Regulating the banks: Eugene McErlean

The absence of enforcement activity has been at the heart of the regulatory failure in the banking system, argues Eugene McErlean. Looking at how the banks might be regulated in the future he sees a fairly dull existence for regulators with a reduced number of old style plain vanilla banks.

Historically the only business chief who was able to earn exactly the same when he tucked into his turkey on Christmas day as he did on a wet Wednesday in October was the chairman of an Irish bank. Those were the days not so very long ago when a bank’s predominant source of revenue was interest income that clicked away 24 hours a day, seven days a week, 365 days a year. This activity was regulated strictly and managed with a stern approach that required tellers to stay behind for as long as it took to find a missing five pounds.

However this started to change in the late 1990s when banks began to shift the balance of their earnings from interest income to fee income. Light touch banking regulation came to prominence largely leaving the giants of the finance industry alone to generate spectacular wealth. It is now accepted as conventional wisdom that one of the

fundamental causes of the current crisis was the willingness of banks in some western countries to indulge in an asset and debt financed growth binge that was allowed to get out of control by a failure in regulation. There was a huge build up of hidden risk in the system that went undetected by the regulators. In hindsight it seems obvious when we compare the strict supervision of the regulated market with the absence of activity in the unregulated financial system. The 46,000 publicly listed companies worldwide were worth about $63 trillion before the slump. They are required to make a constant stream of public disclosures to financial regulators, engage in discussions on financial news channels and provide quarterly financial statements to make sure that there is trading transparency and enforcement of rules. Yet for the $58 trillion market in credit default swaps there is no regulator, no public information and no one in charge. The $2.25 trillion hedge fund industry similarly is barely regulated and is largely based in impenetrable offshore tax havens.

It is something of an understatement to describe as sweeping the new legislation that is under consideration internationally to rectify these deficiencies. It is planned to cover the whole gamut of financial activity from executive compensation, consumer protection and the supervision of hedge funds, private equity firms and derivatives to the so called need for a systemic or super regulator to supervise everything.

Following the recent public outrage at the excessive size of executive salaries in the financial services industry legislators and regulators across the globe have focused particular attention on the bonus culture in banking. Salary caps have been introduced to accompany bailouts including appropriate limits for the chief executives of AIB and Bank of Ireland. The UK Financial Services Authority has recently published a new code linking bankers’ pay deals to long-term profitability. Despite this, Vince Cable, the Liberal Democrat spokesman, summed up a popular view of the new rules when he said: “These watered down plans send out entirely the wrong message to an industry which is already forgetting that, just a matter of months ago, it had to come with its begging bowl to the taxpayer.”

However well intentioned these moves have been, history shows that there is no- one more creative than a financial executive in finding original ways to boost his or her reward package. It remains unclear how these restrictions will directly discourage excessive risk taking.

The excesses in sub-prime lending and the consequent spreading of the financial virus to pandemic level internationally by virtue of trillions invested in credit default swaps and mortgage backed securities have been well documented. However in Ireland we managed to avoid the worst of this malaise because our banks had not polluted their balance sheets with any of these infected financial instruments. While our regulators congratulated themselves on their prudence in avoiding this financial disease, little did we realise that the banking patients were already showing signs of another terminal illness caused by that age old killer, over-lending to the property sector. This was the killer which had brought banks to their knees throughout economic history and which had spawned expensive and sophisticated risk management machinery so that the banks remained inoculated and vigilant. Or so we thought.

In restructuring the regulatory framework in Ireland it is important to remember exactly what created the conditions for financial collapse locally. Clearly it is important to have regard to the general regulatory solutions that will be designed internationally. However in my view it is the historic absence of enforcement activity that has been at the heart of the regulatory failure. In Ireland it is not an issue of a “rules based” versus a “principles based” system but an issue of failure to enforce any rules or principles for the large players. Earlier this year, at an Oireachtas committee, Senator Shane Ross managed to extract the admission from the financial regulator that prior to 2008 no enforcement action had been taken against any major Irish financial institution. We now know that there was no shortage of issues upon which the regulator could have exercised some regulatory discipline. Indeed in a recent report published by the Consumer Panel of the Financial Regulator it was noted that there should be no distinction between “principles” and “rules”. Both are required in any system of governance. Principles in the absence of enforcement of rules are ineffective.

There is also the issue of what will be left to regulate. Not only is the Irish growth model in crisis but also the banking business system that funded it is left in tatters following the nationalisation of Anglo Irish. Those who assume that either debt fuelled consumption or Lehman-style banking will return are ignoring the consequences of the credit crunch. On a pessimistic view the sophisticated army of regulators who will form the new Banking Commission will have nothing more exciting to regulate than a reduced number of old style plain vanilla banks. Perhaps that will be a good thing.

While the New York Times has – probably unfairly – described us as the “wild west of European finance”, there is little doubt that this charge was at least in part based on the fact that the Irish Sheriff had gone fishing when the cowboys were shooting up the town.