Paying the price of poor regulation in Banking

Anon:  Morgan Kelly’s UCD paper on the Irish Bubble reproduced here on 29th December is a chilling view of the kind of policies which nearly brought this economy down, and a warning that worse may yet come – much of it due to poor regulation. It is worth the effort to read it.

He found that it was “the increased supply of credit rather than improved fundamentals drove lending.” “All of these factors were present for Irish banks, and their impact was magnified by failures of regulation by the Central Bank and government. The rapid expansion of credit in the Irish economy and the consequent rise in property prices and construction activity represent systematic failures of control at all levels of the Irish economy.”

Kelly said that “In summary, the activities of the Irish banks remained extremely simple by international standards and could easily have been regulated, had the will to do so been present.”

He concluded that “Given the weak independence of the Irish Central Bank, (IFSRA, in fact) the will to control banks derived ultimately from government.”

The claims on systemic failure; at all levels of power in the economy; and the lack of will to regulate are correct. He does not say that all of these failures stemmed from the strong ideological economic hostility to regulation by the state.

It is worth exploring the governance and composition of IFSRA in this and a subsequent Blog. As Kelly pointed out, the government ultimately controlled the banks – all the appointments to these boards are made – carefully and politically - by government. The advice of the deeply conservative (albeit in this instance, not conservative at all) Department of Finance dominates too. It is clear that while some of the directors had a considerable knowledge of economics and/or finance, others had no such knowledge or skill and some may have been hostile to regulation.
The cost of the collapse of the Irish banking system is still unknown. The ultimate buck stopped, not with Patrick Neary, the CEO of the Irish Financial Services Regulator, nor his predecessor, Liam O’ Reilly, to 31 January 2006, but with the board to which he reported.
Much has been made of Patrick Neary, the inadequate and overpaid CEO of IFSRA, but the board he reported to remains largely in place. What links did they have to Fianna Fail/PDs? What influences were there on Mr McCreevy, Ms Harney and Mr Cowen in the selection of the board, in additional to the political?

At the time of IFSRA’s establishment in 2002, Siobhan Creaton, of the Irish Times commented very pertinently, that “The restructuring of the Central Bank has been a lengthy and controversial process and was finally agreed in a compromise between the Department of Finance and the Department of Enterprise, Trade and Employment.”

Creaton said, “The degree of complexity involved in tinkering with an organisation as fundamentally important to the Irish economy as the Central Bank has resulted in the creation of a complicated structure”.

But interestingly, she also said that “It has been described as unwieldy and unworkable by observers in the financial services industry and politicians, with Fine Gael finance spokesman, Mr Jim Mitchell, pledging to seek a more streamlined organisation if his party gets into Government in the months ahead.”

What if the late Mr Mitchell’s Fine Gael/Labour had attained power in that general election? Would a new government have meant real change as IFSRA, in the system of regulation, in attitudes to enforcement, in the state’s attitudes and dealings with builders, speculators and other creditors? Would Ireland today not be facing such gigantic financial problems and almost facing bankruptcy if NAMA does not deliver, as Morgan and others believe that it wont/cant?

Why did all the key people in and around financial regulation fail Ireland so badly?

The reason was because of the over-riding philosophy by so many people in powerful positions who really, sincerely believed in the workings of markets. Many of these people were not very tolerant of differing views. Most in the media promoted the view that markets worked best when left largely un-regulated and were totally “free” - of interference.

There has been much questioning and debate on the profound ill-effects of this economic ideology in the UK, France Germany and even in the US. But little here in Ireland – even now. The view that this is a recession, a temporary downturn and it will be back to business as usual soon, may cost us, yet.

IFSRA set out its philosophy clearly in its annual report in 2006:
“We adopt a principles led approach to supervision.”

What this means is that “the Board of Directors of a financial service provider are responsible for setting their tolerance for risk and for ensuring that management establishes a framework for assessing the various risks.” [The banks - Not IFSRA]

“Financial service providers are also required to develop a system to relate risk to their level of capital and establish a method for monitoring compliance with internal policies.” [The banks - Not IFSRA]

“Our role [only] involves oversight of the quality of the institution's corporate governance including risk management and internal control systems, the focus being on structures and methodologies used.”
In December 2005, Brian Patterson, chairman of the financial regulator, announced the appointment of Patrick Neary as CEO of the regulator. Patterson claimed that “Mr Neary had played a central role in the shape and direction of the financial regulator since its establishment. "Pat is ideally suited to take the financial regulator through the next phase of its development.”.
Mr Neary was the unanimous choice of the selection panel, which was made up of non-executive members of the authority and an international regulatory expert from Finland.
It is of interest that the Irish Times reported that Mr Neary's appointment was welcomed by Financial Services Ireland, a trade association for the financial services sector, affiliated to the Irish Business Employers Confederation, which said “tackling the cost of regulation should be top of Mr Neary's agenda.”
IBEC did not want better regulation – it wanted lower cost of regulation…………! Ironically they had a case. Its members were paying most of the cost - for no effective regulation of finance.
In 2006, the staff was 350 and the cost including consultancies etc., was €49m. There is now 400 staff. The cost today is €63.6m of which €34.4m is raised from the industry plus a subsidy of €29.2m, given by the Central Bank, which makes up for the shortfall from the credit union sector and some other areas.
The composition of the IFSRA board will be examined in a second part of this Blog.