Banking regulators ignored early warning signals

A senior Central Bank official this week told the Moriarty tribunal he did not wish, in his evidence on the monitoring of Guinness & Mahon bank, to suggest a situation akin to a John Grisham novel.

It was Mr Justice Moriarty who mentioned the US author and the possibility of there having been "some degree of orchestrated conspiracy" within the Central Bank to silence Mr Terry Donovan when he started asking questions about G&M in 1988.

At the time Mr Donovan was a trainee conducting his first bank inspection. He was getting "too close to embarrassing events", Mr Justice Moriarty suggested, no doubt thinking of the Grisham novel, The Firm. Was that a scenario Mr Donovan was proposing by his evidence, Mr Justice Moriarty asked. Or was he suggesting the Central Bank was "unduly hasty in disparaging matters" raised by him in 1988 and which were later revealed to be important?

Mr Donovan said he was not suggesting the conspiracy scenario. Nevertheless there are the makings of a conspiracy thriller in what was happening in February 1988 in the G&M building on College Green, Dublin. The conspirators, however, were in G&M and not in the Central Bank.

The seriousness of what was happening is now widely known. Not only had G&M set up a structure that allowed some of the foremost business figures in the State to avoid the exchange control regulations of the 1970s and 1980s, it also allowed some of them to salt away what were probably undeclared fortunes offshore.

These people could even make withdrawals from their hidden stashes through G&M. In order that large withdrawals would not bring the Revenue's attention to the offshore deposits, the bank gave what have been termed back-to-back loans to these customers. When Central Bank examiners perused the bank's books and queried these loans, they were told they were "zero risk" loans, secured by "hypothecated" deposits held offshore. Hypothecated simply means pledged against a debt.

The primary focus of Central Bank examiners conducting an examination of a bank is on prudential matters. Their function is to ascertain if the bank's finances are sound, and one of the central issues is whether its loans are adequately secured.

In 1976 Mr Adrian Byrne was a Central Bank inspector assigned to conduct an examination of G&M. He discovered loans issued to Irish residents and backed by offshore deposits. He decided the loans were part of a tax evasion scheme. He and his fellow inspector described the situation as evasion in their draft report, but a superior scratched out the word evasion and re placed it with the less critical word, avoidance.

Mr Byrne, who is now the head of banking supervision in the Central Bank, took part in a further investigation of G&M in 1978. He formed the view that the G&M directors were not particularly competent as bankers. "In addition to that, because of what had emerged on the tax position, one could have said that they weren't indeed suitable, fit and proper people to be in charge of a bank," he told the Moriarty Tribunal in March.

The Central Bank reviewed its options and decided that, despite its misgivings, it should do nothing to have the directors removed. To do so could have led to the collapse of G&M and the avoidance of that was the Central Bank's main purpose.

Mr Des Traynor, then the de facto chief executive of G&M, gave a commitment to the Central Bank that G&M would wind down loan business to Irish residents that was backed by offshore deposits. The Central Bank decided to trust Mr Traynor.

What happened next is that instead of ceasing to provide new backed loans to Irish residents, the merchant bank continued to do so and, in fact, expanded the business. While doing so it buried the evidence deeper than had hitherto been the case.

There existed within G&M a "bureau system", or a secret account of who owned what within large deposits that were supposedly deposits from offshore subsidiaries. This bureau system revealed that the large deposits that offshore subsidiaries had placed with the Dublin bank were in fact pooled funds from a range of individual accounts. This was the secret "bank within a bank" that is now known as the Ansbacher deposits.

Because the Central Bank had not discovered the secret bureau system it believed the large deposits from offshore subsidiaries that it found on the G&M books were simply that: deposits made by subsidiary banks.

The closest the Central Bank came to discovering the secret banking system was when it became concerned about the back-to-back loans, because those loans led straight to the Ansbacher deposits. Now the trail was running cold and Mr Traynor must have felt pleased.

The Central Bank conducted further examinations of G&M in 1982, 1986, 1988 and 1992. The Ansbacher deposits were working away and the regulatory authority never discovered them. By this stage, of course, the most powerful politician in the State, Mr Charles Haughey, was among those who had money in the secret banking system.

Prior to Mr Byrne and others giving evidence to the tribunal in March, lengthy background work was conducted within the Central Bank. Most senior officers were aware of what was happening. The preparatory work was on the agenda of a staff meeting held in the Central Bank in February. Mr Donovan, one of Mr Byrne's two deputy heads of banking supervision, attended that meeting. He made no contribution. That same month Mr Donovan was offered an opportunity to read Mr Byrne's statement prior to it being given to the tribunal. He chose not to.

However, Mr Donovan had concerns. In 1988 he was, as Mr Justice Moriarty was to describe him, a neophyte in the banking supervision department. He was sent to accompany Ms Ann Horan and Ms Elaine Byrne, two examiners who were conducting an on-site examination of G&M. While working on that job he developed concerns that he subsequently felt did not get the response they deserved. Over the following years he would recall the matter and mull over it, and he always felt that at some stage what he had discovered would raise its ugly head. He was certainly right about that.

Following the hearing of evidence in March concerning the Central Bank, the Moriarty Tribunal decided to send a questionnaire to every Central Bank inspector who had been involved in inspections of G&M. When Mr Donovan received his, he put down the concerns that had been troubling him since 1988.

During the 1988 examination, Mr Donovan said, he had come across the terms "hypothecated loans" and "hypotheticated deposits" and had not understood them. He asked Ms Horan and she suggested he ask Mr Martin Lannigan O'Keeffe, the G&M executive who was the main point of contact for the examiner.

Mr Lannigan O'Keeffe told Mr Donovan the terms were linked to loans backed by Cayman deposits, but Mr Donovan remained unclear about what he was being told. "I formed the view that it was possible that full information was not being provided to the Central Bank by Guinness & Mahon."

During a later routine encounter between the two men, Mr Lannigan O'Keeffe asked Mr Donovan if he had accepted his explanation. Mr Donovan said he believed the matter deserved further investigation. He then found himself pressed into meeting the bank's general manager, Mr Michael Pender.

At the meeting Mr Pender "mentioned Mr Des Traynor, a name which had no particular significance for me at the time other than perhaps as chairman of Cement Roadstone, and said that Mr Traynor had already explained the back-to-back loan arrangement to Mr Adrian Byrne of the Central Bank. Mr Pender recommended that I discuss the matter with Mr Byrne before deciding whether to proceed further."

"I formed the opinion that Guinness & Mahon management regarded the matter as serious and sensitive," Mr Donovan told the tribunal this week. When he returned to the room he occupied in the merchant bank he told his fellow examiners what had happened. Ms Horan, he said, recommended he take the matter up with Mr Byrne.

This is what Mr Donovan did. Mr Byrne expressed concern about a trainee having unaccompanied meetings with senior management of G&M. "Mr Byrne did not provide me at that time with any information regarding any knowledge he may have had of the back-to-back loan arrangement."

Back in G&M, Mr Donovan continued examining the G&M files, comparing information on deposits serving as security, with information contained in loan file summaries. He was finding inconsistencies between the two sources of information. In other words, he may have been getting close to discovering that the merchant bank was secretly continuing to issue loans to residents that were backed by offshore funds. Only a brief mention of this work ended up in the report written at the end of the 1988 examination (see panel).

At the end of the two-week onsite examination Mr Donovan started to work on a report on his study of the back-to-back loans, a matter that had formed only part of his overall work. Ms Horan told him she saw no need to include this contribution in the final report. All that would be included would be information that would show the level of such loans. Mr Donovan formed the impression that what he had discovered was already known to the Central Bank.

Nevertheless he remained unhappy with what was going into the report and asked that his name not be put on it. Ms Horan would not agree to the omission of his name.

When Mr Donovan began preparing his response to the Moriarty Tribunal questionaire earlier this year, it soon became a sensitive matter within the Central Bank. He was given his own legal team and time off to make his preparations. Ms Horan, who is now managing director of commercial finance with the Bank of Ireland, was informed of what was happening and also engaged lawyers. When Mr Donovan gave evidence this week he was questioned aggressively by counsel for the Central Bank, Mr Kevin Feeney SC, as if he, Mr Donovan, were a witness hostile to the bank.

However, what transpired was not quite the battle that had been expected. Ms Horan, when she gave her evidence, said she could not remember the various conversations and events detailed by Mr Donovan, and accepted that they could have occurred. Mr Donovan had said his memory was probably so good because the 1988 examination of G&M was his first examination, and Ms Horan supported this by saying she too probably remembered her first examination better than subsequent ones.

Coincidentally, her first examination had also been of G&M, in 1986, and she too had developed concerns about the back-to-back loan scenario. She too had raised her concerns with her superiors, and been reassured that the bank was aware of the issue.

However, she was never given the full picture as to what had happened in the 1970s, the suspicions the Central Bank had developed and the discussions that had occurred with Mr Traynor. Even when, two years later, she was heading the Central Bank's 1988 examination of G&M, she still did not know of this background to the authority's relationship with the merchant bank.

Mr Byrne, for his part, also could not remember the conversations Mr Donovan had recounted in his evidence, but conceded that they could have occurred. If Mr Donovan had mentioned his concerns about the attitude to the merchant bankers, he said, he might have thought this sensitivity related back to what had happened in the 1970s but had since, as far as he had been concerned in 1988, been resolved.

Pressed by Mr Jerry Healy SC, for the tribunal, Mr Byrne acknowledged that, with hindsight, it would have been better if the examiners going into G&M had been fully aware of the history of the back-to-back loans. If they had been, then Mr Donovan's concerns might have been given more weight.

As a result of this week's hearings, more is known about the Central Bank's policing of the 1978 arrangement with Mr Traynor. Mr Justice Moriarty may also now be more inclined to see that policing as inadequate.

Meanwhile, Mr Donovan has to return to his office where he works immediately under Mr Byrne. Relations between the two men, he said on Monday, had been excellent up to the time he filled in the questionaire from the tribunal. His failure to mention his views prior to March was partly due to his fear of the consequences for his relationships within the bank, he said.

By leaving it until after March, however, and bringing the Central Bank back before the tribunal for a second innings, he made matters look even worse. It must have been a tense week in certain sections of the Central Bank.