Mr. Alan Gray:

Thank you. Chairman and members of the inquiry, as an independent economist, I believe that major mistakes were made resulting in the economic, fiscal and banking collapse. To help understand what happened and why, I have submitted new evidence which I hope will help the inquiry.

I am head of economic research with an independent Irish economic practice. I joined the board of the Central Bank in 2007 as a non-executive director. I am on the Government's labour market council and I'm a director of the IDA and chairman of London Economics.

My work as a professional economist has given me the opportunity, since the 1980s, to offer impartial advice to consecutive Labour, Fine Gael and Fianna Fáil Governments and to governments internationally. When I provide any informal advice to Irish Governments or serve on State boards, I request that I do not receive fees or expenses, a practice which is not unusual for economists.

My statement and supporting material comprises extensive notes and documentation I prepared at the time. I ask the inquiry to excuse any references to publications that I have written. These are not to give these publications particular significance but to confirm views I've held at key periods. As well as the banking crisis, I have provided evidence on a number of matters of public interest, including the meeting on unemployment with An Taoiseach on the morning of 28 July 2008 - I should say with the then Taoiseach - and the continuation of the discussion over dinner at Druids Glen. These show that I expressed concerns on the economy at the meeting and I suggested actions to prevent an even more rapid decline. I have provided the 11 pages of detail notes I circulated at the discussion and I would be happy for the inquiry to release those notes and all of the approximate 80 pages of evidence I have submitted.

I turn to the causes of the crisis. Before addressing the significant Irish mistakes, I would like to briefly note the design flaws in the single currency and the impact of the bankruptcy of Lehman's. In considering why there was a crisis in Europe, the Nobel Prize winning economist, Professor Krugman, concluded:

The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects [...] that played a major role in causing [...] the Great Depression.

The design flaws in the single currency were particularly significant for Ireland due to our dependence on trade and the declining competitiveness. In a publication I edited prior to Ireland joining the euro, one of my academic collaborators, Professor Jeffrey Sachs, then at Harvard University, concluded that, "This is surely a big risk for a small country that is dependent on export-led growth - perhaps even too big a risk."

One concern I hold is that the required European institutions and policy instruments may not yet be in place, and complacency exists about this inadequacy. The ideologically driven US decision on 15 September 2008 to let Lehman Brothers go bankrupt resulted in an international banking crisis of a scale not seen since the 1930s. The combined impact of the Lehman collapse and design flaws in the single currency had horrendous implications for Europe. The larger lending countries and international agencies tend to downplay these two factors and shift most of the blame onto peripheral countries.

Central Bank directors are understandably reluctant to criticise the international institutions, particularly given their extensive funding support for Ireland. However, I believe the decision of these institutions to prevent Ireland from burning the bondholders and requiring Irish taxpayers to then bear the cost was morally indefensible. This forced a small state to socialise losses and impose the burden on ordinary working people, while private sector gains were protected.

Reference to the design flaws in the euro and the Lehman's collapse is not to deny the scale of the Irish mistakes. An unpredictable and once-in-a-century external crisis was made much worse by a gross over-dependence on the construction sector and by a failure of bankers, policy makers and regulators to adequately respond to the risks. In my view, the key Irish mistakes were mistakes in lending decision by banks, the failure in the regulation of banks, the impact of Irish macroeconomic policy and intervention in the property sector.

The lending decisions made by individual banks provided loans to developers and others which turned into bad debts. I believe this was the fundamental driver of what happened in Irish banks. There was also a failure of bank regulation and deficiencies in stress testing and macro-prudential policy. Detailed stress tests were undertaken but failed to anticipate the scale of the impending crisis or the level of increased capital needed. In the aftermath of the guarantee, I felt the banks were still in denial of the necessary capital requirements. Writing to the Department of Finance and the Central Bank to provide a contrary, external perspective, I said the banks' own assessment has indicated that they may have sufficient capital to meet regulatory requirements after dealing with anticipated bad debts and that PwC reports suggest that, under certain scenarios, this may be the case. My letter states that I do not accept this and concluded that action on capitalisation is needed and as soon as possible.

In addition to deficiencies in the interpretation of stress testing, there was insufficient regulation of banks and inadequate capital requirements, particularly in the period from 2000 to 2007. Accurate information was not obtained on major borrowers dependent on property and I raised this at board meetings. More intensive involvement in the approval of directors of banks would also have been appropriate. At my very first board meeting in 2007, a new policy was outlined to dampen the growth in the property sector. This new measure required the banks to increase to 150% the capital requirement for lending to speculative property. It was suggested that speculative lending could then only happen after 50% of the property value had been pre-sold. Not surprisingly, as an economist I was very supportive of this revised action as I felt it was beginning to respond to the risks. However, I accept this proved far too little and far to late to address the scale of the crisis which emerged.

Regulatory weaknesses did not cause the crisis but they did not do their job and did not prevent the crisis. This weakness was not due to the absence of supervisory powers and these cannot be used as an excuse for the misjudgments about endogenous risks and the failure to discover practices in the banks. Once developments in individual banks became clearer and more information was available to the board, I concluded that radical changes were essential to the system of financial regulation. I wrote to the Central Bank and Financial Regulator and to the Department of Finance, and I quote, "It has been my opinion for some time that radical changes are needed to the system of financial regulation in Ireland" and I went on to say that "I believe a fundamentally changed basis for regulation of financial institutions is required". As you know from the letter I have submitted in evidence, I suggested major changes at the time, including: increases in the minimum requirements for capital; new controls on lending practices; changes in the incentive structures; greater levels of inspection of financial institutions; new requirements for approval processes for directors and senior management; greater levels of public disclosure and transparency; changes in the relationship between external auditors and the Central Bank; and measures to facilitate and protect internal whistleblowers.

Irish macroeconomic and fiscal policy also played a part in the period post-2000 and there was an over dependence on stamp duty and VAT from property and there was too rapid growth in public expenditure. This was based on a belief that economic growth would continue, together with a consensus on the desirability for increased public expenditure. Concerns on macroeconomic policy were a recurring theme for myself and for other economists in Ireland years prior to the crisis. In a publication to honour Dr. T.K. Whitaker's 80 years, I indicated - and I'll quote - "while the lessons of previous policy errors are well known, there are potential dangers ... particularly if public expenditure programmes are planned on an assumption of continued rapid growth."

I emphasised the difficulty of adjusting public expenditure programmes which could result in the emergence of a large deficit and an expansion of public debt if there was an economic downturn.

Interventions in the property sector also fuelled the fire of property prices. In 1997, I argued that policy should, by appropriate planning and zoning decisions, ease the shortage of land for residential housing. Restrictive zoning meant windfall gains to property speculators, increased housing costs and opened up opportunities for corruption. The escalation in property prices was further fuelled by the build-up of tax incentives. My views on this were informed by an investigation of property tax incentives which I and other economists completed for the Department of Finance in 2005. My views at that time indicated that while the incentives were supported by a range of vested interests, including investors, property developers and banks dependent on property, my report concluded:

There is absolutely no case for further government incentives. Continuing to approve new projects would contribute to oversupply and represent a clear waste of scarce public resources.

I strongly recommended the abolition of the vast range of property incentives.

On crisis management, in the period since I joined the board of the Central Bank in 2007, there were detailed plans by the Central Bank to deal with the liquidity position and a domestic standing group was established jointly with the Department of Finance to examine risks and responses. The focus was on liquidity risks and this intensified over time. On 16 September 2008, a note to directors of the Financial Regulator pointed out that term funding was effectively closed. It stated that post-Lehman's, public concern was increasing and the tone of media comment was systemic rather than institution-specific. Investors were cutting lines to Irish banks and requesting breaks in the terms of deposits. In addition to two institutions which were being very closely monitored, one of the other major institutions advised that, "If markets do not improve, they risk breaking liquidity ratios in a matter of weeks." This signalled to me the danger of a full scale run on the Irish banking sector.

While liquidity risks were monitored, there was much less understanding of solvency and this was a major mistake. This may have been due to the belief that solvency and liquidity were separate. The week of the bank guarantee, leading to the guarantee decision, resulted in Irish citizens paying a very high and unjust cost for the banking crisis. The guarantee was not thought up on the night of 29 September but arose from extensive analysis by the Department of Finance, Central Bank and regulator, with the teams of external advisers. I first heard of the guarantee as the main option being considered in an emergency joint Central Bank-IFSRA board meeting which was called on 25 September but this option must have been developed earlier. As is evident from the official board minutes which I have supplied you with, the Governor and the Central Bank and the Department of Finance indicated that a guarantee of the liabilities of the six financial institutions was being considered. There was no suggestion at that time of any option to guarantee some banks but to nationalise others. The Central Bank board was never asked for a view on that revised option. The minutes of the Central Bank board meeting on 25 September show: "The Governor and the Chairman of the Authority briefed the meeting on the ongoing discussions with the banks and the Department of Finance regarding the liquidity position of the Irish banks and policy options to be considered if the position continued to deteriorate". It indicated that the Minister for Finance ... the then Minister for Finance had convened a meeting on Wednesday, 24 September, attended by the Central Bank, the Financial Regulator, the NTMA and the Department of Finance and, I assume, by their advisers.

The Government had also met with the Minister ... the Governor of the Central Bank had also met with the Minister for Finance and the Taoiseach. The outcome of this meetings ... of these meetings was that the Government wanted policy options for the future of the financial sector to be developed and refined, as a matter of urgency, over the weekend for consideration by the Cabinet at the start of the following week. Following a detailed discussion on the liquidity pressure on all the banks in what was referred to as ... unprecedented international credit crunch, it was suggested that if the liquidity situation did not improve, the issue for the authorities would be how to address the whole financial system.

The minutes highlight what was seen as the key policy option. The minutes explicitly noted that a key policy option for the weekend was whether or not the Government should issue a formal guarantee for the liabilities of the six domestically-owned credit institutions. If a decision was to be made in this regard, the Government would require the formal advice of the Central Bank and the Financial Regulator on the necessity of such a measure and its impact. On hearing this proposal, I raised the following questions at the board. Would it be illegal under state aid rules? I suggested I expected it would be challenged. How could one minimise any exposure to the State? Would financial markets and the public view this as a credible guarantee? Had all alternative options been fully exhausted? And was there any hope of ECB-wide action before consideration was given to such a radical decision? I knew the Government ... the Governor of the bank had been very actively exploring ECB action for some time. And how would any guarantee interact with the necessary restructuring action on individual institutions in order to ensure viability? I clearly remember the representative from the Department of Finance and the Governor and some other directors also expressed strong views on that latter issue.

I made suggestions to attempt to protect the taxpayer and reduce the risk to the State if such a policy was subsequently decided - firstly, by ensuring any guarantee was for as short a time period as necessary and I argued against any long-term guarantee. I indicated if the State felt obliged to give a guarantee, we should get out of these obligations as quickly as possible. I suggested that in the event of any guarantee, the banks should be forced to pay in full for this and the payment levels should reflect the value to the banks and the risk to the State. Some of these points which I and the other directors made were reflected in the formal, signed-off, agreed minutes of the meeting, and I quote:

In discussing the option of a Government Guarantee, the meeting noted that the market would have to be convinced of the credibility of the Guarantee. There was also a likelihood of a legal challenge on competition grounds if it was confined to the domestic credit institutions. The meeting agreed that the issue of an explicit Government Guarantee supported by a willingness to supply additional funding, if necessary, warranted detailed consideration. In this context, however, it would be necessary to identify a viable long-term strategy for the industry and [to] pursue this objective vigorously.

I had the distinct impression at the meeting that a guarantee of all banks was the favoured option and probably the only option in serious consideration which was explained to the board. I felt strongly at that stage that all available options should be examined, rather than simply the guarantee option, and I decided that evening to write to the Department of Finance, the regulator and the Governor of the Central Bank. As is evident from my correspondence of 25 September 2008, which I have provided to the committee, I outlined my view on the principles which should be followed: (i) State exposure to be minimised where possible; (ii) the knock-on impact of any decision should be taken into account and the minimisation of contagion; the cost of any assistance to be paid for fully by the sector, even if this means over time; and wider economic implications should be factored in. The best option was, in my view, a European-wide, EC-wide ... ECB-wide action. My opinion was there was a reluctance by the ECB to recognise the scale of the problem or to take necessary responsibility for their role, but I felt pursuing that action was desirable.

On the option of a guarantee of all six financial institutions, as proposed by the Department of Finance and the Central Bank, I was ... felt there was a need to consider different formulations if this was the chosen option. I also raised explicitly my concern over whether it would postpone necessary restructuring of Irish banks. I had concerns over whether a guarantee would be effective in preventing a bank run and what would be the market reaction. This was still a major concern to me in the days and weeks after the guarantee was announced. I also suggested the payment terms could be structured in a way which would neutralise the competitive impacts, i.e. some banks should pay proportionally more. My suggestion implied much higher costs for institutions such as Irish Nationwide and Anglo. I highlighted the need to take action to reduce Exchequer exposure and to restructure the sector. In my written advice on 25 September 2008 to the Governor of the Central Bank and to the Department of Finance, I outlined three other issues which I felt needed to be addressed as well as the immediate issue of liquidity, namely, a response to individual banks with liquidity issues, actions to reduce risk and potential exposure and plans to restructure the sector. The options for action in relation to individual banks which I proposed on 25 September 2008 included management changes, restrictions on loan ... on loans and a restructuring plan, including managing-down of loans.

Over the next few days, it was very clear the crisis was getting much worse and I felt a bank run was now a real possibility. There was a sense of incredible panic in world financial markets and policy makers were in uncharted waters. I had come to the view that Ireland could face the total collapse of the banking system and the ECB was taking the attitude that we were on our own. By the time we had reached 29 September, I knew from the previous board meeting of the Thursday - of the 25th - that the Government ... that the Governor had indicated he'd previously been against the guarantee but then ... by then felt things had changed. The decision of the US Congress to reject the bailout plan ... their bailout plan - which was an extraordinary decision - meant there was now ... while there was up to then a chance that liquidity pressures would ease, things had now fundamentally changed. My view is that given this development, the guarantee was the sensible option, but of the terrible options available. However, I always understood that a response to the liquidity crisis would at best only buy time to address the underlying problems and to deal with the issues in individual banks. As soon as the guarantee was introduced, my focus was on how to minimise the exposure to the taxpayer and I wrote, on 20 October 2008, to the Governor of the Central Bank and to the Department of Finance stressing that "the day we give a time limited guarantee is the day we need to plan for exiting".

In conclusion, I would like to very briefly suggest a number of issues for possible consideration by the committee that may help to avoid another crisis, namely: supply issues in the housing market, unless addressed, could result in the re-emergence of rapidly increasing property prices and rental prices and even greater levels of homelessness; Governments might usefully consider using any unexpected windfall gains in Exchequer return to repay national debt, rather than fund tax reductions or increased expenditures; the Central Bank should base its policy in regulation on an assumption that any regulated institution could fail and, if it is of systematic importance, will be bailed out, and regulation should reflect that; there is ... a renewal in bank governance and personnel should be a requirement; changes in the nature of auditing of banks are required; and banks need to incentivise long-term gains, rather than spurious short-termism. Thank you, Chairman and members of the inquiry.