Mr. Liam O'Reilly:

Thank you for the opportunity to provide you with my perspective on the matters under review by the joint committee. First of all, I'd like to talk about principles-based regulation. The approach of the Financial Regulator was that of a principles-based regime. Such a regime was also the standard approach throughout Europe and was in line with the Basel capital requirements. The approach was well known and enunciated by the Financial Regulator, and by Government, and publicly accepted. It was the centrepiece of strategy of the Financial Regulator from the beginning. The policy laid a heavy responsibility on the boards and senior managements of banks. It demanded of them that they had high standards of corporate governance, a clear business risk policy, and risk controls in place to monitor and control that risk. Resources in the Financial Regulator were based on that premise. The Financial Regulator's main focus at the time was on determining the quality of corporate governance, including risk controls, within the bank. An important aspect of corporate governance regime was that non-executive directors had a controlling role in the audit committee and remuneration committee. The regime required direct reporting lines between both the internal auditor and external auditors to the board audit committees.

The Financial Regulator asserted its influence by requiring a financial institution to take remedial action as a result of findings of inspections or as a result of other issues that came to light or in some other way. For example, issues might arise in the course of a review meeting with the bank during themed inspections, by a bank itself reporting a problem or by information supplied by the external auditor, the internal auditor or members of staff. There was a view that taking over-aggressive action might cause reputational damage to a banking institution, with possible consequent contagion effects. In general, the foregoing measures were seen as appropriate at the time. The approach then adopted by the Financial Regulator in line with our principles-based approach was to expect a board would implement the necessary changes and in an expeditious manner. With the benefit of hindsight, it is now clear that this system did not work. More robust and intrusive measures should have been taken.

At the time, the Financial Regulator was of the view that enforcement action would be more effective if there were in place a set of legally based codes and if administrative sanctions were applied for breaches of such codes. The appropriate legislation for administrative sanctions was enacted in 2004. The use of such sanctions was viewed as a more effective and lower key way of keeping non-compliant institutions in line. The system of codes was well developed in the consumer area and where a set of consumer codes were being finalised in 2005, towards the end of my tenure. Administrative sanctions would apply to breaches of the codes. A sanction could range from an official caution to monetary penalties or a disqualification of a service provider. In the prudential area, it was planned that sanctions would be imposed on institutions in the event of breaches of corporate governance codes and other codes. Updated requirements were being developed in relation to being a fit and proper person to hold a senior position in a credit institution. Directors' compliance statements were also being developed. These were to be implemented following an extensive consultative period.

Resources in the Financial Regulator devoted to regulation were determined by the principles-based approach which was not as intrusive as the present system. The idea was that the internal audit departments, risk committees and external auditors were to be leveraged to fulfil the role of the Financial Regulator. The Irish principles-based system was endorsed by the IMF FSAP report published in 2006. That report provided a favourable conclusion as to the adequacy and effectiveness of this system. However, it is now internationally recognised that the principles-based regulatory system was flawed. It failed, not only in Ireland, but worldwide. As a result, regulatory systems are now more intrusive and aggressive. Greater responsibility is being taken by financial regulators to ensure that adequate systems are in place to measure and mitigate risks. The Basel II initiatives have also been completely revised to ensure that capital is adequate to cover for adverse and unforeseen circumstances.

The interrelationship between the Central Bank and the Financial Regulator: it was clearly set out in a memorandum of understanding between the Central Bank and the Financial Regulator that macro-prudential stability was the primary role of the Central Bank and micro-financial stability, i.e. the soundness of individual institutions, was the role of the Financial Regulator. Both of these parties were determined to make this system work. This was our mandate under the law. One of the most important elements for its success was to ensure that there was adequate information exchange. To achieve this, the following mechanisms were in place: the CBFSAI board, chaired by the Governor, consisted of six Financial Regulator board members and five other board members. The secretary of the Department of Finance was on the board.

All board papers of the Financial Regulator were circulated to senior management in the Central Bank and board minutes would have been made available to board members. A paper entitled, "Financial Regulator update", which reported on the activities of the Financial Regulator, was an item on the agenda of the monthly meetings of the CBFSAI board. All pertinent areas of concern of the Financial Regulator were communicated orally to the board and board minutes on these items were recorded. The offices of the Governor, the director general of the Central Bank, the CEO of the Financial Regulator and the prudential director were physically in close proximity to each other and day-to-day concerns would have been discussed as a matter of course. The channels of communication were always kept open. If any significant action was being contemplated, be it against a given bank or banks generally, such matters would have been brought to the attention of the Central Bank before implementation.

The effect of EMU on financial regulation: after the establishment of EMU, the Central Bank, the Financial Regulator and the banking system operated in an environment characterised by a strong exchange rate and low inflation, low interest rates. Cheap credit was available to the banking system from Europe. The control of credit growth, through changes in domestic interest rates, was no longer possible. Because credit was cheap, there was an over-reliance on short-term lending from the EMU interbank market. Customer deposits is usually the more stable source of liquidity as a proportion of balance sheets continued to contract. Increasing reliance was being placed on large, commercial depositors which, by their nature, would have been more mobile. EMU was formed without the provision of mechanisms for measuring and controlling risks, arising from aggregate euro credit flows, in terms of their destination and-or a concentration in certain sectors. Therefore, the inherent risk of a financial stability problem on a pan-European basis, due to the build up of credit risk in certain sectors or countries, was neither being monitored nor controlled. This was a fundamental flaw of the EMU system at its inception. It was thought that individual countries could look after their own regulatory affairs and markets would do the rest. This flaw has now been rectified. Without the use of the interest rate tool, Ireland depended on euro interest rates changing favourably, changes in fiscal policy and moral suasion to rectify the situation over time. By way of a macro-prudential policy instrument to replace interest rates, two options had been mentioned in the Honohan report and in evidence to this committee: change general capital requirements to reflect the increase in risk and the application of sectoral limits on a mandatory basis. Subsequent to my departure, increases in capital requirements were applied to high loan-to-value mortgages and speculative property development in May 2006 and January 2007, respectively. However, in terms of their effectiveness, to quote from the Honohan report, "The measures were in reality also rather modest in their likely [effect]."

Concerns about credit growth: the Central Bank and the Financial Regulator regularly voiced concerns in its publications, quarterly bulletins, annual reports, financial stability reports, about credit growth and the increase in personal indebtedness, particularly in property. Concerns about commercial property lending were also voiced. The following are two examples of public statements made by the Financial Regulator. On 29 July 2005, the Financial Regulator warned about 100% mortgages, saying that they had to be appropriate to each borrower. Clearly such mortgages were not appropriate to first-time buyers. At the time, 100% mortgages were a very low proportion of mortgages provided. A warning also was given on 26 July 2005 in the Financial Regulator's press statement at the launch of its report for the period 2003-2004:

There is an increasing debate about the rapid growth in credit in the economy and I want to address this area as a matter that could cause concern in the future. Along with the Central Bank, we are concerned about the rapid rise in the level of indebtedness in the economy and are well aware that if conditions changed adversely, many people could be severely affected. ... It is the responsibility of each financial institution to ensure that their credit standards, provisioning policies and levels of capital are appropriate to provide not only for today but in the event of a future downturn in the market. ... In short, institutions should only advance loans where they are confident [that their customers are ... have an] ability to repay. They have the responsibility to inform their customers about the risks they are taking on borrowing large amounts of money and that they retain some flexibility to cope with changes in their personal circumstances like unemployment and higher interest rates.

It is important to emphasise that, in making that statement, the Financial Regulator had no evidence that conditions might deteriorate to such a level that the banking system would succumb to a traumatic shock of the magnitude that occurred in 2008.

The following were the factors which provided comfort. There were demographic and other structural reasons for the need for increased activity in the construction sector and the increase in the level of credit necessary. However, a view emerged that property was becoming overvalued and there was a need for correction. At the time of my departure, that correction appeared to be in train. Fiscal policy was moving in the right direction - through the removal of incentives in the building industry - interest rates in Europe were set to rise and house prices were stabilising. The regulator had no serious or imminent concerns about the solvency of any particular financial institution. As the IMF Article IV report emphasised, Irish banks had sufficient buffers of capital to meet any shock that faced the system. Annual stress tests reinforced this view. Moreover, the general consensus in the market was that the Irish banking system was well capitalised and the Irish economy was healthy and growing.

General conclusions. In hindsight, the principles-based approach to regulation had major shortcomings. The Financial Regulator can no longer place the same degree of trust which it previously did in the boards and senior management of banks. In future, the Financial Regulator must adopt a more intrusive and aggressive approach. Moreover, the regulatory system did not appreciate the full extent of the credit exposures. I deeply regret that these failures in the system were not recognised during my tenure in office.