ECONOMICS:The fund's analysis reveals its shift from advocating bigger financial systems to a wariness of them, writes DAN O'BRIEN

IRELAND’S BLOATED financial sector should be taxed down to size. Senior bankers’ pay should be targeted with a special additional tax. A tax on financial transactions should be introduced as a means of putting sand in the system’s wheels. A further levy on top of all this should be placed on banks, with institutions which the regulator adjudges to be engaged in more risky activities paying more than those it believes are less exposed. These measures should be put in place to achieve a number of outcomes, including the shrinking in size of the sector.

This may sound like the manifesto of a hard-left anti-capitalist organisation, but it is in fact the view of the International Monetary Fund (IMF), as expressed this week in its detailed paper on the Irish economy.

How the world has changed.

A decade ago, the IMF attributed the Asian economic crisis in part to the East’s underdeveloped financial systems. Countries, it then advocated, should work to make their financial systems bigger and more sophisticated so they could efficiently allocate capital, sourced domestically or flowing in from abroad, thus avoiding the sort of turmoil that engulfed that continent in 1998.

Now it appears the IMF believes too-big financial systems need to be squeezed because they overallocate and misallocate capital, thereby posing a systemic risk to economies.

The comparative analysis of the Irish banking system contained in the report demonstrates just how disastrously bad capital allocation here has been.

Unsustainably high dependence on non-deposit funding continues. Capital ratios for the large banks have fallen, while they are rising elsewhere in Europe. At last count, more than 60 per cent of liquidity needs were being provided by the monetary authorities. Almost one-tenth of the banks’ aggregate loan book was not performing as of the end of 2009 – twice and three times the proportion in Spain and Britain respectively.

This sorry situation, and the wider international picture, have radically changed the IMF’s views on finance and how it should be regulated, as is clear from this week’s report. The fund’s staff were wholehearted in their backing of the Government’s more “assertive” approach to regulation and supervision.

The debate on whether regulation should be principles-based or rules-based is over. In the future it will be, to coin a phrase, “intrusion-based”. In this brave new world, Matthew Elderfield and his fast-expanding legions will march into banks to peer constantly over the shoulders of everyone from middle managers to board chairmen.

The report was also pointed on how banks are managed, supporting the Government’s stated objectives of raising “the fitness and probity requirements of senior managers and board members”. Given the weakness the Government has shown vis à vis both groups, it is hardly unsurprising the IMF drily states that implementation will be the key challenge.

The failures of the domestic banking system, however, are not unique. Almost everywhere one looks in finance internationally, market failure and risk mispricing are in evidence: in mortgage issuance; in securitisation; in pensions and the fund management industry; in derivatives; in the enduring duopoly of the credit card business; in the sovereign bond market; in municipal bond insurance and in many other areas.

The costs of these failures collectively have been massive. In response, regulatory change will be great. Domestic and EU-level changes have already been put in place. Much more European regulation is in the pipeline. As the costs of the financial crisis continue to rise, the regulatory response will ratchet up further.

It is worth recalling that the defining piece of financial market legislation to follow the great crash of 1929 in the US entered into law a full four years after the collapse.

There are likely to be many implications, including for the IFSC, something to which I will return in the future.

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The appointment of Peter Nyberg to head the inquiry into the causes of the banking crisis received little attention when it was made late last week. We will note it here as it could hardly have been a better choice.

Nyberg ticks all the boxes. He has expertise in managing financial crises, having helped clean up the mess made by Finland’s banks in the early 1990s. And he has relevant international experience, having worked at the IMF, writing the same sort of reports (on European countries) that that organisation published on Ireland this week.

As Finland is very similar to Ireland economically, he will have an understanding of the background. Finally, the appointment of a Finn can only add credibility to the report given that country’s reputation for standards in public life, unbettered anywhere. Just as the appointments of Patrick Honohan and Klaus Regling to write the earlier scoping reports sent all the right signals, Nyberg’s does too. It deserves praise.