Mr. John Hurley:

Thank you and good morning, Chairman and members of the committee. I propose in my opening comments this morning to set out three areas which I've been asked to address in my written statement. These are: firstly, the impact of the Central Bank and Financial Services Authority Act 2003 on the role and responsibilities of the Central Bank; secondly, the approach taken by the Central Bank in responding to one of its key objectives, that of contributing to financial stability; and, thirdly, the appropriateness of the decision of the Government to guarantee certain liabilities of the bank on 29 September 2008.

In relation to the first matter, there is, I believe, some confusion about the effect of the 2003 Act on the role of the Central Bank. The bank is sometimes perceived as being a co-regulator or co-supervisor, which it was not. In fact, under the 2003 Act the Central Bank was divested of its responsibility for prudential regulation and supervision of financial institutions.

As a result it was unique among the so-called periphery countries.

Part of the reason for the confusion about the role of the Central Bank relates to the power of the bank to issue formal guidelines to the Financial Regulator under section 33D of the Act. Any such guidelines must be concerned with policies and principles in pursuit of Central Bank functions, mainly financial stability. The bank considered the financial stability reports prepared and agreed with the Financial Regulator as constituting the appropriate advice. The bank never saw a reason to issue formal guidance. Such guidance which was required to be published in Iris Oifigiúilwould have arisen only if the Financial Regulator did not accept the overall risk assessment set out in the reports. That situation simply never arose.

As an autonomous entity within the Central Bank, the Financial Regulator had responsibility for prudential regulation and consumer protection. The 2003 Act was absolutely prescriptive in this arm's length legal autonomy. The relevant powers of the Central Bank were transferred to the Financial Regulator and under section 33C of the 2003 Act the regulator had a separate governing structure with a membership of ten directors, including its chairman. To underline its autonomy vis-à-visthe bank, section 33C(11) of the Act provided that the Financial Regulator was required to perform the functions transferred from the Central Bank on the basis of its own opinion, belief or state of mind. The bank had, however, the core responsibility to contribute to financial stability, a role shared with the Financial Regulator and the Department of Finance, and I will comment in some detail on this role later.

The decision to remove the prudential powers of the Central Bank over the banks was opposed at the time by the Central Bank and the Department of Finance. An appendix to the McDowell report set out an alternative approach locating the Financial Regulator within the Central Bank and subject to a single board. I strongly supported that approach and worked hard to promote it when I was Secretary General of the Department of Finance. Eventually, under the 2003 Act the Government adopted a structure that gave the Financial Regulator its own board, the regulatory authority, within a restructured Central Bank. During the financial crisis the Government decided to reunite both functions again in a unitary organisation with one board, chaired by the Governor.

In seeking to clarify the respective roles of the Financial Regulator and the Central Bank I want to emphasise that this is not intended to be a criticism of the Financial Regulator. I do not believe that regulation could, on its own, have stopped this crisis from happening. The forces that were at work, both domestic and international, were very formidable and involved many authorities and organisations, including the Central Bank. I accept the Central Bank's share of responsibility for what has occurred.

The Financial Regulator adopted a policy of principles-based supervision. This was in accord with the philosophy of the time and reflected a shift in favour of market discipline with a greater emphasis on the role of boards and managements of banks. The Basel accords and EU directives under which the Financial Regulator functioned were the internationally recognised blueprints for regulators at the time. The Basel-based framework has now been shown to have been fundamentally flawed and unsuitable to the challenges of the time. Among the main weaknesses were that both the quality and the quantity of capital requirements were far too low and liquidity risk was largely ignored. These flaws are addressed in Basel III which includes for the first time the promotion of macro-prudential regulation.

The supervisory framework here was favourably assessed in 2006 by the International Monetary Fund. The weaknesses in the Basel-based framework were not appreciated at the time. I believe these weaknesses are relevant in the context of assessing the performance of the Financial Regulator and, to some extent, the Central Bank in a pre-crisis period. The central question is the extent to which flawed yardsticks as well as more general market failures impinged adversely on the performance of the two entities. To this would be added the significant over-correction of property prices in Ireland. The unprecedented global recession was also a major factor.

Turning now to the second issue, financial stability, the prevailing international orthodoxy in the pre-crisis period was that monetary policy, financial stability analysis and micro-prudential regulation constituted a sufficient framework to maintain overall financial stability.

Macro-prudential analysis was normally referred to as financial stability analysis at the time. It involved the identification of risks and vulnerabilities in the financial system and communicating these to a broad range of stakeholders, including, for example, other authorities, market participants and the general public. This approach was followed in Ireland by the Central Bank. As was also the practice internationally, moral suasion was the main instrument employed. The crisis has given rise to a search for a new approach and the centrepiece now is a major emphasis on macro-prudential regulation. Its instruments are still being defined and developed.

In his evidence to this committee, Mr. Regling, managing director of the European Stability Mechanism stated, "Today, every[body] who deals with these issues talks a lot about macro-prudential supervision, but that was not very fashionable at the time globally, and not alone in Europe." As a result of the de Larosière report in 2009, much more emphasis is now being placed on macro-prudential regulation. He recommended that an EU level institution be entrusted with this responsibility. The European Systemic Risk Board has now been assigned this task.

Turning now to the reports themselves, at the outset, I wish to acknowledge that the financial stability reports published by the bank underestimated the risks facing the Irish financial system. This is because they did not foresee how the international financial crisis would combine with our existing domestic weaknesses to create such a critical position for Ireland. The reports were concerned about typical recessions of the past several decades. The scale of the international crisis, the worst since at least the 1930s, was not anticipated by any institution, domestic or international. The effect on Ireland was magnified by the interaction of these risks, domestic and international, which dramatically increased the social, economic and financial consequences for Ireland. This is not to fully recognise the part played by our domestic weaknesses prior to the crisis, including the dominant role of the property market. However, I believe these weaknesses on their own would not have given rise to anything like the severity of the crisis we experienced. I believe Lehman's was more than the trigger or catalyst. It precipitated the near-collapse of the international banking system. It destroyed, on a wide scale, trust between lenders and borrowers, the very foundation block of the banking system. The market suffered what has been called a type of financial cardiac arrest affecting most western banks. In particular, it triggered large-scale declines in the value of many assets, especially property, across the world. It is clear that, in hindsight, the warnings in our financial stability reports should have been much stronger, and I very much regret that the bank underestimated the risk that subsequently materialised. The fact that similar criticisms can be made of central banks in other countries that experienced systemic crisis is no consolation to me. However, for an insight into the thinking at the time, the very favourable assessments of both the international economic environment and the Irish economy by most domestic and international commentators need to be taken into account. In particular, these assessments reflected the soft landing consensus. To save time, I do not propose tor recite these assessments here. They're set out in my written statement.

So far as the financial system was concerned, the assessments made by the International Monetary Fund, both in its Article 4 reports and in its 2006 financial stability assessment update on Ireland, were quite positive. The International Monetary Fund concluded in 2006, following its stress testing of Irish banks, that they could cope with substantial falls in property prices. As late as 2008, the OECD stated that the rise in property prices was largely driven by higher incomes and demographics and that the Irish banks were well capitalised and profitable and should have considerable risk absorption capacity. Given their cross-country perspectives and their experience of crises, the Central Bank regarded the views of OECD and IMF as very important. Against this background, the financial stability reports highlighted the risks and vulnerabilities in the Irish financial system in the light of the information available at the time. These risks included, in particular, the high level and rate of credit growth, the high concentration of loan books to property-related business, the high increases in property prices, and the increased funding gap. Notwithstanding the warnings in the financial stability reports, they all assessed the overall health of the banking system to be sound based on the internationally accepted yardsticks, notably capital adequacy.

The draft financial stability reports were prepared initially by the financial stability unit of the bank and processed through the financial stability committee, which included senior staff of the Financial Regulator.

They were subsequently agreed, normally at two joint meetings of the Central Bank board and the regulatory authority. The risks outlined, together with the Financial Regulator's own assessments, were to be the basis for regulation. Once the reports were agreed, I took full ownership and responsibility for them and launched them at press conferences, where my introductory comments highlighted the key risks. The financial stability reports formed the basis for my discussions with the Minister and the autumn letter sent by me each year to the Minister in advance of the budget. They were also discussed at round-table meetings with the banks.

The reports of the Nyberg commission and Regling and Watson suggested that there was a basis for taking some action by about the end of 2005. I've recently re-read some of the relevant documents from that time to get some insight into our mindset. This is not easy with the elapse of close to ten years since the 2005 financial stability report was published. Nevertheless, with the benefit of hindsight, I agree with the view that there was a basis for action in 2005. The Central Bank should have escalated and reinforced its warnings on risks and vulnerabilities at the time. At the time, the bank considered that the approach taken was the correct one and I would like to set out why it held that view.

The Central Bank was aware of plans to phase out tax incentives for property. In October 2004, because of the increases in property prices and also the growth of the property sector, I raised the issue in the Governor's pre-budget letter to the Minister for Finance. I advised that no further extension should be allowed to the termination date of mid-2006 for the range of tax-driven incentives. In the event, a review of tax incentives was announced in the budget in 2004. The review was completed in 2005 and the budget in December 2005 announced their phased withdrawal. The Central Bank was also very much aware that a slowdown in credit growth and property prices was dependent to a significant extent on the future increases in interest rates. It was clear that interest rates would not remain for long at their historic low levels and the Central Bank made this known to other authorities, to the banks and to the general public.

In my introductory comments at the launch of the 2004 financial stability report, I warned that the then level of interest rates did not reflect where the euro area economy would be in the medium to long term. In the round-table discussions with financial institutions in December 2004, the Central Bank representatives pointed out that the equilibrium rate for retail mortgages was approximately 6%. While it could take time to reach that level, it was twice the prevailing rate. The spring bulletin of February 2005 and the summer bulletin of May of that year also cautioned about the effects of rising interest rates on borrowings. The impact of rising interest rates was widely picked up by the media following our reports. One leading newspaper reported that interest rates may double. Other media also gave good coverage to prospective interest rate increases. A further message to the same effect was given at the same time ... at the time of the publication of the financial stability report in 2005 with, again, extensive coverage by the media. In preparing that report, the bank emphasised the psychological impact of the expectation of interest rate increases. In the event, interest rate rises were later than expected by markets because of adverse developments in the euro area. Interest rates did increase in December by 0.25%. This was the start of aggressive monetary tightening, with six further increases of the same amount in the period between December 2005 and March 2007. Because of the importance of the effect of interest rate rises for credit growth, the Central Bank's warnings on prospective rate increases were persistent and strong.

Towards the end of 2005, house price growth eased considerably as part of an international trend. The real price index of commercial property, as the Nyberg commission shows, was fairly flat since about 2000. The Central Bank considered that increases in interest rates were the most effective way of cooling the property market and, with a lag, easing credit growth. The bank also considered the exchange rate to be an important factor in slowing the economy. The euro appreciated by 35% and 12% against the dollar and sterling, respectively, between 2000 and 2005. As indicated, the decision of the Minister for Finance to phase out the tax incentives for property was also expected to play an important part. So too were the measures being considered by the Financial Regulator on risk ratings for high LTV mortgages and speculative commercial property. The bank considered that this range of measures should be sufficient to reduce the growth in property prices and, later on, credit.

However, it wasn't until about 2006 that evidence of some slowing in house price growth started to emerge. Later in the year, there were the first indications that growth in credit was beginning to ease. Many of the aggregates continued to moderate throughout ... through 2007. It seemed that the expected soft landing had begun. The delayed response to the measures outlined earlier, and the weaknesses which were subsequently revealed in the risk management practices of the bank, had significant consequences for the banking sector. My description here of the thinking during the relevant periods is not intended to take from the fact that, with hindsight, we were wrong.

Turning to the third matter, the appropriateness of the guarantee, by way of background, I in fact returned to the Central Bank shortly after the collapse of Lehman's on 15 September 2008. I'd been absent from the bank from 19 July due to a serious illness. I was briefed by staff in the Central Bank on the deteriorating liquidity situation. At that time international financial markets were extremely turbulent and liquidity provision by the ECB was increasing significantly. One bank, Anglo, was very seriously affected, while other banks were also experiencing increasing outflows. If outflows continued on the scale experienced, it would only be a matter of time before the Irish financial system was threatened. Following discussions in the Department of Finance, the deposit guarantee limit was increased, and a strong statement of support from the Minister for Finance was issued, confirming the Government's commitment to the Irish financial system. Consideration was also given around this time to the desirability of guaranteeing the liabilities of the banks. While I did not support such a guarantee when it was first raised, I was conscious that if matters deteriorated significantly, and the Irish banking system faced imminent collapse, there would, in the absence of a European initiative, be no choice but to do so.

The matter was subsequently discussed at joint meetings of the boards of the Central Bank and the regulatory authority and it was accepted that such an approach could be necessary in the light of the liquidity pressures. In the meetings held during the weekend before the guarantee decision, it appeared likely that the financial institutions would have significant liquidity ... sufficient liquidity to get through the following week. The liquidity outlook changed quickly on the morning of 29 September, when it became clear that, without assistance, Anglo would not be able to open for business the following morning. Arising from contacts with the ECB, the view at the time was that Ireland was expected to stand behind its banks and a Lehman's-type situation was to be avoided. When the Anglo situation arose, the major concern was how to prevent contagion from Anglo spreading to other banks, which were not then illiquid but were experiencing significant outflows. Arrangements for the provision of assistance to Anglo had already been made in the ... the Central Bank and the necessary letter of comfort from the Minister for Finance was subsequently received. Emergency liquidity assistance was extended to Anglo overnight to enable it to open for business on the morning of 30 September.

The bigger issue was how to avoid the risk to the entire banking system materialising, with catastrophic consequences for the entire country. Without decisive intervention, the risk of such an eventuality was very likely. I supported the guarantee in these circumstances. The question of emergency liquidity assistance, at national risk, for an Irish bank had been under consideration since the Northern Rock crisis in 2007. The granting of ELA to Northern Rock, and its becoming public, had undermined public confidence in the bank, increased panic and gave rise to a bank run that eventually required nationalisation as well as guarantees by the UK Government. Here, all the necessary arrangements, including the identification of non-ECB-eligible collateral in the banks and the legal arrangements for their transfer to the Central Bank, had been made. The roles of the Minister for Finance and ECB had been fully taken on board. The real concern in relation to ELA was the potentially serious effect it might have on a financial institution where market confidence had already been shaken, as well as the risk of contagion to other financial institutions. The provision of ELA was not seen as a solution to the systemic crisis that had arisen. The additional funding for Anglo agreed with the AIB and the Bank of Ireland in the context of the guarantee decision was designed to mitigate the risk of negative market reaction, with severe consequences for the credibility of the guarantee for the other banks if liquidity flows into Anglo did not materialise in sufficient quantity.

The option of nationalising Anglo, together with the issue of a guarantee for the remaining banks, was considered on the night.

Overall, it was considered that the signal effect of nationalising Anglo would be more negative than positive and could raise markets' concerns about the systemic weakness of the financial system and, as with ELA, threaten the credibility of the guarantee. Moreover, there was a strong view on the night that the Government had one opportunity to assuage the markets. The markets were extremely volatile, with the decision of the US Congress to reject the proposed troubled assets relief programme, TARP, was likely to result in increased market volatility the following morning. If the decisions taken were considered inadequate and failed, the consequences for the banking system would be devastating and lead to very serious economic and social fall-out for the country as a whole. I supported the decision taken as being the one most likely to ensure that these consequences for the banking system and the country would be avoided.

Before concluding, Chairman, I would like to take the opportunity to say that the Central Bank, in identifying the risks and vulnerabilities pertaining to the Irish financial system in its financial stability reports, considered at the time that its assessment was sufficiently strong and balanced and that it would provide the necessary guidance for the other authorities, market participants and the general public. In hindsight, these assessments, as I have indicated, were not adequate. I fully accept the role of the Central Bank and my role as Governor in underestimating the risks to the Irish financial system, which had such serious consequences for our country and from which we are only now beginning to emerge. Again, I would like to reiterate my regret that the bank underestimated the risks that subsequently materialised. These turned out to be much greater than we had anticipated.

To conclude, Chairman, I hope that my recollection of events will be of assistance to the committee in the very important work that it is now undertaking. Thank you very much.