Professor Patrick Honohan:

The report that I submitted to the Minister for Finance in May 2010, entitled The Irish Banking Crisis, Regulatory and Financial Stability Policy 2003-2008 responded to a request by him for a "preliminary investigation of the performance of the respective functions of the Central Bank and Financial Regulator" over that period. Drawing on internal files as well as interviews with key officials, the report was able to provide answers to two questions. First, why was the danger from the emerging imbalances in the financial system that led to the crisis not identified more clearly and earlier and headed off through decisive measures? Second, when the crisis began to break, were the best containment measures adopted? The report noted the relevance of factors other than the performance of the Central Bank and the Financial Regulator, including the performance of directors and senior management at the banks, their auditors and accountants as well as pro-cyclical elements of Government policy. However, in line with the terms of reference, it focused on the design of micro-prudential aspects, the approach to overall financial stability and the failure to undertake decisive and effective remedial measures.

The report runs to 130 pages, as members know, so what follows is very telegraphic. As far as micro-prudential policy is concerned, the supervisors did not accumulate enough relevant information for several reasons, the first being an excessive reliance on a regulatory philosophy that implicitly trusted that well-governed banks could be relied upon to remain safe and sound. This approach emphasised process over outcomes and downplayed the quantification of risk. The second reason was a deficiency in skills and staff resources. There should have been a greater degree of intrusiveness and assertiveness and a less deferential approach to the banking industry. This would have disrupted the pattern of inconclusive engagement with the banks, a pattern which spilled over into the macro-prudential area, reflected in the fact that the belated and relatively modest tightening in 2006 of capital requirements for high loan-to-value mortgages was adopted only after prolonged and agonised debate.

In terms of the analysis of systemic risks, the language of successive published financial stability reports was too reassuring, representing a triumph of hope over reality. Much has been made of the institutional separation of the regulatory authority from the rest of the Central Bank. The 2003 legislation that did that created the risk of ambiguity with regard to which entities were responsible for what. Certainly communication between the macro-economic specialists assessing systemic risks and the micro-prudential supervisors dealing with individual banks was not fully effective. Each side subsequently felt that they would have acted more vigorously had they been more aware of what the other knew. That probably reflected a lack of mutual understanding of the methodology and professional language as between economists and supervisors more than the institutional separation, which was by no means rigid. In the end, senior officials in both institutions or both parts of the institution, as well as many elsewhere, both at home and abroad, were too optimistic about the strength of the economy and the Irish banks. One should recall that several other central banks and financial regulatory authorities suffered similar failures in the run up to the crisis. However, with the exception of Iceland, they had not allowed the scale of their banking systems to get so completely out of control as happened in Ireland.

The report's section on crisis containment includes an assessment of the 29 September 2008 decision to guarantee substantially all of the liabilities of the banks. While several other countries followed suit in subsequent days with more limited guarantees, the guaranteeing of subordinated debt of the banks was clearly a mistake. The formal guarantee, backed by legislation, of all long-dated debt was also unnecessary and bound to constrain the authorities' ability to restructure or wind down failed banks before the expiry of the initial guarantee. That is the best summary I can give of that but I am sure that members will want to discuss it in more detail.

With the benefit of hindsight, had the regulatory authorities had any notion that heavy losses - or rather such heavy losses - could be involved, an alternative strategy, as mentioned in a footnote in the report, of putting Anglo Irish Bank and Irish Nationwide Building Society into liquidation on 29 September while standing behind the rest of the system should have been more favourably considered. I am not saying that it should have been done but it should have been more favourably considered given how resistant external authorities subsequently proved to be to the imposition of losses on unguaranteed senior bank debt of failed banks. External partners might, at that moment, have responded to such an idea with compromise proposals that might have alleviated subsequent pressures on the Irish Exchequer. More generally, greater consultation with EU partners would have been highly desirable and could have helped Ireland to be less on the back foot in subsequent negotiations.

Despite the passage of time, I have seen no reason to alter the assessments I made in May 2010. Obviously there are a few bits and pieces that one might add but overall, there is no reason to alter the assessments. I wish to add a footnote here on costs. At the time of the report, only a broad indication of the potential fiscal costs could be attempted, given the unprecedented scale of troubled loans and the fact that so few had yet been worked through. At that point in May 2010, only a handful of NAMA’s loan purchases had been priced, for example, and there were other complexities. Even now, five years later, a precise estimate is not yet possible. Current valuations of the State’s banking shares suggesting a figure for the net long-term fiscal costs of bank recapitalisation of the order of 22% of 2008 GDP may be compared with the phrase, “in excess of 15%” used in that report. Moreover, the latest figure of 22% still is within the maximum of the range I conjectured here in this room before an Oireachtas committee hearing in the summer of 2009, before I became Governor. Consequently, broadly speaking, even in that case I do not really need to make a substantial alteration of the assessment. We could talk again about costs as the costs of the crisis are much bigger than the costs simply of the bank recapitalisation.

Accordingly, extensive changes have taken place within the Central Bank, in view of those conclusions, to ensure that identified shortcomings have been removed as far as possible. While not strictly the topic for today’s hearing, if I may I wish to include some words on this point for completeness. On institutional reform in the Central Bank since 2009, the 2010 legislation, that is, the Central Bank Reform Act 2010, confirmed the reintegration of the regulatory and supervisory apparatus fully within the Central Bank. The separate authority was abolished and its powers transferred to what used to be the board but now is the renamed Central Bank Commission, with most regulatory powers delegated to the deputy governor financial regulation. The legislation also introduced some changes, including a clearer definition of the goals of the Central Bank. Extensive actions were launched to enhance the Central Bank’s capacity and ensuring its delivery of an intrusive and effective risk-based financial supervision, as well as a proactive approach to systemic financial stability policy. These have been addressing, inter alia, the identified issues of insufficient co-operation and limited communication between different divisions and sections, an unduly hierarchical structure and deference to authority and a reluctance to carry decisions to conclusions and effective action. There have been significant changes in the policy approach. For example, banking is no longer de facto exempt from enforcement actions as it was in practice before 2008. Banks now know that regulatory breaches leave them open to penalties. Thanks to the new legislation, the Central Bank’s focus no longer is blurred by the potentially conflicting objective of developing the financial services industry. There has been substantial expansion of staff on supervision and regulation, responding both to objective assessment against comparators that more staffing was needed and to public demand that underachievement could not be tolerated. This included injecting new energy and a fresh approach by opening up the numerous senior appointments that needed to be made to candidates outside of the bank.

I will not elaborate here on the additional powers that have been sought by the bank and granted by the Oireachtas on various regulatory and resolution issues. However, as far as bank supervision is concerned, the European Union's single supervisory mechanism, SSM, has since November 2014 taken over much of the decision-making, while implementation remains primarily a locally-managed task. There are improved decision making processes in regulation in the bank, including separation of policy and risk, as well as enforcement functions from supervision, significant strengthening of the legal division and an emphasis on better working interaction between the macro and microprudential staff. There is an extensive and continuing programme of cultural renewal engaging all staff and using many tools including a clearer definition of mission, performance management, all-staff meetings, monthly cascade briefings, investment in information technology systems, leadership training etc., all to ensure a more effective working environment that is more conducive to, among other things, constructive challenge internally. Current plans involve even greater use of on-site inspection of banks, as well as a thoroughly overhauled organisational structure to decentralise further decision-making, co-operative working and career progression.

I will conclude by noting no regulatory system can or even should attempt to eliminate all possibility of failure and regulation and supervision must be able to change with a constantly-changing financial industry. However, I think the more assertive and risk-based system of prudential supervision we now have in place has struck the right balance and will help ensure that the banking system helps the economic performance of Ireland, rather than causing the economic destruction which we all have been seeking to repair and rebuild.