14 May 2012 at 15:25 BST

The right sort of regulation

EU institutional reforms are key to ensuring the financial crisis never happens again. Donnacha O Connor reports from Ireland

The financial crisis exposed the failure of supervision of the financial sector in many countries, including Ireland. There has been an understandable criticism of the private sector and the regulators and their respective roles in the crisis. The crisis also exposed weaknesses in the EU and domestic legal and institutional framework in which regulators operated. Fundamental changes have been made to the laws governing the EU financial sector and to the institutional infrastructure underpinning European financial regulation and supervisory practices. Within this EU framework, Ireland’s law makers and regulators have taken a number of steps to change the way in which firms are regulated.

Short-comings in European financial regulation

There were a number of short-comings in the European system of financial regulation which were identified during the crisis. There was an absence of monitoring of systemic risk at a domestic and European level, as well as a lack of specific regulation and transparency in relation to certain systemically relevant aspects of the financial system. These included the activities of offshore funds, securitisation vehicles and rating agencies, as well as the operation of the OTC derivatives market and of remuneration structures within financial firms.  In addition, the rules set out in certain core laws, such as the Capital Requirements Directive (made up of Directives 2006/48/EC and 2006/49/EC, as amended), the basic  purpose of which were to ensure the financial soundness of credit institutions and investment firms, were ineffective in preventing firms from failing.

National regulators could ignore rules

 There was also an absence of a coherent set of rules across the EU (the so-called single European rule book) due to variations in the transposition of EU Directives,  ambiguities or gaps in the rules, exceptions made, derogations granted or gold-plating of EU rules by individual Member States. Several directives left member states significant options and discretion.The Lamfalussy committees of supervisors (the predecessors of the three new European supervisory authorities) were only able to issue non-binding technical standards which were often ignored by national regulators.

New supervisory framework enacted

In response to the crisis, the European Council adopted new rules to reform the EU framework for the supervision of the financial system and a plethora of new or revised financial laws are in the process of being enacted. The two pillars of the new EU supervisory framework are the European Systemic Risk Board (ESRB) and the European System of Financial Supervisors (ESFS).  The ESRB is broadly responsible for macro prudential supervision and the ESFS, which is made up of an integrated network of European financial supervisors working with three new supervisory authorities, the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA), is broadly responsible for micro prudential supervision. The powers of the EBA, EIOPA and ESMA now include the development of binding technical standards and interventions relating to the supervision of individual firms in certain circumstances.

Ireland’s enhanced governance

In Ireland, at the institutional level, the Central Bank Reform Act, 2010 abolished the separation between central banking and financial regulatory functions introduced in 2003 and the Central Bank of Ireland is now also responsible for maintaining the stability of the financial system and the proper and effective regulation of markets and financial service providers. This 2010 law and subsequent legislative enactments have given the Central Bank enhanced supervisory and enforcement powers. One of the key tenets of Central Bank supervisory policy is to promote strong and effective governance.To this end the Central Bank has issued or endorsed a number of industry specific corporate governance codes containing requirements in relation to Board composition, independence of Directors, attendance at meetings and other matters.

Different approach to supervision

The approach to supervision in Ireland has also changed. Principles based regulation has been replaced by a risk based supervisory approach known as PRISM (Probability Risk Impact SysteM). This focuses the most resources on firms considered to have a potentially high systemic impact on the financial system and a high risk to the consumer. While PRISM is intended to result in a common basic approach to regulation across all financial sectors, it is also intended to identify where risk is concentrated most highly within the financial system.

Types and degrees of risk

Furthermore it differentiates between types and degrees of risk in different financial sectors and so avoids an investment fund being regulated to the same degree as a bank or insurance company for example. The Central Bank’s enforcement strategy is to engage in “pre-defined enforcement” which concentrates on high impact areas such as market conduct, consumer protection and financial crime, focussing on firms with significant market share, and “reactive enforcement” which is event or report based, and to operate in a proportionate, consistent, targeted and transparent manner.

The future

EU institutional reforms and particularly the introduction of a single European rule book can be expected to strengthen the integration of EU financial markets. Additionally, Ireland’s own regulatory reforms are likely to boost confidence in its financial sector and increase the appeal of Ireland as a financial centre and gateway to the EU.

Donnacha O Connor is a partner at Dublin law firm Dillon Eustace



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