Today’s Irish Times contains a thoughtful and well-argued piece by Brendan Kelly of Financial Services Ireland, the group within Ibec that represents the international financial services sector. In the piece, Kelly notes that “the financial services industry warned the Financial Regulator about the risks of increasingly complex financial markets for many years” and that the Regulator’s consultative panel of industry representatives “warned the Financial Regulator’s office about the increasingly complex nature of international financial services” and also “highlighted the lack of financial services experience on the board of the Financial Regulator, and the need for a dedicated unit to anticipate the regulatory hazards caused by financial innovation.”
These are all good points and hopefully will be taken on board within the new structure. However, it is important to remember that the key regulatory failure in the Irish case did not involve complex financial instruments. Instead, regulators allowed banks to make loans to property developers on a scale that threatened their solvency once house prices started to decline.
The existing Basle-based regulatory framework has been widely criticised for its focus on mechanical capital adequacy rules (Pillar 1). However, the second pillar of the Basle framework relates to the supervisory process and it’s worth quoting the Basle 2 document at length on the issue of “credit concentration risk” (see pages 179-180 of the PDF file):
770. A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to a bank’s capital, total assets, or overall risk level) to threaten a bank’s health or ability to maintain its core operations. Risk concentrations are arguably the single most important cause of major problems in banks.
772. Credit risk concentrations, by their nature, are based on common or correlated risk factors, which, in times of stress, have an adverse effect on the creditworthiness of each of the individual counterparties making up the concentration. Such concentrations are not addressed in the Pillar 1 capital charge for credit risk.
777. In the course of their activities, supervisors should assess the extent of a bank’s credit risk concentrations, how they are managed, and the extent to which the bank considers them in its internal assessment of capital adequacy under Pillar 2. Such assessments should include reviews of the results of a bank’s stress tests. Supervisors should take appropriate actions where the risks arising from a bank’s credit risk concentrations are not adequately addressed by the bank.
The failures in Irish banking regulation thus did not relate to financial innovations or regulatory arbitrage but to a failure to enforce the Basle recommendations about supervisory oversight of credit concentration risk. We can only hope that the simplicity of this lesson isn’t lost amid the complicated debates about principles-versus-rules and regulating complex instruments.
5 replies on “IBEC on Financial Regulation”
Would the problems of Irish banks have occurred if the old limits on mortgages (in terms of ratios of primary and secondary incomes) had continued to be applied ? (Matt Cooper last night asked Eugene Sheehy if new lending would use this old criterion and got the answer “no”, in so many words)
In the absence of such limits how can future bubbles be prevented?
Why didn’t/can’t the regulatory authorities here insist on such limits?
Is it fair to say that the income limits, per se, are not the core point. The point is more about not having a massive exposure to any single sector.
Basel II was never fully enforced.
Banks chose to adopt some parts of it. Regulators didn’t enforce any of it.
It was seen as a pick’n’mix regulatory framework. Ultimately, the banks were free to choose which parts of it they wanted to adopt in their own internal regulations.
Governments should have brought Basel II into law.
Ideally, it should have been enforced at EU level.
@Paul Power: It was the central bank who relaxed on the rules as a way of appeasing lobbyists. Old multipliers and increased capital ratio requirements would have gone a long way towards preventing this, the argument that ‘we don’t control interest rates any more’ simply doesn’t wash.
@Gaius Baltar: the absence of income limits allowed the exposure to manifest.
I’ve said this before but worth saying again: the financial services industry actually calls for regulation all the time, it is part of what keeps confidence in the system by giving it rules and structure and ensures bad practice is ousted.
The regulator has resisted calls from industry time after time, from both the industry and from the likes of the broker/intermediary channel. If they didn’t think it up then it wasn’t acted on [although by ‘thinking it up themselves’ i would include ‘copying the FSA’].
if the regulator actually took on board some of the advice given from practitioners it would be a massive step towards a safer environment for all concerned.
I have a feeling (but don’t know) that we actually have two banking crises in Ireland. 1. The one we all know about, that is domestically caused. 2. The one down in the IFSC, whose causes and consequences are more vague, but which the country is somehow implicated in whether we like it or not.
It would be good to hear an account of where exactly the IFSC project has progressed to at this stage.
I am a little concerned that we now have all these locksmiths who we haven’t heard from in years coming out and telling us what all the problems were with our barn door locking system, now that the tiger has bolted.