INNOVATION TALK:Innovative research need not focus solely on new technology and the like. It should also study existing industries that are essential to the health of the economy, but run badly, and seek to find more efficient methods of operation.
Irish banking clearly fits these criteria. In the last four years it, has clocked up well over €64 billion of losses in Ireland alone and, given similar problems on Wall Street and the City of London, any research in this area would have considerable export potential not to mention restoring Ireland’s reputation.
The Central Bank has recently affirmed that Irish banking remains dysfunctional. Fiona Muldoon, head of banking regulation, claimed that bankers ignored its requests to tackle the mortgage crisis meaningfully. The Credit Review Office, a government agency, which forces banks to reassess loan decisions to small businesses and farmers, provides further evidence. In fact, this office would not exist if banks were functioning properly.
Gerald Flynn, a lecturer with Dublin Institute of Technology, has recently published research titled Lessons for the Irish Government on Basel II and Accounting Failures which aims to identify the “virus” in European Union regulation that contributed to Ireland’s banking woes. A rule change in 2005, allowing banks to conceal losses, is the main culprit.
A key problem in banking is the silo mentality and poor coordination between lawyers, accountants and regulators – researchers that can find ways of resolving this might be on to something.
For instance, under Irish company law hiding losses or trading while insolvent is illegal, but under the international accounting rules first introduced in 2005, banks trading recklessly and clocking up huge losses, are often permitted to conceal from shareholders their insolvent position.
Many lawyers don’t realise that accountants are hiding losses in this way and many accountants don’t know that this practice is potentially illegal. This breakdown explains why Anglo and other banks were supposedly profitable while bankrupt. Anomalies arise if lawyers and regulators don’t fully understand what accountants do and vice versa.
There are other examples. The interaction of Basel II regulations (these rules determine whether banks have enough capital to withstand losses) and accounting rules has not only encouraged bankers to lend recklessly but to award themselves bonus payments on transactions that are loss-making.
Flynn has found that the interaction of accounting rules, Basel II rules and company law has created a toxic situation. Bankers are awarding themselves flawed bonuses even while insolvent. Politicians have also suffered from this misunderstanding. In 2008, lawyers and advisers should have warned the then minister for finance Brian Lenihan, who relied heavily on auditors’ flawed information when he made the decision to bail out Irish banks.
The common way to clear a virus from your computer is to reboot it to a date before the virus entered your system. In a similar vein, Flynn says a return to the EU rules that existed prior to 2005 is a simple and effective solution. However, researching the banking sector and ignoring the effects of lobbying is perhaps “futile”, as Flynn acknowledges. Vested interests representing bankers on bonuses do not welcome change. The international accounting rules are very bonus-friendly. Under the old rules, banks could not pay bonuses unless they made genuine profits. The architects behind the post-2005 virus-laden rules, the International Accounting Standards Board (IASB), has received such heavy criticism that even its own head appears resigned to failure.
Hans Hoogervorst said the IASB’s credibility is damaged. “It’s indicative of dysfunctional working processes and dysfunctional decision-making,” he said. “Part of the problem is that we have broken deadlines so often that nobody believes them anymore.”
American regulators have similar tales of woe. A strong financial lobby prevented attempts to close loopholes that allowed bankers and others to hide losses. According to Flynn, “there is probably a simple solution to Irelands’ banking crisis, but it involves changing the rules that influence bonuses and incentives”. It’s a task few politicians are brave enough to take on.
A raft of new legislation is about to descend on the Irish financial sector. Basel II will be replaced by Basel III and insurance companies must soon apply similar rules known as Solvency 2. Irish software designers and testers are already preparing themselves for the big projects that lie ahead. But one depressing question emerges. After the banks have spent small fortunes on software and training to implement the new rules – will they work, or is it another case of more viruses bringing about another crisis?
Cormac Butler was a contributor to “Lessons for the Irish Government on Basel II and Accounting Failures”, Vol 6, 1 1–14, Journal of Risk Management in Financial Institutions, Henry Stewart Publications
