Address by Director of Policy & Risk, Gerry Cross, at Irish Funds Breakfast Briefing on 13 January 2017 and the Central Bank’s Independent Fund Directors Briefing on 16 January[...]

Address by Director of Policy & Risk, Gerry Cross, at Irish Funds Breakfast Briefing on 13 January 2017 and the Central Bank's Independent Fund Directors Briefing on 16 January 2017

Good morning.

It is a great pleasure to be here this morning and to speak with you on some topics of current interest.

CP86[1] Background - why we did it

The Central Bank began a body of work to examine and improve fund management company effectiveness in early 2014 (known as "CP86") and that work concluded just before Christmas last year. That work was prompted by the increasing comprehensiveness of regulation, increased expectation of diligent oversight on the part of investors and because the Central Bank no longer made use of a promoter regime. Beyond these, it was motivated by a belief that enhancing the effectiveness of fund management companies improves the protection of investors, both in Ireland and internationally.

In considering fund management company effectiveness from a regulator's perspective, there were three key areas which needed to be examined:

• Governance;
• Compliance; and
• The ability to effectively supervise the firm.

The Central Bank's belief is that a fund management company which is strong in each of these three areas is one of substance and one which can better protect investors.

Stages in consultation process

CP86 was divided over 3 public consultations; the first two of these, in September 2014 and June 2015, looked at governance issues; the third consultation, in June 2016, dealt with compliance and effective supervision.

In advance of the first CP86 consultation, the Central Bank established a group of industry experts to provide us with advice on how boards should go about overseeing delegates. The report of this Group, the Committee on Collective Investment Governance, formed the basis of our first CP86 consultation in September 2014. The Central Bank also published two draft rules in the first consultation - one on a new Organisational Effectiveness role and one to streamline the number of managerial functions. The Central Bank prepared its delegate oversight guidance drawing extensively on that report. By October 2015, we had published two new rules and three new chapters of guidance on Delegate Oversight, Organisational Effectiveness and Directors' Time Commitments.

The final CP86 consultation dealt with compliance and effective supervision. It contained two more proposed new rules on effective supervision (the so-called location rule which I will discuss in more detail later) and a rule on the retrievability of records. It also contained three further chapters of guidance on Managerial Functions, Operational Issues and Procedural Matters. That consultation issued in June 2016 and the outcome of the consultation together with the final CP86 package were published in December 2016.

Final CP86 package

As I mentioned, the Final CP86 package contains 4 new rules and 6 chapters of guidance.

New rules

I. Streamlining of managerial functions - we have reduced the number of managerial functions from 9 (for UCITS management companies) and 15 (for AIFMs) to 6 for all fund management companies.

II. Organisational effectiveness - fund management companies are required to have an organisational effectiveness role performed by an independent Chairman or an independent board member.

III. Effective supervision requirement - fund management companies with a low impact PRISM rating must have (i) at least two Irish resident directors, (ii) at least half of its directors resident in the EEA and (iii) at least half of its managerial functions performed by at least 2 designated persons in the EEA. The rule is the same for fund management companies with a PRISM impact rating of Medium High or Medium Low except that instead of 2 Irish resident directors, they must have at least 3 Irish resident directors or 2 Irish resident directors and 1 Irish resident designated person.

IV. Retrievability of records rule - Fund management companies must keep all of their records in a way that makes them immediately retrievable in or from the State.

Guidance

I. Delegate Oversight - This chapter sets out how directors of fund management companies should be actively engaged in controlling the fund management company and overseeing delegates. There are five specific areas to which the attention of directors is drawn: investment management, distribution, risk management, investment operations and administration, and support and resourcing. One key concept running through this guidance is that of "review and approve". This makes clear that the role of directors is always an active, never a passive one.

II. Organisational Effectiveness - This chapter sets out the Central Bank's expectations about how the organisational effectiveness role should be carried out. The individuals who undertake this task will be on the alert for organisational issues and will be change leaders who bring proposals to improve effectiveness to the board.

III. Directors' Time Commitments - Fund management companies are guided to ensure directors have the time available to them to carry out their roles properly. The key risk indicator for the Central Bank in assessing time commitments is 20 directorships and 2,000 working hours per year.

IV. Managerial Functions - This chapter describes the Central Bank's expectations of designated persons and sets out in detail the measures which should be employed by fund management companies to ensure compliance with regulatory obligations. There are a number of provisions here that will likely change how many fund management companies currently operate. For example, designated persons cannot receive reports from delegates which only identify exceptions. A summary of relevant information for each investment fund under management is required instead.

V. Operational Issues - This chapter contains guidance on both the retrievability of records and on the need to have a monitored email address. In relation to the former, this provides more detail to assist fund management companies in complying with the rule on retrievability of records. Regarding the latter, this provides that each fund management company should have a dedicated email address to which we can send correspondence to and which is monitored on a daily basis.

VI. Procedural Matters - This chapter deals with the application process for authorisation of fund management companies and the information which the Central Bank will require where a fund management company proposes to use its management company passport.

The Central Bank's approach to rules v guidance

As I mentioned at the outset, one of the reasons for embarking on our work on fund management company effectiveness is the ever increasing regulatory burden being placed on fund management companies. Our aim was not to introduce a further raft of new rules for fund management companies - instead we were concerned with ensuring good levels of, and high quality compliance with, the rules already in place and to make clear how such compliance can be demonstrated.

As a result, the final CP86 package contains very few new rules - only 4, in fact. It does, however, contain 6 chapters of detailed guidance which set out our expectations of how fund management companies should operate in order to ensure compliance.

Some of the commentary on the CP86 guidance describes it as being issued on a 'comply or explain' basis meaning that fund management companies can choose whether or not to act in accordance with the guidance. I would caution against viewing our guidance too much in that light. While our guidance is not enforceable in and of itself, it does set out how fund management companies should act in order to comply with their regulatory obligations. If they do not act in that way, they run the risk that they are not complying with their regulatory obligations, and breaches of regulatory obligations are enforceable. So fund management companies would be well advised to pay close attention to our guidance and to follow it.

Key issues that arose during the CP86 process

Directors' Time Commitments

In parallel with its first CP86 consultation, the Central Bank conducted a thematic review in order to assess the number of directorships held by individuals on the boards of corporate investment funds, fund management companies and AIF management companies. The objective was to assess the impact on investment fund governance where multiple directorships are held by individuals in the industry.

The thematic review demonstrated that the Irish funds industry has a substantial population of 2,057 active directors with a broadening range of expertise. However, there was a small group of 13 individuals who held 652 directorships in the funds industry in Ireland with an extensive level of aggregate professional time commitments.

The Central Bank undertook additional analysis of Director Time Commitments in 2016 and found there was a substantial reduction in the number of individual directors with an extensive level of aggregate professional time commitments.

In September 2016 a communication issued to industry highlighting the key findings of this work. In particular, this analysis found that the amount of time allocated annually to sub-funds varies significantly. There are a number of justifiable reasons why this may be the case. Nevertheless, the Central Bank would remind fund directors that they are expected, having careful regard to existing guidance, to consider the impact which sub-funds may have on the required time commitment for their directorships.

The location rule

The proposal in our final CP86 consultation to require two-thirds of directors and designated persons to be located in the EEA garnered a good deal of the attention from stakeholders and commentators. We proposed this rule because the Central Bank's access and presence vis-à-vis a fund management company's directors and designated persons is particularly important when it comes to our ability to effectively supervise the fund management companies we have authorised. Effective supervision, includes the Central Bank's ability to exert effective influence over a firm on an ongoing basis. This influence exists where a firm and its management are appropriately cognisant on an ongoing basis of the presence of the supervisor and of its demands and expectations; and appropriately concerned as to the consequences of falling below expected standards. It impacts the culture of a firm, the way in which it behaves (including the ability to change that behaviour if needs be) and the way in which it interacts with its regulator.

Respondents to the final CP86 consultation expressed concerns about the effective supervision requirement. They focused mainly on the impact of this proposed requirement in terms of increased costs and decreased competitiveness. They argued that our impact analysis underestimated the impact on fund management company boards and their senior management as it could not adequately account for changes in business models resulting from the Managerial Functions guidance. Respondents also argued that the effective supervision requirement did not strike the right balance between expertise and location.

While the arguments concerning increased costs were of course important to be considered and assessed, our further analysis did not leave us persuaded that any potential increase in costs would be on the whole significant or disproportionate. Indeed, this further analysis led us to the view that to the extent that there might be some such moderate increase in costs, this would be largely the result not of the effective supervision requirement but of the increased demands resulting from regulatory initiatives such as UCITS IV and the AIFMD and of course the overall enhanced clarity introduced by the CP86 package of rules and guidance. On the question of Ireland's competitiveness, it is the role of the Central Bank to deliver high quality, effective, and proportionate regulation and supervision. Financial regulation and supervision are there to ensure stability, protect consumers and ensure that financial markets function effectively, thus supporting the economy. Once that is achieved, which we believe it is by our new rules and guidance, it is not the job of the regulator to seek to go further in some sort of effort to enhance competitiveness. The Central Bank did have a mandate in this respect before the crisis. It no longer does.

In finalising the rules, we were however influenced to a certain degree by arguments concerning expertise and the need to facilitate organisational models which draw appropriately on the expertise of the promoter/investment manager. Applying their expertise to the operation of an Irish authorised fund management company should help to ensure that it is run in the best interests of investors and in a way that achieves the best outcomes for investors. It was, and is, clear to us that this is a question of striking the right balance between two aspects that can be, in certain cases, in a degree of tension.

Having given close consideration to the arguments and evidence provided by respondents, we reached the view that while the main principle and features of our proposed approach remained correct - that it is important that the management of the entity is located in such a way that the entity is subject to the effective and ongoing supervisory presence and impact of the Central Bank - nonetheless there would be a benefit in a modulation in the calibration of that requirement. As a result, we adjusted the calibration of the effective supervision requirement to permit more involvement by persons located outside the EEA by reducing the ratio from, in general terms requiring at least two thirds of directors and managerial functions in the EEA to at least half.

We also set out a non-exhaustive list of the factors that we took account of in determining the effective supervision rule and its calibration. I will come back to this in a few moments.

Retrievability of records rule

The final issue which came up during CP86 that I want to mention relates to the retrievability of records rule. In addition to the effective supervision requirement, we also proposed a rule that requires fund management companies to keep all of their records in a way that makes them immediately retrievable in or from the State. We proposed this because it is essential to our ability to effectively supervise fund management companies that they can produce records when we request them. We were not prescriptive about the manner in which records should be stored and we asked stakeholders whether this was the right approach. Stakeholders agreed that it was but they queried what 'immediately retrievable' meant. We have clarified in the guidance that 'immediately retrievable' means documentation requested before 1pm (Irish time) should be provided to us on the same day and documentation requested after 1pm (Irish time) should be provided to us before 12 noon on the following day on which the Central Bank is open for business. A fund management company should store its documents in a manner that ensures it can retrieve them within these timelines.

Transitional periods

We are mindful that it will be burdensome for many fund management companies to revise their organisational structures and make the changes necessary to ensure that they are complying with the rules introduced by CP86. To allow sufficient time for transition planning and execution, we have provided a transition period for existing fund management companies to 1 July 2018. This is of course subject to a "no backsliding" principle - an entity cannot move further from compliance with the rule during the transitional period. For new fund management companies, the applicable date is 1 July 2017.

There are different deadlines for complying with the guidance introduced by CP86 depending on when it was published and when a fund management company was authorised. For example, all fund management companies regardless of when they were authorised, should be complying with the Delegate Oversight guidance since November 2015. We have published a table setting out the various transitional periods in our UCITS QA (ID1053) and AIFMD QA (ID1113) documents.

What do you need to do now?

While the transitional period does not expire for 18 months, there is much for fund management companies to do in the interim. A lot of focus is bound to fall on reorganising the streamlined managerial functions and on compliance with the effective supervision requirement. But fund management companies should also note the guidance around the allocation of responsibility for regulatory obligations amongst designated persons and around proper documentation of policies and procedures. Fund management companies will need to create dedicated email addresses and establish procedures so that these are monitored daily. They will also need to consider how they are going to store their records so that they are immediately retrievable on request. For example, how will they ensure this if they are relying on third parties to store their records?

As you will have seen, there is a lot in CP86. Implementation will pose a number of challenges for fund management companies. Compliance will require careful planning and dialogue with directors, designated persons and service providers. It will not be something that can be rushed through at the last minute so I urge you to include CP86 compliance into your work planning for 2017.

Brexit

I would also like to take this opportunity to say a few words about Brexit. Both because the issue was raised by a number of respondents to CP86 and because we know there is a great deal of interest in the Central Bank's thinking and approach.

I don't have time this morning to give you a full description of our thinking and our approach. However, we have made available a good deal of this previously and you can find it on our website. Where, by the way, you can also find the dedicated webpage that we have set up for firms interested in seeking authorisation in Ireland.

On the website you will find for example, a speech by Deputy Governor Roux at the IIEA on the 1^st December. You will also find an article that I penned for the January edition of Finance Dublin. As Governor Lane indicated in August, we are committed to providing transparency, consistency and predictability with regard to our regulatory and supervisory responsibilities to mitigate some of the uncertainties facing financial institutions.

Amongst the key aspects to note are the following:

Our approach is embedded in the European context, whether as part of the SSM or as part of the European System of Financial Supervisors. This is significant because it means that regulatory differences should not be a driver of where firms, which are considering some restructuring, might choose to locate new entities or business activities.

Firms seeking authorisation in Ireland will find the Central Bank to be engaged, efficient, open and rigorous. In deciding on applications for authorisation to do business in Ireland and Europe, the Central Bank adopts a structured, robust and risk based process by which firms that are authorised are expected to demonstrate compliance with EU and Irish requirements. We interpret our mandate as requiring us to carry out our tasks effectively, efficiently, and on the basis of high quality outcomes^[2].

In the things that we have said we have explained our approach in respect of requiring firms that are authorised and supervised by the Central Bank to have a substantive presence here. This is very important. Businesses that are authorised here must be run from here.

We have explained that while outsourcing (and insourcing) are permitted, that needs to be in line with sound practices and our regulatory and supervisory requirements. We will always want to see that there is the level of expertise and seniority within the entity to effectively oversee and manage such outsourcing. A firm may not outsource to the extent that it is effectively hollowing out an important part of the regulated activity.

We have also made clear that the Central Bank has not ruled out, and is not planning to rule out, any particular business model on financial stability grounds. For any authorisation process we will be focused on understanding the risks, and how they are managed and mitigated. This is the role of all regulatory authorities. Proper business models, with convincing risk identification and management, suitable products, sound finances, and strong boards and executives, can be expected to be approved, whether or not such business models already exist in Ireland.

Turning to the funds sector specifically: clearly, the UK's exit from the EU has not yet occurred and the terms of that departure and the subsequent arrangements remain the subject of major negotiations to come. It is not possible for us to predict the outcome of those negotiations.

The matter is rife with uncertainty. I see no sign of that uncertainty coming to an end soon. Uncertainties around passporting and the basis for access to the Single Market is of course relevant for the funds industry; in particular, having regard to its geographically distributed nature. For example, global distribution networks with investors across multiple jurisdictions add particular complications. Take the example of a UCITS authorised in the United Kingdom but marketed via the UCITS passport to other jurisdictions. Similarly, what will be the position for UK AIFMs that market Alternative Investment Funds (AIFs) throughout the EU via the existing passport regime? Or, conversely, of EU managers wishing to access the UK market?

These uncertainties were highlighted by respondents to the Central Bank's third consultation on CP86. It is important to note that the Central Bank was conscious of Brexit related implications when formulating the final outcome to the consultation. In particular, a number of respondents raised the issue of how the proposed exit of the UK from the EU would affect the Central Bank's approach to the effective supervision requirement. In formulating the final rules, the Central Bank was cognisant of this aspect.

In the Feedback Statement on CP86 we have, very importantly, set out the type of factors that we have taken and will take into account when considering whether we are able to effectively supervise a firm. These are the factors that we have looked at in deciding what minimum proportion of directors and designated persons should be where in order for us to have effective supervisory influence and impact. This is a diverse list and includes matters such as physical proximity; homogenous legal and regulatory environment; demographic, cultural and historical ties; commonalities of legal system; and similarities of approach to regulation, supervision and enforcement; ease of carrying out of investigations and on-site inspections, etc. If / when the UK leaves the EEA as a result of Brexit, we will reassess the UK against the criteria set out in the feedback statement. It is impossible to know for certain at this stage what the outcome of the UK / EU negotiations will be. However, it is clear that many of the factors relevant to effective supervision seem likely to continue to apply given their nature.

Conclusion

So, let me stop there. I hope I have covered at least some of the issues that are of interest to you at the moment. I will of course be happy to take questions in the Q&A session to come.

Many thanks for your attention this morning.

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