Some commentators wrongly claim there is little value in the long and (moderately) expensive banking inquiry. There is much to learn from the inquiry. One important message can be gleaned from the testimony of Central Bank and Financial Regulator executives this past two weeks: the coalition needs to appoint a first-rate economist (like Honohan) as his successor as central bank governor. The coalition should scour the globe and not compromise on analytical firepower.
Brian Lenihan pushed through the appointment of Honohan against the tradition of promoting someone from the senior ranks of the civil service. If the tradition had been followed, the Irish economy might still be wallowing in financial instability. A central bank governor without first-rate economic expertise could have made a total hash of the financial restructuring and recovery programme of the last five years. For example, a former senior civil servant would not have made the phone call to RTE Morning Ireland in November, 2010, getting the Troika programme quickly started. Other painful actions taken in recent years, such as the PCAR and PLAR exercises, and the time-consuming and expensive improvements to the financial sector database, might have never started or been botched. The job requires a highly-competent, well-trained and experienced economist.
Looking back at the banking inquiry testimony over the last two weeks makes clear why a first-rate economist is needed. Defending his time at the helm, John Hurley states:
“As Governor I fostered and welcomed open discussion. In Board discussions, as is normal, there were varying views expressed from time to time. A clear consensus always emerged after careful consideration of issues.”
This is the essential vision of the central bank governor as a type of senior civil servant. He chairs lots of consensus-finding meetings with important people. This hands-off management style, where the leader does not provide analytical input or make difficult decisions based on measurable data, but just chairs meetings and looks for a consensus, works fine in some institutional environments, but not for a central bank head. Meanwhile, if we briefly analyze the economic data, the financial system was hurtling toward Armageddon at the end of Hurley’s term:
• In the five years from 2003 to 2007, the domestic banking sector grew by 250%. This 250% growth does not include the growth in lending by foreign banks operating in Ireland; this was also growing too quickly.
• Irish property development lending by domestic banks, a particularly risky business line, grew by over 500% over this same five-year period.
• By the third quarter of 2008, the domestic banking system had net foreign borrowing (including lending for foreign property development) equal to 88% of Irish GDP. This was a volatile and skittish source of funding, being ploughed into long-term property development lending assets.
• By the third quarter of 2008, the domestic banking system had outstanding liabilities of €791 billion, equivalent to 439% of Irish GDP, an extremely high ratio by international standards. These liabilities were backed by problematic bank assets heavily concentrated in property-related lending. Foreign banks also had large loan portfolios in Ireland, adding to the risk of a collapse.
There was no sense of urgency in response to these alarming statistics – in fact, the central bank did not even have all this data! It had failed to maintain a decent quality database of the aggregate financial system. One of the first big projects after Honohan arrived was to fix this obvious shortcoming. Prior to Honohan’s arrival, financial stability oversight at the central bank was done without it. The senior management of the central bank analysed and controlled the economy’s financial stability by having lots of meetings with important people.
The situation in the Financial Regulator was just as bad. Mary Burke has testified that the Financial Regulator in fact had no ability to impose any real sanctions – the Financial Regulator’s control of bank’s risky lending policies was entirely dependent upon empty words. To give Mary Burke due credit, it seems clear from her testimony that she knew at the time that the regulatory system was deeply defective. The testimony of Patrick Neary, on the other hand, gives the impression that he was comfortable with the policy of just asking the banks to do things, with no credible sanctions behind the requests. A competent economist at the helm of the central bank would understand the difference between empty threats and credible deterrents, and not allow this sanctions-free regulatory system to fester and collapse.
The yawning gap between the regulatory coverage of the Central Bank and the Financial Regulator also reflects very poor economic analysis. Hurley states clearly in his testimony that the central bank was not responsible for looking at financial institutions, only at aggregate financial stability. Hence the central bank did not concern themselves with individual financial institutions. Patrick Neary notes that Financial Regulator had no responsibility for financial stability, focussing only on individual financial institutions! A competent economist at the helm of the central bank would see the obvious logical inconsistency in this un-coordinated, segregated oversight of macro and micro regulatory control.
The coalition partners might mistakenly think that all the hard work has been completed under Honohan and that they can return to the cosy past of a pliable ex-civil servant running the central bank. There are in fact very dangerous financial risks looming for Ireland. Ireland is a small open economy sited at the intersection of three currency zones. Grexit and Brexit both present big risks for Ireland. There remain basic design flaws in the Euro which could lead to an implosion or stagnation. Grexit could contagiously spread a credit and liquidity crisis to Portugal or elsewhere. Italy faces some very serious problems at the moment. If Italy’s medium-term growth rate goes negative and/or its budget deficit climbs, it could face a sudden stop to its sovereign debt refinancing. Things might turn out well, but there are a lot of big risks for Europe and Ireland, and the central bank needs a first-rate economic decision-maker as head. Ireland’s new central bank governor also should be qualified to contribute authoritatively to international and eurozone financial policy deliberations; this will have domestic benefits through its impact on Ireland’s international voice and reputation.