The Central Bank has unveiled plans to strengthen how it protects client assets after a new report into its handling of failed investment firm Custom House Capital found that it lacked sufficient powers and criticised earlier inspections of the firm.
The report by two of the Central Bank's risk advisers found that the regulator would have preferred to change senior management at the firm but "lacked the power to do so short of revoking the authorisation which was judged as likely to result in greater potential loss to customers."
"The Central Bank was therefore unable to intervene effectively in the management of the business and was hindered by the absence of the ability to appoint an administrator," the report says.
The Central Bank was criticised by investors for failing to do more after it discovered irregularities in the firm in 2009, yet it emerged through a High Court inspectors' report last year that the firm had misused €56 million in client funds to cover shortfalls in property investments.
The court appointed Central Bank inspectors to the firm, run by directors Harry Cassidy and John Mulholland, after discrepancies in client accounts were discovered last year during the transfer of assets to a new firm.
Custom House Capital was described "as a sort of Irish Ponzi scheme" by a High Court judge.
The main recommendation in the risk advisers' report, Review of the Regulatory Regime for Safeguarding of Client Assets, is that the Central Bank should be given the power to apply to the High Court for the appointment of an administrator to take control of an investment firm where it has concerns.
The Central Bank has asked the Department of Finance to include provisions to appoint administrators to investment firms in the new legislation, the Central Bank (Supervisions and Enforcement) Bill 2011, which is going through the Oireachtas.
Risk advisers Andrea Pack and James Bagge also recommended that the Central Bank set up an internal specialist team to supervise client assets and force investment firms to set appoint a director or senior manager to be pre-approved by the regulator who would be responsible for client assets.
External audit reports should be replaced by an annual "client asset examination", the report says, drawn from a new document within investment firms called a "client assets management plan" that will force companies to set out their business model and arrangements for safeguarding client assets.
Matthew Elderfield, deputy governor in charge of financial regulation at the Central Bank, said that the recommendations of the report would lead to the regulator implementing "a significant strengthening" of supervision for client assets and improve powers to take control of a firm when it has lost confidence in its management.
"We need to strengthen the supervision and our powers, and the accountability," he said.
Mr Elderfield said that good regulation of client assets is critical to protect investors. "Where it hasn't been effective - like Custom House Capital and Morrogh Stockbrokers in Ireland or MF Global in the US - the costs can be significant," he said.
The Central Bank plans to strengthen client asset protection through "tougher supervision, better rules, stronger audits, assumption of new powers and more accountability for firms' directors," he said.
The report by the risk advisers, who are professionals from the financial industry, found that the Central Bank had no powers to intervene directly in the management of a firm's business short of withdrawing its authorisation or having the company wound up.
"These draconian measures may not be in the interests of clients and measures such as appointment of court inspectors are reactive and may be too late," it says.
The report, which reviewed the inspectors' report into Custom House Capital, found that the Central Bank's supervision was "not best organised" to assess comprehensively the risks to client assets within and across firms and timely, consistent regulatory responses.
"In their daily work, supervisors and inspection teams have responsibilities other than client assets which may result in client asset issues not being sufficiently prioritised," the report said.
The advisers recommend that where firms are authorised to hold client funds, a cap of 10 per cent of turnover on any unregulated business that they write, such as investment in property, should be imposed.
Pointing to the need for improved external audits, the report found that 284 breaches were identified by Central Bank supervisors in 43 inspections, while audit reports uncovered 110 breaches in 178 audits.
The report also recommends that a joint consultative group from the Central Bank and the investment industry should be set up to develop detailed proposals to revise and improve client asset requirements.
The risk advisers criticised the Central Bank's inspection of Custom House Capital in 2009.
"The Central Bank's response in March 2009 seemed to be too rigid and inflexible to develop a more holistic view of what was going on at CHC," their report says.
"In the conduct of its business CHC drew no boundaries between regulated and unregulated products. The inspections focusing as they were designed to do on the regulated activities and products, failed to identify the bigger picture."
The risk advisers found that an earlier inspection, in 2007, found "significant breaches in the client money regulations".
According to the report, the 2007 inspection found that no daily calculations on client assets were being performed and clients were not being notified of the fact that their money was being held in daily accounts.
Supervisers found that there were "recurring un-reconciled items" on the bank reconciliations which were not notified to the Central Bank, some of which were very significant including one for €4 million outstanding for more than one year.
