see mandatory and frequent reporting to the
register and wants entities that provide credit registry services to be licensed and actively
regulated. We also want to see the introduction of standard credit scores in Ireland.
Second, we think it would be helpful in December of this year to set out best practice
standards on credit risk management, covering areas such as valuation (where standards
were particularly weak). We are reviewing valuation standards for collateral, particularly for
mortgages and commercial real estate loans, and investigating credit risk processes,
behaviours and policies that we consider weak and that were in place prior to and during the
financial crisis. We are benchmarking these against best practice and this will help us to
develop our supervisory approach. We want to put credit risk management standards in
place that are appropriate for the future. And we are reviewing the potential for applying
sectoral credit limits as a macro prudential measure.
Improving supervisory practice
The final work stream underway that I want to discuss involves developing and implementing
a new framework to manage risk across the full range of financial institutions in Ireland that
we regulate. Having a better approach to managing risk across the population of regulated
firms in Ireland is crucial. We will implement a new formal risk assessment framework by the
end of this year. Called PRISM - from Probability Risk and Impact SysteM - this framework
is designed to allow a more structured approach to assessing financial firms based on the
impact they have on the economy or consumers if things go wrong and on the probability that
problems arise.
Impact and probability are important distinct concepts which combine to yield risk. As a
regulator you worry a lot about your high impact events, even if they are low probability,
because the consequences are so severe for the economy and the consumer. One of the
clear organisational lessons from the financial crisis was that we, along with many global
regulators, spent too little time rigorously challenging the really high impact firms - those
firms whose failure, even if low probability, can seriously damage the economy of a country.
The reports on the causes of the banking crisis in Ireland all highlight the problem of this lack
of challenge, both within the Central Bank and Financial Regulator and also within the banks
and they all point to the need for a more structured and systematic approach to assessing
risk. That means having a better way of applying resources to risk, based on impact; a higher
level of engagement and scrutiny with those highest impact firms, taking much less on trust;
a more systematic way of assessing the probability of a problem occurring; and, above all, a
system which obliges supervisors to follow up on risks in a conclusive manner where they
have been identified.
We will have to make difficult choices, unpopular choices even, to ensure that our frontline
staff can focus on the firms that really matter to Ireland. We will categorise all the firms we
regulate into four impact categories, high, medium high, medium low or low impact. We will
have four engagement models to match our four impact categories. For example, for the
small number of highest impact firms we will have dedicated teams following a pro-active
programme of supervision to ensure we always have an intimate knowledge of their strategy
and business models. We will expect firms to co-operate with this level of supervision and we
will make judgements on their leadership and the judgement shown by that leadership. In
contrast, for the many thousands of low impact firms we will use technology to help us
supervise them in an efficient way. Our objective is to have the capacity to get automatic
alerts when a low impact firms fails key financial or consumer related checks so that we can
act immediately on that information.
We will not, of course, be just focused on size. Our supervisors will constantly assess the risk
profile of each high impact firm. The PRISM system will involve taking a structured approach
to assessing the probability of a problem occurring by seeking to identify issues that could
cause prudential or consumer failures. When risks exceed our risk appetite - where the
probability of a problem is too high - we will require action to be taken to mitigate the risks.
Making judgements and taking action on them is important. We will not merely work out that
a firm has a problem; we will work out how to solve it. We have started to set some firm's risk
mitigation programmes requiring firms to deal with issues - these are specific actions
required to reduce risks that have been identified. Our new risk system will help us track
progress on mitigation and we will continue to work to make sure that all our risk mitigation
actions are outcome focused and result in problems being sorted out rather than simply
analysed further. This to me is a very big point from the crisis: if you identify a risk you must
make sure that your mitigation is strong and conclusive enough.
The PRISM framework will be rolled out to parts of our banking and insurance supervisory
departments at the end of this year and then more widely next year. But I am sure it will take
a while to bed down the new framework: it will take some time to embed a more challenging
culture within the Central Bank and to develop our understanding of the business models of
the firms we supervise. We are getting pretty close to our target level of resources but we
need to continue to challenge ourselves to improve our technical skills and our
understanding of the commercial drivers facing industry.
Conclusion
I hope this short summary has given you a good understanding of the various developments
that we believe will combine to provide for a strong, more robust banking sector subject to
more effective governance and regulation.
As a final observation, I would note that these changes occur in the context of the wider
financial services industry, where Ireland is a leading player in the funds and insurance
industries and has an important international wholesale banking sector. These parts of what
is loosely known as the IFSC play a crucial role in Irish economic life. However, the
reputational damage of the banking crisis has cast a long shadow and has indirectly touched
them too. By reforming the banking sector - and strengthening financial regulation more
generally by closing gaps in governance and probity standards, implementing a new risk
assessment framework and adopting forthcoming legislation on new powers - through these
measures Ireland can rebuild its reputation as a financial centre based on strong regulation.
This will help avoid fresh supervisory problems in the future and allow the IFSC to continue
to prosper.
So, progress on the banking agenda, while essential in its own right, has important broader
benefits. There is still some way to go, but I hope I have shown you there are positive
developments on a number of fronts. By the time of the next summer school or two, I would
hope to not only have a few more of Donegal's hills under my belt but also to be able to
report further progress with this ambitious but essential set of reforms.