Comment: Policymakers must put national interest before that of financial institutions, writes Michael Casey

For several years now many agencies, including the Central Bank and the Irish Financial Services Regulatory Authority, have expressed concern about property prices.

All central banks worry about generalised price inflation but some would contend that asset prices are not part of the inflation process per se. In Ireland, property prices are only marginally covered in the Consumer Price Index, but over time they can affect this index through their influence on wage claims and consumer psychology.

It is not clear how concerned the authorities are about this source (or indeed other sources) of home-grown inflation, or whether inflation is regarded as solely a monetary phenomenon, or whether it is believed that Irish inflation must automatically converge on rates prevailing in European Monetary Union (EMU) countries. In any event, the financial regulator seems to be more concerned about the prudential implications of property price increases rather than any inflationary consequences.

The crucial question for regulators is that if property prices were to suffer a significant correction, would any financial institution(s) get into difficulty? This depends in large part on whether property prices are already too high in relation to some measure of long-term fundamental prices.

Various studies have been done and the jury is still out. Research is complicated by the possibility that the property market might be subject to distortions such as dominant market positions of developers, excessive delays by planners, and so on.

All we really know is that property prices in Dublin per square metre are now the highest in the EU, higher than London, Amsterdam and Paris, and that the yield from letting property is the lowest in the EU.

In short, anyone investing in Dublin property would now earn more by putting the funds on deposit in Rabobank or Northern Rock, unless property values were guaranteed to continue to rise above their already high levels. (It is worth noting in passing that, if 100 per cent mortgages become widespread, demand for rented accommodation is likely to be severely reduced; this would put further downward pressure on yields.)

The prudential issue is a most important one, not least because of its potential relevance to taxpayers. If there was a property-induced problem in a financial institution, the chances are that the institution would be bailed out by the taxpayer. Precedents here and abroad suggest that the taxpayer (rather than the share-holder) would end up with the tab.

To pre-empt such a costly - and less than popular - eventuality, the financial regulator has done a number of stress tests with each financial institution, asking them how they would be affected under different adverse scenarios.

This is an important and valuable exercise but it is perhaps limited by the subjective element involved. An optimistic bank is unlikely to admit to the financial regulator that it would get into difficulties in any half-realistic scenario.

Is there something else that the financial regulator should be doing, given its public interest mandate? It cannot of course raise interest rates because of EMU membership, but why doesn't the regulator encourage banks to increase their margins on existing mortgage rates?

"Competition" is one answer. Another is that the financial regulator now has a mandate to protect the consumer and, rightly or wrongly, higher mortgage rates would hardly be viewed by the public or Government as benefiting consumers.

There is a good deal of competition between banks and building societies with regard to mortgage lending and we have seen the introduction of 100 per cent mortgages by some institutions. Competition for market share is normally healthy but banking is an unusual industry and frequently the attempt to grow the business results in taking on more risk, which is not properly priced.

In this sense competition may not be so healthy and could become "a race to the bottom".

In such an eventuality there would surely be a role for the financial regulator to act as a ringmaster. Why, for example, has the financial regulator not used its moral authority to issue indicative guidelines regarding the growth of mortgage credit?

Why does it not rule out 100 per cent mortgages - and for that matter 120 per cent ones? The answers may include concern that intervention of this kind would smack of "moral suasion" which theoretically is out of fashion.

Fear of disintermediation is obviously a factor- foreign banks might take over some of the business of Irish banks. (If foreign institutions did take over some of the riskier business the domestic regulators should of course be happy.)

The financial regulator could also increase the capital adequacy requirements that banks must observe, and/or require banks to increase the risk weightings on property lending, forcing banks to allocate more of their capital to their property loan books.

Again, the fear of disintermediation probably explains, in part, why this is not done. In addition, there would be an understandable reluctance to draw attention to a potential problem and run the risk of weakening the share values of financial institutions.

All policy actions have adverse side-effects. The challenge for the policy-maker is to find where the balance of advantage lies. In doing this, admittedly difficult, calculation, the national interest must be put before that of financial institutions.

The fact that none of the actions mentioned above has been implemented can only mean that the financial regulator does not believe the property boom has been, or will become, a significant threat to the Irish economy or to financial institutions.

Michael Casey is former assistant director general of the Central Bank