Mr. Patrick Neary:

Thank you very much, Chairman. I have an abbreviated version of the statement that I provided some weeks ago and I don't believe the ... either yourself or the members have it. So, good morning again, Chairman, and members of the committee. As the chairman has introduced me, I'm Patrick Neary. I held the position of prudential director of the Irish Financial Services Regulatory Authority from 1 May 2003 until 31 January 2006, after which I was appointed to the position of chief executive from 1 February 2006 until 31 January 2009. Before I begin my statement, I would like to say that, with hindsight, the supervisory measures taken by the authority, which I will be outlining in this statement, were not sufficient to meet the challenges posed by the crisis and the recession that emerged. I am deeply sorry about that.

I'd like to describe the various regulatory actions and initiatives taken by the authority over the period up to end-2008 such as higher capital requirements, new liquidity requirements, new requirements for impaired loans, new fitness and probity tests, new consumer protection requirements for impaired loans, better regulation policy and oversight by the IMF and the OECD.

I will begin with the regime of prudential supervision. The Central Bank Act 1971 first established the prudential supervision of banks in Ireland. The primary purpose of prudential supervision is to safeguard, as far as possible, depositors in banks. In fact, no prudential supervision of any entity involved in lending is required if that entity doesn't also take deposits. The approach to supervision by the authority derived from EU banking supervision legal requirements. The authority’s approach, in the same way as that of other countries' banking supervisors, was subject to ongoing best practice review and external assessment by international bodies such as the IMF and the OECD. These agencies benchmarked in detail the authority against a framework of principles entitled the Basel Core Principles for Effective Banking Supervision. The conclusions of all these assessments by these independent expert bodies in relation to the authority were very favourable, such as would indicate that the approach of the authority was at least as good, if not better than other authorities reviewed by those agencies. The five key constituents of the Basel core principles, which are fundamental to the prudential supervision of banks, are referred to as the CAMEL principles; which is an acronym of capital adequacy, asset quality, management and earnings and liquidity.

A bank’s capital is the ultimate protector of depositors and there are international rules setting minimum requirements for all banks which have been enshrined into EU and Irish law. It provides the cushion to absorb losses that arise in the loans made by a bank. EU law requires that an EU bank must hold a level of capital to a value of at least 8% of the value of its risk assets. I would like to make the following observations. All loans made by a bank have a risk weighting attached to them to determine its total risk assets. Loans to EU governments attract a 0% weight, meaning, under EU law, a bank has to hold no capital whatsoever in respect of these loans. Put differently, it is assumed by the law that these loans will not default and this practice continues today. Loans to other EU banks with a maturity of less than one year attract a 20% weight, which may go some way to explaining the attraction to EU and international banks of funding the activities of Irish banks during the boom period. Recognising that the EU legal requirements were minimum standards, the authority required the Irish banks to hold capital within a range of 8.5% to 11% of risk-weighted assets.

On 1 January 2007, the capital requirements directive, commonly known as Basel II, came into effect. This directive afforded supervisory authorities some discretion to tailor capital requirements to reflect national circumstances. Using this discretion, the authority introduced a more stringent capital regime for property transactions to counter the growing exposure of Irish banks to the property sector. I am not aware of any other instance where an EU banking supervisor imposed tougher requirements on their banks than the basic minimum requirements of Basel II. At the requirement of the authority, the Irish banks were subject to much higher capital requirements than the EU demanded, for instance, Basel II assigned a risk weighting of 35% for residential mortgages, irrespective of the loan to value of those mortgages. The authority set a 75% weighting for such loans by Irish banks having a loan-to-value ratio in excess of 75%. For residential investment mortgages, Basel II also assigned a risk weighting of 35%. The authority made the entire loan subject to a weighting of 75%. Basel II allowed a 50% risk weighting for secured commercial real estate; the authority required 100%. Basel II applied a 100% weighting to speculative real estate loans; the authority demanded 150%.

Staying with residential property, the authority’s decisions reflected the economic and growth forecasts from the Central Bank, which it was obliged to follow. These predicted a soft landing and if that prediction had been fulfilled, there wouldn't have been a banking crisis. In mid-2007, the authority introduced a number of additional supervisory requirements on the banks as a response to the strong appetite for credit for residential property purpose: stress testing of individual mortgage applications to gauge repayment ability at a level 2.75% above the ECB rate; introducing the consumer protection code with measures to address aggressive lending including suitability; a ban on pre-approved credit and obligations to engage early with customers in arrears;

eleven separate press campaigns were carried out in relation to debt as well as numerous interviews and published articles. I have to stress that these were the minimum standards expected of banks. The authority did not run the banks and these minimum standards did not excuse the boards from their duties to set appropriate policies.

In July 2005, well before the crisis in financial markets began to take hold, the authority imposed new conditions on the licences of the Irish banks in relation to credit risk management policies and procedures which required each bank to have specified arrangements in place to monitor and control credit risk, with particular focus on impairments and provisions. Each bank was obliged to comply with international financial reporting standards and was obliged to advise the authority of deterioration in the credit quality of its loans. These reports formed part of the quarterly statutory returns submitted by each bank to the authority and never indicated deterioration in loan quality.

In line with Basel supervisory best practice and corporate governance codes, the authority required that all appointments to the board of a bank and any of its subsidiaries should be subject to its approval. This was to ensure that all directors of a bank, both executive and non-executive, and later, heads of all business critical functions, should be fit and proper persons with the necessary competence and experience in banking to contribute to the proper running of the bank. A final framework was introduced by the authority in January 2007 and applied to all new appointments from that date. Existing persons were "grandfathered" under the new arrangements.

In January 2007, the authority imposed new liquidity rules by way of conditions on the licences of the Irish banks. This made Ireland a leader in Europe in introducing a forward-looking system of liquidity management. Ireland was the only EU country to have updated its liquidity requirements in advance of the liquidity crisis. The reporting frequency was increased from monthly to weekly reporting in August 2007 to coincide with the onset of the international liquidity crunch. In relation to all of the foregoing, I should mention that the OECD, in its Economic Survey of Ireland 2008, commented that the authority had introduced the new consumer code to limit the scope for predatory lending practices and introduced a forward-looking liquidity regime just before the international financial market turmoil struck.

Just a few words, Chairman, about regulatory strategy. The authority adopted a principles-led approach to supervision from its inception in 2003, which essentially placed boards and management of banks at the centre of responsibility for the prudent conduct of business. The authority was legally obliged, at least three months before the beginning of each year, to prepare a strategic plan and submit this plan to the Minister for Finance. The plan had to specify the objectives of the authority for the financial year concerned, the nature and scope of the activities to be undertaken and the strategies for achieving these objectives. This principles-led approach to supervision was followed by all EU countries. The strategy also set down the objectives of the authority. One of its objectives was that its regulatory approach would facilitate innovation and competitiveness. It is clear that both of these elements played an important part in the increased availability of credit in Ireland in the years before the crisis, through a combination of more banks entering the market and more innovative types of lending products being developed.

In January 2004, a White Paper entitled Regulating Better was issued by Government to improve national competitiveness. The paper called for wider consultation and more regulatory impact assessment on any new regulations. This illustrates the context in which all supervisory initiatives of the authority required extensive consultation with a wide range of what are termed stakeholders - Government Departments, representative bodies and the industry and consumer panels, for example. Detailed regulatory impact analysis was extensive. In fact, the authority also put in place an arrangement with industry, called the stakeholder protocol, which enshrined time commitments by the authority to respond to industry requests for regulatory approvals, issuance of the findings of inspection reports, etc. I can understand that initiatives such as this formed a perception of the authority as a can-do entity, willing to prioritise industry demands rather than appearing more detached and discerning. This is something which I believe, in hindsight, both myself and the authority got wrong.

The growth in private sector credit arose mainly from the appetite for property acquisition and associated construction activity. This expansion in these areas was due to a number of factors, including strong economic growth, an increase in the level of household formation, very low interest rates, lower personal tax rates, a vast range of tax incentives for property investment, the desire of Irish people for property ownership, a feel-good element generated by increasing property values which quickly seasoned loan-to-value ratios, and all supported by readily available bank loans.

A further, and extremely important, factor was the consistent pattern of very positive economic commentary in relation to the performance and prospects for the economy and the property market from the Economic and Social Research Institute, the Central Bank and the Department of Finance. In formulating its strategy, the authority always took full account of the output of these authoritative sources which predicted that the Irish economy would continue to show growth above the EU average and that the property market would experience a soft landing. The authority relied on the Central Bank, which maintained an economic services division with 86 staff, including a dedicated financial stability department, to monitor and assess the overall health of the financial system. Had these predictions held, there wouldn't have been a bailout.

Questions have rightly been asked in relation to number, skillset and experience of resources devoted to the supervision of banks. As mentioned in the Honohan report, staff numbers in the banking supervision department increased marginally from 44 at end 2005 to 48 at end 2008, and were allocated in teams to supervise portfolios of banks. Apart from considerable day-to-day contact with their respective banks, staff in banking supervision carried out over 50 inspections of banks between 2003 and 2008.

The authority had approved higher staff. However, the HR department of the Central Bank, which performed recruitment activities on behalf of the authority, experienced difficulty in attracting persons with banking experience to the department. This reflected constraints on salary levels available to public servants and very strong salary competition for such persons in a market operating at a high level of economic activity. I agree with the conclusion in the Honohan report that the authority did not have the mix of skills necessary for a more intrusive style of supervision. The difficulty in attracting new staff with good experience in banking, and the rapid pace of evolution of the new regulatory directives which had to be implemented, stretched existing staff to the limit, to both engage in ongoing supervision work, while at the same time having to maintain training programmes for newer staff transferring in from other departments in the authority. There is little doubt that staff were stretched more thinly in banking supervision, and thus the capacity to foresee and react to the unfolding crisis was made more difficult.

In July 2007 an MOU was put in place between the Central Bank, the authority and the Department of Finance to establish a committee called the domestic standing group to help in the management of financial stability issues and to prepare to handle the financial crisis. Frequent and regular meetings of the group were held, and a number of work streams emerged dealing with emergency liquidity, deposit protection, draft legislation, as well as the updating of a manual to be used in the event of a crisis. As the crisis deepened the Department of Finance retained consultants to assist in preparations to nationalise a bank or a building society, and work to determine to what extent there may have been a need for further capital injections to meet market expectations. I see no reason to call the adequacy of the DSG process into question. Its operations meant that many issues that could arise in a crisis were identified and examined, and several initiatives relating to emergency liquidity arrangements, draft bank legislation, and capitalisation of banks were undertaken.

I will now address the bank guarantee decision. On the evening of 29 September 2008 I accompanied the chairman of the authority to a meeting at the Department of the Taoiseach. The meeting seemed to have only recently begun when we arrived and was in the process of discussing the serious liquidity position of Anglo, and what facilities could be made available to it to help it survive until the weekend. Mention was also made of the fact that the two larger banks had sought a guarantee for the deposit holders from the Government earlier that afternoon. The chairman and I advised the meeting, in relation to the solvency position of each bank, from the point of view of the authority. We advised the meeting that on the basis of the information available to the authority, all banks were in compliance with their required capital ratios, were in a position to meet their obligations on a going concern basis, but liquidity was becoming a critical issue for them, especially Anglo.

Both the chairman and I left this meeting after about an hour. We were asked by the Secretary General of the Department of Finance to remain on in the offices of the Department in case our presence was required later. We rejoined the meeting some hours later, possibly around 11 o'clock. On our way back to the meeting room we were met by the Governor of the Central Bank who indicated that the discussions that had occurred since we had left the meeting had narrowed things down to two options, either nationalisation of Anglo coupled with a guarantee of the five remaining banks, or a guarantee of all the banks. He suggested to us that our view was likely to be sought in relation to these options.

When we rejoined the meeting, the chairman and I raised a concern about whether there would be confusion in the minds of the market practitioners in the following morning as to who was or was not guaranteed, and that making a distinction between nationalised banks and guaranteed banks ran the risk of being misinterpreted by the markets. We raised a concern that this would neither encourage the inflow of liquidity that would be expected to occur, nor would it stem outflows of deposits. Questions would undoubtedly arise whether the nationalised bank was stronger or weaker than the guaranteed bank and in that situation, all banks would risk being adversely affected. The chairman and I expressed the view that if a guarantee was going to be put in place, we would be inclined to favour it being extended to cover the depositors in all banks concerned in the same manner. Some two weeks earlier, confusion had arisen in relation to the increase in the deposit guarantee scheme limit to €100,000, especially as regards whose deposits it covered and the eligibility criteria. The effects of the guarantee were evident immediately, the daily liquidity reports being submitted by the banks to the Central Bank showed inflows of both market and retail resources and an end to the pattern of outflows which had been occurring prior to the guarantee. The guarantee was viewed positively by market commentators and was seen as addressing satisfactory the concerns of depositors and thus the funding and liquidity difficulties that had been affecting the banks.

So just in summary, Chairman, in this brief statement I have set out for you the authority's approach to prudential supervision of banks, as well as the various initiatives taken by it to strengthen its oversight of banks such as the higher capital requirements liquidity, impaired loans, fitness and probity, consumer code and the influence of the White Papers on regulatory policy. I also acknowledge, Chairman, with the benefit of hindsight, that the supervisory measures introduced by the authority were not sufficient to meet the challenges posed by the crisis and the recession that emerged and I regret that very deeply, Chairman. So thank you, Chairman, and members of the committee for your attention.