Financial regulation must be toughened up in wake of this crisis

ANALYSIS: THE GUARANTEE of €400 billion announced yesterday is unprecedented

ANALYSIS:THE GUARANTEE of €400 billion announced yesterday is unprecedented. It is equivalent to three times Ireland's gross national product and it is not clear what it will cost the taxpayers of this State. Neither is it known whether the Government sought any equity participation in the banks in return for this guarantee, writes Michael Casey

Shares in the banks have already improved and their credit ratings have moved up, while the Government's credit rating has deteriorated because of the huge contingent liability it has taken on. This means that borrowing, which the Government must undertake for the imminent budget, will now be more expensive.

We do not yet know what charges the banks will have to pay for the guarantee.

Opposition politicians have observed that the banks will have to be strictly supervised to ensure they do not use this guarantee to run additional risks, and that the moral hazard problem must be kept to a minimum.

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Unfortunately, it will not be possible to monitor this in a satisfactory way. Before the guarantee, a bank might have been forced to seek repayment from a property speculator, say, pressing him to sell off property at a discount. With this guarantee, there is nothing to stop a bank removing pressure from its major borrowers.

Some rescue or guarantee had to be put in place, but whether the interests of the tax-paying public have been - or will be - adequately protected remains to be seen.

A fundamental question is whether the regulatory apparatus was adequate in the first place. The authorities will claim that the Irish banks were well regulated and had adequate capital and a capacity to resist shocks.

Stress-testing exercises had shown the banks to be robust. A strong statement to this effect had been issued some weeks ago at the launch of the Central Bank's annual report.

It was also pointed out that Irish banks had access to the European Central Bank for substantial amounts of liquidity in exchange for mortgage-backed collateral.

Assuming this was a fair assessment of the situation at the time, did something happen in subsequent weeks to alter this belief?

We may never know. The failure of the US rescue package to win congressional approval exacerbated the situation and put downward pressure on Irish bank shares, despite the ban on short-selling.

Was there more the Financial Regulator could have done?

Financial regulation is not a panacea anywhere in the world. A UK regulator once observed that regulators could not prevent bad things happening; they could only lessen the probability. Unfortunately, this cannot be quantified. In Ireland, we simply do not know whether regulation lessens the probability of banks getting into difficulty by 1 per cent or 30 per cent. Neither can we benchmark the performance of regulators on an international basis.

Some commentators believe the Financial Regulator and Central Bank should have used their moral authority to limit the banks' lending during the property boom.

They could not raise interest rates to cool the market, but they could have used "moral suasion" to ensure more prudent behaviour. Stress-testing was not a good substitute for this because it was difficult to challenge the banks about their assessments of their own state of health.

The failure to "prevent" the banks offering 100 per cent mortgages at a late stage in the boom seemed a questionable judgment call. It was quite late in the day when the risk weightings for property lending were increased. It might also be asked why the ban on short-selling wasn't introduced at an earlier stage.

It was recognised fairly early on that property prices had risen significantly above their equilibrium values.

It was known that some banks were offering mortgages of up to seven times' salary. It was also known that about one-third of mortgages were for second homes.

Thus, there was a general awareness of the existence of a speculative bubble in the property market. Against such a background, it is surprising that the laissez-faire approach was allowed to continue.

The loss of the interest-rate lever was significant, but there might have been other ways of intervening constructively. Until the 11th hour, the then minister for finance claimed the property market was working well and there was no need to intervene. This attitude may well have influenced the Financial Regulator and Central Bank.

Perceptions are all-important where equity values are concerned. Since it was common knowledge at home and abroad that Irish banks were substantially exposed to property, it would have been logical to infer that, if and when international stock markets came under pressure, Irish banks would suffer disproportionately. This inference should have been drawn, even though the Irish banks were well capitalised.

This is not being wise after the event. It was predictable that Irish banks' exposure to property would create a perception of weakness, even if this did not accord with the facts.

We will never know if a more proactive form of regulation - as opposed to the "principles-based" model - would have avoided the present situation; possibly not.

But lessons will have to be learned for the future. Financial regulation will have to become tougher and rely more on sanctions.

James Tobin, a Nobel laureate in economics, once proposed a tax on foreign exchange transactions in an effort to limit excessive volatility. There is a strong case for a tax on banking - or a self-insurance scheme for banks. Taxpayers must never again be placed on the hazard.

• Michael Casey is a former chief economist with the Central Bank and member of the board of the International Monetary Fund