27 April 2012

Patrick Honohan: Philosophy of regulation and supervision

In his speech Mr Honohan, Governor of the Central Bank of Ireland, talked about the bank's approach to supervision in Ireland, including a characterisation of its regulatory philosophy.

After the crisis broke, it was clear that three major challenges faced Irish financial regulation: these relate to facts, philosophy and resources:

• the objective circumstances and condition of the financial system were difficult;
• the policy approach to regulation had failed; and
• the resources applied to supervision were manifestly inadequate.

First was the condition of the banks, with looming hard-to-measure, but evidently large credit losses in prospect. Second, was recognition that the policy approach had failed and this meant that it needed to be replaced. I would pinpoint the location of the flaw in the policy approach to regulation as lying in the presumption that the instinct for self-preservation of well-governed firms would be sufficient to protect the system, thereby allowing light-touch regulation. Third, I won’t repeat what has been written already about the quantitative insufficiency of the supervisory resources that were brought to bear on banking in Ireland. This prevented a sufficient flow of information that could have made top decision-makers aware not only of the possibility that there could be a property bust – everyone knew that this was not only possible but inevitable, with only the scale in doubt – but also the degree to which property loans were insufficiently secured against anything other than the bubble-inflated property itself.

A word on enforcement: the days when the raised eyebrow of the Governor could be relied upon to ensure compliance are long gone (though sometimes we have a go). Financial firms know that they operate in a rules-driven environment and that compliance is expected. Failure to enforce could, I am afraid, be taken as an implicit waiver of rules. Such lack of clarity is not consistent with the new philosophy. To help ensure that these matters are not side-lined by on-going supervisory responsibilities, the responsibility for enforcement in the Central Bank has been organisationally separated from supervision. Here too staffing has been stepped up: there is plenty of enforcement to be done. While the ideal result would be no successful prosecutions because of 100 per cent compliance, recent experience makes it clear that we are still far from that ideal. As such, I am pleased with our recent record of completing enforcement cases: this sends an important and effective signal to regulated firms.

Not all instances of non-compliance can be detected. While our risk-based approach to supervision may appear to mean that the information flow to the enforcement directorate implies that enforcement cases in practice might focus more on systemically important firms, we take steps to ensure that this is not the case. The threat of enforcement is there for all, big and small, and this is evidenced by those cases taken to date.

Full speech

© BIS - Bank for International Settlements