Financial Regulation and the Irish Banking Crisis.stephenkinsella.net/WordPress/wp-content/uploads/2011/02/Lecture-2... · Financial Regulation and the Irish Banking Crisis. Vincent

Financial Regulation and the IrishBanking Crisis.

Vincent O’Sullivan,

Department of Economics, ULwww.vincentosullivan.com

[email protected]

What this Lecture will Cover

• What is Regulation and why is it important??

• What about Financial Regulation?

• Evolution of Financial Regulation in Ireland

• Regulatory Failure and the Irish Banking Crisis

• Meta-risk regulation


• What is Regulation and what is its purpose??

• What about Financial Regulation




How do I define Regulation?

• Standard Definition: an effort exerted by an authoritativeagency to change the behaviour of economic agents to acertain, pre-defined condition.

• Effort- some element of standard setting, informationgathering and monitoring.

• Changing behaviour- the purpose regulation is usually toinfluence individual and firm-level behavioural patterns

• Authoritative agency- recognises the growing importance ofnon-state institutions as regulators.

• Economic agents- reflects regulation as fundamentally apolitico-economic concept which can be best understood inrelation to economic or legal organisation.

Why do we Regulate?

1. Market Failure (Public choice theories)

– Externalities

– Monopoly / oligopoly

– Information failure

– Principal/agent problem

– Information failures

Why do we Regulate?

2. Economic Theory (Private Choice Theories)

– “regulation is acquired by certain interests who designand operate it for their own benefit” (Stigler 1971).

3. Institutional Theory

– Organisations create regulations and regulate new areasto establish legitimacy, expand their budgets and,ultimately, survive.

Why has it become so important

• Growth of the ‘risk society’ (Scott 2000), wheregovernments are increasingly responsible forregulating risk.

• Privatisation of semi-state firms during theReagan/Thatcher administrations.

• Propagation of the “regulatory state” and biggovernment (Majone 1994).

• Industrial and financial failures (e.g. Collapse ofEnron resulted in the Sarbanes-Oxley Act).

What are the pit-falls

• Regulation can be introduced to protect institutional orprivate constituencies and not address market failures.

• “Mindless rule worship”- Regulation can result in theproliferation of unnecessary and complex rules.

• Lack of information by the regulator may result inunintended and negative consequences.

• High costs of compliance may stunt economic growth.

• Poorly designed rules may result in creative compliance.







Why is Financial Regulation important?

• Banks play a very important role in the economy through:– efficiently allocating resources;

– increasing capital formation;

– stimulating productivity growth; and

– acting as a repository of national savings

• Banks are prone to periods of instability resulting in large andexpensive consequences to the wider-economy (i.e. Ireland!!).

• Financial regulation seeks to limit the risk of loss by depositorsand maintain confidence in the financial system.

Financial Regulation

• Two types:

1. Prudential

– Objective: to limit the probability of bank failure

– Example: minimum capital/liquidity requirements

2. Conduct of Business

– Objective: to protect the interests of bank customers

– Example: guidelines of acceptable behaviour andbusiness practices between banking institutions and theircustomers







Early years

• Central Bank created in 1942.

• Initially, the authority was given very specific powers, themost important being to safeguard the integrity of thecurrency.

• Following the Central Bank Act 1973, it acquired the role ofcustodian to the banking system.

• Throughout the 1970s-1980s, it introduced strict creditrestrictions on bank lending, deposit requirements on netcapital inflows and liquidity ratios for licensed banks.

• By the mid-1980s, the Irish banking system was the most“intensely regulated” in all developed countries.

De-regulation in 1990s

• Neo-liberal hegemony of deregulation or regulatory reformspread to financial markets.

• Ironically, many of the regulatory provisions which weredesigned to protect the stability were either removed orrelaxed.

• D.I.R.T. enquiry found that the Central Bank failed to supervisebanks effectively.

• Report outlined that the relationship between the regulatorand banks was “particularly close and inappropriate.”

• The Central Bank was “too mindful of the concerns of thebanks, and too attentive to their pleas and lobbying”

Creation of a Single Regulator

• Single Regulator created in 2003 (IFSRA).

• “Curious hybrid” institutional structure of the newregulator.

• Financial Regulator adopted a principles- basedregulation (PBR)

• In PBR, the Financial Regulator sets out basicprinciples.

• Banks can decide how best to align objectives withpre-defined regulatory outcomes.

Principles-Based Regulation (PBR)

• The integrity of PBR requires:

1. the “ethical behaviour” and “transparency in businessdealings” of board members (IFSRA).

2. self-observing and responsible organizations within itsframework.

3. a high degree of mutual trust and doesn’t work withindividuals “who have no principles” (FSA CEO).

4. Strong enforcement and monitoring by the regulator.

• However, these factors weren’t present and the new PRBregime gave financial institutions the freedom to expand theiroperations.







Irish Banking Crisis

• Banks had discretion to expand their operations with littleregulatory oversight.

• They applied this freedom to exercise a profit maximizationapproach by ramping up their credit outflows.

• The majority of this expansion was property related, eitherthrough the financing of commercial developments or by theprovision of mortgage credit to the personal sector.

• Banks funded this lending through disproportionately highborrowing from the ECB, as their deposit accounts could notkeep pace with the huge growth in lending

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Financial Intermediation

Construction

Manufacturing and Mining

Agriculture, fisheries andforestry

Increase in Loan book

Other factors supporting bubble

• Favourable monetary policy resulting inlow/negative real interest rates.

• Risk equalisation following entry to euro.

• Procyclical fiscal policy.

• Tax incentives for property development

• Rising income levels

• Pent up demand for housing.

Bursting of property bubble

• The sharp decline in property, starting in mid-2007, has exposed reckless lending practices andfunding models across the banking system.

• Irish society must deal with the consequences ofthe imprudent and high risk lending practices.

• The capital base of banks has been destroyed andyears of steady progress and integrity have beeneroded in a few years.







Gov. Solutions to Regulatory Failure

• More intensive supervisory regime.

• The PBR approach has been sidelined—nonew regime outlined.

• Financial Regulator is abolished.

• New Banking Commission created—CentralBank is the regulator again. What about theCB’s previous failure?

Future Regime

• Senior Management at banks failed to developappropriate risk management structures.

• The objective of future reforms will bestrengthening the competence of seniorpersonnel at banks to detect and forestalloccurrences of imprudent risk taking.

Meta-risk regulation (MRR)

• Three Mile Island crisis in 1979.

• Move from just inspecting compliance of rulesto evaluating risk management systems.

• Seeking to establish if senior managers havethe “risk analysis intelligence” to deal withunforeseen events.

• Regulator needs to establish institutionalstructures to support a more towards MMR

Where can I learn more?

Regulation

• Stigler, G. (1971). "The Theory of Economic Regulation", The Bell Journal of Economics and ManagementScience, no. 3, pp. 3-18.

• Black, J. (2002) Critical reflections on regulation. Australian Journal of Legal Philosophy 27(2) 1-35.

• Ayres, I. and Braithwaite, J. (1992) Responsive regulation: transcending the deregulation debate. Oxford: OxfordUniversity Press.

• Baldwin, R., Lodge, M. and Cave (2010) Oxford Handbook of Regulation, Oxford: Oxford University Press.

• Scott, C. (2000) Accountability in the Regulatory State. Journal of Law and Society 27(1): 38-60.

• Morgan, B. and Yeung, K. (2007) An Introduction to Law and Regulation. Cambridge: Cambridge UniversityPress.

• Majone, G. (1994). "The rise of the regulatory state in Europe", European Politics, 77 77-102.

Financial Regulation

• Goodhart, C., Hartmann, P., Llewellyn, D., Rojas-Suarez, L. and Weisbrod, S. (1998) Financial Regulation. Why,how and where now? London: Routledge.

• Eichengreen, B. and Bordo, M. (2008) Bretton Woods and the Great Inflation. NBER Working Paper No.14532.

• Black, J., Hooper, M. and Bank, C. (2007) Making a Success of Principles Based Regulation. Law and FinancialMarkets Review 1(3): 191-206.

• International Centre for Monetary and Banking Studies (2009) The Fundamental Principles of FinancialRegulation. Geneva: ICMB.

• Zingales, L. (2004) The Costs and Benefits of Financial Market Regulation. SSRN eLibrary

Where can I learn more?

Banking Crises

• Rogoff, K. S. and Reinhart, C. M. (2009) The Aftermath of Financial Crises. American Economic Review 99(1):466-472.

• Eichengreen, B. and Bordo, M. (2008) Bretton Woods and the Great Inflation. NBER Working Paper No. 14532.

• Bernanke, B. (2009) Lessons of the Financial Crisis for Banking Supervision. Chicago, Illinois: Federal ReserveBank of Chicago.

• Englund, P. (1999) The Swedish banking crisis: roots and consequences. Oxford Review of Economic Policy 15(1)80-97.

• OECD (2009) The Corporate Governance lessons from the financial crisis. OECD Journal: Financial MarketTrends 2009(1): 52-81

Irish Banking Crisis:

• Regling, K. and Watson, M. (2010) A Preliminary Report on The Sources of Ireland’s Banking Crisis. Dublin:Government Publication Sales Office.

• Honohan, P. (2009) Resolving Ireland’s Banking Crisis. The Economic and Social Review 40(2): 207-231.

• Central Bank (2010) The Irish Banking Crisis Regulatory and Financial Stability Policy 2003-2008. A Report tothe Minister for Finance by the Governor of the Central Bank. Dublin: Central Bank.

• O'Sullivan, K. P. V. and Kennedy, T. (2010) What caused the Irish Banking Crisis? Journal of FinancialRegulation and Compliance 18(3): 224 - 242.

• O'Sullivan, K. P. V. (2010) Supervision in Ireland. Where to now? In: S. Kinsella, Leddin A. (eds.) UnderstandingIreland's economic crisis Prospects for recovery. Dublin: Blackhall, Chapter 2.

Documents

Financial Regulation and the Irish Banking Crisis.stephenkinsella.net/WordPress/wp-content/uploads/2011/02/Lecture-2... · Financial Regulation and the Irish Banking Crisis. Vincent