Banks should be afraid of regulator – Anglo was not
The structure is familiar to any Irish person. The stout walls, the battlements designed for heavy artillery, perched on an elevated site with good views around it, normally on a military road or overlooking a large river or a bay. The Martello Tower is something we in Ireland hardly even notice now, but spotting a Martello Tower here in Quebec City prompts a double-take.
The Martello Towers in Quebec City remind you that this was a British garrison town deep in French territory for nearly 200 years. The towers were designed to keep watch over the colony and to ensure that the authorities had an early warning system to signal trouble.
The last time I was in Canada, I was working in a restaurant in Toronto in the 1980s, and there was a perception that the Quebecers were far too radical in their approach to language. The other debate that was raging in Canada at the time was whether the banks were being too reckless in lending to the construction sector. Ontario was in the middle of a housing bubble.
Like all bubbles, it burst, plunging Ontario into a recession in 1990.
However, the fascinating aspect about Canada now is just how strong the Canadian banks have been throughout the latest global financial crisis. The Canadian banks – unlike banks in the US, the UK, Spain, Greece, Italy and, of course, Ireland – didn't need any bailouts.
The reason is regulation. The Canadian regulators did their jobs in the 1990s and the 2000s. They kept a tight rein on the banks and what they were doing, knowing full well that, left to their own devices, banks will over-lend if they get the chance because banks make money from lending out money, not taking in deposits.
The Canadians also understood that, unless the regulators are vigilant, banks will undermine the economy because banks are not like normal businesses.
Think of the banks as pyromaniacs, the economy as a dry forest and the regulator as the firemen constantly looking for dangers. Forest fires are much easier to prevent than put out.
This is why bank regulation is so important because, when it goes wrong, it goes wrong big style.
Regulation is all about policing the banks when they start to lend too much at the very beginning of a credit upswing. By the time the public starts taking money out of the banks and by the time the other banks that were financing Irish banks start calling in their loans as they were doing from 2008, it is already too late.
At this point, the authorities have a choice: do something or do nothing.
Doing nothing means you let the banks go bust and adopt an "it will be grand approach". That's hardly an option. We know from the Great Depression and the Asian crisis of 1997 that immediate liquidation of the banks in a panic makes the subsequent recession much worse.
Betrayed by an arm of itself – the regulator and the central bank – the State is left choosing between bad and worse.
The famous English economist, John Stuart Mill, said the following of crashes: "The crash doesn't destroy wealth, it merely reflects the extent to which wealth has already been destroyed by bad investments made in the boom."
Wealth in Ireland wasn't destroyed by the crash but by stupid decisions made in the boom, driven by the effervescence of the herd and fuelled by reckless lending. Every time some mad-cap dream of a developer was financed, the deposits of the ordinary depositor were put at risk. When those loans went bad, the bank had to find the money to make up the shortfall.
This is what the regulator is paid to spot – years before it gets out of hand. The financial authorities weren't up to the job. The Anglo Tapes reveal the extent to which banks were not fazed by the regulator. To put it mildly.
Banks should be afraid of the regulator. The regulator should be the policeman that is respected and feared – yes, feared – by those it is regulating. If they are not, banks have an almost in-build tendency to lend too much during a boom, pushing up share prices. Share prices rise with profitability but the more profitable a bank is in a boom, the more risk it is taking.
Rather than celebrate bank profits, a regulator should feel queasy and call the bank in and impose limits on lending. But it seemed that in Ireland, the regulator was happy to just watch from the sidelines and cheer on bank profits, continuing until the very end to say that the banks were "well capitalised" when the opposite was the case.
By then, the government had to act to protect deposits. It couldn't do this by merging bad banks with good ones because there were no good banks in Ireland. They all needed help. The State could have nationalised the banks there and then – but that wouldn't have protected taxpayers. The government could have let them go bust, which would be like a fireman allowing a forest fire to burn itself out and just hope for the best. The State could have let go toxic banks but AIB, the biggest bank in the country, was on the verge of bankruptcy. Would letting AIB go have been a good idea? We could have grabbed deposits as they did in Cyprus.
There is a narrative in Ireland that blames the bank guarantee for everything, as if there was some other easy, painless option. We didn't even have a bank resolution mechanism in place! It ought to have been temporary, used to stop the panic, then assess the situation and introduce a bank resolution law negotiating with the bondholders. But, for some reason, the guarantee was extended and extended.
It is important to understand that the guarantee and the bailouts were the consequences of reckless lending and woeful regulation, not the cause. If there had been no reckless lending, there wouldn't have been a crash and no need for any remedial action.
This is why poor regulation in the boom from 2000-2007 lies at the root of the great Irish credit/property crash. The Anglo Tapes reveal the banks knew the regulator wasn't at the races.
Unlike the Martello Towers – a form of military regulation – the financial regulator in Ireland, and all over much of the West, was more paper Tiger, than stout fortress. The strength of Canadian banks today shows that regulation can work.