OPINION:Brian Lenihan says that bank regulation is to be changed. If the new system is to work, it must be much tougher, more efficient and without political interference
IT IS NOW abundantly clear that bankers cannot be trusted to manage risk properly or to treat their customers in a fair way. That is why regulation is required. The existing form of regulation has failed, however – most spectacularly in the US – but also in Ireland.
The fact that banks need Government support in terms of deposit guarantees, capital and liquidity injections – and in one case nationalisation – means that moral hazard is embedded in the system. In other words, the actions of the Government have proven to the banks that they will not be allowed to fail. Hence they have no incentive to mend their ways. This is one reason why regulation has to become a great deal tougher and more efficient.
We don’t regulate sweet shops or furniture factories and we don’t bail them out. What makes banks so different? It is essentially because they provide credit and money and because they have an important role in the national payments system. Without these, the whole economy would suffer. Few other industries provide services which are of such widespread importance. The ESB might be the closest analogy; without electricity the whole economy would be in trouble.
So the banks are not just in the business of making profit for their shareholders, they also provide, or should provide, a vital public function. That should have made them far more responsible over the past several years, but they failed dismally in that regard, and we now have no choice but to keep them functioning, somehow or other – and prevent them from turning into zombie banks.
This must be done, even though it is at the taxpayers’ expense in terms of higher national borrowing costs. One or more of the banks have been rightly accused of economic treason. This is another reason why regulation has to be much tougher. So what kind of regulation should we have?
First, it should be a system where the rules are enforced by the full weight of the law and where penalties are much higher than heretofore. For some breaches, there should be instant dismissals and custodial sentences for senior executives.
For other breaches, the penalties should be so large as to encourage shareholders to sanction the executives and board members.
This high-penalty approach is sometimes called the “bus card” system. In some European cities, a passenger doesn’t have to pay cash on boarding a bus, but if he or she is caught without a bus card, the penalty is very heavy.
The great advantage of this scheme is that relatively few staff are needed to police it. In fact, we could have better regulation at much lower cost to the State.
The fear of penalties does most of the work. Clamping of cars is a similar idea. The fear of being clamped has a major influence on drivers’ behaviour. A good financial regulator should be feared.
Second, the board of the Central Bank and the Financial Regulator should no longer be political appointees.
Financial regulation as we have learnt to our cost is far too important to be left to non-specialists. Board members and senior executives should be appointed on the basis of open competition, not by politicians and not by choreographed exercises where recruitment consultants are told who to select. If governments do not accept this approach, then there is little hope for the future.
Third, a comprehensive list of high-risk financial products (eg securitised assets, structured derivatives, leveraged funds) should be drawn up and proscribed, at least until the regulator is satisfied that the banks fully understand the risks inherent in these products and have ways of measuring the risks.
New products not on the list will have to be cleared by the regulator in much the same way as new drugs have to be approved by medical bodies such as the FDA in the US. Free-market economists might not agree with this proposal, but look where the free market has landed us!
It should not be forgotten that a former chairman of the Federal Reserve welcomed the development of the subprime loan market on the grounds that it was innovative and consistent with “completing” the market. No one but a free-market ideologist could have welcomed these lethal products and their subsequent transmission around the world by means of securitisation.
Fourth, financial regulators should not put so much faith in one-size-fits-all risk models. Senior executives of banks don’t fully understand the nature of financial risk and the models are usually based on unrealistic mathematical assumptions.
If risks can’t be managed properly, there will be a tendency to bundle them up and sell them on to some unsuspecting bank. This only makes the problems worse. It is far safer to avoid risky products and revert to “non-Polonius” banking eg, basic borrowing and lending.
One aspect of risk management that needs urgent attention is the degree of concentration of loan books. It seems incredible that Anglo Irish Bank was allowed to have such a high proportion of its assets in commercial property-related lending. The fact that some €500 million was lent to each of 15 property speculators is bizarre. This should not have been allowed and must never happen again. Rules about the diversification of loan books must be strengthened and policed.
Fifth, banks should be instructed to establish a self-insurance fund that can be accessed in future by a bank in trouble. It might be argued that this would have much the same effect as higher capital ratios.
Nevertheless, a belt-and-braces approach is clearly necessary. The existence of such a fund would quickly improve the reputation and credit rating of Irish banks and allow them more scope to borrow liquidity from the interbank market. It would also reverse the reputational damage to Ireland and would avoid the need to put taxpayers’ money at risk in future. Such a scheme would eliminate moral hazard.
If banks object to this proposal, the Government should take over and administer the insurance scheme by imposing a special tax on the banks. In this event, the Government should also charge for its services.
Sixth, corporate governance and the role and responsibility of auditors – internal and external – should be re-examined. There should be sanctions for auditors who fail to meet professional standards. Bonuses should not be paid where a staff member’s contribution to profits is associated with a high degree of risk. Systems should be established to assess the possibility of different risks occurring at the same time.
Seventh, there should be one or two State banks, possibly along the lines of the old ACC and ICC. These banks would compete with the others and would, of course, keep lending going even in the event of any future meltdown.
Eighth, it is possible that we would be better off with a fairly large number of small banks in the future. This might mean that no one bank would pose a systemic threat and could be allowed to go bankrupt. There would also be advantages for consumers in terms of competition. However, there is also something to be said for large institutions. This aspect should be carefully examined to find where the balance of advantage lies.
Ninth, there has to be much more distance between the Financial Regulator and the banks. All forms of corporate hospitality should be eliminated and senior regulator and Central Bank staff should no longer join the boards of the banks or of any institutions they once regulated.
The so-called global architecture of regulation will no doubt be altered following the De Larosiere committee findings, and Ireland will have to play its part in any new international arrangements. Whether the regulator is separated out from the Central Bank or put back into it – the recent “commission” idea – does not seem to be of major importance. What is important is that the principles put forward above must be adhered to.
If not, serious questions will have to be asked about the usefulness of regulation. Without radical reform and associated changes in legislation, the regulatory apparatus might as well be abolished since it would merely absorb scarce resources without giving much value for money.
Since private banks without proper regulation cannot be trusted, the entire banking system would have to be nationalised.
That would not be the end of the world, but it might give Ireland a socialist image abroad which could damage, inter alia, the attraction of foreign direct investment. This is why it is vital to reform the regulatory system radically and make it fit to purpose. It should be noted, however, that we do not seem to be good at real, fundamental change in this country. Where financial regulation is concerned, incremental or cosmetic reform will not be worth the candle.
Michael Casey is a former chief economist at the Central Bank and a board member of the International Monetary Fund