Accountability and sustainability: key themes in financial regulation - Gerry Cross, Director Financial Regulation Policy and Risk

16 May 2019 Speech

Gerry Cross

Remarks delivered to ICSA Ireland Conference 2019: Governance beyond Compliance

First of all my thanks to ICSA Ireland for inviting me to be here today at your 2019 conference on the important thee of governance beyond compliance.

I would like to speak today about two concepts that feature strongly in the current regulatory agenda. And that will continue to do so for the foreseeable future. They are firstly, accountability and secondly, sustainability.

I am sure that I am saying nothing surprising to participants in this gathering of members of ICSA, the Governance Institute, when I say that well run corporations need to be well organized, with clear lines of responsibility and accountability, and that they should be run to be successful not just today or tomorrow but over the longer term.

Enhanced individual accountability is necessary if we to ensure that financial firms are serving the interests of their customers and the wider economy. Enhanced sustainability is necessary to ensure that they will continue to do so over the medium and longer term.

Accountability

Let me start with accountability and the Central Bank of Ireland’s proposal for the introduction of an Individual Accountability Framework for regulated financial firms. It is widely acknowledged that ineffective governance and poor corporate culture have contributed significantly to failings and failures within the financial industry in the recent past. We have seen, both domestically and internationally, misconduct scandals and failures of significant firms, the root cause of which is never far from weak governance, poor culture, and management failures.

Whether it be the global financial crisis, including its Irish manifestation, the tracker mortgage scandal, LIBOR rigging, forex manipulation, or major money laundering episodes, to name just a few. All of these have been rooted in organizations failing to maintain the minimum expected standards of governance and to foster an effective culture. These failings have had severe consequences for customers and shareholders and in the case of the financial crisis, for the stability of the financial system and the economy as a whole.

One thing that is necessary to restore trust in the banking system and to increase confidence in the wider financial system is ensuring that financial firms are structured appropriately and are well run, with clarity as to who is responsible for what, and accountability when decisions are poorly made or poorly implemented.

Global and national experience indicates that in order for a regulatory framework to work most effectively, delivering good outcomes for customers and the wider economy, individuals in these firms need to see, and believe, that what they do and how they behave, really matters; that there is a direct link between the role they perform and how they perform it on the one hand, and outcomes for the customers of that firm, and indeed for the wider public interest, on the other hand. Putting this another way, we need to be clearer about the conduct that is expected in financial firms. And, overall, we need to raise expectations about that conduct. 

A number of jurisdictions have already implemented individual accountability frameworks - in 2013, the UK Parliamentary Commission on Banking Standards recommended the establishment of a new framework that would increase individual accountability and improve professional standards in banking in the UK. This led to the implementation of a Senior Manager and Certification regime.  it was applied to banks in 2016, to insurers in 2018, and is currently being extended across the whole financial services sector.

In 2017, the Australian Government announced a comprehensive package of reforms to strengthen accountability and competition in the banking sector including BEAR, the Bank Executive Accountability Regime.

And in April 2018, the Financial Standards Board identified lack of accountability as a key cultural driver of misconduct and recommended that national authorities identify and assign key responsibilities, hold individuals accountable and assess the suitability of individual’s assigned key responsibilities.

Last July, the Central Bank submitted a report to the Minister for Finance on the Behaviour and Culture of the Irish Retail Banks which concluded that consumer-focused culture in the banks remains under developed and that banks need to overcome embedded patterns of behaviour in order to transition to maturity. While our report primarily examined culture through the consumer lens, culture impacts all aspects of firms' activities including their behaviour on wholesale markets and their attitude to financial or prudential risks. To address this, the Central Bank recommended that it be given the power under legislation to introduce an enhanced individual accountability framework, which would apply to banks and other regulated financial services providers. The Government has indicated that it is supportive of this proposal and work is underway to introduce the necessary legislation.

Our proposals include the implementation of a Senior Executive Accountability Regime (SEAR). This will place obligations on firms to set out clearly where responsibility lies for all aspects of their business. It will drive better governance structures in firms by identifying the Senior Executive Functions within the firm and stating clearly, by means of statements of responsibility, which individuals are responsible for what. Not only will this mean that it is clear where responsibility lies for each of the key aspects of a firm’s business and for its governance and control activities, we also propose to introduce a number of prescribed responsibilities – such as responsibility for ensuring and overseeing the integrity and independence of the compliance function; the risk function, internal audit etc – which must be assigned to an individual, so that there cannot be gaps in the framework of overall responsibility.

All of this is of course without prejudice to the collective responsibilities of boards and senior management which will remain fully in place.

While the framework is designed to be fully flexible so as to reflect different business models and different size of firms, for efficiency and smoothness it is proposed that a phased approach be adopted, with the framework initially being applied to a range of higher impact institutions and then rolled out more broadly.

It is proposed that enhanced enforceable conduct standards be imposed on these individuals in senior executive function. This will include taking all reasonable steps to make sure that their areas of responsibility within the business are effectively controlled, that they do not give rise to regulatory breaches, that any delegation is to an appropriate person and effectively overseen etc. This will limit the ability of individuals to hide behind the collective when failures occur. Under our proposal there will be introduced a duty of responsibility which will mean that senior executives are held accountable if they responsible for the management of any activities in relation to which their firm contravenes a regulatory requirement, and they have not taken all reasonable steps to avoid the contravention occurring or continuing.

More generally it is proposed to introduce enforceable conduct standards setting out the behaviour expected of regulated firms and all individuals working in them. These are relatively straightforward and include acting with honesty and integrity, with due skill, care and diligence, and cooperating with regulatory authorities. These would expand and enhance the rules already in place, for example in the Central Bank’s Consumer Protection Code and the Fitness and Probity regime. We believe that such standards are very much in line with what any well run firms would expect of the people working for it.

Overall the proposed Conduct Standards will provide a benchmark and make it clear what the Central Bank expects of individuals and firms. Where firms or individuals fall below these standards we will be empowered to take regulatory action and impose sanctions where necessary.

Our proposals for an individual accountability framework are not of course coming in the context of a blank piece of paper. Far from it. They will sit alongside and be integrated with our existing fitness and probity framework which has proved an extremely valuable framework developed to respond to some of the lessons of the crisis as to the suitability of individuals running financial firms. We are also proposing enhancements to the current F&P Regime including a requirement for firms to certify the ongoing fitness and probity of individuals in key roles.

Finally, and very importantly, we have proposed a unified enforcement process, to include a key improvement that the requirement of "participation" be removed as a hurdle to holding individuals to account. Under this proposal the Central Bank should be able to pursue individuals directly for their misconduct, rather than only where they are proven to have participated in a firm’s wrongdoing. The removal of the participation requirement is essential to enhancing the accountability of individuals for failing to maintain basic standards of conduct.

These proposals will require legislative change in order to be effective and we are currently working with the Department of Finance in this regard. Following the finalisation of the legislation we intend to set out detailed proposals in a consultative document. The Department hope to have draft heads of bill before the summer recess and on this basis we hope to be able to publicly consult on our proposals early next year.

In concluding on individual accountability, the proposals aim to drive positive behaviours and the recognition of responsibilities by individuals, which will in turn facilitate greater individual accountability where they have been involved in wrongdoing or seek to hide behind the collective. The proposals will improve governance among firms through increased clarity of individual responsibilities, better documented governance arrangements, improved challenge and oversight by boards, and more effective supervisory engagement.

Sustainability

Let me turn now to the second key governance concept that I want to talk about today: sustainability.

Let me be clear from the start that there are two broad and interrelated meanings of sustainability that are relevant for these purposes. The first is the sustainability of financial firms' business. And the second is environmental sustainability. Both are important.

There are three reasons why the Central Bank of Ireland and other financial regulators are giving sustainability an important place in our strategy.

Firstly, in order to ensure that financial firms are sound and well run so that the interests of their customers are protected it is important that their business models are sustainable. By this is meant that the profits they generate to support their continuing successful operation are predicated not just on short term opportunities but also fully reflect a longer term risk perspective. Well run financial firms will be looking beyond this year’s apparent success to ensure that the risks that will arise next year and beyond are being considered now and planned for.

Secondly, from a regulatory perspective, incorporating environmental, social and governance considerations - the ESG factors - in how financial firms are run is no longer a nice to have. It is expected. And this for solid business reasons. Let me just focus on the environmental aspect of this for now. As Governor Philip Lane explained in his recent economic letter, Climate Change and the Irish Financial System (PDF 833.08KB), climate change is not only giving rise to increased frequency of severe weather events, which themselves have consequences for financial firms and risks for financial stability, and is likely to do so even more significantly in the future, it is also driving a policy response designed to transition economies from an over-reliance on carbon to renewable energy sources. This change in one of the key features of how economies function, their energy supply, has implications for financial firms because their business is inextricably linked with how the economy functions. For this reason, not only do firms need to be identifying and addressing environmental and transition risks, the financial regulatory framework is also becoming increasingly focused on the issue. In this regard, I would refer you also to a speech being made today by Deputy Governor Sharon Donnery on Risks and opportunities from climate change, at a conference organised by the Department of Finance and Sustainable Nation Ireland.

And this brings me to the third reason, why sustainability has become such an important feature of the financial regulatory landscape. Financial regulation is there to ensure that the financial system operates well to support both consumers’ interests and the economy. As we have said in our recently published three year strategy: as regulators we serve the public interest including by seeking to achieve “a trustworthy and resilient financial services system that sustainably serves the needs of the wider economy and its customers”.

The Central Bank serves the public interest and seek to ensure that the financial sector serves the needs of the economy. What we have seen over the recent period is a significantly enhanced set of decisions by leaders and elected bodies, now becoming reflected in laws and regulations, that the public interest requires that economies transition away from their heavy reliance on carbon sources of energy and that the financial system play its important role in supporting this transition. In this you see both of the aspects of the financial regulatory mandate that I have mentioned: a determination by the political leadership that the public interest requires transition and an identification of the role of financial service in supporting the economy through such transition.

As of now 194 states and the European Union have signed the Paris Agreement on climate change agreed in December 2015 and the UN 2030 Agenda for Sustainable Development. In March 2018, the European Commission published its Action Plan on ‘Financing Sustainable Growth’. This Action Plan has three main objectives: to reorient capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth; to manage financial risks stemming from climate change, environmental degradation and social issues; and to foster transparency and long-termism in financial and economic activity.

From these objectives, 10 action points that will directly impact on financial regulation have emerged. Some of these will be implemented as new stand-alone regulations and some will be implemented as amendments to existing regulations and directive, some of these will be implemented next year, others will be further developed and implemented over the next number of years.

A key proposal is seeking to create an EU taxonomy, or classification system, on what can be considered a green economic activity for investment purposes. Firms presently identify sustainable economic activities and sustainable investable assets in-house and on a voluntary basis. This is time consuming and costly, and the result is that different financial institutions use different taxonomies. Consequently, investors often find it too burdensome to check and compare different information for different financial products. This creates uncertainty and discouragement for investors and hampers the transition towards a sustainable economy. To address this, a taxonomy of commonly agreed principles and metrics for assessing if economic activities can be considered sustainable or “green” for investment purposes is currently being finalized in the European legislative process.

While the governing legislation can be expected to be completed during the coming months, allowing for a delay as a result of the European Parliamentary elections, the full taxonomy process will take place over a number of years and be somewhat staggered. It will identify economic activities that substantially contribute to one or more environmental objectives. This will include activities that have an environmental purpose, i.e. having a positive impact on the environment (like renewable energy production).

However, the taxonomy will also likely include economic activities that may continue to have a negative impact on the environment, but where these economic activities have substantially reduced that negative impact. This will enable polluting sectors to move onto greener pathways.

Another area where we will shortly see new obligations is in the integration and disclosure of sustainability risks by institutional investors, such as asset managers, insurance companies, pension funds, or investment advisors. Currently, while existing rules for investment and insurance products require firms to act in the best interest of their clients and provide scope for integrating sustainability risks, they do not require firms to integrate such risks in a consistent way in their investment decisions and disclosure processes. In addition, while firms when providing advice must act in the best interest of their clients, there is no requirement for them to explicitly consider ESG risks in their advice nor to disclose those considerations. Furthermore, there are divergent disclosure standards across the market, which can make it more difficult for end-investors to compare different products thereby distorting investment decisions and reducing opportunities for sustainable investments.

To address this, such firms will have to, assess the risks arising from sustainability factors in their investment and advisory processes and to disclose to end investors the result of this assessment and any potential impact on returns. It will be also be incumbent on firms to have risk policies in place addressing sustainability risks. This means that firms can no longer use a client’s indifference to sustainability as a reason not to consider ESG factors. These new rules will require firms, whether they are manufacturers or distributors of investment products, to be able to determine whether a product has ESG characteristics or not and if so how they would be compatible for their target market. Agreement on the proposal was reached between Council and Parliament on 7 March.

Furthermore, the EU has recently agreed the creation of two categories of voluntary benchmarks designed to orient the choice of investors who wish to adopt a climate-conscious investment strategy. The climate-transition benchmark will offer a low-carbon alternative to the commonly used benchmarks. And, a “Paris-aligned” benchmark will only comprise companies that can demonstrate that they are aligned with a 1.5˚ Paris target. These new benchmarks are designed to give assurances to investors who wish to invest in companies on the basis of sustainable activity. Alongside these developments, we can shortly expect guidance on the green bond standard and the use of Ecolabel framework for green financial products. Of course, the development of the taxonomy is key to all these proposals.

These are only a flavour of the proposals, but the momentum with which new rules and policy are being developed and implemented in this area is significant.

Conclusion

In conclusion I hope I have been able to give you a few insights into the key issues of accountability and sustainability as seen from the financial regulatory perspective. While they are individually and separately significant they are also jointly so. They both go to the central issue of ensuring that financial firms, and financial services, are run in a way that they serve the interests of their customers and the wider economy.

Thank you for your attention.

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My thanks to Philip Brennan and Mary Ferguson for their contributions to this speech.