BANK REGULATION:NEITHER THE Central Bank nor the Financial Regulator believed that any financial institution faced serious difficulties, let alone potential insolvency, in the run-up to the financial crisis, the report by the new governor of the Central Bank Patrick Honohan has concluded.
Dr Honohan said there had been major failures in the regulation of the banks and the maintenance of financial stability.
The potentially very large loan losses that would threaten insolvency at several institutions were not foreseen in any of the regulator’s supervision documentation “even as far as late 2008”, he said.
Regulators failed to challenge in detail the security which was backing the banks’ large developer loans and “did not realise just how vulnerable the lenders were to property price declines”, said Dr Honohan.
Only a small number of staff supervised institutions – no more than two in each major institution. A three-person team was responsible for supervising Bank of Ireland and Anglo Irish Bank, while a two-person team monitored AIB and Irish Life Permanent.
Dr Honohan said regulators showed “an unduly deferential approach” to the banks and this “may have contributed to a reluctance to second-guess bankers in any aggressive manner”.
Lobbying by banks stopped attempts to formalise some principles – in one instance in the face of concerns expressed by the Department of Finance, he said.
There was inconclusive engagement by the regulator on certain issues and a lack of follow-through on decisions with the banks, allowing important issues to drift.
There was limited appetite for legal challenge by the regulator and this meant banks were given the benefit of the doubt. As a result, no penalties for breach of prudential regulations were ever imposed on a bank before 2008.
“If unsuccessful, test legal cases could have helped garner support for additional legislative powers.”
The introduction of new bank capital rules to rein in lending in 2006 on high loan-to-value mortgages, “designed mainly as a warning sign, were adopted only after prolonged and agonised debate”.
Dr Honohan said regulatory measures “inevitably have some disturbing effects on the market”.
“The luxury of waiting until more clear-cut evidence becomes available must be set against the costs of inaction,” he said. This was especially so when banks were “comforted and implicitly encouraged – or not sufficiently discouraged – to continue with risky borrowing and lending behaviour”.
Dr Honohan said the language of Central Bank’s financial stability reports was “too reassuring” and “did little to induce the banks – or the public and policymakers – to adjust their behaviour to avoid the threats that lay ahead”.
“Deference and diffidence . . . led to insufficient decisive action or even clear or pointed warnings.” There was “an unresolved anxiety” that an aggressive stance would lead to a loss of business by the domestic institutions, triggering a collapse in confidence, at first in the property market and later for depositors in the banks.
There was “too much confidence” placed in the reliability of stress tests carried out for the reports. As the Central Bank was not sufficiently close to hands-on regulators, “those relying on the stress tests may have had an unrealistic appreciation of what the banks could and could not know”,
Dr Honohan said the banks’ stress tests were “insufficiently severe” and their capacity to undertake them “differed greatly”.
None of the banks had reliable models which could credibly predict potential loan losses, he added. “Furthermore, the banks were naturally prone to over-optimism and even [later] denial.”
There should have been closer interaction between staff involved in financial stability at the Central Bank and regulatory employees.
The separation of the regulator from the rest of the Central Bank organisation meant that there was “insufficient appreciation” of the links between the risks to the system posed by individual banks.
Rivalry between the Central Bank and regulator may have contributed to “inadequate communication” between the two entities.
There clearly was “some friction at board and senior management level” relating to human resources and the cost of services provided to the regulator, he said.
Other factors weakened the Central Bank and Financial Services Authority of Ireland (CBFSAI): the quality and skills of staff in banking regulation; an unduly hierarchical culture discouraging challenge; management problems; an “unwieldy organisational structure”; and “weaknesses in preparing for a crisis”.
Dr Honohan said the governor of the Central Bank had powers to authorise a CBFSAI employee to investigate a business or carry out on-site inspections.
The regulatory authorities failed to spot the emerging crisis through 2007, Dr Honohan said.
“They do not appear to have realised – or at least could not bring themselves to acknowledge – before mid-2007 at the very earliest, not only how close the system was to the edge, but also the extent to which the task of pulling it back from the edge fell to the CBFSAI,” said Dr Honohan.