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Why regulation failed to curb runaway banks (Sunday Business Post)

04 November 2011
 The culture of the organisation may be behind the failure to challenge the banking industry, writes Richard Curran.
Alack of communication within the Financial Regulator’s office is being blamed for the fact that nobody told Minister for Finance Brian Lenihan about the Sean FitzPatrick loans when they were first discovered.
Such a lack of internal communication may be a mistake, similar to what can happen in any organisation. However, if true, it is more likely that it reflects a culture within the regulatory office which has simply not been challenging enough to the banking industry. It may also reflect an acute lack of resources allocated for bank supervision since the Financial Regulator’s office was set up.
In light of the banking crisis, the Financial Regulator has decided to double the number of staff working directly on the supervision of Irish banks from20 to 40.
It seems extraordinary that so few people could have been allocated to such an enormous sector, with a distinctly dubious track record, for so long.
Serious questions have been asked about the performance of the office of the Financial Regulator since it began doing the job in 2001.
The establishment of the Irish Financial Services Regulatory Authority (IFSRA) was itself a compromise to appease civil servants and those who worked in the former Central Bank.
Instead of having a greenfield Financial Regulator, completely separate to the old Central Bank, a twin pillars approach was taken.
The old Central Bank continued and retained a link with IFSRA through a joint coordinating board.
IFSRA was left to its own devices with its own board, but only up to a point. It is extremely difficult to create a new culture in a new standalone organisation if it isn’t truly new or standalone. Over the course of the last 18 months, various criticisms have been made of the performance of the regulatory authorities in relation to the banks during the boom years.
I n its favour it may argue that, despite the current crisis, no bank has gone bust. But that is not such a great achievement when the taxpayer has put in place a €450 billion guarantee and is now about to start writing cheques to recapitalise the banks.
It also doesn’t take away from the fact that one or two of our financial institutions possibly should have gone under.
The Central Bank publishes an annual financial stability report.
Not surprisingly, this year’s one has yet to appear.
As far back as 2001, it warned about the implications of rising house prices and the changes taking places in the business models of the banks. However, nothing was done about it. Banks were dramatically increasing their exposure to the wholesale lending market as a source of funding and heavily increasing their total exposure to property.
The deregulation of the financial markets meant a virtually infinite supply of money, relative to the size of the Irish market, was available to lend.
In 1997, less than 5 per cent of money lent by Irish banks came from funds other than Irish deposits. In 2003,that figure breached 30 per cent. In 2006, it was the highest in the eurozone at 46 per cent. The percentage of all bank lending going to property was increasing rapidly. In 2003, it breached 50 per cent for the first time.
The Financial Regulator was not in a position to just put a cap on how much the banks could lend.
It could not introduce rules that didn’t apply to foreign banks operating in the Irish market. That would have put domestic banks at a disadvantage.
However, what it could do was alter its guidelines on lending criteria and stress testing. It could also change the rules on the level of capital that banks had to set aside for various types of lending.
Changing capital ratios would have been a very effective instrument in slowing lending and controlling the property boom if applied sooner. However, it would also have been politically very unpopular.
The Financial Regulator did change the capital ratios mix on residential lending in May 2006 where the loan was for more than 80 per cent of the value of the house. Interestingly, the property market peaked just three months later.
Also in 2006, it introduced new restrictions on banks lending to developers to purchase greenfield sites. These measures were aimed at controlling the potential problem of massive loans being given out to fund sites, where the site was the only security on the loan.
However, even though the regulator made detailed proposals on changes to these rules in early 2006,when it came to implementing them, it introduced a watered-down version of the plan that was not as restrictive.
In July 2005, Patrick Neary the then prudential director of IFSRA, said he would not rule out raising capital ratios if credit risk was reaching unacceptable levels.
He did act on it a year later, as chief executive, but it was too late.
The current probe into how IFSRA handled the discovery of the FitzPatrick loans is likely to have more serious long-term implications for the way the regulatory authorities conduct their business from now on.
The seeds of the problem may have been sown sometime ago.