Summary: Regling-Watson report

My summary of the Regling-Watson report is below; 12 quotes in all.

The Honohan one will be done later.

Watson and Regling:

Preliminary Report Into Ireland’s Banking Crisis 31 May 2010

1. Fiscal policy heightened the vulnerability of the economy. At the macroeconomic level, it should have done more to dampen the powerful monetary and liquidity impulses that were stimulating the economy. Budgets that were strongly counter-cyclical could have helped to moderate the boom, and would also have created fiscal space to cushion the recession when it came. But budgetary policy veered more toward spending money while revenues came in. In addition, the pattern of tax cuts left revenues increasingly fragile, since they were dependent on taxes driven by the property sector and by high consumer spending. Ireland was also unusual in having tax deductibility for mortgages, and significant and distortive subsidies for commercial real estate development, yet no property tax.

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2. There was scope to mitigate the risks of a boom/bust cycle through prudent fiscal and supervisory policies, as well as strong bank governance – thus raising the chances of a “soft landing” for the property market and for society at large. In the event, official policies and banking practices in some cases added fuel to the fire. Fiscal policy, bank governance and financial supervision left the economy vulnerable to a deep crisis, with costly and extended social fallout

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3. In other words, a marked slowdown in the economy, and in the property sector in particular, was unlikely to end in a soft landing for significant parts of the banking system. Serious stress in the financial system was almost unavoidable – even if the Lehman Bros event had not administered a huge shock to liquidity. Ireland’s banking exuberance indulged in few of the exotic constructs that caused problems elsewhere. This was a plain vanilla property bubble, compounded by exceptional concentrations of lending for purposes related to property – and notably commercial property.

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4. The response of supervisors to the build-up of risks, despite a few praiseworthy initiatives that came late in the process, was not hands-on or pre-emptive. To some degree, this was in tune with the times. The climate of regulation in advanced economies had swung towards reliance on market risk assessment. Domestically, moreover, there was a socio-political context in which it would have taken some courage to act more toughly in restraining bank credit. The weakness of supervision in Ireland contrasts sharply, however, with experience in those countries where supervisors, faced with evident risks, acted to stem the tide.

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5. Moreover, bank supervisors in Ireland were not called upon to deal with technically complex problems. Ireland’s banking exuberance indulged in few of the exotic constructs that caused. Ireland’s banking exuberance indulged in few of the exotic constructs that caused problems elsewhere. This was a plain vanilla property bubble, compounded by exceptional concentrations of lending for purposes related to property – and notably commercial property.

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6. Thus it is clear that, in various ways, official policies and bank governance failings seriously exacerbated Ireland’s credit and property boom, and depleted its fiscal and banking buffers when the crisis struck.

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7. For a long time, Ireland’s overall fiscal policy was considered to be exemplary because the country achieved fiscal surpluses every year from the mid-1990s to 2006, including the creation of a Pension Reserve Fund to make budget surpluses politically more acceptable.

However, the nominal budget figures mask an underlying deterioration in the fiscal situation after 1999. The cyclically-adjusted fiscal surplus was rather small during much of the last decade according to the data available at the time. As already mentioned, statistical tools to capture the full impact of asset bubbles on tax revenue are not well developed, otherwise it would have become clearer much earlier that the structural, underlying fiscal balance was much less favourable than assumed at the time. The IMF estimates now that in 2007, when the headline budget was approximately in balance, the underlying, structural deficit (taking into account the large positive output gap and the effects of the asset price bubble) had deteriorated to 8 ¾ percent of potential GDP and amounted to 4 to 6 percent in the run-up to the crisis. The conclusion is that overall fiscal policies were pro-cyclical during most years up to, and including particularly, 2007 thus adding markedly to the overheating of the economy.

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8. From 1999 to 2008, Ireland’s real effective exchange rate increased more than that of any other country in the euro area. Of course, some loss of competitiveness is the natural mechanism through which growth is slowed in a euro area economy that is overheating. In Ireland, however, an imprudent expansion of bank lending, accompanied by an unwise policy on tax exemptions, resulted in this natural economic cycle becoming much more extreme than should have ever have been the case. The loss of competitiveness went much too far; and then the pro-cyclical swings in fiscal policy and the banking system, once the cycle turned, were bound to cause a sharp slowdown. This process was already underway when it was exacerbated by the savageness of the Lehman Bros shock.

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9. The assessment above should help place in perspective the performance of individual institutions. It speaks to a collective governance failure, and in part it reflected an uncritical enthusiasm for property acquisition that became something of a national blind-spot. It was in this sense at least a wide political and social phenomenon, and some of the underlying misjudgements about debt and property were so embedded in collective psychology that this can be imagined, perhaps, to mitigate institutional failures to some degree.

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10. … the scope in this twin-headed regulatory structure to devise and implement a decisive macroprudential strategy that would dampen the property boom was exploited only to a limited degree. Supervisory analysis and implementation fell short in just the area, macroprudential risk, where the IMF had hoped that the framework might prove valuable. In this sense, design was not the issue, at the end of the day. Implemented in the right spirit, there is no question that this framework could have been made to work sufficiently well to mitigate the impact of the credit/property cycle.

There were also some questions, in this framework, about ultimate responsibility and about lines of command. These were issues that the regulator’s partially interlocking relations with the central bank seem to have left open to interpretation. Again, however, such questions should not have stood in the way of firm and proactive supervision. The issue was implementation.

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11. The fact is that supervisors, right to the end, clung on to the hope of a soft landing for the economy and the property market, as did a much wider community of opinion in Ireland (to the extent such opinion foresaw any end to the boom at all). Supervisors did not focus strongly on the extent of the possible, and really rather likely, swing in commercial property values, when the economy would slow down after a period of high consumption and overbuilding. It is hard to view the eventual impact of this on the capital of certain institutions as an exceptional or unforeseeable event.
Moreover, this property lending was of a common-or-garden kind: not exotic, or complex, or hard to assess through esoteric statistical models. And it constituted a sword of Damocles hanging over the banking system.

This was a major misjudgement, since published central bank data on sectoral lending by banks would have given a reasonable clue about the scale of the problem, and the cyclical characteristics of such lending are quite well-known.

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12. There was some valuable research in the central bank into financial institutions’ exposure to the commercial property sector in general. For example, a background paper to the 2007 Financial Stability Report does a good job at analysing aspects of this issue, while eventually expressing some agnosticism about the probabilities of a serious problem. However, in the core macroprudential analysis of the central bank, and it seems also in its private advice to government, the risks of a “hard landing” for the commercial property market, the banking system, and the economy – even without a savage external liquidity shock – were seriously underestimated.