Honohan Report on Banking Crisis: Comments

Prof. Honohan's report is an impressive piece of work. The media has to be careful to not dilute the message in the report by making this a debate about the government and about arguable policy decisions. The low hanging fruit - bad regulators, management breaching internal rules and misleading shareholders, directors who ignored their fiduciary duties, auditors who slept at the wheel, lawyers who advised these firms, rogue actors at the banks, etc have to be tackled and held responsible before getting bogged down in abstract debates about policy. These quarrels are a distraction from the main task of bring those responsible to justice. The accountability process does not have to wait for a commission of inquiry. In fact, commencing the process of holding those responsible to account under the law now can only aid the job of a public commission of inquiry by creating more incentives for responsible parties to cooperate.

Below are what I thought were the highlights with my comments in blue:

P.20: Domestic policies did not act as a sufficient counterweight to the forces driving this unsustainable property bubble. Bank regulation and financial stability policy clearly failed to achieve their goals. Neither did fiscal policy constrain the boom. Indeed, the increased reliance on taxes that could only generate sufficient revenue in a boom, made public finances highly vulnerable to a downturn. Specific tax incentives also boosted rather than restrained the overheated construction sector.

P.25: Banks were certainly not tightening credit conditions as the average LTV ratio loan rose. Overall, despite the traditional nature of lending during the period while prices rose, there was a distinct decline in loan appraisal quality for residential mortgages.

P.26: Complicated crosscollateralisation meant that banks were much more exposed than they seem to have realised. And although some of the property collaterals were located in several foreign locations vulnerability to a correlated downturn in the different markets meant that banks would have needed a greater capital buffer to protect against a possible property crash.

On the government's policies:
P.27: Competitive pressure on the leading banks to protect their market share was driven especially by the unprecedentedly rapid expansion of one bank, Anglo Irish (whose market share soared from 3 per cent to 18 per cent in a decade, growing its loan portfolio at an annual average rate of 36 per cent).

P.30: The rates of stamp duties, which were high, were lowered several times in recent years (in 2001, 2002, 2003, 2005, and 2007), sometimes with the aim of improving the affordability of housing to first time buyers (as was the case with the Bacon initiatives 1998-2000). In addition, different classes of construction investment have attracted sizeable income tax concessions extending over long periods.

P.31: The ceiling on the income tax deductibility of mortgage interest for owner-occupiers was increased in 2000, 2003, 2007 and 2008. By 2006 Ireland was one of only four OECD countries which allowed income tax deductibility while not taxing imputed rental income or capital gains for owner-occupiers. Furthermore, no residential property tax existed.

I think these criticisms are not terribly persuasive. There are sound arguments to be made for lowering stamp duties and offering deductions for mortgage interest for homeowners. Prof. Honohan also seems to be suggesting that tax rates ought to have been higher. Why? Why should people give free money to the government in the form of higher stamp duties, fees and other taxes? The trend in most civilised systems has been to reduce these sorts of transaction costs. I cannot imagine that people were lining up willingly to give up more of their income in the form of higher taxes. His argument about the share of tax revenue from corporation tax, stamp duties etc is also not very persuasive. It only grew from 8% in 1987 to 20% in 2007. Is this out of line in a small economy with few natural resources or other large industries? He is right that the government ought not to have gone on a spending spree when the contribution of corporation tax, stamp duties etc was an inflated 30% of tax revenues in 2006.

Further, there are sound arguments to be made for policies aimed at encouraging home ownership. Was the crisis here caused by this policy or just by poor lending practices and dreadful regulation? I don't think the report establishes the case that encouraging home ownership caused the crisis or that first-time home buyers are the root of the problem. I'm surprised that the government has chosen to be so docile on this one.

On regulators:

P.37: The Governor was also given powers to authorise a CBFSAI employee to investigate the business, and carry out on-site inspections, of licensed credit institutions, building societies, trustee savings banks, approved stock exchanges, authorised investment businesses and authorised collective investment schemes....These powers were not, however, used in the period under consideration.

Why not? At least it puts to bed the theory that there was a deficiency in powers available.

P.39: ...it would be fair to say that, in practice, the composition of the CBFSAI Board and Authority is closer to the generalist model of a central bank board than to the expert model. ...this type of board, whose members are drawn from a cross-section of professional and public sector groups, may be less likely to detect and head off a macroeconomic bubble which is believed in by peers and which is generating very considerable prosperity throughout society.

The poor skill level of those expected to make the tough decisions is highlighted at several points and cannot be stressed enough, especially as it relates to the judgement of those who appointed these sorts of people to demanding positions.

P.50: In briefing the Authority, the CEO noted that the resistance to this proposal from industry was very strong. There was a particular concern with the lack of a materiality threshold and it was also suggested that the relevant provisions were unconstitutional.

p.51: The Authority was also informed in December 2006 that the Minister for Finance felt that it was important to assess the competitiveness issue.

4.23 Following a discussion with the Department of Finance it was agreed by the FR not to implement the provision as set out in the Central Bank Act, 1997.

While the Minister for Finance might have acted in good faith, this illustrates the point about regulatory capture and the idea that regulators must not have too cosy a relationship with those they seek to regulate.

P.54: However, an executive decision was taken in early 2007 to delay the corporate governance code for
credit institutions
 
...One of the reasons why one of the three initiatives was abandoned related to competiveness concerns. While such concerns were part of the mandate of the Authority, they were given too much weight in the decision not to proceed with the introduction of these key features.
 
Enforcement issues:
 
p.55: Banks and building societies were seen as important institutions deserving appropriate respect and
threats of action by the FR in the absence of compliance were not typically part of the process. It was felt that there was a danger that court cases might be lost, while attaching conditions to licenses and similar measures might attract unseemly adverse publicity and discourage promotion of the Irish financial sector. It was considered much better to resolve regulatory issues through voluntary compliance and discussion. (italics mine)

This is extraordinary. A regulatory system built on the regulators' fear of litigation is surely a recipe for disaster. This, once again, illustrates the need for having staff with the right skill sets.

Underlying this model of enforcement was the view that those running the banks and building societies were honourable persons striving to do their best to comply with the principles... The latter were extensive and technical in nature and often quite difficult to understand. Thus almost of necessity breaches would occur, perhaps on more than one occasion.

A strange approach to the need to follow legal rules! Imagine if the police and courts took a similar approach when ordinary people break the rules.

p.56: ... there was evidence on the files of BSD that suggested instances of persistent breaches of codes, regulations and principles occurred.69 Although in some instances the unethical behaviour is concerned with consumer (e.g., overcharging) rather than micro-prudential issues, the behaviour nevertheless reflects a willingness to evade appropriate procedures.

p.57-58: The frequency of use of administrative sanctions powers, once the powers, guidelines, training and procedures had been put in place in 2004-05 was as follows: 2006: 2;2007: 5; 2008: 10; and 2009: 9. This pattern indicates a very slow build-up of administrative sanctions cases.72 Furthermore, training programmes which had been run in 2005-06 were not run again or further developed. Also, the kind of cases brought
through the administrative sanctions process predominantly involved intermediaries and related to failures of internal controls in small firms and breaches of the Consumer Code. Prior to the financial crisis in 2008, there were no sanctions imposed on credit institutions...

One can understand a reluctance to pursue criminal prosecution. But why the coyness to use administrative sanctions? Their very raison d'etre is the ease of use due to lower requirements in terms of proof of intention, knowledge etc. Regulators in the US use these tools quite extensively. Given the documentation of repeated instances of rule-breaking, it is difficult to excuse the regulators for their failure to impose admin. sanctions. This must rank as an egregious failure.

p.58: There is other evidence that the FR was reluctant to use its regulatory powers to address serial governance failures by one credit institution (Box 4.2).

On the skills of regulators:

p. 63: Apart from volume issues, there were concerns about the skill mix of BSD resources. The supervision teams were led by middle management and lacked some of the specialised expertise needed. ...Where it existed, this skills gap will have reinforced the tendency to diffidence in engaging with the regulated entities.

p. 64: a three person team was responsible for Bank of Ireland and Anglo Irish Bank;

3 people to supervise Anglo and BOI, when the former's management was known to be "slick" and "buccaneering"?

p.68: the inspections did qualitatively identify a wide range of risks including those related to concentrations of lending on property, and the difficulty of evaluating the long-term recoverability of property-related loans...
Irrespective of the relevant aspects of provisioning of loans, the potentially very large loan-losses that would threaten insolvency in several institutions were not foreseen in the supervision documentation even as far as late 2008.

Supervisors also saw that although banks may have had good written internal lending policies, in some cases exceptions were very frequent. At one bank in the mid 2000s fully 35 per cent of development property credits approved represented exceptions to policy. Two-thirds of these exceeded an 80 per cent LTV ceiling – some exceeding 100 per cent LTV; six of this bank‘s top 20 exposures had LTV in excess of 80 per cent
at that date.
 
Why did they not act when the internal lending policies were breached?
 
p.70: illustrates the pernicious role of large developers:
 
Complacently, ―all institutions confirmed to the inspectors that they have no concerns with the current or future repayment capacity of any of the borrowers included in the inspection to which they are exposed.‖ This optimism subsequently proved in all cases to have been mistaken.
 
―The inspectors were advised that certain valuation updates are based on ‘management estimates‗. However, such estimates (which may be performed by the [identified senior management officer]) do not appear to be recorded.‖ It is clear that the inspectors have detected a deeply flawed process, which should have caused great alarm.
 
Again why were these red flags ignored?
 
M1: ―The inspectors noted that institutions have been unable to obtain a Net Worth Statement from [Mr. X], as he is unwilling to disclose such details in writing. In addition, the statements provided by [Mr. Y and Mr. Z] have not been certified by a third party‖.
 
p.72: An examination of the record of enforcement and follow-up action suggests the following features:

(i) A pattern of engagement between the FR and a credit institution of identifying a problem, negotiations on an action plan to resolve the situation and then receiving assurance that the plan had been implemented;

(ii) In some credit institutions a persistent pattern of breaches of regulations and failure to implement in full action plans;

(iii) Little or no escalation in terms of the type of action in response to compliance failures. Indeed, there rarely seems to have been any consideration given to what options for action; and,

(iv) Accommodation of (ii) through the view that there would be some alternative strategy to deal with the situation – but not an escalation – such as a new action plan.

This is a brutal indictment of the regulators!

p.74: Anglo:

... it can be said that the inspection teams did comment on governance issues, including instances of non-compliance with internally approved policies. They also commented on, among other matters, the extent of reliance on personal guarantees in the loan book, the high percentage of interest-only loans and some aspects of the loan approval process. However, the severity of these problems was not deemed to be such as to warrant being High Priority.

Why was Anglo given a free ride? This is a terrible record of enforcement and why did the government keep these people in their jobs? It seems the regulators were nothing more than glorified paper pushers.

On macro-prudential policy:

p.107: The first worry was that stronger regulatory action would adversely affect the competitiveness of credit institutions regulated by the FR..

108: There are also more fundamental problems with this argument. As noted in Chapter 3, while the CBFSAI‘s mandate does include the promotion of the Irish financial services industry, it also states that this is subject to promoting financial stability. Indeed, if, as a result of more aggressive intervention, Irish-regulated institutions had ceded some of their property lending activities to others, their own situation today could have been considerably stronger.

Devastating point! If foreign banks had indeed offered these stupid loans our taxpayers would not have had to suffer. Instead, Irish taxpayers were forced to swallow a bitter pill on the argument that the pill was necessary when it was not!

p.108: The second concern was that more robust regulation might make Ireland less attractive for international financial investment.

If this is the price for attractiveness, perhaps we are better off without it! In any case, the kind of businesses attracted by low or non-regulation are not the sorts that any sensible system wants or needs.

110: conclusion on CB/FR:

Central Bank/Financial Regulator could and should have used to a much greater extent the array of instruments available so as to effect a change in institutions‘ behaviour and thereby reduce substantially the emerging risks to financial stability. Although Roundtable Discussions were held between CBFSAI staff and representatives of credit institutions following the publication of FSRs and the Governor met with CEOs on
several occasions, there is no evidence that any stronger warning messages were conveyed during these contacts. Neither was the avenue of writing to the institutions – a practice that had been followed in earlier years – accompanied by a concerted campaign, perhaps in cooperation with the Government, explored.

On the bailout:

130: Turning to the question of Anglo Irish Bank, in normal times, policy should not exclude the possibility that a small failed bank should be wound-up with losses to uninsured creditors.
Given the increasingly tense confidence situation in the weeks after Lehman‘s, the failure of almost any bank began to be seen by European policymakers as something to be avoided at almost all costs.
There can be little doubt that a disorderly failure of Anglo would, in the absence of any other protective action, have had a devastating effect on the remainder of the Irish banks.

I am not so sure that Anglo was "systemically important" but it is a difficult thing to prove in any case. To be fair to those making the decisions, there was no way to know for sure and they had to act under extraordinary pressures.

p.135: In contrast to most of the interventions by other countries, in which more or less complicated risk-sharing mechanisms of one sort or another were introduced, the blanket cover offered by the Irish guarantee pre-judged that all lossesany bank becoming insolvent during the guarantee period – beyond those absorbed by some of the providers of capital – would fall on the State.
The inclusion of subordinated debt in the guarantee is not easy to defend against criticism. The arguments that were made in favour of this coverage seem weak: And it lacked precedents in other countries (although subordinated debt holders of some other banks since rescued abroad have in effect been made whole by the rescue method employed). Inclusion of this debt limited the range of loss-sharing resolution options in subsequent months, and likely increased the potential share of the total losses borne by the State.