The global financial crisis of 2008 created an international political consensus on the need to tighten regulation of the financial services industry. From an Irish perspective, the benefits of new, tighter financial regulation should not be over- sold. Such changes will have limited impact on Ireland’s deep financial problems. Over the short term, it is possible that some of these reforms might make things worse. Nonetheless, it is important to push forward with these policies for the long-term health of Ireland’s economy, and to remove Ireland’s pariah status in the international financial community.
An unfortunate effect of globalisation is the ease it provides for tax and regulatory arbitrage. Companies and wealthy individuals tend to migrate to whichever national jurisdiction offers the lightest regulation and/or the lowest tax rate. During the early years of this century this gave rise to a “race to the bottom”
between national tax and regulatory authorities. There are strong international pressures to stop this practice wherever possible.
Ireland’s role in tax and regulatory arbitrage is not entirely commendable. The establishment of the International Financial Services Centre (IFSC) in 1987 seemed a sensible, even brilliant, strategy at the time. Irish policy-makers and the business élite realised that Ireland’s regulatory weaknesses – in particular a tradition of political and business secretiveness and weak regulatory enforcement – could be marketed as strengths for attracting “offshore” financial services. These features (secretiveness and weak regulatory enforcement) became an integral part of the package which was the IFSC.
No-one in 1987 could have foreseen the 2008 credit crisis and the enormous losses that activities at the IFSC would inflict on international banks operating there. These IFSC-connected losses
post-2007 run to hundreds of billions of euros; in rough magnitude they may approach the losses of the domestic Irish banks from the 2002-2006 Irish property bubble. Also, until it was too late, no-one realised how the lax regulatory regime used to attract business to the IFSC would infect the regulatory regime imposed on domestic banks, indirectly playing a key role in the Irish financial debacle. The Irish Central Bank and Financial Regulator have made wise moves to change fundamentally the regulation of both domestic and IFSC- located banks.
‘Too big to fail’
One goal of the regulatory overhaul is to eliminate the “too big to fail” problem of modern banking. The complex interlinkages between banks mean the failure of one bank can endanger the entire inter-bank trading system. It is sometimes called “too connected to fail” since even relatively small banks might potentially cause a liquidity freeze-up.
Ireland, along with several other countries, has re-written its archaic bank resolution laws to allow swift regulatory takeover of troubled banks. Most analysts view this is a positive step, but not sufficient to solve “too connected to fail”. Additional changes are needed. Regulation-enforced changes to bank capital structures are another possible bulwark. Economists at the Bank of England have suggested requiring banks to use contingent-convertible bonds (called co-co bonds) that automatically convert to equity when specific risk ratios are triggered. In this way, a bank will get an automatic equity injection (and debt removal) as soon as trouble appears. The proposed regulatory change is not universally popular: some economists worry that it creates more complex capital structures, and that it might unduly increase the cost of funds for banks.
One of the simplest, and perhaps most effective, proposed regulatory changes is the imposition of much higher required equity ratios (the ratio of bank equity to total assets). Ireland is ahead of the pack in this regard. The IMF-EU bail-out deal requires Ireland to increase bank equity ratios to 12 per cent, an unusually high ratio, which might eventually become the new international norm. Increased equity ratios not only lower the risk of bank failures, they also may help to shrink the too-large global financial services industry, and dampen the super- profitability of the industry during boom times, which helped to engender many bad practices. It is likely that banks will increase equity ratios at least partly by shrinking assets, and not entirely by raising new equity capital, so this regulatory change might possibly tighten lending activity.
Openness and accountability
Another regulatory goal is to increase the transparency of bank funding and lending activity, and of banks’ securities trading and net positions. One of the causes of the US credit crisis was the use of off- balance sheet special purpose vehicles backed by solvency guarantees, which obscured the true risk position of banks. The prudential capital adequacy review and prudential liquidity adequacy review currently taking place for all Irish domestic banks are time-consuming and expensive exercises, but worth the effort if they succeed in “opening up” the true risk profile of the Irish banking sector.
Information openness by the Irish banking sector is still a substantial problem, and improvements are needed. As one example (many could be listed) there is still a government-imposed information black-out on property transaction prices, due to legislative bungling and an aversion to information openness in the last Dáil.
Rahm Emanuel, former White House Chief of Staff under Barack Obama, remarked: “You never want a serious crisis to go to waste.” The push for improved financial regulation could serve as a valuable impetus for much broader change in Irish political and regulatory culture. The extremely destructive failure of Irish financial regulation in 2002-2006 reflects widespread weaknesses in the Irish political system. Not just in financial services but more widely, there is need in the Irish political and corporate spheres for better governance, more openness, and stronger accountability.