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.