HONOHAN REPORT:SOME MIND-BOGGLING statistics within Patrick Honohan's 180-page report into the causes of the banking crisis highlight the woefully inadequate level of resources applied to the regulation of the financial sector.

They explain why the regulator did not spot that Anglo Irish Bank, the weakest bank in the system, was the one closest to collapse right up until late 2008.

In essence, the Honohan report found that the regulator believed it was dealing with a liquidity crisis – a shortage of money to fund day-to-day operations – during the autumn of 2008.

But it was in fact facing a solvency crisis in the financial system – Irish banks had not set aside enough to cover losses on loans into a foundering economy.

The timid and excessively deferential system of regulation and the shortage of individual regulators, who were insufficiently challenging and not persistent enough, meant the risks went unnoticed.

The number of people working in the regulator’s banking supervision department increased from 38.5 positions in 2000 to 56.5 positions in 2008 while the number of institutions under supervision remained broadly flat at 82.

Over the same period, the number of assets at the regulated institutions more than trebled from €355 billion in 2000 to €1.4 trillion in 2008 – a massive increase that was not matched by the resources at the regulator.

This explains why the new head of financial regulation Matthew Elderfield is seeking to bolster staffing levels by 150 to reach a headcount of 532 by the end of this year and possibly by a further 200.

The report found that the regulator’s banking supervision department had to make choices as to how to assign responsibility for the 80 or so institutions falling under its responsibility.

For example, when it came to the big domestic banks, the department assigned three people to monitor Bank of Ireland and Anglo, which combined had loans of about €200 billion at their peak.

Dr Honohan said it was generally felt the number of supervisors assigned to these banks was “inadequate” but the regulatory approach being adopted was “not an intrusive one, and as such need not call for a lot of resources”.

The report found that the regulator’s inspections of banks focused on whether they complied with governance rules and procedures, rather than on whether they had too great a concentration of property loans and whether these loans could be recovered.

“The potentially very large loan-losses that would threaten insolvency in several institutions were not foreseen in the supervision documentation even as far as late 2008,” the report said.

“Even the detection of serious deficiencies in loan appraisal and approval procedures of the major banks did not seem to trigger alarm.”

Stress-testing of Anglo’s €72 billion loan book did not raise warning flags until April 2008 when concerns about the books brought the bank up to the regulator’s “high priority” risk level.

The old management team at the bank, led by chief executive David Drumm, expected long-term loan losses to top €2.76 billion over three years in December 2008.

This, as it later emerged, was well wide of the mark.

Impairments on Anglo’s loans and investments topped €15 billion by the end of last year, warranting State support of €14.3 billion so far with the total bailout heading towards €20 billion.

Anglo executive directors had “no inkling of the problems to come” judging by the sizeable blocks of shares in the bank that they bought and held close to the bank’s peak in 2007.

Anglo management were not alone in not foreseeing mounting problems coming down the line.

Dr Honohan said that while many banking observers were becoming “increasingly concerned” about the long-term prospects of Anglo, which was under most pressure through September 2008, neither regulatory staff nor the consultants engaged by them “envisaged Anglo being insolvent”.

PricewaterhouseCoopers was recruited in the autumn of 2008 to assess the capital requirements of the banks and concluded that they had sufficient capital to absorb the expected losses on loans.

There was a mismatch between the expertise and seniority of staff at the regulator and those at the institutions that they supervised, which “hampered effective supervision”.

Inspection records and correspondence at the regulator revealed “a pattern of inconclusive engagement” with the banks on prudential matters and lack of “decisive follow-through”.

Problems that had been identified long before the crisis were not corrected and by not adhering to deadlines, the regulator “allowed some important matters to drift”.

“Given the model of engagement, decisive corrective action that might have prevented the deterioration of the situation was unlikely ever to have been imposed,” said Dr Honohan. The regulator’s appetite for taking on legal actions was “very limited”.

“This meant in practice that the regulated entities got the benefit of the doubt,” he said.

Had the regulator taken even unsuccessful legal actions, it might have helped increase the regulator’s powers, which were never tested in court. Dr Honohan said that a ceiling could have been placed on a growth in lending at any institution, “especially those experiencing dangerously high growth”.

This would have been “a major departure” but would have been justified during the lending boom as it “could have been very effective in stopping the bubble in its tracks”.

The rate of growth of Anglo – the fastest in the market whose loan book was increasing at an average rate of 36 per cent a year – should have been “the trigger for much more intense scrutiny of its business than it received” and forced the regulator to consider restraining its growth directly.

Even in the run-up to the bank’s demise, the regulator was missing clear warning signs about the inherent risks facing Anglo.

“The weakest bank was given a relatively favourable assessment until close to the edge of the cliff,” said Dr Honohan.

This helped “shape the incorrect assessment by many key policymakers at the time that the liquidity problems the bank was experiencing in late 2008 reflected worldwide market failures and not an underlying lack of solvency,” he said.

Honohan Report - What It Said About The Regulator

The Honohan report found that the Financial Regulator failed to challenge large development loans or understand how vulnerable the banks were to property price falls. Inspections by the regulator, 2005-2007 - Honohan's examples:

Bank A (not identified):A May-June 2007 inspection on commercial property lending at this bank found that 28 per cent of loans had breached the bank's credit policy, but inspectors reported no "high priority" issues.

The bank said customers who borrowed for unzoned land were "very high-net worth individuals" and had "years of development experience" and that it also had recourse to the borrowers.

The concentration of risk among a small number of borrowers was not reviewed. This proved to be the "Achilles' heel" of the overall banking system's loans.

Bank B:The bank rejected three "high priority" findings in an inspection of commercial property lending in April-May 2006. These included breaches of the bank's credit policy which were not reported up to more senior decision-makers and the formal credit policy "not being sufficiently prescriptive".

Five large commercial property borrowers at five institutions: In December 2007 inspectors were told that the lenders had no concerns with the ability of the borrowers to meet future repayments.

"This optimism subsequently proved in all cases to have been mistaken," said Dr Honohan. Only two "high priority" issues were identified, both at the same lender.

A problem case: One firm attracted serious and persistent concern following repeated inspections over the years.

As early as August 2000, a Central Bank official found "failings at every level in the organisation from the chief executive and board to staff on the ground".

Difficulties continued for eight years as the Central Bank and then the regulator sought to correct "severe governance deficiencies".