Philip R Lane: The development of the European and Irish financial
systems
Speech by Mr Philip R Lane, Governor of the Central Bank of Ireland, at the European Financial
Forum, Dublin, 31 January 2018.
* * *
Speech delivered to the European Financial Forum, Dublin Castle
Introduction
It is a pleasure to have the opportunity to address the 2018 European Financial Forum. The
European economy is currently in a robust expansion phase, which is supported by the ongoing
accommodative monetary stance of the ECB and the improvement in global economics
conditions that was highlighted by the IMF last week.
The Irish economy is also performing well, as was outlined in the Quarterly Bulletin that we
published last week. While the headline GDP data are tricky to interpret, our labour market
forecasts capture the recovery in the domestic economy: we expect unemployment to fall to just
over 5 percent in 2019, with employment growing by 2.2 percent in 2018a and 1.8 percent in
2019. In turn, the tightening of the labour market will contribute to earnings growth of 3.2 percent
in 2018 and 3.4 percent in 2019.
The normalisation of European economic and financial conditions provides an opportunity to
move forward with the further development of the European and Irish financial systems, even if it
remains important to maintain focus on addressing the legacy problems from the crisis (such as
the excessive stock of nonperforming loans). In particular, it is desirable to make progress on
banking union and capital markets union, while also further strengthening the institutional
architecture underpinning monetary union. At the same time, the financial integration agenda
among the EU27 sits side by side with the impending departure of the UK from the European
Union, which will lead to a new configuration of the broader European financial environment. In
particular, the extent and nature of post-Brexit trade in financial services between the EU27 and
UK financial systems will critically depend on the outcome of the current negotiations between
the EU and the UK.
In my remarks today, I will address three topics. First, I aim to provide you with an update on the
impact of Brexit on Ireland's role as an international hub for international financial services.
Second, I wish to outline an innovation - the concept of sovereign bond backed securities
(SBBS) - that may prove helpful in supporting the development of banking union, capital markets
union and monetary union. Third, I will briefly discuss diversity in financial services, which is the
theme of a panel discussion this afternoon.
Brexit, International Finance Services and Ireland
The Central Bank of Ireland has been focused on Brexit since the announcement of the UK
referendum. At a macroeconomic level, we monitor the impact of Brexit on the Irish economy
and assess the potential macro-financial risks that may arise as a result of Brexit over different
forecast horizons. So far, the main channel by which Brexit has had a macroeconomic impact
has been through the 15 percent depreciation of Sterling against the euro since the referendum.
This has affected exporters to the UK but also contributed to a decline in good prices in Ireland,
given the important role of imports from the UK in the Irish consumption basket. The buoyancy of
domestic demand and global economic conditions has allowed the Irish economy to expand at a
robust level, despite Brexit. Still, we remain of the view that Brexit will have a long-term negative
impact on the Irish economy, to the extent that it leads to trading frictions between the UK and the
EU27 and affects long-term UK economic performance.
Turning to the financial sector, one part of our work has been to ensure that Irish-resident
financial firms with UK exposures are making adequate preparations for Brexit. Even if firms may
hope for a soft type of Brexit, it is essential that all entities with significant exposures are
prepared for downside risks.
In addition, Brexit is driving an expansion in both the size and complexity of the
internationallyorientated section of the Irish financial services industry.
In engaging with firms, it is clear that there is considerable uncertainty and complexity for firms in
dealing with Brexit. Among the issues raised by firms are: risk transfer; appropriate governance
structures; contract continuity; and the treatment of third country branches by both the home and
host regulators. This uncertain environment is a complicating factor, since applicants for
authorisation need to prepare robust plans that deal with a range of scenarios.
The European regulatory system is hard at work in formulating the supervisory guidance on the
many thorny issues raised by Brexit: the Central Bank of Ireland is heavily involved in the design
of these policies through our participation in the SSM and the European Supervisory Authorities.
At the same time, the final impact of Brexit on the financial services industry depends on the
outcome of the negotiations between the EU and UK: it is too early to tell.
Many types of entities - including banks; insurance companies; asset management firms; and
payments and electronic money institutions - have made applications to the Central Bank of
Ireland. We have received applications both for new legal entities and from existing entities
seeking to extend their current authorisation. The applicants intend to sell directly to Irish
customers or sell from Ireland into the European Union. The potential activities range from:
broker dealers; trading venues; electronic money institutions; commercial insurance; and retail
insurance.
We expect the current levels of authorisation and supervisory engagements with firms to
increase further. We have put in place authorisation processes that are transparent, predictable
and consistent. Firms that are engaging with us will find us open, engaged and pragmatic. At the
same time, firms will find that we are insistent that governance and control arrangements should
be commensurate with the size, scale and complexity of operations.
Our approach in assessing the plans of existing firms and new authorisations is straightforward.
We seek to ensure that a regulated firm: has sufficient financial resources; is well governed, with
effective risk management and control frameworks and appropriate cultures; has a profitable
business model over the long term; and can recover if it gets into difficulties or be resolved
without significant externalities or recourse to the taxpayer if it cannot. These principles are
shared across the EU regulatory community: in seeking host locations in the EU27, firms know
that attempts at regulatory arbitrage will not succeed.
To ensure that we are equipped to respond to the increased Brexit-related activity, we have
implemented a number of measures. These include: dedicating our most senior and experienced
supervisory and regulatory experts to work on Brexit, in terms of assessing the potential
prudential and consumer impacts; establishing dedicated Brexit authorisation teams across all
sectors; approving recruitment of additional regulatory staff to ensure we have resources with
appropriate skillsets to authorise and supervise new entrants or changes to existing firms;
engaging in cross-sectoral collaboration to leverage expertise across the Central Bank; working
with external experts to assist and support the assessment of new risk areas where we have
less experience; and conducting regular monitoring of the pre-application pipeline for early
identification of specialist resource requirements.
While many firms are moving forward with Brexit preparation plans, the final impact of Brexit on
Ireland has a host for international trade in financial services will depend on the outcome of the
EU27-UK negotiations, with the nature and duration of transition arrangements an important
factor in determining the speed of adjustment. As the negotiations move forward in the coming
months, the Central Bank (in tandem with the wider European System of Financial Supervision)
will be agile in responding to the regulatory implications of the new EU27-UK trading relationship.
Sovereign Bond Backed Securities (SBBS)
As I indicated earlier, it is desirable that Europe makes progress in deepening banking union,
capital markets union and monetary union. Earlier this week, the report of the ESRB High-Level
Task Force on Safe Assets (which I chaired) was published. This report examines the feasibility
of a new asset class: sovereign bond backed securities (SBBS). An intriguing potential feature of
SBBS is that the development of this asset class could contribute to all three types of union:
banking, capital markets and monetary.
The SBBS asset class would consist of re-packaged bundles of national sovereign bonds that
are split into three tranches with different risk characteristics. The lowest-risk (senior) SBBS
would provide banks across Europe with access to a common safe asset, in contrast to the
current configuration by which banks in each country tend to hold disproportionately national
sovereign debt. The higher-risk (mezzanine and junior) SBBS would be held by other types of
investors, in line with different capacities to bear the risk of some European government
defaulting in an extreme scenario. Importantly, the creation of SBBS would not require countries
to share fiscal risks: each national government would remain fully responsible for its public debt.
The bundles of national sovereign bonds would be assembled from all member countries that
are able to issue debt to market investors, in proportion to capital key.
Although simple in concept, the design of this new asset class throws up many issues and
challenges. The task force report runs to two volumes and 300 pages in its attempt to provide
strong analytical foundations for a wider discussion of this concept among finance ministries,
investors and market analysts. In terms of policy issues, a core finding of the task force is that a
necessary condition for the development of SBBS markets is for European regulation to treat the
senior SBBS securities no more severely than national sovereign bonds, while the regulations
covering the riskier mezzanine and junior SBBS securities should reflect their greater exposures
to sovereign risk. To this end, the European Commission is currently examining an enabling
regulatory framework that would remove such barriers to the issuance of SBBS.
In relation to the wider regulatory agenda, it is clear that demand for senior SBBS would be
enhanced by more extensive reforms that would encourage banks to adjust their current holdings
of government debt. Still, there is a diversity of opinion among taskforce members as to whether
such banking regulation reforms are needed for success (especially in relation to the fostering of
banking union), while taking into account the important role for non-bank investors in sovereign
debt markets.
After the necessary regulatory adjustments have been implemented, market development should
be led by demand from investors. Over time, a deep and liquid market could develop. The senior
security could become a benchmark low-risk asset, which the euro area as a whole currently
lacks. With such an asset, banks would be safer and capital markets more efficient.
Accordingly, the SBBS asset class could support the completion of banking union, capital
markets union and monetary union, without weakening market discipline and without taking steps
towards fiscal risk sharing. At the same time, there are many other factors at work in driving the
dynamics of European integration on all three fronts and it is important to bear in mind the
interactions between SBBS and these myriad other influences. As discussions on the nature and
extent of European integration continue to unfold in the coming months, the taskforce report may
be helpful in providing guidance on the potential role of SBBS in the broader design of the
European monetary and financial architecture.
Diversity
Let me turn to my third topic: diversity in the financial services industry. The inclusion of this
issue as part of this year's European Financial Forum is indicative of the welcome and
necessary recognition of the importance of improving diversity across the financial services
industry.
At the Central Bank of Ireland, we have increased our focus on diversity over the last couple of
years, in relation both to the firms that we regulate and also ourselves.
We have focused on diversity from a regulatory perspective because there is strong research to
show that diversity at senior levels of regulated entities can help to reduce the likelihood of group
think, increase the level of challenge and improve decision making and risk management. There
is also a clear connection between the diversity in an organisation and its culture. These are all
attributes that as a regulator we care about. Group think, in particular, was identified in the
Nyberg Report as a contributing factor to the financial crisis in Ireland. The financial services
industry can certainly expect to see a continued increase in the intensity and intrusiveness of our
engagement on diversity.
As an employer, we see the importance of all these aspects in the running of the Central Bank.
We also see diversity and inclusion as vital to ensuring we have the right mix of people to deliver
our complex and diverse mandate and that all our people have the chance to reach their
potential.
Conclusions
Let me conclude. In these remarks, I have pointed out that the development of the European and
Irish financial system in the coming years turns critically on major policy decisions. For the EU27,
the potential gains from the deepening of banking union, capital markets union and monetary
union require policy makers to move forward in taking the steps required to facilitate further
cross-border integration. At the same time, the extent and nature of international trade in financial
services between the EU27 and UK financial systems (and vis-à-vis other parts of the global
financial system) will depend on the outcome of the current negotiations.
Under all scenarios, the Central Bank of Ireland stands ready to fulfill our mandate to safeguard
stability and protect consumers. The consistent application of a core set of principles will guide
our regulatory and supervisory work, such that firms know that we will maintain our focus on
ensuring that regulated entities meet our expectations and are subject to robust supervisory
engagement.
Finally, let me congratulate the organisers of the European Financial Forum on putting together
an excellent programme: it will be a fascinating and stimulating day for all participants.
Acknowledgements: I thank Eoin Battigan, Lorna Bowles, Sean Fitzpatrick and Siobhan Kirrane
for their assistance in preparing this speech.