Opinion of the European Central Bank of 15 October 2008 at the request of the Irish Minister for Finance on a draft Credit Institutions (Financial Support) Scheme 2008 (CON/2008/48)

OPINION OF THE EUROPEAN CENTRAL BANK of 15 October 2008 at the request of the Irish Minister for Finance on a draft Credit Institutions (Financial Support) Scheme 2008 (CON/2008/48) Introduction and legal basis

On 10 October 2008 the European Central Bank (ECB) received a request from the Irish Minister for Finance (hereinafter the ‘Minister’) for an opinion on a draft Credit Institutions (Financial Support) Scheme 2008 (hereinafter the ‘draft scheme’) to be adopted by the Minister by means of a statutory instrument under the provisions of the Credit Institutions (Financial Support) Act 2008 (hereinafter the ‘Act’). On 13 October 2008 the ECB was informally provided by the Irish Department of Finance with an updated version of the draft scheme (hereinafter the ‘updated draft scheme’) . The scheme implements the more general rules contained in the recently adopted Act, on which the ECB has been consulted and issued its Opinion CON/2008/44 on 3 October 2008 . In accordance with the Act, the Minister may not adopt the scheme until a resolution approving it has been passed by each House of the Oireachtas (National Parliament) . The Minister requested the ECB’s opinion on the scheme as a matter of urgency, prior to its submission to the Oireachtas. The ECB’s competence to deliver an opinion is based on Article 105(4) of the Treaty, in conjunction with the third and sixth indents of Article 2(1) of Council Decision 98/415/EC of 29 June 1998 on the consultation of the European Central Bank by national authorities regarding draft legislative provisions , as the scheme relates to a national central bank, the Central Bank and Financial Services Authority of Ireland (hereinafter the ‘Central Bank’), and contains rules applicable to financial institutions insofar as they materially influence the stability of financial institutions and markets. In accordance with the first sentence of Article 17.5 of the Rules of Procedure of the European Central Bank, the Governing Council has adopted this opinion.

1. Purpose of the scheme

1.1 The primary objective of the scheme is to provide a legal basis for the Minister to stand as guarantor of the ‘covered liabilities’ of a ‘covered institution’ for the period of two years from 30 September 2008 to 29 September 2010, as a form of financial support provided under the Act . In accordance with the Act, the scheme has been brought forward as the Minister is of the opinion that: (i) there is a serious threat to the stability of credit institutions in Ireland generally, or would be such a threat if he did not provide the financial support; (ii) the provision of the financial support is necessary, in the public interest, for maintaining the stability of the financial system in Ireland; and (iii) the provision of the financial support is necessary to remedy a serious disturbance in the economy of Ireland . 1.2 The scheme further specifies the scope of the State’s guarantee by clarifying the means by which credit institutions are covered by the scheme and the types of liabilities of the covered institutions for which the State guarantee will be provided, as further discussed in paragraph 3 of this opinion. A covered institution will be under an obligation to pay a quarterly charge to the State for a guarantee, calculated on the basis of, inter alia, its risk profile . The scheme confers extensive powers on the Minister, the Governor of the Central Bank and the Irish Financial Services Regulatory Authority (hereinafter the ‘Regulatory Authority’), as further discussed in paragraph 4 of this opinion.

2. General observations

2.1 The ECB notes that there is an ongoing discussion at both the international and European levels with a view to coordinating the many diverse actions of countries aimed at preserving confidence and stability in the international financial markets. In line with the common principles to guide the action of Member States agreed at the Ecofin meeting on 7 October 2008: (i) interventions should be timely and the support should in principle be temporary; (ii) the interests of taxpayers should be protected; (iii) existing shareholders should bear the due consequences of the intervention; (iv) the government should be in a position to bring about a change of management; (v) management should not retain undue benefits; (vi) governments may have, inter alia, the power to intervene with regard to remuneration; (vii) legitimate interests of competitors must be protected, in particular through the State aid rules, and negative spill-over effects should be avoided . Moreover, the ECB notes that on 12 October 2008 the Heads of State of the euro area issued a ‘Declaration on a

concerted European action plan of the euro area countries’ , in which they confirmed their commitment to act together in a decisive and comprehensive way in order to restore confidence and proper functioning of the financial system, aiming at restoring appropriate and efficient financing conditions for the economy. They agreed on common principles to be followed by the EU and euro area governments, central banks and supervisors to avoid national measures adversely affecting the functioning of the single market and the other Member States. Against this background, the ECB highlights that all the initiatives put in place by national governments to restore the confidence in financial markets should be aimed at implementing such common principles, in the spirit of close cooperation with other Member States and EU institutions. 2.2 The ECB underlines that the recommendations expressed in this opinion in relation to the scheme should be taken together with the recommendations expressed by the ECB in relation to the draft Act in its Opinion CON/2008/44 . The ECB wishes to draw the consulting authority’s attention to the recent ECB opinions issued at the request of other Member States, whereby the ECB has commented on legislative proposals sharing some of the features of the scheme . It is the ECB’s intention to facilitate coordination of the various national efforts addressing the current financial situation, inter alia through timely adoption and publication of ECB opinions on such draft national legislation.

3. Scope of the financial support provided

3.1 Selection of covered credit institutions Under the scheme on which the ECB was originally consulted, the institutions covered are those credit institutions and subsidiaries which the Minister, following a recommendation from the Governor of the Central Bank, specifies by order under the Act as requiring financial support . A credit institution joins the scheme by executing a guarantee acceptance deed in the form to be specified by the Minister and, if required by the Minister, its parent or any other group company also executing such a guarantee acceptance deed . A subsidiary of any parent credit institution which is not regulated by the Regulatory Authority may qualify as a ‘covered institution’, but in the case of a covered institution which is a subsidiary of any non-Irish parent credit institution, the only liabilities covered would be those which relate to the subsidiary’s own business . 3.2 In the context of the above provisions, the ECB notes that on 30 September 2008 the Irish Government announced that it had decided to put in place a two-year guarantee arrangement to

safeguard liabilities with six explicitly named Irish credit institutions and such specific subsidiaries as may be approved by the Government following consultation with the Central Bank and the Regulatory Authority . The ECB notes that on 9 October 2008 the Minister announced that the two-year scheme would also be available to five explicitly named ‘banking subsidiaries’ in Ireland ‘with a significant and broad-based footprint in the domestic economy’ . Against this background, the ECB has the following comments. 3.3 First, the ECB notes that the original proposal whereby the Governor of the Central Bank would be entrusted with the authority to ‘make recommendations’ to the Minister as regards the credit institutions to be covered by the scheme has been modified by the updated draft scheme to the effect that the Minister would instead take a decision to designate those systemically important credit institutions which the Minister specifies require financial support. Given that the purpose of the scheme is to maintain the stability of the Irish financial system, the original proposal to confer this particular role on the Governor would have complemented the Governor’s financial stability 17 18 role under the Act and, more generally, the Central Bank’s statutes . The Governor’s financial stability role at domestic level also facilitates the discharge of his responsibilities as a member of the ECB’s Governing Council to contribute to the stability of the wider European and global financial systems under Article 105(5) of the Treaty. The ECB would have a preference to revert to the original proposal and in any case ensure a proper involvement of the Governor when taking any decision under the scheme with a bearing on financial stability, including all decisions by the Minister to revoke the guarantee in whole or in part in relation to a credit institution. 3.4 Second, the ECB reiterates the stance taken in its previous opinion, according to which arrangements which may be seen as providing preferential treatment to specified credit institutions should be avoided . In this respect, the ECB appreciates the provision of the scheme stating that it is introduced by the Minister having regard to the objective of ensuring compliance with the requirements of EU State aid and competition law , as well as the statements made in the explanatory memorandum to the effect that the scheme is designed to ensure that the covered institutions will not be unfairly advantaged by making undue use of their guaranteed status to engage in a heightened level of activities which create market distortions and facilitate abnormal

balance sheet growth . In this regard, the ECB underlines the importance of establishing appropriate safeguards such as for example limits to marketing of financial products or limits to expansion of activities on the basis of the state guarantees . 3.5 The ECB understands that the Commission has confirmed the compatibility of the guarantee arrangement proposed by the Irish Government with Community State aid rules . The ECB reiterates the importance of ensuring that the further regulatory practice under the proposed arrangements will be conducted in full compliance with the relevant Community law provisions, in particular as regards competition and State aid rules, as well as EU financial services legislation and the single market principles . 3.6 Types of liabilities covered by the guarantee Under the scheme ‘covered liabilities’ are defined as those liabilities of covered institutions existing on 30 September 2008 or at any time thereafter up to and including 29 September 2010 in respect of: (i) all retail and corporate deposits (to the extent not covered by existing deposit protection schemes in Ireland or any other jurisdiction); (ii) interbank deposits; (iii) senior unsecured debt; (iv) covered bonds; and (v) dated subordinated debt (Lower Tier 2) . In the case of a covered institution which is a subsidiary of any non-Irish parent credit institution, the only covered liabilities would be those which relate to the subsidiary’s own business and in respect of which there is no recourse to any other entity (and would not include liabilities which, in the absence of the guarantee, would normally be those of other members of the covered institution’s group) . 3.7 As a further comment as regards the scope of coverage of the State guarantee, the ECB notes that, in line with the declaration made by the euro area Heads of State mentioned before, Member States have to act in coordinated manner to avoid that significant differences in national implementation could have a counter-productive effect, creating distortions in global banking markets. The euro area Heads of State also acknowledged the need to work in cooperation with the ECB so as to ensure consistency with the management of liquidity by the Eurosystem and compatibility with the operational framework of the Eurosystem. Against this background, the ECB notes that uncoordinated decisions to guarantee interbank deposits in some Member States should be avoided as they may involve a fragmentation of the euro area money market. The extension of the guarantee

to cover interbank deposits, as is the case under the scheme , could entail a substantial distortion in the various national segments of the euro area money market by potentially increasing short-term debt issuance activity across Member States and therefore impairing the implementation of the single monetary policy, which is a competence of the Eurosystem under Article 105(2) of the Treaty. The ECB also notes that the summit declaration states that the euro area Governments would make available a Government guarantee of new medium term (up to 5 years) bank senior debt issuance, whereas the scheme proposes to cover senior unsecured debt and asset covered securities, without limitation as to maturity, and dated subordinated debt (Lower Tier 2) . 3.8 The draft scheme on which the ECB was formally consulted indicates that it remains to be clarified whether the covered liabilities would exclude any inter-group lending and any debt due to the ECB . The exclusion of debts due to the ECB from the liabilities covered by the guarantee under the scheme would be incongruous, however. Under the Act the borrowings, liabilities and obligations of any credit institution or subsidiary in respect of which the Minister may provide financial support include borrowings, liabilities and obligations to the Central Bank . This would imply that the following liabilities to the Central Bank would be covered liabilities under the scheme: (i) deposits made by the Central Bank with covered Irish credit institutions as part of the Central Bank’s investment operations; and (ii) senior unsecured debt securities and covered bonds issued by Irish credit institutions covered by the scheme and held by the Central Bank as collateral in the Central Bank’s Eurosystem monetary policy and intra-day credit operations . By contrast, deposits made by the ECB with these same Irish credit institutions as part of the ECB’s investment operations would not be covered liabilities under the scheme. As a practical matter, this would, in all probability, provide a strong incentive to the ECB to refrain from making deposits with such Irish credit institutions in the future, since the ECB could no longer rely on the normal credit ratings attributed to exposures with these Irish banks, which would be based on the presence of the Minister’s guarantee . 3.9 The ECB further understands that because of the abovementioned inclusion of covered institutions’ liabilities towards the Central Bank within the scope of the State guarantees provided under the scheme , the Central Bank may find itself in a situation where it is lending to a credit institution against collateral which may, at least partially, take the form of a guarantee provided by the State.

Such central bank lending to a solvent credit institution on the basis of a State guarantee is, in principle, possible, provided that the Central Bank’s compliance with the monetary financing prohibition under Article 101 of the Treaty is ensured. Specific criteria for such compliance must be respected as noted by the ECB in a recent opinion issued with respect to another EU jurisdiction which has legislated in response to the current market turmoil . In this opinion, the ECB underlines its earlier recommendation that nothing in the legal framework governing the provision of financial support by the Irish authorities should prejudice the Central Bank’s compliance with the prohibition on monetary financing under Article 101 of the Treaty . 3.10 Finally, as regards the payment of the claims in respect of covered liabilities, the ECB highlights that in general the existing funding mechanism of the deposit-guarantee scheme should be used to the extent possible. In this respect, in fact, the ECB notes that the scheme covers all retail and corporate deposits to the extent they are not covered by existing protection schemes in the State or any other jurisdiction . However, the ECB notes that the relationship between the scheme and the existing deposit guarantee scheme as regards the treatment of claims and the reimbursement of deposits should be further clarified.

4. Allocation of supervisory powers related to provision of financial support

4.1 The scheme confers extensive powers on the Minister, the Governor of the Central Bank and the Regulatory Authority, which are divided as follows. (i) The Minister has the power to: (i) impose specific obligations on covered institutions which are subsidiaries of non-Irish parent credit institutions to ensure that the scheme is not used for the benefit of any entity other than the relevant covered institution ; (ii) in consultation with the relevant overseas regulator (subject to the requirements of the Treaty and the ESCB Statute), require certain obligations of the scheme to apply to the parent of a covered institution or any member of its group ; (iii) receive confirmations from covered institutions regarding compliance with relevant regulatory standards and (through covered institutions’ auditors) with the conditions of the scheme ; (iv) direct, following consultation with the

Governor and the Regulatory Authority, a covered institution to submit a restructuring plan to ensure compliance with the objectives of the scheme ; (v) direct a covered institution to appoint non-executive directors to its board from a panel approved by the Minister and admit observers appointed by the Minister to observe the meetings of the internal committees of the covered institution ; (vi) direct a covered institution to take specified steps to restructure its executive management responsibilities, strengthen its management capacity and improve its corporate governance ; (vii) impose sanctions on the covered institution, if in the opinion of the Minister it is in material breach of its obligations under the scheme ; (viii) following consultation with the Governor and the Regulatory Authority, prevent a covered institution from acquiring shares in any other credit or financial institution, establishing any subsidiaries or entering into or acquiring any new business where this would increase the State’s liability under the guarantee ; (ix) following consultation with the Governor and the Regulatory Authority, make rules governing the payment of dividends by a particular covered institution ; (x) establish an independent oversight committee to impose controls on the executive remuneration of covered institutions ; and (xi) in the event of any default of a covered institution which creates a liability on the State, direct the covered institution concerning its business and corporate structures . (ii) The Governor of the Central Bank has powers to: (i) together with the Regulatory Authority, set regulatory requirements for the covered institutions ; (ii) together with the Regulatory Authority and following the consultation with the Minister, require a covered institution to conduct its affairs in a manner that progressively reduces the risk to the State under its Guarantee . Further, the Governor may be consulted by the Minister regarding institutions to be covered under the scheme . The Governor is also consulted by the Minister before the Minister exercises any functions under the scheme which relate to the Governor’s statutory

responsibilities , as well as with respect to the exercise of certain more specific powers of the Minister under the scheme . The Governor monitors, together with the Regulatory Authority’s Chief Executive, the operation of the scheme and reports regularly to the Minister thereon . (iii) The Regulatory Authority, apart from the abovementioned functions performed jointly with the Governor: (i) receives (on behalf of the Minister) from the covered institutions reports, addressing their key supervisory parameters and submits to the Minister reports on the compliance by covered institutions with the terms and conditions of the scheme ; (ii) after consultation with the Minister, may require a covered institution to establish appropriate funding structures ; (iii) if so directed by the Minister, may require any report or other information to be provided by a covered institution to be audited by an independent auditor ; (iv) is consulted by the covered institutions towards developing a code of practice for effective risk management, in furtherance of the purposes of the Act ; (v) may, following consultation with the Minister, require changes in the composition of a covered institution’s board in order to achieve an appropriate balance between executive and non-executive directors ; and (vi) may, after consultation with the Minister, require changes in the specific elements of the commercial conduct of the covered institution . 4.2 On the one hand, the ECB welcomes those provisions of the draft scheme that allow the Governor to be involved in the exercise of the Minister’s powers under the Act and the scheme for purposes of maintaining the stability of the Irish financial system. Moreover, the ECB welcomes the express safeguards introduced under the draft scheme as regards the role of the Governor, in particular the clarifications that: (i) nothing in the scheme shall prejudice the independence of the Governor ; (ii) the Governor’s authority to disclose information concerning a covered institution or its subsidiaries to the Minister and the Regulatory Authority is subject to the confidentiality

requirements imposed on the Governor by the Treaty and the ESCB Statute ; and (iii) the Governor’s monitoring and regular reporting to the Minister regarding the operation of the scheme is without prejudice to the Governor’s responsibility for the performance of functions conferred on the Governor and the Central Bank under the Treaty and the ESCB Statute . These provisions satisfactorily incorporate, as far as the draft scheme is concerned, the recommendations made in this respect in the recent ECB opinion on the Act . 4.3 On the other hand, the ECB notes that the division of responsibilities to be performed in the implementation of the scheme by the Minister, the Governor and the Regulatory Authority provides the Minister with substantive powers to review, direct or otherwise influence the conduct of the credit institutions concerned. The ECB appreciates that the Minister must protect the financial interests of the Irish taxpayer . However, the ECB would also wish to draw attention in this context to the principle of operational independence of banking supervisors, which are to pursue supervisory objectives free from political pressure, which is an internationally recognised supervisory standard specified in the Basel Core Principles for Effective Banking Supervision . In line with its previous opinions , the ECB recommends that the allocation of powers related to the operation of the scheme be reconsidered, with a view to assigning to the Regulatory Authority and/or the Governor those powers under the scheme that are closely connected with the performance of supervisory tasks. 4.4 As a general remark, the ECB notes that the powers conferred under the scheme could be defined in a more coherent way. For example, in the updated draft scheme there appears to be an overlap between the two separate references to the functions of requiring the covered institution to ‘put in place improved structures to ensure long-term stability of funding’ or to ‘restructure its executive management responsibilities, strengthen its management capacity and improve its corporate governance’ . Also, a greater consistency in the method of allocating the various powers under the

draft scheme could be ensured . The ECB recommends that a more coherent delineation of the powers of the respective supervisory authorities is introduced.

This opinion will be published on the ECB’s website.

Done at Frankfurt am Main, 15 October 2008.

[signed]

The Vice-President of the ECB

Lucas D. PAPADEMOS