ECONOMICS:Why did Central Bank and Financial Services Authority board not blow the whistle? My guess is that it did not see the trouble coming, writes PAT McARDLE

PATRICK HONOHAN, the governor of the Central Bank, will submit his report on the performance and functions of the Central Bank and the Financial Regulator to the Government on Monday.

It is one of two preliminary reports – the other is a more general one by Klaus Regling, former director general of economic and financial affairs at the European Commission, which will be presented to the Dáil “shortly thereafter”. This will be followed by the establishment of a statutory commission of investigation, which will report by the end of the year.

The commission will examine individual banks, bank directors and the banking system generally, as well as the performance of the regulatory and central bank systems and the response of the relevant Government departments and agencies.

It is a broad canvas, so we will have to narrow it down. For the purposes of this article, we will assume that banks, with a few notable exceptions, behaved honourably but excessively in an environment where the profit motive was paramount and competition extreme. The latter came from both domestic and foreign sources, was encouraged by the regulator and manifested itself in extraordinary lending to developers and 100 per cent mortgages at (loss-making) margins half a per cent above the cost of funds.

We will also assume that borrowers entered into contracts willingly and share responsibility for subsequent losses.

This brings the regulatory authorities into focus as the external agencies that were responsible for financial stability and the only ones that might have stopped the party.

Bank regulation in Ireland was provided by a hybrid with a cumbersome title – the Central Bank and Financial Services Authority of Ireland (CBFSAI). This was an Irish solution to an Irish problem, which did not serve us well and left confusion as to who was responsible for what.

It had two components, the Central Bank, which replaced the old Central Bank of Ireland but retained most of its functions, and the Irish Financial Services Regulatory Authority (IFSRA).

IFSRA was also known as the Financial Regulator because its full title was too much of a mouthful and, to add to the confusion, was an autonomous component with its own board, responsible for financial sector regulation and consumer protection.

The IFSRA board included its chief executive and consumer director, but not its prudential director.

The ability of the public sector to confuse is endless. Here was an example, where Con Horan had the title prudential director and was pictured with the board in the annual report, but was not a board member. His opposite number, consumer director Mary O’Dea, was a full board member. There is no suggestion that this influenced their performance but my experience is that board selection usually says something about a company’s priorities.

The Financial Regulator and the Central Bank came together as the board of the CBFSAI, which was responsible for financial stability. This had 12 directors, six from the regulator board and six others. The chairman and chief executive of the regulator as well as the director general of the Central Bank and the secretary general of the Department of Finance were on the main board.

Here we have another source of confusion. John Hurley was frequently referred to as the governor of the Central Bank but, in fact, he was the governor of the CBFSAI and also chaired its meetings.

There is no way, therefore, that the buck can be passed from the Central Bank to the regulator or vice versa. Clearly the stability of the financial system was a joint responsibility and there was a memorandum of understanding between them. The information available to the CBFSAI was also available to the regulator, the Central Bank and the Department of Finance, via its membership of the board.

I am not for a minute suggesting that the institutional structure was the cause of the crisis. Far from it, but the schism that was the CBFSAI did not help; the first thing the Government did after the crisis broke was to announce that it would again merge the two entities under a single board.

The big question is, why did the CBFSAI board not blow the whistle? My guess is that it, like everybody else, did not see the trouble coming.

In saying this, I discount ritualistic or run-of- the-mill qualitative warnings about the housing market or the budget, which were plentiful on the part of commentators, Opposition politicians and economists, as well as the Central Bank and the ESRI. Neither do forecasts that real house prices would fall by up to 20 per cent count, as they were invariably accompanied by an assumption that this would be achieved via a period of static prices in nominal terms with no disruption to the banking sector.

To be effective, a proper warning would have had to be made by 2005 at the latest and would have to have pointed to severe consequences for the economy and the banking system. By mid- 2006, private sector credit was growing at 30 per cent per annum while lending for real estate was close to 70 per cent.

Morgan Kelly’s first apocalyptic warning came at the very end of 2006 when he forecast a 50 per cent fall in house prices, but this was spread over a decade at 5 per cent per annum with no focus on the banks at that time.

The stability reports, which were prepared jointly by the Central Bank and the regulator, show that their public view was that the banking system was in good shape right up until a late stage. Did they have a different view in private?

Why did the Central Bank which, by law, had an objective of “contributing to the stability of the financial system”, and/or the regulator, which was required to “support the bank’s objective of contributing to financial stability”, not tell the banks to change tack or take the minister aside and ask him to act?

Hopefully, the Honohan report will shed light on these critical questions.

Meanwhile, we already know Prof Honohans general views from the numerous speeches he has made. The following are some of them, all from the period before he became governor:

• an extensive guarantee was needed;
• some people jumped the gun by calling for outright nationalisation;
• the cause of the problem was too much mortgage lending financed by foreign borrowing;
• Ireland was far from unique in experiencing a credit crunch;
• regulation had self-evidently failed;
• the failure was one of insufficient scepticism by the regulator;
• fixing the banks will not solve all our problems.

It will be interesting to see if and how his views have changed, now that he has had the benefit of seeing things from the inside.

Pat McArdle is a member of the Financial Services Consultative Industry Panel of the Financial Regulator and a former chief economist with Ulster Bank