Friday 20 September 2019

Central Bank must boldly go where it has not gone before

Brendan Keenan

Brendan Keenan

AN Ancient Greek dramatist could have made something of the Irish banking tragedy. The banking system failed partly - perhaps largely - because its regulators were obsessed with protecting it. (Enter Chorus).

You do not have to go back quite that far to remember the epic struggle over whether to hive bank regulation off from the Central Bank.

One old salt said he had never seen such a battle in the corridors of power. Former Bank Governor and Finance Secretary-General Maurice O'Connell is credited with achieving the umbrella link between the two bodies.

It is easy to forget what the row was about. It was caused by a belief that the Central Bank was looking after the banks, at the expense of their customers. Not that separating them completely would necessarily have averted disaster.

In a credit bubble, the existence of two such bodies might even make things worse. How exactly does one look after customers when property prices are soaring and banks are willing to lend whatever it takes for customers to chase those prices?

Only Prof Hindsight would say that the best way to protect the customers was to stop them doing what they wanted - taking out big mortgages to buy expensive houses. At the time, it was obvious from the start that the Financial Regulator was really part of the central bank and it became obvious very soon that Patrick Neary took the same view about protecting customers - protect the banks first. The best protection for the customer, he would intone, was a healthy banking system.

Hence the need for the services of a Greek tragedian. Their version of how to protect banks led to the destruction of those banks. And it is true that, as customers took their money out of Irish banks from 2009 onwards, the last thing on their minds was whether they had been overcharged.

The tragic error was that the Central Bank's view of protection centred almost entirely on bank profits. Keep them healthy and all would be well. They were not alone in this at the time, which explains some of what happened. The main excuse of Alan Greenspan, master of the Federal Reserve, is that he assumed that, if left largely alone, bankers would know enough not to destroy their business.

Still, everyone should have known that bank profits are not like other profits because they can be largely, and legally, created out of nothing. And everyone who knows anything about human nature should realise that, unless watched and controlled, people with that power will eventually succumb to temptation and either convince themselves that their business are not at risk, or just not care.

We still do not have the answer to that question in the specific Irish cases and it is hard to know at this distance whether the banking inquiry will shed any more light on it.

The concentration of what happened afterwards - from guarantees to Trichet phone calls - is, in former minister Pat Rabbitte's well-chosen words last week, another example of our fascination with the peripheral. It is much more important to know how it happened than how the consequences were handled.

Our own regulators seemed to have an extraordinarily casual attitude to risk. The inquiry seemed to bear out one's own impression that whatever competence existed in the regulator and bank was further down the chain and that at the top, incompetence ruled. Was that bad luck, an accident or the result of deliberate policy? From what one saw, the members of the inquiry did not find that question as intriguing as I do.

The history of the Central Bank of Ireland is interesting in itself. It was not established until 21 years after the State came into being, and did not have all the usual functions of a central bank. It could expand credit but not restrict it and "in what pertains to the control of credit the constant and predominant aim shall be the welfare of the people as a whole".

Ten years later the first governor, James Brennan, resigned because of disagreements with the government over the bank's criticism of policy. These centred on "the need for restraint in prices, wages and expenditure." He was replaced by James J McElliott, former secretary-general at the Department of Finance.

One might add that in 1974, when the economic crisis required restrictions on credit, lending for housing was exempted. In other words, not a happy history. These are not happy times either. The permanent challenge of saving the banks from themselves, which usually means upsetting the bankers, their customers and the government of the day is, if anything, more challenging than ever.

Of course the old Central Bank is no more. Whatever "the welfare of the people as a whole" was taken to mean, it is now secondary to the operation of the Euro system of central banks, otherwise known as the ECB.

There was a sign of the times last week regarding AIB's plans to begin raising junior debt on the markets to replace some of what it owes to the government. It may seek the government's approval, as essentially its sole shareholder, but it will need the approval of the new European bank regulator as well.

We are about to have the second governor to serve under this new dispensation. Part of the job now is deciding what the central bank can do, and ought to do. Dr Honohan's speech at the weekend was a fine example of the old task of holding government to account, and one must hope its forcefulness did not owe anything to the fact that he is about to depart.

Consumer protection has been beefed up, although the financial industry is still cosseted to a remarkable degree compared with most countries and there has been noticeable improvement in competence and activity. However, safeguarding the banking system, which used to be thought so easy as to require little thought, remains the most difficult part of the job.

The imposition of limits on mortgage lending by value and income is more dramatic than anything in the bank's history, with the possible exception of the 1991 currency crisis, and would not have been feasible under the old system.

Officially it is a decision by Dame Street, and relations with government must be as bad as in Brennan's day, but we can be sure Frankfurt takes a keen interest and would want to approve any changes.

Without control of interest rates and a fixed exchange rate, incoming governor Prof Philip Lane will have to go where the bank has not gone before, if it bank is not to become an expensive irrelevancy.

Those lending limits mean it is anything but at present but it cannot be just a question of having them or abolishing them. They may be pointers to the bank's future role, however difficult it may be.

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