Is financial regulation in Ireland a fair-weather activity?
OPINION:If Irish banks eventually need injections of money, the Central Bank and the Financial Regulator will have some explaining to do, writes Michael Casey
NO ONE expects even the most rigorous form of bank regulation to improve substantially the performance of inefficient banks with poor corporate governance. But we do expect bank regulation to lessen the chances of bank(s) getting into difficulties. If this were not the case, why bother with prudential regulation at all? It is a very expensive business in Ireland, involving hundreds of well-paid staff, mainly accountants.
Many commentators are coming to the conclusion that financial regulation in Ireland is a fair-weather activity. It works all right when things are stable but it can't cope very well when the going gets rough. It is a feature of bureaucracies in most countries that corrective action is deferred until it becomes absolutely necessary. The recent massive State guarantee which now exceeds €500 billion does seem to be an example of this.
If action were taken at an earlier stage then the bureaucrats might have been accused of removing the punch-bowl in the middle of the party. Also, taking action sooner than later involves forecasting - a difficult exercise at the best of times. The third factor inhibiting timely action is the risk that any such intervention might "frighten the horses" - and in the worst case lead to a self-fulfilling crisis.
Despite these inhibiting factors, however, the Financial Regulator and Central Bank should have been more proactive at a much earlier stage in cooling the ardour of the property market. Even without the interest rate instrument there were several things which could have been done, ranging from moral suasion, to insisting on prudent loan-to-income and loan-to-property price ratios, from raising risk weightings for property to insisting on more diversified loan books within the banks. Whether higher capital ratios were needed remains to be seen.
For almost 15 years the growth in bank credit outstripped the nominal growth in GNP by a factor of about two or three. This development was unsustainable and gave rise to a situation where ordinary Irish people have become highly indebted.
Now that the economy is in recession (and the Government is going to have to borrow substantially), financial distress among households is going to become commonplace. The speculative nature of the property market was apparent for the last five years at least, and the prudential implications for banks did not require any special degree of insight.
If, however, it turns out that none of the Irish banks needs to be recapitalised, then the Central Bank and the Financial Regulator may, in retrospect, be seen to have done a reasonable job.
In that eventuality it will probably be accepted that the main problem affecting Irish banks was the lack of liquidity and the seizing-up of the global inter-bank market - problems which the present State guarantee are designed to address. In this context though, it is not entirely clear why the Irish banks cannot access enough liquidity from the European Central Bank by pledging their mortgages as security. We had been told that this was a significant advantage they had over UK banks, for example. We had also been told that the mortgage books of Irish institutions were mercifully free of subprime dross.
If, on the other hand, it turns out that some Irish institutions do need recapitalisation, then it will be difficult to exonerate the Financial Regulator and Central Bank. Those institutions stated quite clearly as recently as mid-July last that Irish banks had not experienced a material increase in loan arrears, that they were well capitalised with good asset quality and that their shock-absorption capacity remained strong.
More recently, on October 3rd last, it was stated again that the Irish banking system had not to date had to write off significant losses on loans and investments, so that bad debts and loan losses were not the key issues for our financial system. The issue was the unprecedented shortage of liquidity in financial markets.
In other words, the capital of the banks was not a problem. This seems to have been the advice given to the Taoiseach who, following the recent EU meeting in Paris, has not indicated any intention of the Government's acquiring equity in any financial institution.
Commentators who say that loan write-offs and capital shortage are in fact the main problems facing some Irish banks are essentially saying that they do not believe the financial authorities. These commentators do not of course have the detailed information of the authorities and simply point to anecdotal evidence about distressed property speculators and half-finished building sites. They also seem to assume that the speculators who are selling Irish shares are behaving rationally; this is not necessarily the case at all. It is much more likely that irrational panic and herd instincts are the dominant motives. But it is vital to diagnose the problem accurately. Is it one of liquidity or one of capital? Which view is correct? Only time will tell.
If, however, financial regulation is to survive in anything like its present form, it will have to be substantially revamped. This should start as soon as possible in the US, where the most egregious mistakes have been made. Incidentally, regulators also have the responsibility for ensuring that the top decisionmakers in financial institutions are "fit and proper persons". In some countries this function needs to be given far more importance. At the end of the day the most crucial aspect of banking and finance is personal integrity.
There also needs to be a more global dimension to regulation to prevent the international transmission of toxic products. When the time is right, there is a compelling case for a tax or levy on banks, the yield from which could build up a fund for use in any future crisis; this would be a form of self-insurance by banks which would avoid the use of taxpayers' money in the future.
Regulation will have to be a good deal tougher - this does not mean more regulators, rather more sanctions and penalties. Close relationships between regulators and banks - difficult to avoid in a small country - will have to be ended. It is not being suggested here that the Irish system suffers from "regulatory capture", but the long-standing practice of former governors and senior regulators joining the boards of banks on their retirement should be stopped. The ordinary taxpayers of this country have been placed on the hazard for an unprecedented amount of money. They deserve no less than that those already on the boards of institutions which they once regulated, should stand down, if only for symbolic reasons.
Finally, the end of the financial turmoil is not yet in sight. But the stampeding herd will tire at some stage. The fact is that there is a lot of liquidity in the system - one only has to look at rapid money supply growth in the major countries over the last several years.
For the moment the liquidity is not circulating, but it will in due course. It doesn't go away.
The question then will be how much inflation will it cause in a couple of years' time, given all of the additional injections provided by central banks and the lowering of interest rates? If inflation is not curbed at that stage, who will suffer the most? Yes, consumers and taxpayers, pensioners and those on fixed incomes. But we have enough to worry about for the time being.
• Michael Casey is a former chief economist with the Central Bank and board member of the International Monetary Fund