Speaker: Matthew Elderfield, Group Director, Conduct and Compliance, Lloyd’s Banking Group
Date: 13 February 2014
Venue: Guildhall, Gresham Street, City of London, EC2V 7HH
Time: 12.30pm till 2.30pm
Chair: Robert S. Childs, Chairman of The Bermuda Society and Chairman of Hiscox
Matthew Elderfield is Group Director, Conduct and Compliance at Lloyds Banking Group. From January 2010 to September 2013 he was Deputy Governor of the Central Bank of
Ireland and responsible for financial regulation, prudential, conduct of business and markets supervision of financial services companies in Ireland.
Prior to taking up his position at the Central Bank of Ireland, he was Chief Executive of the Bermuda Monetary Authority (BMA) from 2007-2009, with responsibility for
supervision of all financial services companies in Bermuda.
Prior to joining the BMA, he spent eight years at the UK Financial Services Authority (FSA) as a Head of Department in a variety of posts. Before joining the FSA, Matthew Elderfield established the European operations of the International Swaps and Derivatives Association (ISDA) and held posts at the London Investment Banking Association, the British Bankers Association and a Washington-DC based consultancy firm.
Synopsis of Speech:
It is a great pleasure to be invited to attend this meeting of The Bermuda Society and offer a few brief personal reflections of my time as a regulator in Bermuda and also in Ireland. I am very glad to be able to support the work of the Society. I have fond memories of my period at the Bermuda Monetary Authority, of the beauty of the island – a picture of Coopers Island Long Bay has pride of place in my flat – and of the kind support I received from many people, including Sir Richard Gozney and Rob Childs. Sir Richard was a source a good advice and moral support during the difficult phase of the banking crisis in Bermuda, which I will talk about in a moment, and I still have fond memories of Rob giving me a master class in reinsurance underwriting and the risks of a soft market. I’m very glad to be able to support them in their current affiliation with the Society.
I would like to take the next fifteen minutes or so to personally reflect on banking bailouts and bail-ins from the perspective of two relatively small countries, Bermuda and Ireland. Bermuda is of course best known as a prominent reinsurance centre and whilst the financial crisis left a few scars in some parts of that market, principally those insurance companies that had strayed into banking by guaranteeing credit instruments, the insurance and reinsurance industry was mostly resilient and the main focus on work was preparing for international solvency standards.
However, Bermuda also had its own mini-banking crisis and bank bailout. The Bank of Butterfield held a portfolio of structured finance instruments that were subject to increasingly adverse market to market adjustments, which was eroding the bank’s capital position. It became increasingly clear to the BMA that an injection of capital would be required to absorb further losses. A stress testing exercise by the BMA confirmed that fact and sized the necessary injection as at least $200 million. There followed an intense period of contact between the bank and potential investors, but the list of possible suitors dwindled and then, when Lehmans failed in late 2008, evaporated entirely, creating a very difficult situation and requiring government support.
The then Finance Minister, Paula Cox and Financial Secretary, Donald Scott did not shirk from the necessary action.
However, the circumstances were very challenging. A deposit guarantee scheme was not in place. Lender of last resort facilities did not exist with any central bank. Most difficult of all was the size of the necessary recapitalisation – $200 million – relative to the size of the Bermuda annual budget – then $1.1 billion. Directly funding that sort of an injection would be problematic and instead the decision was taken for the government to guarantee a $200 million preference share issue, which – if I remember correctly – was almost entirely subscribed by local residents and businesses.
There were a number of twists and turns in getting the deal over the line. I recall that shortly after the final cabinet meeting there was a leak to local TV and the prospect of a destabilising media report 12 hours before the official communication sequence was due to kick off. I remember a somewhat fraught conversation with the producer of the TV station about 20 minutes before air requesting that they not run the story in the interests of the Island’s financial stability. After a rather intense exchange, to his credit the producer agreed, with only minutes to go before the top of the programme and rushed off to reset his running order.
I’m pretty sure that the Irish or British media would not have been so responsive. As it was, the bailout news broke in an orderly way and the position at Butterfield was stabilised for the time being. There was a breathing space that allowed outside investors to be brought in a year later with a further $500 million or so injection to further strengthen the capital position.
This Bermuda experience was, in hindsight, a useful dress rehearsal for Ireland. Arriving at the Central Bank of Ireland at the start of 2010, it was already very evident to all observers that the domestic Irish banking system was in a critical position. The Irish banks had become exposed to imprudent commercial and residential property lending during a property boom fuelled by a number of factors. The Irish banks were also, crucially, very exposed to liquidity risk. They had all borrowed heavily in the wholesale financial markets in order to fund their expansion and had perilously weak loan-to-deposit ratios. This wholesale source of funding was vulnerable to changes in investor sentiment and that is indeed what happened in a number of waves. First, and before my time, the Irish government sought to fend off a liquidity crisis by guaranteeing the liabilities of the banking system, including not only depositors but also bondholders.
Then, after my arrival and a first round of surgery on the banks to transfer their stricken commercial property portfolios and to recapitalise them, the euro zone crisis struck in Greece in the spring of 2010. The magnitude of the Irish banks losses, the weakening economic position and the government guarantee meant that Ireland was caught in a vicious bank-sovereign negative feedback loop. A weak economy and falling property prices created worse losses that required government recapitalisation. Government support added to national debt and therefore led to austerity measures to reassure markets. But austerity weakened the economy yet again, fuelling the feedback loop.
At the Central Bank we knew we had a problem and the markets knew we had a problem too. Bond yields rose and in the autumn we experienced a bank run. A wholesale bank run that is. The modern bank run is not manifest by a queue outside a bank branch but by a number on a piece of paper circulated each evening at a central bank. As that number – the tally of outflows from the banking system – increased, it was clear that Ireland would need support from the EU, ECB and IMF.
What followed was an extraordinary period with more than a few twists and turns as the shape of the EU-IMF bailout was negotiated and then we proceeded to conducted a major stress test and recapitalisation exercise. Time is too short to recap this all, but I can say that I recall very clearly the final round of the negotiations, returning home late at night in a snow storm, having an over-sized glass of wine and looking at that photograph of Coopers Island Long Bay wondering if perhaps I had taken a wrong turn somewhere along the way.
The Government of the day – especially the late Finance Minister Brian Lenihan, a very brave man who was battling cancer at that time – and indeed the current successor Government, took some very hard decisions, as did my boss the Governor of the Central Bank, Patrick Honohan. By the time the recapitalisation process was through, some €64 billion had been injected into the banking system. The 2010 budget deficit was in the order of 30% of GDP. However, the programme of actions that followed to assess and then strengthen the financial position of the Irish banks and also to improve the fiscal position led to a gradual turnaround in market sentiment. Ireland successfully exited the EU-IMF programme at the end of last year and has fully re-entered the bond markets. That has been quite an achievement, which reflects a significant sacrifice by many ordinary Irish men and women.
What lessons can be drawn from this experience across two jurisdictions? Perhaps three: size matters, tools matter and supervision matters.
Size matters in the sense that for a relatively small country, the risks of an overlarge large banking system can have critical implications for the fiscal position of a government that is forced to undertake a bailout. That is of course the central lesson of the euro zone crisis and of the banking-sovereign feedback loop. In the Bermuda experience, this is illustrated by the limited room for manoeuvre available for providing fiscal support to Butterfield in 2009. I think a few policy implications flow from this. First that it is welcome that the principal Bermuda banks now have the financial support of large well capitalised parents or investors.
Second, Bermuda has been cautious about developing into a large banking centre due to concerns over reputational risk: this is, in my view, a sensible policy and one now reinforced by financial stability considerations. Taking a prudent view on the size of the sector, especially of domestic banks, and of the stand-alone capital and liquidity position of the entire sector is an important lesson.
For Europe, the size matters lesson is of course very clear but is prospectively somewhat uncertain – should we measure the impact of the failure of a bank relative to its country of supervision or to the euro zone as a whole. This is where banking union comes in. Banking union is envisaged as an effort to unify the euro zone banking markets through a single supervisory mechanism and common prudential and resolution tools.
And so to the importance of the right tools. I have mentioned some of the gaps in the Bermuda tool kit in 2009. In Ireland, a well-developed resolution framework – i.e. the ability to continue the critical operations of a bank while apportioning financial losses to equity and bond holders – would have been very useful at the time of the guarantee and could have made a huge difference to the way the crisis unfolded. The post crisis policy initiatives of various bodies have attempted to address this gap, by making banks easier to resolve and by providing the capacity to “bail-in” creditors so that no bank is too big to fail and therefore require taxpayer support.
Bail in, whereby bond holders (or possibly some depositors) bear losses as well as equity holders, is a critical new tool. It was under-used in Ireland due to EU concerns over the implications for bank access to senior debt funding. It was over-used, if you like, in Cyprus, by being applied to retail depositors. The new EU policy framework now tries to get the balance just right. It establishes that if private sector capital is not available to support a distressed bank, bail-in of bondholders should take place before government support. Also such national government support should take place before common European funds are used for a bail out. This is a very important new calibration of the tool set – the right balance between bail-in and national or pan-European bail out – but one that has yet to be tested in a live situation. However, on the horizon the new EU single supervisor is undertaking a stress testing exercise where this may come into play. This will be an important moment for euro zone financial stability later in the year and a test for the ECB as the new euro zone supervisor.
So, finally to the importance of supervision. Good supervision will hopefully prevent the necessity for having to use resolution. Good supervision – that is well-resourced and independent supervisors – is important for Bermuda, both for its banking industry and its insurance industry. The size matters financial stability issue is different for insurers because insurers are fundamentally different types of financial companies to banks and crucially they tend to fail in a very different way (provided they stay away from quasi banking activities). But that said, Bermuda is the home to a sizeable number of important, global insurance groups. Financial distress at one of these companies could, if not managed effectively, have wider disruptive effects and would certainly have adverse reputational implications for Bermuda.
This underlines the importance of continuing support for the work of the BMA under my able successor Jeremy Cox. In my time in Bermuda I was impressed by the Finance Minister’s determination to preserve the operational independence of the BMA and by the Minister and industry’s support to ensure that it was properly resourced to do its job. I know that has continued after me. My concluding thought is simply to ask that the people in this room do all you can to continue to support high standards of regulation and supervision in Bermuda given its importance to the country’s continuing success.
Group Director – Conduct and Compliance
Lloyds Banking Group
13 February 2014