That semantic distinction, between 'better regulation' and ‘improvement of reputation’ encapsulates the sometimes emotional debate between those who might use the language of the political left to describe financial services as a sector that needs to have 'manners put on it', and those who see the IFSC as a sector like any other that, furthermore, is central to the success of the modern Irish economy. Elderfield sees it as a sector that needs to be well regulated and compliant so that it can continue to contribute to the Irish economy.
The IFSC employs 25,325 directly (as of December 31st last) and more than 25,000 additional people indirectly, if one is to include both professional services devoted to international financial services and other well paid employment financed by the taxes it contributes to the Exchequer.
The IFSC has exhibited a remarkably low incidence of misdemeanours by international standards throughout the financial crisis and for this reason the IFSC, to its general frustration, has tended to see itself as unfairly tarred with the sins of the gross excesses witnessed in Ireland in the management of domestic credit in the years running up to 2007.
Whatever about the nuances of the above terminology, Elderfield clearly shares a passion for establishing a financial services sector that demonstrates a 'gold standard' international class of regulation.
Our interview attempted to probe a number of areas where that 'gold standard' might be in danger of being exceeded, perhaps resulting in a level of 'gold plating', at the cost of introducing inappropriate levels of over regulation that make doing business impossible. This is a concept that Elderfield accepts, given his alignment with concerns expressed recently, for example by the funds industry, and the Taoiseach. For example, speaking recently in a keynote speech on funds industry regulation at the IFIA annual conference he said, in relation to revised MIFID rules that seem to militate against the workings of the single EU market in financial services ‘A lot of disappointment has been expressed that some of the issues that were heavily debated in ESMA - and where we believe sensible proposals were reached - have been revisited and changed. I can understand that sense of frustration. For example, we think it's important to recognise that the business model of the funds industry involves a significant degree of delegation and outsourcing of activity. We hope that the final Level II text being developed by the Commission reflects the very reasonable concerns that have been expressed by stakeholders and regulators in this area.’
Our interview also focused on international banking, where we raised concerns that there may be a reluctance on the part of the Central Bank to encourage growth in international banking as an IFSC activity, and lack of clarity on future policy in view of the uncertainties that surround the final shape of the proposed ‘European Banking Union.’
Ken O’Brien: ‘Would it be fair to think that the Central Bank now is not particularly keen to encourage the growth of large international banking entities in Ireland, whereas Luxembourg, a fellow eurozone member, is not so constrained?
Matthew Elderfield:
‘There are some business models that I would be concerned about. I think that if somebody wanted to set up a central counterparty that was lead supervised out of Ireland and there was a high concentration of derivatives trading in the Irish entity that would create a big risk for the Government. Or if you used Ireland as your principal source of proprietary trading, and we were the lead supervisor, you have to worry about systemic risk. These are, however, pretty hypothetical scenarios and in fact the current developments in the international banking sector are quite challenging.
When I look at all the sectors of the IFSC it's obvious that the banking sector is the one that's got the most head winds facing it, in terms of future growth. A lot of IFSC banks had structured finance as their principal business activity and obviously that's declined a lot, so I think there has been a natural retrenchment in the numbers and the size. And what you're seeing in international banking generally is that there is a consolidation and a retrenchment back to home base.
There is certainly a debate about systemic risk and regulation, and what standards you apply to systemically important entities. That's mainly been happening at a global level, this idea of identifying your GSIFIs and DSIFIs (global systemically important financial institutions and domestic systemically important financial institutions). This is happening on the banking side and there is also an effort to do this on the insurance side.
When you have identified them you must decide what mitigation or extra standards you have in place and on the banking side that's clearly requiring higher capital. And now that's being done at a global level where there is a shortlist of banks for that but also I think regulators are thinking about systemic risk closer to home. The idea is to identify them, make sure the appropriate loss absorbency and capital are in place and make sure there is sufficient supervision around them.
We approach this through the PRISM framework by saying we will assess each institution in the IFSC for its impact. The impact on consumers is one leg of the approach. It could be said that the IFSC does not have that much of an impact on consumers but there are examples where it does. For example, there are cross border retail insurance operations in Ireland that operate all across Europe.
A second measure or metric we use is the prudential impact. We have some large banks that rank high in our impact category and what we do there is that we give them more attention. Our engagement model is to say that we will spend more time looking at them, more time talking to their CEOs, and more time thinking about their business models and risk profile.
KO’B: Would that be a very large bank like Citibank or Bank of America/Merrill Lynch, banks like that, which might be 'high impact', by your definition.
M.E.: We don't disclose which banks are in which impact categories, but what I could say is that the largest banks in the IFSC with the biggest balance sheets and the biggest activities are the ones that tend to be the highest impact and would have a very high level of engagement.
Q: Are you approaching the question from a primarily global, or perhaps, ECB perspective then?
A: I wouldn't say that. However, one must be aware of that context and that a calibration between international and domestic standards of regulation can only improve the reputation of Ireland as a financial centre.
Q: Yes but you are talking about very big international banks. They are not owned by Irish tax payers or the Irish Government and certainly if one of them failed there would be no obligation on the Irish tax payer or on an Irish Government, because they are not systemically important to the Irish economy, unlike the domestic banks who are systemically important, to bail them out in an international context. So what you're doing is adopting a global regulatory perspective when you're doing that, when you are taking that point of view.
A: We don't have any GSIFIs. For the ones that we have here, we look at their Irish impact and therefore should we have more engagement with them or not? What do we think of systemic risk; is there a risk of a particular business model coming in that would expose the Irish tax payer?
Q: But how could a particular business expose the Irish tax payer? A decision to guarantee is a decision taken by the sovereign, by the Government. For example, the Government didn't have to bail out international banks, or implement a bank guarantee back in 2008, it could have left them fail. Indeed it didn't guarantee Depfa which actually was an Irish bank. Just because it is here doesn't mean it has to be guaranteed. I just think that sometimes there is a kind of thinking that just because it happened in the past, it has to happen again the future. Does that assumption creep in in any way to the regulatory perspective?
A: I think in terms of the impact categorisation and the level of engagement. If you're big and you could have a big impact on the local economy or on the consumer you would need more attention. Perhaps sometimes we would have to say to a company 'this is extremely systemically risky and we don't want you at all'. I would say that this would be quite exceptional.
Q: Could it be that these are perhaps 'too big to regulate' as distinct from 'too big to fail'? In the sense that we don't have the capacity, the abilities, domestically within this hub of the future potential banking European Union the regulatory sophistication to regulate such an entity?
A: No, I don't think that's it. I feel confident that within the banking union, or on our own, you can develop the expertise to do that. But no matter how good a regulator you are, you always have to be prepared in case you are not successful and in the event of failure.
I think for the globally systemic entities, if you are the lead supervisor, that gives, potentially, a lot of risk to the tax payer.
Q: Because the assumption is being implicitly made by the Regulator that the taxpayer might have to bail it out?
A: Could become exposed: exactly.
Q: How could such an exposure arise, though, if the politicians said ‘we're not bailing it out.’ There would not or could not be an exposure in that case?
A: If your systemically important entities fall over, they could cause disruption to the economy, to the global financial markets. With the 'too big to fail' entities, you want to avoid having to bail them out by putting in a lot of capital and regulating them very thoroughly, but you want to be very wary I think about taking those on if you don't have the balance sheet or the GDP to be able to deal with the remote risk that they pose.
Q: There is another particular aspect that you also might touch on in relation to this topic. I understand that the Bank is not in favour, or at least doesn't look favourably on, the establishment of branches of non-EU banks in Ireland other than as fully capitalised subsidiaries, an American or a Japanese bank for example?
A: For EU firms there is no restriction. For non-EU firms I think you'd look at it case by case, and see about the home country supervision there and whether you'd feel comfortable with a particular business model.
Q: So it would be possible for a bank from outside the EU to establish a branch here for the first time, that was not necessarily a fully capitalised subsidiary, as the sole regulated entity within the European Union?
A: I wouldn't rule it out as a matter of absolute policy but you would have to look at it very carefully and decide whether or not you'd want to do it.
Q: Although the European Banking Union hasn't happened yet, how do you view it as of now?
A: ‘It will change how we work in quite a significant way. It is still under negotiation and discussion. There's a lot of open issues to be decided, particularly the size, which types of entities come in, how quickly they would be subjected to supervision, what's the structure in terms of what decisions are delegated to us and so on. We want to break the link between banking systems that are under pressure and sovereign finances that are under pressure. If we have the banking union being introduced as the possibility to disentangle those and stop this negative feedback loop, then the costs of recapitalisation of banks and doing resolution could be spread across the eurozone as a whole. So, we think it’s very important to do that. But we think it’s important that this clarity of how recapitalisation works and how resolution works is introduced. We also think that it’s important that you still make sure that the single market works effectively and therefore the European Banking Authority stays as an important rule-maker and policy maker and that therefore you still have the EU twenty seven as a single market operating effectively.
Questions on Enforcement: - On enforcement issues, he was asked whether he was aware of a widespread concern that the sins of the domestic banking sector are being inappropriately visited upon the IFSC, that IFSC companies, by and large, were parts of well governed international organisations, subject to regulation across many jurisdictions, and that an overly zealous approach, particularly on the enforcement side, was a concern that was justifiably held. Examples given were the application of the Criminal Justice Act provision to a relatively minor oversight such as the first application of a sanction under the Criminal Justice Act 2011 for a relatively minor misdemeanour under money laundering legislation, and the case of a captive insurance company publicly sanctioned and fined for a relatively minor oversight in maintaining prudential ratios, subsequently rectified and notified to the regulator.
A: While I cannot comment on individual cases, it is our policy to adopt a proportionate approach. Public enforcement is important in driving change including cultural change. Enforcement, and penalties, and the demonstration effect of penalties are essential parts of modern effective regulation, and this is an essential part of our toolkit in establishing a better regulatory regime in Ireland.
With regard to IFSC companies, most are parts of well governed international organisations, but there have been several instances where this was not the case, and where we have discovered, for example, serious internal deficiencies. We make no apology for taking appropriate action where we find breaches. This sector needs to be well-regulated and compliant so that it can continue to contribute to the Irish economy.
Q: How would you comment on the idea that far too much emphasis has been devoted to date to enforcement rather than to detection (for example by adequately resourcing the Fraud Squad of the Garda Siochana), for breaches of the law, mirroring the approach, of, say, the United States, that sees the FBI resourced to engage in detection through good police work?
A: As I said, enforcement is an essential part of a regulator’s toolkit and effective enforcement is essential to change the culture and to encourage compliance. Detection is of course also very important. While the resourcing of the Garda in this regard is a matter for the Government, effective enforcement and detection can only improve the reputation of Ireland as a financial centre.
Q: The Central Bank is seeking new powers (in the Central Bank (Supervision & Enforcement) Bill 2011) to double the existing maximum penalties under the administrative sanction regime from €0.5m to €1m for individuals and from €5m to €10m for firms found in breach the law. How would you justify this?
A: It is important to ensure that if you have a deterrent in place it is an effective deterrent. Increasing these penalties is aimed at making individuals think about the consequences of their actions and putting in place a strong disincentive to breach the regulations. Transparency is also important as a deterrent and I have encouraged the publication of fines and sanctions.
Q: Do you feel there is adequate redress for regulated entities who might feel themselves as unjustly treated as part of the enforcement process?
A: I feel the channels of legal redress are adequate and available to anyone who wishes to avail of them.
Q: What is the Central Bank's role in promoting Ireland as a financial centre?
A: The Central Bank Act 2010 explicitly omitted an earlier requirement for the Central Bank to pay heed to the promotion and development of the international financial centre, and the benefit of this was to remove an element in which the Central Bank was conflicted. I see our role as ensuring that we have a well-regulated centre with a good international reputation which will in turn encourage financial firms to establish here.
This article appeared in the November 2012 edition of Finance Dublin.