ECONOMICS:The banking report makes depressing reading but it is impressive and honest in tone and content

THE REPORT, The Irish Banking Crisis – Regulatory and Financial Stability Policy, 2003-2008, by Patrick Honohan, governor of the Central Bank, makes depressing reading.

So many different areas of Irish life seem to be dysfunctional – health, the legal system, treatment of children at risk, the church, Government performance generally – that one is tempted to wonder whether there is some ingrained ineptitude in the community as a whole. Have we all depended so much on American investment and on directives from Brussels that we cannot organise our own society any more?

Honohan’s instrument of choice is the scalpel, and he cuts deep. The only upside of the report is its refreshing frankness and independence of thought. This augurs well for the future – at least for central banking and financial regulation. It may also raise the Central Bank’s profile in the provision of general economic advice to the Government.

The main conclusions have been well aired by now – the fact that we can no longer blame the collapse of Lehman’s for our sorry state, which is largely attributable to the failure of banks, regulators and government. It is likely that the failure can be spread more widely to include borrowers, builders and property developers who paid “mad money” for land, and our national obsession with bricks and mortar.

The report also questions whether subordinated debt holders (risk-takers) should have been covered by the deposit guarantee.

The government’s failure was two-pronged. Far from cooling the property market, it fanned the flames with property-based tax incentives. But the government also used fiscal policy to overheat the economy and ignored the inherent fragilities of the exchequer, such as the growing dependence on revenue from property transactions which were ephemeral. These critiques are echoed in the Regling and Watson report.

As might be expected, the report focuses on regulatory failure. It contends that the financial regulator did not delve sufficiently into the workings of institutions he inspected, that it did not quantify the risks involved, that it was not intrusive or assertive enough.

Regarding the last point, it is stated that if junior inspectors were occasionally assertive, the banks being examined would sometimes report them to their bosses. This was outrageous, bullying behaviour on the part of the banks, and the tragedy is that it seems to have worked. This suggests, in turn, that the senior people in the financial regulator’s office were not prepared to inconvenience the banks.

The language of financial stability reports published by the Central Bank was too reassuring and probably watered down by senior people who feared adverse market or government reaction, the reports state. Closer interaction between the regulator and the financial stability unit was needed but senior management failed to arrange this, despite a memorandum of understanding. Stress-testing the banks was undertaken in a couple of different ways but, generally speaking, it was not very effective.

In 2000, the financial regulator discovered that one bank had “failings at every level”. This appalling situation was not improved over the next seven to eight years. Nothing was done. In the light of this, it is passing strange that the managers in the office of the Financial Regulator still do not accept that principles-based regulation is the same as light-touch regulation!

It is also hard to accept the finding that, at no point, did staff or management believe that any of the institutions were facing serious financial difficulties – even at a late stage.

Given the disproportionate concentration on commercial property lending by Anglo Irish and Irish Nationwide, alarm bells must have been ringing loudly. Did the regulators pass their concerns up to their authority?

Did the politically-appointed members of the authority (and of the Central Bank board) then discuss these concerns with members of government? This matter is probably best left to the commission of investigation which will carry forward the inquiry.

The commission should also examine the role of government in postponing legislation bearing on corporate compliance.

It is a little difficult to accept Honohan’s contention that the regulator had too few staff. The problem was more one of allocation. With a staff of about 350, surely six or seven could have been devoted to each of the 10 most important Irish institutions?

But the suggestion that the regulator was too deferential towards the banks rings true.

Where, for example, was the concept of the national interest? What of the effects of corporate hospitality and the long-standing tradition of retiring governors and senior regulatory staff joining the boards of institutions they once regulated?

This highly questionable tradition continues to this day.

Although interest rates could not have been raised to cool the property market (or the economy generally), Honohan believes other methods could have been used, such as increasing capital adequacy ratios,and discouraging 100 per cent loan-to-value mortgages etc. The fact that he, as a market economist, believes in these approaches is highly significant.

The inaction by the regulator and Central Bank could be explained in another way which seems scarcely credible. Suppose the regulators never had any intention of intervening to prevent a meltdown? They may not have seen this as part of their job description. If this was the case, and there was no endgame, then the question arises: what is regulation for? This fundamental issue should be examined by the commission of investigation.

It might also be mentioned that financial regulation should be reviewed and restructured before additional staff are employed.

The report by Honohan is impressive and honest both in tone and content. It gives hope of a new beginning.

Michael Casey was a former chief economist and assistant director at the Central Bank during part of the period examined by Prof Honohan and was interviewed by Prof Honohan in the course of his report