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Joint Committee of Inquiry into the Banking Crisis díospóireacht -
Thursday, 5 Feb 2015

Context Phase

Professor William Black

The committee is in public session. In session 1 we have a discussion with Professor William Black on banking policy, systems and practices. I welcome Professor William Black to the seventh public hearing of the Joint Committee of Inquiry into the Banking Crisis. Later this morning we will hear from European Commissioner, Mr. Mario Nava.

At our first session we will hear from Professor William Black, University of Missouri-Kansas City school of law, on the subject of banking policy, systems and practices. I welcome Professor Black to the meeting and to Ireland. I am aware he is a regular visitor and I hope his stay is pleasant. Professor Black is an associate professor of economics and law at the University of Missouri-Kansas City. Previously he was executive director of the Institute of Fraud Prevention. He has taught previously at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin and at Santa Clara University. He was litigation director of the Federal Home Loan Bank board, general counsel of the Federal Home Loan Bank of San Francisco and senior deputy chief counsel, Office of Thrift Supervision, and recently helped the World Bank develop anti-corruption initiatives and served as an expert for the Office of Federal Housing Enterprise Oversight in its enforcement against US financial institution Fannie Mae's former management. Professor Black is also author of the book The Best Way to Rob a Bank is to Own One.

I advise that by virtue of section 17(2)(l ) of Defamation Act 2009, the witness is protected by absolute privilege in respect of his evidence to the committee. If he is directed by the Chairman to cease giving evidence on a particular matter and continues to do so, he is entitled thereafter only to a qualified privilege in respect of his evidence. The witness is directed that only evidence connected with the subject matter of these proceedings is to be given and, as he has been informed previously, the committee is asking him to refrain from discussing named individuals in this phase of the inquiry. I remind members of the long-standing ruling of the Chair to the effect that they should not comment on, criticise or make charges against a person outside the House or an official by name or in such a way as to make him or her identifiable.

Again, I welcome Professor Black and invite him to make his opening statement.

Professor William Black

I thank the Chairman and members of the committee. My statement will be forward-looking as to what one can do to prevent a future crisis. There are a number of restrictions as to what one is able to do currently in terms of the existing crisis so my focus will be on the future. My message is one of hope, in large part, that we can succeed at this. We cannot succeed in stopping all bank failures and we cannot even succeed in preventing all future crises but we can prevent many of them and we can dramatically reduce the severity and length of the crises as well. That is because the great bulk of the worst crises and the great bulk of the worst individual bank failures will follow a characteristic pattern that can be identified well before a crisis stage and can be the subject of successful regulatory intervention.

I am coming to the committee with four hats today, as we would say in US parlance. My primary appointment is in economics. I have a joint appointment in law. I am a recovering litigator but I also have a doctorate in criminality. My specialty is in elite white collar criminals, particularly in the financial area and I think I will be the only successful regulator the committee is like to have appearing before it. We not only write about regulation, as members will see from other parts of the statement we are cited as the exemplars of how to make regulations succeed by public administration scholars.

We were the only people to come out of a crisis with our reputation enhanced, which is difficult to find in the current crisis. We made many mistakes and the committee can take advantage of what we did wrong and what we eventually figured out worked well. The first thing that needs to be done is to identify where the future institutions which will cause massive losses will be found, and how they can be identified when they are still reporting record profits so action can be taken while they are still doing so.

The committee has asked me to speak about principles-based regulation, which can mean many different things. The gloss put upon it throughout Europe and the United States was one which ensured it would fail against precisely the kinds of schemes I will talk about. This is not necessarily inherent in principles-based regulation. It is such a vague phrase it can mean different things to different people. Throughout Europe and the United States it came to have the same gloss, which was, basically, BFFs, which means best friends forever and is a cliché for American teenagers. This was the idea the banker could be the BFF and we could all have a Kumbaya moment and strum folk songs together, and if we were just nice to the bankers who were oppressed by regulation and removed this terrible hand of government they would work with us and we would all sit around the campfire and it would go very well. This has no basis in human history, or anything we know about human beings, but it was mighty convenient if you were a non-regulator because you did not have to do much of anything, and the world would be better because you did not do much of anything.

Here is the recipe which leads to something distinctive. It is the recipe that the institutions follow which produces the worst losses, is most likely to cause hyperinflated bubbles, is most likely to cause catastrophic individual losses, and is most likely to cause future crises. I am speaking about the past throughout the world, but my focus is going forward in Ireland with regard to policies the committee might consider recommending. The recipe has four ingredients: grow like crazy; make terrible quality loans - not kind of bad but absolutely terrible and obvious on their face loans; while employing extreme leverage, which means a whole lot of debt compared to equity; and while setting aside no meaningful loss reserves for the inevitable catastrophic losses which will follow.

If these four ingredients are followed it is mathematically guaranteed - and let me emphasise it is not hypothetical but mathematically guaranteed given how the accounting works - there will be three sure things. The bank will report, almost immediately, record profits. Under modern executive compensation the senior leadership will promptly be made wealthy but many other people in the food chain will also be made wealthy because the same perverse incentive structures are used to ensure they make those really crappy loans I talked about. The third sure thing is that down the road there will be catastrophic losses.

Thinking about it from the flipside, if you tried to devise a strategy that would cause catastrophic losses it would be with these four ingredients. Using them, you will cause huge losses and you will have no loss reserves. You are particularly vulnerable outside the United States in terms of the accounting rules, as you follow the international accounting rules, which also purport to be principles-based. The principle they purport to follow is an anti-fraud principle that is concerned with what we call the trade cookie jar reserves. These are loss reserves that can be established in good times and taken out in a bad quarter to allow officers to meet their targets and maximise their bonuses. This was the principle that the rule was designed to prevent, but it is being interpreted in a way which creates the perfect crime. It is being interpreted as saying loss reserves cannot be established currently for future losses, even in institutions which follow the recipe where it is absolutely guaranteed that because of their terrible underwriting they will have catastrophic losses.

Right now the anti-fraud principle is being interpreted as the most pro-fraud principle we can possibly imagine. As we speak today, six and a half years after the crisis hit, we still have the same international accounting rule. There have been all kinds of efforts to change it, but none of them has come to fruition. This is an area that could be addressed through regulatory policy. We could have regulatory accounting principles that require appropriate loss reserves. If we did that we would block the recipe I have been talking about and that would be a very good thing. It makes perfect sense that if you are doing things that are very risky you should establish loss reserves today. Otherwise you will create fictional income and you will get everything we have done. As I said, in a poker sense, this creates a tell. The tell is that in order to follow the strategy there has to be pathetic underwriting. What you will find when you look at all of the crises in the past and in other places is precisely this destruction of underwriting.

Underwriting is a process that a bank goes through to ensure it is likely to be repaid, and that if it does loan it will do so at an appropriate interest rate that reflects the risk. The committee can see that this was not done all through the world. I will talk about other places because of pending issues in Ireland and the Constitution. This is precisely what we did in the United States in the savings and loans crisis. We saw terrible underwriting, very low reported losses and record reported income, and we said this is too good to be true and it is. We all teach our children about things that are too good to be true, but we do not, in fact, follow this policy in reality in financial regulation. If we had, there would be none of these current crises, but we did in the past, which allowed us in the savings and loans crisis to identify when institutions were reporting record earnings, and literally reporting they were the most profitable savings and loans in America, and when they did so we targeted them for closure. In fact, we took the list of the allegedly most profitable and made it a priority to investigate each of the institutions in the top list.

To do this you have to understand the accounting and the econometrics. Econometrics is a fancy word for economic statistics. Here is the key: if a regulator examines with a standard econometric analysis - and cost-benefit analyses using this kind of econometric test are mandated throughout Ireland - they will give the worst possible result if an institution is following the recipe. Any characteristic or practice such as ultra-concentration in commercial lending to 25 families during the run up when the bubble is still inflating will show the highest positive correlation with reported profits. It has to do so. If we do standard econometric analysis we will say we should encourage everybody in Ireland, England and the United States to loan to only 25 people who should put virtually all of their money in commercial lending.

That mathematically has to follow, so you have to not rely on those kinds of test. You have to understand that if you do not underwrite, as we have known for centuries, it will produce adverse selection. This selection means you get the worst possible borrowers, and the expected value - in order words, what will normally happen - is that you will lose money. It is like gambling against the house in Las Vegas. Statistically, you are going to lose money in these circumstances.

I will leave you with the most important thing, which is a phrase that you probably have not even heard to date - Gresham's dynamic, which is the opposite of that hypothetical Kumbaya dynamic - "All will be well." There is this guy named Swift who identified it in 1726 and put it in Gulliver's Travels, but it has also been dealt with by Nobel laureates in economics. It says "What happens if cheaters gain a competitive advantage in the markets?" Then bad ethics will drive good ethics out of the marketplace. This will happen in the professions as well. All of those supposed controls - credit rating agencies, outside auditors, what we call appraisers but you may call valuers - can be hired and fired by the senior management of the banks. That is why, worldwide, in this crisis you see them deliberately going to top-tier audit firms and always getting insane financial statements blessed with clean opinions - because that reputation is valuable and easily manipulated by creating a Gresham's dynamic. You can block that Gresham's dynamic. You can block these crises. We intervened to stop 300 of these frauds that were expanding at over 50% a year in terms of growth, typically while they were still reporting high profits. We adopted a rule restricting growth which attacks the Achilles heel - the need to grow very rapidly. We deliberately intervened to pop the real estate bubble - particularly commercial real estate - in Dallas-Fort Worth. We intervened to stop loans that were in those days simply called low-documentation loans but now in the American parlance are called liar loans. This was in 1990 and 1991. We drove them completely out of the savings and loan industry and prevented a crisis.

Our current crisis is sometimes called the sub-prime crisis, but it is far more of a liar loans crisis in the United States, and even in the United Kingdom. We successfully prosecuted more than a thousand elite people from the banking industry with felony convictions. Even with the best criminal defence lawyers in the world, there was a 90% conviction rate. So you can succeed. We would be very happy to help. If it would be useful, in terms of training, I will provide a week of free training on how we did whatever we did for your regulators or prosecutors, or anything you find helpful, without charge.

I thank Professor Black for his opening statement. The order of questioners this morning is as follows: Deputy Joe Higgins will have 15 minutes and Deputy John Paul Phelan will have 15 minutes, and from then there will be six-minute rotations for the following: Deputy Eoghan Murphy, Senator Marc MacSharry, Deputy Kieran O'Donnell, Senator Sean Barrett, Senator Michael D'Arcy, Senator Susan O'Keeffe, Deputy Pearse Doherty and Deputy Michael McGrath.

Before I bring in Deputy Higgins, I wish to comment. I thank Professor Black for his opening address. He described in detail the problems associated with rapid growth in banks' balance sheets. Can he give us some specific indications on how regulators could apply rules to limit the growth rate? Is he suggesting that regulators should stop a growth rate that is excessive by his reckoning?

Professor William Black

Yes. You are probably particularly aware of what I am going to say. This is a federal agency that had three presidential appointees, so you get the best you can. You have to reach agreements. The best we could get was a restriction on 25% growth annually. The rule of thumb in banking for many decades has been that if you grow more than 25% a year you will likely fail, so this is a very weak limit. But here is the good news. It was still a cutback from growth of over 50% a year, which proved fatal to all 300 of these institutions. When I say "fatal", remember - they are dead but they are reporting that they have record profits. So you are not causing the failure, but you force recognition of the failure. In essence, these are Ponzi schemes. Ponzi schemes must grow extremely rapidly to appear to succeed for a while.

Later today, in our second session, we will discuss the regulations set out in Basel I, II and III and the credit directives and so forth which are post-crisis measures established at the European level, particularly in regard to the eurozone. Does the professor think those measures are robust enough to protect us against a future crisis, going with his own metric of what he considers the sure things that would create a crisis into the future?

Professor William Black

Basel II was a very substantial contributor to the crisis, particularly in Europe. In the United States, because of heroic resistance by the Federal Deposit Insurance Corporation against the Federal Reserve economists, who are very much in favour of Basel II, we established a minimum leverage ratio. Therefore, leverage is roughly on average twice in Europe what it is in the United States in terms of the crisis. Leverage will magnify either gains or losses. If the FDIC had not done that, US losses would have been roughly twice as large. In fact, that is an understatement, because losses do not grow linearly but tend to grow exponentially in these circumstances. Yes, Basel II was a disaster, because it facilitated the recipe that I have just gone through - grow like crazy. It allowed massive growth. With extreme leverage, it allowed extreme leverage.

Is Basel III better? Yes, but Basel III is horrifically complicated. It would be vastly better to go back to much simpler rules. The position I am taking is, frankly, the majority position among people who are involved in regulation and economics.

I thank Professor Black for coming across the wide Atlantic to assist us with the banking inquiry. I had intended to ask him to give a short résumé of his experiences that have led him to be an expert on bad practices in the banks but he gave some of it in his introduction, which was quite interesting.

He referred to the prosecutions and the investigation into the savings and loan crisis. I remember it was a huge scandal in the United States back in the 1990s. It was a high profile case and was national news in the United States. With that success and what was shown, why was that not brought into legislation or regulation? Why, 17 years later in the United States and internationally, were the same bad practices allowed to create mayhem?

Professor William Black

That is a superb question, not just a good question.

At the moment of our greatest success in 1993 - there is this period that basically ended in 1993 - a new government came in. It brought with it, as its primary domestic priority involving government, the re-invention of government which is, essentially, principles-based regulation. They absolutely adored the lessons of the savings and loan crisis. I personally witnessed the following. We were instructed that we were to refer to the banks as our "customers". I said, "Surely you mean the people of the United States of America?". They said, "No, the banks." I left government at this point, as you would imagine.

I do not say it was a conspiracy, but it was a deliberate choice to move to a very different strategy without looking at the successes of the response to the savings and loan debacle. In order to produce over 1,000 felony convictions, we created a criminal referral process that provided the key information from the regulators. I remind the committee that we have vastly more expertise in the industry on accounting issues, etc., than the FBI white-collar folks. We made over 30,000 criminal referrals. That criminal referral process was eliminated. In the current crisis, there were no criminal referrals in the United States, as far as anyone can tell.

That was the Clinton Administration. Is that correct?

Professor William Black

Yes. That was Clinton and Gore. The Vice President was tasked by the President with being the principal person in reinventing government. It was actually worse than I said. The person who was in day-to-day charge - Bob Stone, who was picked by Vice President Gore - has an autobiography out at the moment. He says he was selected by Vice President Gore at a meeting. They had never met before. At their first meeting, Mr. Stone said one substantive thing to Mr. Gore, which was that he should not waste one second worrying about fraud.

Okay. Was it a wilful decision to move towards deregulation, rather than encompassing the lessons that had been learned?

Professor William Black

Yes. It was expressly "the government is a failure, the private sector is an enormous success, we need to bring in private market principles to reinvent government".

Professor William Black

We needed to think of ourselves as a partnership with the banks - that was the explicit language they used.

Professor Black said something that might worry some people out there following on from that. He said a few minutes ago, if I understood him correctly, that nothing has "come to fruition" in effective regulation in the six and a half years since the most recent crisis started. Why does he think that is the case?

Professor William Black

When I used that language, I was actually testifying explicitly about the accounting rule on loss reserves. It is true that in general, financial regulation has not been transformed. We are still vulnerable to precisely the things I have laid out. That is because we have not focused on the Gresham's dynamic and we have not focused on the concept that is referred to in the economics literature as "looting". The key document in this regard was written by Professor George Akerlof, who is a Nobel laureate in economics, and Professor Paul Romer in 1993. The article in question, Looting: The Economic Underworld of Bankruptcy for Profit, lays out precisely the strategy I have discussed. They chose to conclude that article with a paragraph emphasising that because economists had no concept of looting, they were unable to aid "the regulators in the field who understood what was happening from the beginning" and suggesting that "now we know better". In other words, if we learn the lessons of this crisis, we need not experience this again. That very concept is forgotten. If the committee checks all the articles and all the testimony it is given, I bet it will find I am the only person who has cited Professor Akerlof, who is a Nobel laureate in economics in the heart of this specialty.

Could it be a factor in the United States or even in Europe that the financial markets and the massively powerful financial institutions have exerted pressure through lobbying, etc., to try to slow down or halt the type of radical regulation about which Professor Black speaks?

Professor William Black

By the way, "radical" in this context simply means regulation that proved incredibly effective for 50 years.

Professor William Black

It was adopted on a bipartisan basis by conservatives, liberals and moderates. It is interesting that what was absolutely centrist in banking for half a century has now become "radical". The race to the bottom is another key example of a Gresham's dynamic. The regulatory race to the bottom was a real thing. If the members of the committee look at their counterparts in the United Kingdom - the parliamentary inquiries there - they will see it was absolutely explicit in the regulatory statute of the UK Financial Services Authority at that time that there was a need to win the competition. The aim was to keep the City of London as a top centre by deliberately weakening regulation.

Professor William Black

Of course Wall Street always pointed to the City of London to say it needed to weaken or get rid of the Glass-Steagall law in the United States. It thought financial derivatives should not be regulated because that would result in all such activity being moved to the city of London.

Professor William Black

Everybody loses during this race. The city of London won the race to the bottom. It is the absolute worst in the world. Wall Street is a close second in terms of the worst in the world.

We will put this question to the Commission representative who will be here later. We will ask whether there was such a race to the bottom in Europe. We await a response in regard to that. I would like to ask Professor Black briefly about the recipe he has laid out for bank failure, the drive for very rapid growth and the types of loans, etc. He said that one of the sure things is that this leads to immediate and vast profits.

Professor William Black

Reported profits.

Reporting profits.

Professor William Black

Fictional.

Could he explain very briefly to our people how that is possible? How do they make such profits in such a short time?

Professor William Black

They do not, but they report enormous profits. If I make a very bad loan at 9% and my funding cost is 4%, the difference, which is known as the spread in finance, is 5% or 500 basis points. If I make much worse loans, I will report a much bigger spread. That is not real profit, obviously, because I am taking vastly more risk.

Professor William Black

In fact, I am taking so much risk that on every loan I make, I lose money in real economic terms. I should have an established loss reserve, perhaps of 600 basis points, which would make it clear that I was losing money every time I made one of these loans. The international accounting rules essentially provide for the establishment of a loss reserve of zero.

Professor William Black

To put it simply, the riskier or crazier the loan I make, the more fictional profits I will report, the bigger the losses and the bigger the compensation.

How does that work for the person taking the loan, who is paying higher interest rates?

Professor William Black

They are sometimes paying that rate, but frequently of course they are not paying that rate. The saying in the trade is "a rolling loan gathers no loss". To roll a loan is to refinance it. As long as the bubble is expanding, I can simply play this game by refinancing or giving what is due. It is really easy in commercial real estate. Someone who has €60 million in projects already funded is given another €100 million for a new project and told to use the cashflow to keep himself or herself alive.

Okay. I would like to ask Professor Black a question about Ireland. According to the Nyberg report, lending by the six banks covered by the bank guarantee of 2008 increased "from a stock of €120 billion in 2000 to almost €400 billion by 2007". The report points out that "the three years ending in 2006 marked the highest sub-period of sustained growth, with loan assets more than doubling overall, growing at a compound rate of almost 28% per annum". Would that kind of practice fit in with the bad practice or type of practice outlined by Professor Black at the beginning?

Professor William Black

It is the first ingredient in the recipe, obviously. It is also a question of concentration of risk. We also looked at concentration of risk. This is a sure tell that something is absolutely imprudent. The really good news is that there is no need to predict whether there is going to be a bubble or a crisis. Really bad underwriting is unambiguously bad for the world. When it is stopped, that makes everybody better off, except for the bad people, by blocking a Gresham's dynamic and allowing the honest bankers to succeed in the marketplace.

I will move on. As part of a discussion on the Nyberg report, Professor Black said that the Irish economic environment before 2007 was not benign and that it was the largest bubble proportional to GDP of any developed nation. He further said that what happened in the banks was exceptionally profitable to the senior officers leading the banks.

Professor William Black

Yes.

Professor Black is probably familiar with Professor David Harvey. I do not have time to quote from his book, The Enigma of Capital and the Crises of Capitalism, but he referred to senior hedge fund managers getting bonuses of as much as $1 billion a year as a result of their activities in the financial markets. One can understand how that extreme level, as many people would regard it, of compensation could lead to recklessness but in the Irish case where we would not have figures of that dimension, would Professor Black say that the same type of incentive would prevail, with perhaps smaller levels of compensation?

Professor William Black

You do not need $1 billion to incentivise disastrous behaviour. Seriously, in the lower ranks, the bonuses would often be in the $500 range. It must be remembered that we are talking about people who are pretty close to the minimum wage. If we look at the United Kingdom and the payment protection insurance, PPI, abuses, this is often incentivising people who are pretty much the working poor, and that can be done with just a few hundred dollars. By the way, they do not always do it just with money. In some places, if someone did not sell enough, they literally put a cabbage on their desk. It is the insult in the UK context of being considered a cabbage head.

This is the Deputy's last question for the moment.

Mr. Nyberg ascribed most of the problems to bad judgment rather than bad faith. Without going into specific cases, at which point does Professor Black think our people should judge the activities of the bankers as failed banks crossing the line from bad judgment to bad faith?

This is my last question. In view of the type of excesses we have seen and that Professor Black has devoted his life to countering, and what was found in the United States to be criminality etc., rather than having these huge financial resources swilling around the world in private hands, what would be his view of a publicly owned banking system subject to democratic ownership, control and accountability?

Professor William Black

In terms of the last one, postal savings banks have been very successful throughout large parts of the world, not just in Europe. Japan had them for a very long time. There is a concept in economics of Nero banks, and that fits well into that category.

As to the Deputy's other question, one of the critical things this recipe does is allow us to differentiate between behaviour that is "reckless" or "optimistic" and behaviour which is deliberate. We get deliberate behaviour when we deliberately create adverse selection. We must remember that underwriting looks like a cost centre but it is really the primary profit centre of an honestly-run bank. I have not mentioned this, as a banker sitting on credit committees and such, that you make money by doing good underwriting. When you deliberately do bad underwriting and when you push out the people - this is in the Nyberg report - who object and who try to have good underwriting, that is deliberate behaviour. It allows you to distinguish. I have an entire article in the literature on criminology about how to distinguish between criminal behaviour and not; the Deputy can read that article. That is what allowed us to cut through these defences. We must remember these are the best criminal defence lawyers in the world. They are people in elite positions who could hire the best defence and get those convictions with a 90% conviction rate. It is possible to distinguish which of these things is really happening. There is literature available, and there is an experience.

I thank Professor Black.

Before I call Deputy Phelan, will Professor Black tell us the role external auditors have to play in what he has been discussing with Deputy Higgins? There is an agency that comes in and examines the bank's balance sheet in terms of risk concentrations and everything else. Surely it has some responsibility or is in a position to make a judgment on it.

Professor William Black

This is in the context where there has just been a very large settlement against a credit rating agency, in the United States context, Standard & Poor's. That is another example of the Gresham's dynamic. There is explicit stuff in our equivalent. I was the deputy staff director of this equivalent in the United States that looked at the US crisis in the savings and loan debacle. The Chairman will see in that that it explicitly states there was a Gresham's dynamic among top-tier audit firms. In that context they were the big eight; we are down now to the big four.

What does that mean in layman's language?

Professor William Black

That means I hire the audit partner. The senior banker hires the audit partner. We have a dog and pony show in which they pitch for the business. This is how one becomes a "biggie" in a top-tier audit firm. One brings in a whale of a client, as the phrase goes, and signals in the course of that, and we could have a complete video tape and it would not matter, that one is the right kind of auditor. That is who gets hired, and that is why we will find throughout Europe and throughout the United States preposterous financial statements that got clean audit opinions from top-tier auditors. They deliberately go to top-tier auditors because that reputation enhances both looting and the fraud. Places that are massively insolvent with terrible underwriting invariably get clean opinions from top-tier auditors.

I thank Professor Black for that because we will be speaking to Mr. Nava later this morning and I understand that under the Basel III framework auditing companies can still concentrate 80% of their business within one company, so we will certainly be dealing with that. I thank Professor Black for that answer. I call Deputy John Paul Phelan.

I welcome Professor Black. To continue the point the Chairman just asked him about auditors, he said in his opening statement that we are still operating under the same accountancy rules today as we were six or seven years ago. Will he outline for the committee the changes to those rules with regard to external auditors that could be made?

Professor William Black

The straightforward answer is to not allow the bankers to pick the auditors. There should instead be a panel of qualified auditors that are assigned to them, and we should track the performance of those auditors. It would be like relegation. If someone had a record of screwing up, they get yanked from the panel, assuming what they did was not criminal. If it was criminal, they are driven out of business, but if it was just inept, they get relegated. They do smaller accounts and prove over the five years that they can do it right, and then get back up to the "bigs".

Who should operate the relegation?

Professor William Black

The United States Government, or the Irish Government in this context.

I refer to the answer Professor Black gave earlier to the first question asked by the Chairman about the growth rate in banks' balance sheets. Professor Black spoke about the 25% cap in the United States. Wearing two of his four caps that he mentioned at the start in terms of economics and regulator, what does he believe is the optimal sustainable growth rate for a bank?

Professor William Black

There is no such thing. It depends on the growth of the economy. The more sensible answer is to look at the real growth of the economy and the relevant sectors being loaned to. If you are greatly out of line with that and if you did so by lending cheap relative to risk, then you are a disaster waiting to happen. Actually, you are a disaster that has happened that needs a solution immediately.

Professor Black has written extensively, and it was touched on earlier, about this perverse compensation and employment incentives within banks.

Does Professor Black have a view as to how the remuneration systems within financial institutions should be run differently from the way they have been?

Professor William Black

Yes, it should be run consistent with all the literature on how it should be done. All the literature from people of all ideological persuasions says it should be ultra long term so you get in off a living wage and then in the US context you can send one's kid to university. Ours are expensive. However, beyond that, the big kill comes not two years, but ten years down the line. You show sustained performance that is real for at least a decade. That is what all the literature, again by Nobel laureates, on this subject says. We simply do not run executive compensation in accordance with what we purport. We purport that we align the interests with the shareholders but we distinctly do the opposite. That is at the high end. At the lower end, never ever set banker compensation for, say, loan officers based on volume. We have known for centuries that this will produce a disaster. There is no upside to that. It should always be weighted with quality and people's bonuses should be deferred to establish that they were making quality loans, not simply volume loans.

In particular, the PPI is an unbelievable disgrace. This was a product, again according to the testimony in the parliamentary inquiry in the UK, that had an 80% mark up. They talk about unsuitable and while some people could never recover under the policy, it was unsuitable for everyone. It was a pure, rip-off product and they created incentive structures that ensured that it was not just money, but it was also about the humiliation of people who refused to do the wrong thing. That should never be allowed at all. The dollar amount does not matter.

With regard to financial reporting by banks and other financial institutions, does Professor Black believe they should be treated the same as other businesses in providing quarterly stock market reports and results or can a case be made to treat them differently?

Professor William Black

It is true that there is a generic problem with executive compensation that is not limited to banking. I have literature that I have written about how things should be cleaned up more directly but banking is the worst of the worst and it is the one that has been shown to have the most intensive fault. In the US context, for example, we are back where we were before the crisis with 40% of total corporate profits in finance. Finance is simply supposed to be an intermediary, a middleman, and the efficiency condition for a middleman is clear - lean and mean. Instead it has become a parasite that is the leading enemy in the US context of Main Street. The Brits would call it High Street; I do not know whether there is a phrase in Ireland for this. It is bad for regular people and small businesses now. Banking, therefore, needs to be fundamentally changed to make it an engine of what it claims to be - economic growth and strength.

Does Professor Black feel six or seven years on from the major difficulties financial institutions got into that current regulation is fit for purpose?

Professor William Black

No, it is clearly not fit for purpose. That does not mean there have not been improvements in some areas but you can see that they are still talking in very much similar terms, for example, cost-benefit analyses and econometric studies. If such studies are followed, you guarantee that you will do things that most facilitate the looting recipe I outlined. That would be an absolute disaster. You will still see that they do not understand the concept. I guess I am the first person that even used the phrase, "Gresham's dynamic" here. That dynamic is used. The testimony at the parliamentary inquiry in the UK highlighted that dynamic and the US has consistently sued institutions such as Standard & Poor's where the allegation after investigation is they engaged in fraud as part of a Gresham's dynamic. We have done that not just to those ratings agencies, but we have strong proof that this happened in the appraisal context. The then New York attorney general, now governor, Andrew Cuomo, found this in investigations. We found it in the top tier audit firm the Chairman asked me about. This is a pervasive problem and there is no Basel-type action to break this dynamic.

Professor Black gave a number of interviews to Irish media outlets at the end of 2010. In one newspaper interview, he said the Lehman Brothers crisis had saved Ireland from an existential threat. What did he mean by that? Did international factors have an impact on what happened in Ireland?

Professor William Black

Yes. Back in the time machine, as the Deputy will recall, when the crisis originally broke out, in Europe the meme was that it is all the stupid Americans. Europe was clean and it was all about those idiot Americans and sub-prime lending and so on. That has changed a fair bit. My point was that Lehman Brothers precipitated the crisis stage but it would have been far worse if the crisis had continued to build for another two years. In the Irish context, the worst banks had losses well in excess of GDP. They were simply becoming big banks, vastly bigger than the economy. If that bubble expansion had gone on for another two years, think what the losses would have been. For example, in the Icelandic context when Lehman Brothers precipitated the failure, the bank had ten times the GDP of Iceland and it was growing at more than 50% a year. With compounding, when something grows at 50% a year, it doubles in size approximately every nine months. If the expansion had gone on for another two years, it would been more than 40 times the GDP of Iceland. The losses per person in Iceland would have been hundreds of thousands of euro. Everybody there has an EU passport and, therefore, pensioners would have been the only folks left.

At the end of 2010, in a Irish television interview, Professor Black said, "Nobody has responded to the crisis as stupidly as the Irish Government have responded". Will he elaborate on what he meant at the time?

Professor William Black

It was, in soccer parlance, the most destructive own goal in history. The Government, as everyone knows, guaranteed. This is the consequence in large part of truly terrible anti-regulation. If the regulators tell the Government, there is no problem here, there are no losses and it is a temporary liquidity problem but if it does not act within the next 12 ours, the entire system will melt down, what is it likely to do? If those are the facts as presented to you, it becomes very likely that you will do a guarantee. Giving an unlimited guarantee with no reliable facts turned a banking crisis into a fiscal crisis - not just any fiscal crisis, but clearly one that would crush Ireland. On top of that, Ireland guaranteed not just unsecured claims, it guaranteed subordinated debt.

Subordinated debt is subordinated so that it will constitute capital, so that it will be at loss. The entire theory of why, under Basel II, it was tier-2 capital is because it would be lost. Those concerned made a deal, a contract deal. The deal was that if this bank cannot pay because it is insolvent, we get wiped out entirely, so in recompense we get a much higher interest rate. They got their interest rate. They are supposed to die and are supposed to be concerned with risk capital, and they got bailed out. I never understood this. Even with all the bad information they got from the regulators, and obviously from the banks because the banks had to file statements - all of those statements for the covered banks were hopelessly false - and even if you relied on that falsity and on the regulators, who were disasters, you would never, ever bail out the subordinated debt holders. They did not bail out every subordinated debt holder but bailed out the great bulk of them. To my knowledge, nobody else does that. That is why I said "the worst in history".

I thank Professor Black. I noticed in his discourse that he differentiated between "banks" and "bankers". I know that in our earlier discussion, he just wanted that point noted.

Professor William Black

Yes, particularly for the folks who are going to be reporting on these issues and hearings, almost always when we use the word "banks", we actually mean "bankers". It is really important to distinguish which is really being referred to. Banks do not feel; they are not real and they operate through bankers. When you hear "the banks became optimistic", you should say "No" and always focus on the bankers. The bankers are not the best friend of the banks. Throughout history, the greatest risk to a bank has always been the bank's CEO. The CEOs are the ones who caused the catastrophic losses throughout history. That does not mean that most bank CEOs are crooks. Do not go from that. Really catastrophic failures are very unusual in banking. When they occur, it is most commonly because of the banks' CEOs. That is what I was referring to when Deputy John Paul Phelan asked me about the auditors. If a bank could choose, it would choose very conservative and very reliable auditors, but banks do not choose auditors. Bankers do, and bankers want a clean opinion that shows they have record profits and, therefore, should get really big bonuses. Bankers will choose, and characteristically did throughout this entire system.

When there is a Gresham's dynamic, you will no longer get just episodic problems with bankers. You can get very widespread problems with bankers, which is why in the United Kingdom, for example, claimants on these products are winning over 80% of their claims. It became absolutely the norm. In fact, the testimony in front of your counterparts is that virtually all the profits that UK banks were reporting came from PPI.

To come back to the recipe Professor Black was outlining to us earlier, the second step is the making of bad or terrible loans. What is the motivation behind the making of those loans?

Professor William Black

That is a wonderful question. Let us look at the counter-factual. What if you try to grow very rapidly and charge a premium nominal interest rate by making good loans in a relatively competitive industry such as banking with a mature product? In other words, it is not like the invention of the iPad for the first time, when you could sell it to billions of people. If you wanted to grow 50% a year by making really good loans, what would you have to do? You would have to buy market share and reduce your interest rate to be able to get really good borrowers and their business. Good borrowers find it very easy to buy and get loans in normal times. What would your competitors do when you chopped your interest rates?

They would follow suit.

Professor William Black

They would respond. At the end of the day, do we make more money? We would all make a lot less money. However, in any society there is a significant proportion of people who are not creditworthy, and they will agree to pay a higher interest rate. That higher nominal rate, if you do not establish loss reserves, has to show up as a spread — a very big positive spread. It is just mathematics and accounting at that point, although in this regard I would emphasise something I have not emphasised: the really pernicious part that gets added on is when a lot of this income is non-cash. You have to understand the basics of accrual accounting. Is the difference between accrual and cash accounting familiar? With non-amortising or, at least, non-fully amortising loans — Ireland has had these — banks are booking as income things that they have never received in cash. That is how accrual accounting works. I can agree to do lots of things where I am not actually paying in cash. That is why people make bad loans or why bankers make deliberately bad loans. They will create this phoney income whereas trying to make good loans would produce real losses.

The point I am trying to come to concerns making bad loans deliberately, with the knowledge they are bad.

Professor William Black

Absolutely.

What about where people are investing themselves in what their own bank, or banker, is investing in, as we have seen in certain cases? They are losing money in that scenario also.

Professor William Black

Some of this occurs but vastly less than people think. Let us talk about it. One thing is that compensation is often paid in shares. Those concerned say, "Look, how much I lost when the bank failed", because the share price fell. However, the share price was never real. The only reason the share price reached those kinds of numbers was precisely because of the strategies of the recipe. Therefore, they never lost money because it was not there. Also, even the bankers who are running these schemes do not know when the bubble is going to end; nobody knows. Sometimes people stay too long in the game but frequently, even in those circumstances, you will find it was not really their money but the banks' money. I would be far less impressed with the line of logic that states those concerned must not have been doing anything deliberately wrong because they, too, suffered some losses in these circumstances. That does not follow logically.

Let me go back to the prior step in terms of this extreme growth and the role commercial property lending plays for a bank in managing to make that extreme growth, and the relationship with the regulator in that context.

Professor William Black

Again, extreme growth is itself something that should not be allowed by a regulator. We have centuries of experience that tell us that is true. The concentration of risk is something that is insane for a large institution. In other words, small players that cannot reach economies of scale have to have niche strategies, so they will concentrate. That is riskier but they have no great choices. All their choices involve material risk but you do not want a very large financial institution concentrating its risk in a product line like commercial lending. Even if you were going to concentrate on commercial lending, you would never prudently concentrate in a small number of borrowers. The old joke they tell about banking is absolutely true. If you borrow $10,000 from a bank, the bank owns you but if you borrow $100 million from the bank, you own the bank. The banks will extend even bigger loans to you and, as long as new money is coming in, you can keep the thing alive a bit.

That is always a bubble disaster. We have known this for many past crises. This was something that was easy for the bankers and for the regulators to figure out. The Irish crisis was one of the most easily preventable crises by either competent bankers or competent regulators.

I thank Professor Black.

I call Senator MacSharry.

Has the Chairman nothing to add himself on this occasion?

I thank Professor Black for joining us and for making the trip over. Just to start things off, he described the guarantee as an insane decision. We have had Governor Honohan from the Central Bank in and we have had Peter Nyberg, as Professor Black is aware. They have said that these were the best of all bad decisions. In Professor Black's own experience and without the benefit of hindsight, what would he have done?

Professor William Black

That is what I am saying. We are actually saying very similar things. It ends up being an insane decision. It was the worst possible decision that could be made, but in the circumstances one finds oneself - if the bankers are lying to you and the regulators are utterly incapable of seeing reality and, on top of that, are telling you that, tomorrow, the world ends unless you take this action - you are likely to take terrible actions. I think that our testimonies are consistent.

Professor Black may have done the same thing in the same circumstances.

Professor William Black

No.

That is what I am asking. What would he have done?

Professor William Black

Personally, no, because I know banks and I would not have relied on the regulators, but-----

If Professor Black was a politician as opposed to an expert-----

Professor William Black

Yes. A politician is not someone who spent his or her life doing these things and knows that it is too good to be true.

For sure. When I asked Professor Edward Kane, who we had in lately, in the context of Europe's response to the crisis, he said that, in many ways, Ireland got a hard deal from its European partners in relation to bank debt. In the subsequent reforms that we have seen, does Professor Black think that there has been sufficient reform so far in the eurozone to make sure that a scenario like this does not happen again and to account for the need for a fiscal union?

Professor William Black

No.

Okay. In terms of the likelihood of a repeat, does Professor Black think that the set of parameters that currently exist make it quite likely that it will all happen again?

Professor William Black

Yes, and it will be worse. This is not just Ireland and Europe - this is the United States. There has been no accountability for the bankers and no accountability for the regulators. So, it will take the next boom before this happens again. In the savings and loan crisis, as the committee heard we got over these 1,000 felony convictions. None of those people, to my knowledge, participated in the current crisis precisely because they had criminal records. That is what we call specific deterrence. There will be no specific deterrence out of this crisis. The worst actors who know exactly how to use these four ingredients of the recipe that I told the committee are out there, and what they have learned from this crisis is that it is a sure thing and not much of anything happens to one. That is a really perverse incentive structure. It is critical that one reverses that.

We heard from the Governor of the Central Bank in previous testimony. As to the Governor's role on the ECB's Governing Council, does Professor Black believe that this is a flawed construct in the eurozone, where the fiduciary duties of the governor of a state is to the bank and the institution rather than, for want of a better expression, wearing one's nation's jersey?

Professor William Black

The Chairman said that everyone should take off one's jersey. I never had a jersey; I am not from here. Structure matters. Creating conflicts of interest is a bad idea, but all of these structures failed. I spend less time worrying about if it is an FSA consolidated approach or is it from the Central Bank or not from the Central Bank, and far more about whether the people in charge understand the concept. As Professor George Akerlof, the Nobel laureate in economics, said, not understanding the concept, they were helpless to deal with it. If you do not understand the concept, what can you do? It will happen again and you will never even see it.

I focus on leadership. How did it work in the savings and loan crisis? It worked because the chairman of the agency listened to the people in the field, who in business school terms are the closest to the facts. Each month he got 1,000 pages. He actually read and he said that the people in the field were right, and then he went out and he hired the two people in America who had the reputation for being the toughest regulators in America and put them in charge of our two worst areas.

Just very finally-----

Professor William Black

That is just how you do business. Right? If you are a business person, what do you do? You go out and hire some people.

I would like to bring Senator MacSharry in for his last question, please.

Last question, and I thank the Chairman. Professor Black's writings, to me, would seem to suggest that Ireland took the hit for the European banking crisis.

Professor William Black

Absolutely.

Professor Black would agree with that statement.

Professor William Black

Ireland tried to bail out the German banks, basically, and that was never going to work.

Would Professor Black feel that the euro, therefore, is arguably unfit for purpose because of the smaller economies on the periphery like Ireland, which are less than 1% of the eurozone?

Professor William Black

The euro is a disaster. It never made sense in terms of the economic literature on an optimal currency area. My colleague, Professor Stephanie Kelton, who is now the chief economist on the US Senate budget committee, is one of a number of scholars who wrote this in advance and their predictions have proven absolutely correct.

I thank Professor Black.

I welcome Professor Black. I will just go back. He wrote a blog on 13 November 2013: "Irish fish, and banks, rot from the head". I want to give him a quote. He said: "The Irish people are distinct, however, in blaming themselves for the crisis." Can he elaborate on that? What does he mean?

Professor William Black

Yes. I come here frequently for the Kilkenomics festival, in particular, in Kilkenny, Ireland. You get stopped on the street by people, just regular Irish people, who want to talk about economics and such.

Does Professor Black charge for it? I know he is coming here for free, but are we-----

I am assuming-----

Professor William Black

We are not paid.

I assume it is as an economist rather than as a comedian.

Professor William Black

The Deputy can actually check the literature where that has been confused at times. The point is, we get feedback from hundreds of Irish folk over time. I am brought to many other places, like Iceland and such, for the crisis. Ireland is distinctive in the degree to which the average people on the street blame themselves for the crisis.

When Professor Black says "blame themselves", what does he mean?

Professor William Black

"We were too oriented towards home ownership" and "we did not just buy a home - we bought a second, speculative property".

As an objective observer from outside these shores, what is Professor Black's view as to the view that the Irish people should-----

Professor William Black

In the schema of responsibility, the Irish people are so low on the list that they do not much matter. It is a serious thing. The research on behavioural economics is very, very strong and it is completely ignored by regulatory agencies. Going into this crisis and even afterwards in the United Kingdom, there is all this stuff on consumer education. One cannot try to get everybody in Ireland or the United Kingdom to be able to understand a collared swap, which is what was being pushed for small businesses.

I teach courses in this. At the end of a semester-long course for graduate students, if they understand a collared swap I go out and treat myself. The concept that an average person-----

It does raise an important question.

Professor William Black

-----would ever understand this is absurd. This attempt to apply the concept of caveat emptor-----

Professor William Black

That is right-----and laissez-faire in this context produces situations in which one gets an 80% mark-up - a product that no one should ever buy and that should never be authorised, and on which claimants win more than 80% of their challenges saying it is inappropriate.

Professor Black made a comment that the Irish crisis could have been prevented. How could it have been prevented?

Professor William Black

Because it followed absolutely the characteristic recipe according to Nyberg. If one looks through the Nyberg report, it states that the banks grew like crazy. In fact, you just read the statistics about it.

The former Anglo Irish Bank, one of our banks, grew by nearly 30% per annum over an eight-year period.

Professor William Black

It is not limited that. If you look at the covered banks, which is what his report is on, the growth number is there. You can look at it. The fact that it was extreme leverage is there. The fact that the underwriting was terrible is there.

On the four key points Professor Black speaks of, what would have been the antidote to that lethal cocktail to ensure that the Irish banking crisis did not happen?

Professor William Black

When we saw that in the United States, we acted immediately. Within a year of a deregulation law, in our context, which was 1982, there was a full-scale re-regulation of the industry, over the opposition of the Reagan Administration, over the opposition of a majority of our House of Representatives, who co-sponsored a resolution telling us not to re-regulate the industry, and over the opposition of the Speaker of the House, who is the second most powerful elected-----

Let us get to the point. What should have been done? What would have prevented it?

Professor William Black

You would have done what we did. You would have restricted growth. You would have said, "You cannot do this terrible underwriting." You would have investigated the places that were doing it and you would have closed them down.

From what year would we have done that?

This is the Deputy's last question.

Professor William Black

Within a year of being appointed, which is when we did it.

No, in the Irish context.

Professor William Black

That is what I am saying. You are asking what year, and I am saying we did it as soon as we were appointed.

So you would have moved in straight away?

Professor William Black

We would moved straight away.

I have a final question. There was lower tier 2 subordinated debt as part of the bank guarantee. To the ordinary person, what is lower tier 2 subordinated debt? It is one feature of our bank guarantee that was very unusual and has never really been properly explained. What is lower tier 2 subordinated debt?

Professor William Black

"Subordinated" means that you come later in bankruptcy priority, and as a practical matter, it means you will essentially never recover if a bank fails. That is what it is supposed to mean. Because of that, the banking regulators actually encouraged the issuance of subordinated debt - because this was supposed to create ideal private market discipline.

It is bought, typically, from a minimum size of $10,000 up to multi-multi-million-dollar slugs, so it pays to exert private market discipline. It is bought by elites - allegedly financially sophisticated people - and because of the subordinated feature, if the bank fails, the argument goes, they will lose their money. You are supposed to get ideal private market discipline and because of that, it is treated as part of your capital to meet your capital requirement. It is expressly defined, therefore, as risk capital. That means it is supposed to be lost if the institution fails - otherwise, all that theory stuff goes out the window. So the one thing you would never, ever bail out or guarantee is subordinated debt.

It would make no sense.

Professor William Black

From any perspective, based on even what they knew then, you would never bail out subordinated debt.

I welcome Professor Black. There are approximately 12 references in Professor Black's ten-page paper to Gresham's dynamic. Could he explain that to people watching on television, bearing in mind that here, the Gresham is a very eminent hotel? Even the folks in the hotel may be looking in. Could he explain what he means when he refers to the Gresham?

Professor William Black

It is named after an English economist whose dad was the originator of the idea of creating stock exchanges. It is referred to as "Gresham's law" in the economic literature, and it says that bad money drives good money out of circulation in hyper-inflation.

Professor George Akerlof, the Nobel laureate in economics, in his most famous article, "The Market for Lemons," in 1970, used it as a metaphor to describe a Gresham's dynamic in which bad ethics drives good ethics out of the marketplace. This is because, if you gain a competitive advantage by cheating, markets will become perverse and the cheaters will prevail. It also applies to professions, such as appraisers. This is dealt with in the report published by our analogue to you folks, the Financial Crisis Inquiry Commission, and you can read it.

I thank Professor Black for that.

Professor William Black

Basically, they extorted appraisers. When I say "they", I mean the lenders. If you were not willing to inflate the appraisal, they blacklisted you and you could not get a job. No honest banker would ever inflate an appraisal. That is an example of a Gresham's dynamic. As I say, Swift actually identifies this with the Lilliputians in 1726.

I expect the people in the hotel will feel much better after that. Could Professor Black explain the concept of PPI abuses - payment protection insurance - and the 80% mark-up for those watching on television?

Professor William Black

PPI is an insurance policy that is sold along with a loan as an allied product. It tries to take advantage of people's fear of unemployment. It basically says that if you lose your job after a certain period - and only for a very limited period - it will pay some or all of the loan. It is, in United States terms, sort of like a credit life policy. As an undergraduate 40 years ago, I was taught never to buy a product like this. We have known for a very long time that it is a complete rip-off product. On top of that, it was sold to people who were self-employed - who literally could not collect under the terms of the policy.

One of the things we will be discussing when all the witnesses have gone away is an important recommendation Professor Black makes - that Ireland should not have junked GAAP for IAS 39. It is important for us to understand that change in accounting standards and how Professor Black thinks it contributed to our problems.

Professor William Black

The generally accepted accounting principles, GAAP, rule is that at the time you are making the loans - immediately, in other words - you have to establish loss reserves that are appropriate for the risk you are taking. If you are not underwriting a loan and making it to people with ultra-concentration and such, you have to immediately establish much larger loss reserves. If you had established appropriate loss reserves, the accounting would have shown from day one that the loan was actually a loss.

I am sure that is something we will come back to. Is there any literature Professor Black has come across that states "No bank should fail"?

Professor William Black

No. Banks should fail. Indeed, our function as regulators is to force them to recognise that they failed a year and a half ago and close them through receivership.

I have a final question before the Chairman calls this to a halt. Professor Black's presentation states: "I do not believe any of the purported horrors of increased capital requirements for banks." What would Professor Black have in mind? What percentage of equity should they bring to the scene?

Professor William Black

I think the proposals to push it up into the 20% range are eminently sensible. I think there is no chance that Basel will do that.

I thank Professor Black.

I welcome Professor Black.

With regard to the bank guarantee, Professor Black used the analogy "the worst own goal in history" when referring to subordinated bonds being paid. Was the game fixed against the Irish nation by external players?

That is a leading question. The Senator needs to frame his question in a manner that allows the witness to give his own testimony, not to be led by a member of the committee.

How did the own goal happen? Specifically, I ask Professor Black to address the external factors of the own goal for subordinated bonds.

Professor William Black

There have been subsequent disclosures of the documentation involved stating that there was, in fact, express pressure from the European Central Bank to do these things.

I think I have answered the question. The banks provided statements to the Irish Government and the regulators that had no relationship to reality. They were grotesquely inflated in terms of reported capital at a time when the banks were in fact massively insolvent. That is fact one. Fact two is that the banks came and said if you do not give us this guarantee, we will fail and we will fail within hours. Fact three is that the regulators were asked and, by all reports, said something to the effect of "there is no asset problem here, it is just a short-term liquidity". Fact four is that, for some reason, subordinated debt was not broken out of this explanation. We have gone through that as well in my testimony. Fact five is that, with pressure from the ECB as well, collectively, they said that if there is not an asset problem but there is an imminent liquidity crisis that is going to bring down the banking system tomorrow, we had better give the guarantee. That is how the decision was made.

What is Professor Black's opinion on the intervention of the then US Secretary of the Treasury, Timothy Geithner, in regard to subordinated bonds being paid as well?

Professor William Black

I am not personally aware of him taking a role in whether the subordinated debt should be paid in Ireland. I can tell the Senator that I have never run into anyone in any context who thought that this was appropriate. There is unanimity among all the financial experts that this part was simply insane.

Am I correct in saying that savings and loan institutions in the US equated to the building societies here?

Professor William Black

Yes.

Can Professor Black expand upon the parallels between savings and loan and what happened in Ireland and how they affected the overall banking scenario in Ireland?

Professor William Black

The most parallel crisis to the Irish crisis, of which I am aware, is the savings and loan debacle. There are many differences, obviously, but it is the closest in that it was same in both cases and it was a bit different from building societies. Because of deregulation in 1982, savings and loan institutions were allowed to be essentially universal banks, as the Senator used that parlance, and so they could take equity positions, and unlimited equity positions in the case of the California institutions. They followed the recipe that I talked about and did so not only in residential lending but in commercial lending, and they produced a very large bubble. Our bubbles were regional but we are a much larger country geographically, and those bubbles were of similar magnitude to Ireland, but regional, and compared to our national economy, it was never anywhere near as large.

A final question, Senator D'Arcy.

We are discussing traditional banking and how the traditional banking sector ended up where it has ended up in Ireland. Can I ask about the newer models because Professor Black said he wants to look to the future, and we also want to look to the future? I refer to the newer models of banking such as equity funds which operate in all but name as a bank with their investment in commercial property, and in particular the new disruptive technologies that are disrupting the banking system, as we currently know it, in terms of the tech platforms that have been made available. I refer to what Ana Botín, the chair of Banco Santander has said. These are new challenges that are coming down the tracks rapidly and that are unregulated. What is Professor Black's opinion on those entirely, or substantially, unregulated sectors that could give rise to catastrophic problems in the future?

Professor William Black

It is a complex mix. The Senator is correct that many technological changes have created rivals to traditional banks and that these rivalries have reduced the profit margins in banks and are likely to do so in the future. There is testimony in the Senator's counterpart, about which I would be a bit sceptical, of banks claiming that they lose money in traditional activities. Whether or not they are correct, if they have that mindset, it is going to create pressures to find higher yield. There are two ways to create higher yield, one of which I have talked about at length, which is the recipe, but the other one produces large profits and it is basically fleecing one's customers. That is the PPI model. Both of those are very, very bad things that one would want to prevent. I do not think we are going to be able to prevent technology from changing. It does not particularly upset me that there are private entities that take equity risks as long as they are not bailed out and do not create a systemic risk to the system. If their shareholders want to have an equity fund and win or lose, that is okay by me, but it brings me to the subject we have not mentioned yet, the other grave danger, which is the systemically dangerous institutions, the ones that are so-called too big to fail. One simply should not ever have an Irish champion like that. That is nuts. You cannot bail out Europe in that sense. If one puts oneself hostage to a champion, it is not a champion anymore. As soon as it fails, and it is a question of when and not if, Ireland would be back in a crisis. Do not hitch your star to an institution too big to fail. It will create absolutely perverse incentives.

I call Senator O'Keeffe.

To return to politicians, faced with a great crisis that is happening all around them, what role could, should or would due diligence play in that scenario?

Professor William Black

Due diligence is underwriting. If one insists on good underwriting, one will find these problems years before, maybe as much as a decade before, as we did with liar loans, and it can be dealt with when it will not cause-----

In terms of what Professor Black means by liar loans, are they loans on which people more or less self-assess themselves?

Professor William Black

Yes. It is US business parlance, which was-----

When the borrowers self-assess themselves.

Professor William Black

This is how the industry in the United States referred to these loans behind closed doors. In the United Kingdom they are referred to as self-certified loans so-----

Should politicians have sought due diligence?

Professor William Black

Right. One of the great stories of the savings and loan crisis is the reason we succeeded in those criminal prosecutions is that Congressman Doug Barnard held a hearing, as part of the regular oversight function, and embarrassed the heck out of our agency, the FBI and the Department of Justice. He exposed the fact - this is around 1983 - that there was no effective system for making criminal referrals and for prosecuting people. Yes, vigorous oversight hearings by the Legislature, to use a generic phrase, are critical.

No, I am talking about the moment of a crisis when everything is going wrong.

Professor William Black

I am saying before a crisis. The crisis is too late. At that point if a committee started getting involved-----

If a decision is going to be made about guaranteeing something, would Professor Black seek at that moment to do some diligence on what he was about to guarantee?

Professor William Black

Absolutely. I would be in a different situation with regard to the ability to do that due diligence even quickly, in terms of it being too god to be true-----

Professor William Black

-----but politicians are generally not going to be in a position to do that then.

But I am saying-----

But should they seek it?

Professor William Black

-----well before the crisis, you can be an important part of preventing future crises by holding hearings and bringing in the regulators and asking the tough questions when there is ample time to deal with it, literally years before if you keep in mind the underwriting tell, the Gresham’s dynamic, this recipe, the concept of too good to be true.

Could any bank have embarked on this recipe Professor Black has described by accident, or would they know that they were doing what they were doing?

Professor William Black

Again, if I might chide Senator O’Keeffe, that is where we should use the word “banker” as opposed to “bank”.

Professor William Black

That is my professorial response. No, that is how you distinguish. No honest banker is going to gut underwriting because we have known for centuries if you do that you will lose money. But bankers who want to follow this recipe will do it because it will produce these three sure things, and that is how we got convictions even against top criminal defence lawyers by explaining that to juries. I was the expert witness in a number of these cases. I trained the FBI agents and the assistant US attorneys in precisely how to distinguish. That was among my functions.

Would bankers in that recipe scenario know that their own bank was insolvent? Could they have confused it in any way?

Professor William Black

No, they knew and took lots of actions to ensure that did not become public, including the ones in which I have testified at some length in terms of accountants and the creation of the Gresham’s dynamic.

Would it be fair to use the term that they were actually creating personal profit centres – that that is what they were at?

Professor William Black

Well, the term used by a Nobel laureate in economics is that this recipe is all about looting. That is a pretty strong term.

It is a very strong term. I am very interested to know how the bankers make the money. Professor Black talked about cashing out, the extra shares, the golden handshakes and all of that. How do they actually make the money? Were they taking it out when no one was looking or was it just in their salary? Did they have deals going on?

Those questions are leading.

What was happening in Professor Black’s experience?

Professor William Black

I can answer a generic question.

Based on his experience.

Professor William Black

In my experience and I am answering the question generically not with regard to Irish banks-----

Professor William Black

There are myriad ways to take it out. In fact, if the Senator reads my broad testimony, the national commission that investigated the savings and loan crisis referred to every way possible being used, but the primary way, the cleanest way that reduces the risk of prosecution is to simply take it out through modern executive compensation in which one’s bonus is tied to performance. For the reasons I have stated, it creates a sure thing of high reported profits. That makes one wealthy within months or a year, depending on the situation.

What is the myriad of other ways? Can we find them?

Professor William Black

There are all kinds of other ways you can do it. There are many institutions that lend to the senior officer. There are others where they never repay it. There are others where they use that and they take projects. The usurpation of corporate opportunity is the jargon in the United States and probably in Ireland as well.

I am sorry, but that is a leading question.

Cuirim fáilte roimh an tOllamh Black chun an coiste. I welcome Professor Black. We are short on time and, as he can see, we have a very strict Chair. I will delve straight into an article Professor Black wrote in 2009 entitled “Those Who Forget the Regulatory Successes of the Past are Condemned to Failure”. He presents in it a model of how to build an effective financial regulatory body. He talks about an analysis of data to look for patterns of emerging risks, including patterns of incomes that are too good to be true. He discussed what that means earlier in his testimony. The final point of his six-point plan calls for the prosecution of “elite control frauds" regardless of their political patrons. That is the issue I would like Professor Black to discuss. What does he mean by "political patrons"? Based on his knowledge in terms of his vast experience in the United States, could he tell the committee what political patrons mean in this context and the effect such a relationship would have on the financial crisis?

Professor William Black

We have not set this up but I thank Deputy Doherty. My answer is not in response to Ireland. I am not talking about Ireland. I am responding to the generic question. Here is an example of that dated 15 July 1987 from Charles Keating, our most notorious fraud in the savings and loan crisis to his chief political fixer. “Highest priority - get Black. Good grief - if you can't get Wright [the Speaker of the House] and Congress to get Black - kill him dead - you ought to retire." That is the kind of thing I am talking about. Our joke in the savings and loan crisis was the highest return on assets was always a political contribution for any banker. In our context, the Speaker of the House held hostage our Bill to get funding to close the institutions, to extort special favours for several fraudulent Texas savings and loan branches. Five US Senators who became known as the Keating Five sought to keep us from taking enforcement action against the worst fraud. The President of the United States attempted to appoint two members, chosen by Charles Keating, to run the agency. I told the committee it was a three presidential appointee agency that ran it. A Mr. Phelan, doubtless a distant cousin, was hired by the House ethics committee to investigate the ethics complaints against the Speaker of the House, James Wright. He did resign at the end of this process, but three of the recommended charges by Mr. Phelan after his investigation were that an ethics case should be brought against the Speaker of the House for his effort to fire William Black, his effort to fire Joe Selby, who was one of those two top regulators I told the committee about, and because he held hostage our funding to extort favours on behalf of folks.

In the United States context, these people do not go quietly. If you bring cases against powerful bankers, they will enlist their political allies and they will give very large political contributions to do that. In our context, Alan Greenspan was used to recruit the Keating Five, the five US Senators. He was hired as a lobbyist initially by Charles Keating to recruit those Senators. The United States is not unusual in those terms. If you take on really powerful bankers you will find that you get political push-back. If you do not pick regulators who will stand up to that – this is what I referred to as the Mike Patriarca level - Mike Patriarca was asked by a US Senator, one of the five who was meeting with us, whether he was saying that Arthur Young & Company, then one of the top tier audit firms, would prostitute itself for a client. Committee members, as legislators, know that if they ask that of a bureaucrat what the only possible answer is. When there are five Senators the only possible answer is, “Oh no sir, I would never say that.” The actual answer from Mike Patriarca was “Absolutely, it happens all the time.”

I need to move on to another question as my time will run out. In his opening statement Professor Black talked about the ultra concentration of commercial lending is a tell to use poker analogy. He said that is a characteristic in the rapid model of growth. In relation to the ultra concentration of assets of other witnesses, we have had various reports done on behalf of the Irish Parliament on the concentration of lending in two specific banks. A total of 50% of the loan book of Anglo Irish Bank was in the hands of 20 individuals and Irish Nationwide Building Society had 51% of its loan book in the hands of 25 individuals. In Professor Black’s experience in the United States, would that type of concentration of commercial lending be unique or common?

If one came across such a concentration, what should one do? Should one ignore it or should it raise alarm bells? What should be the response?

Professor William Black

I have never seen a concentration that high at any financial institution of any size anywhere in the world at any time in history. It is absolutely - no questions and no ifs, ands or buts - utterly unsafe and unsound and I would have begun efforts to stop it immediately. At those levels we would have been gearing up for receivership.

Professor Black said a rolling loan gathers no loss.

Professor William Black

And you thought bankers could not be lyrical.

You have proven that you are more than a banker. With regard to rolling loans and a stagnant commercial property market, where there is a downturn in commercial property sales and investment but a bank's loan book to commercial developers keeps growing, is that a tell? Whether it is or not, what should the reaction be?

Professor William Black

It is absolutely a tell, and it is why the recipe is so dangerous in hyper-inflated bubbles. The first ingredient of the recipe is "Grow like crazy," and this is met if rents are already declining and there is an abundance of what we call see-through buildings, which are those that have been constructed have no occupants, but the bank keeps on lending. That was exactly the experience in the savings and loan debacle, which is one of the parallels. This is a superb device for hyper-inflating the bubble. It was absolutely done in the United States in the current crisis. We have excellent numbers showing that it was liar loans that grew by over 500% from 2003 to 2006. They became 40% of all residential loans in the United States while conventional lending was falling sharply. We know the marginal loans that hyper-inflated the bubble were these fraudulent loans. We have data showing that 90% of liar loans are fraudulent in the United States. They will be the worst loans, and the lenders will continue to lend even when the stagnation is obvious. Akerlof and Romer talk about that explicitly in their paper. It is a sure tell.

I welcome Professor Black. I want to ask about the inclusion of subordinated debt in the guarantee. He is highly critical of it and makes the point that the Irish response was the worst in history because of the inclusion of subordinated debt. What possible justification could there have been for including subordinated debt? I want to put the figures in context. The guarantee was €375 billion. The amount of subordinated debt included was €12.2 billion and, of this, €1.4 billion was actually redeemed during the guarantee, which expired in September 2010. It is a very important but relatively small proportion of the overall amount. Why does Professor Black say because of this it was the worst response in history? Why, possibly, was it included?

Professor William Black

I do not say it is because of this that it was the worst. It was the worst because it sank an entire nation. It produced a gratuitous fiscal crisis, as it turned out. I distinguish by what you know and when you know it when you make decisions. The inclusion of subordinated debt is simply indefensible and it tells you that you need to look at whoever would have included it. Every regulator in the world should have instinctively said "No" to that. It is contrary to everything we do to include the entire concept of subordinated debt. Remember, precisely because subordinated debt is owned exclusively by people who are considered to be highly sophisticated, they are the ones least likely to run due to liquidity - if it is a liquidity event only and not an asset event - and they cannot run because subordinated debt has a term. It is not like they can take out like a depositor, which is why the number is so low in terms of redemptions at those levels, and you do not have to redeem it after all if you will be paid in full. I add these clarifications to the Deputy's numbers.

What is Professor Black's view on what happened two years later when the guarantee ended? Approximately €20 billion in senior bonds, which were unsecured, came out of guarantee and there were efforts to impose losses on them but those efforts did not work. We will explore that issue and the role of the ECB will come into question. Should losses have been imposed at that stage when the guarantee ended?

Professor William Black

Yes, but under a good bank and bad bank structure we would normally have put all of that in the bad bank and it would have been wiped out. From everything we can tell, this was designed to do exactly the opposite. They were trying to prevent subordinated debt from doing exactly what it is supposed to do, which is-----

I asked about senior debt.

Professor William Black

Senior debt got a smaller additional yield, but it still got a high yield because it is supposed to be subject to loss. While in some ways the subordinated debt is most egregious, as you say, it is the rest of the bailout of people who were not supposed to be bailed out that is a terrible shame and is risky going forward in terms of moral hazard.

In terms of an alternative strategy in the teeth of the crisis in 2008, would it possibly have been to let banks fail or to take them into receivership, as Professor Black put it, separating good assets from bad assets, protecting depositors and burning bondholders? What is his alternative model?

Professor William Black

That is precisely what we did in the savings and loan crisis. We would put them into receivership, the subordinated debt would be wiped out and the shareholders would be wiped out. That is what is supposed to happen to risk capital. The insured depositors would be paid in full and the other folks would get a haircut appropriate to what they signed onto - that is, in bankruptcy they take in proportion to whatever is left in those situations. What is different about Ireland is the enormous extent of non-depositor liabilities. That should have been a huge warning flag to your regulators.

You are saying that in Ireland deposit insurance was up to €100,000 and when the crash hit in September 2008 anyone with deposits in excess of that, such as corporate deposits, institutional investors or those with personal savings in excess of €100,000, should have been burned.

Professor William Black

They should have been under your own system. That was your rule as to what was supposed to happen. They got a higher interest rate because of that. That is how economics works.

What is curious is that you say with absolute certainty that the worst possible decision was made, but can you say with certainty that it was better than letting the banks fail and letting €170 billion of deposits included in the guarantee fail? How can you say with certainty that that would not have been worse or better? I do not know.

Professor William Black

You are asking me in retrospect?

Professor William Black

In retrospect we can tell because receivership would have been a vastly better solution. The banks were in fact deeply insolvent. That is the reality. The claim by the banks that they were not was false and the assurance by regulators to the politicians that there were no asset problems was preposterous based on the facts they knew.

We will need to substantiate that. I take Professor Black's presentation on that, but we will need to substantiate it as we go through the inquiry.

Professor William Black

Which element? That the assurance was preposterous?

Professor William Black

The assurance was preposterous given what the regulators knew, because, for example, the regulators knew all of the things that are summarised in the Nyberg report. They knew about the stagnation that people have asked me about. They knew the difference with rents. They knew that the asset book was terrible and had pathetic underwriting.

They knew very large numbers of things. Your regulators did an enormous disservice to the nation. I do not put primary blame on them. I certainly agree it is the banks - more precisely the bankers - to follow my own chiding and I will chide myself. I meant bankers, not banks. The bankers knew these things and the senior regulators assuredly had the facts to be able to do vastly better analytics.

I wish to ask a last question. Professor Black said one of the reasons it could all happen again is because there was no accountability for bankers and regulators. What does that mean?

Professor William Black

At this juncture worldwide, and I will talk about the United States, instead of 1,000 plus felony convictions in a crisis that was less than 1/100th the size of our current crisis we have zero people convicted who actually were in charge of running the places that made these loans. In a US context, we have scores of lawsuits in which the United States of America and various agencies say, after investigation, that these were caused by fraud but they have failed to bring criminal charges in every case in which they say it was caused by fraud. That is what I mean by the death of accountability in the current system.

I shall bring this section of the meeting to a conclusion by inviting Deputies Higgins and Phelan to conclude. Before doing so, I have a few questions on the final point made by the professor. Is he aware of the Sarbanes-Oxley Act 2002 which was passed by the United States Congress?

Professor William Black

Yes, I am well aware of the Sarbanes-Oxley Act.

My Cork accent does not travel well across the Atlantic. The Act was passed in 2002. As Deputy Higgins said earlier, the US had an early crisis in the 1990s, lessons were learned and legislative Acts were put in place but another crisis happened. Can the professor give us his opinion on the Act?

Professor William Black

Yes.

It was introduced in 2002.

Professor William Black

Two very different Bills became law as this single Act. Oxley, in our context, was a very conservative member of the Republican Party and he was not a very big believer in regulation. His Bill was weak. I do not mean that as a criticism but it did not have very much in it. Sarbanes, a member of the Democratic Party, was more in favour of regulation. The Sarbanes Bill was considered dead-on-arrival when it happened. Then the Enron scandal was followed by the WorldCom scandal so suddenly politically the Administration had to respond and the Sarbanes Bill was the only thing on the plate that was credible. Therefore, this dead-on-arrival Bill suddenly became law. As a result, it is not well thought out and logical but is a weird pastiche compromise. I am sure everyone here understands better than I how these things become law. The Act contains a useful provision and concept. The thing it does is say that the senior people must actually sign off on the financial statements. The concept is that internal controls have to be tested, not just fictionalised.

That is exactly what I want to talk to the professor about. The long title of the Act reads: "An Act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes." That means senior officials, as bankers in banks, must put their name to the assurances being given to the wider world with regard to the bank's credibility, operational structures, etc. That is what it does in a nutshell. Am I right?

Professor William Black

Yes.

Professor Ed Kane attended the committee last week. He gave a number of recommendations to this committee for the future, very much as Professor Black indicated in his opening statement, on how to avoid this type of crisis in the future and the necessary levels of accountability at senior banker level. I shall outline one of the figures he gave us. He said that the fines to date of US and European banks since 2008 are worth €180 billion. These are just fines and not prosecutions, bailouts or anything else. That sum will be paid in fines and is many multiples of the cost of the Irish guarantee. How should we deal with this matter into the future? Do we continue to fine institutions? Do we need to increase the tariff or penalty imposed on bankers along the lines of what was indicated in the Sarbanes-Oxley Act?

Professor William Black

When I was an enforcement and litigation director I negotiated these things all the time and here is the key that you need to understand. Bankers make the decision and their priorities are not to go to jail, not to lose their job and not to have their bonuses clawed back. To accomplish those three things they also have a fourth priority to not throw anybody junior to the wolves. In the United States we have much broader plea bargaining powers than exists in most of Europe. If you throw the junior person to the wolves we will flip him which means we will get him to plead and to testify about the more senior people. The committee will note that in all of these major deals in the United States nobody got named, loses their bonus, loses their job or goes to jail and they are happy to trade off fines.

The fines sound large. They are large in absolute terms but relative to JP Morgan Chase, to pick a non-random example, they are literally a few weeks' revenue so they do not care. Also, bankers do not pay the fines; it is the shareholders. This is the third in a triple whammy hit if you follow the recipe to the extent that the banks have followed this recipe. First, they have caused huge losses to the shareholders directly by making bad loans intentionally. Second, they have taken a whole lot of money that should have gone to the shareholders in the form of bonuses for destroying the institution or at least causing huge losses. Third, they come along and are happy to sign an agreement in which the shareholders pay the fines to make sure that they have no accountability. Therefore, this is an utterly useless exercise in terms of deterrence.

I want to clarify the bottom line before I bring in Deputy Higgins. In the next session we will discuss Basel III and the credit directives. The latter talk about increasing and enhancing sanctions but we do not know what the sanctions are. Do we need to re-examine the basis of the fines approach? Do we need to move, as in the Sarbanes-Oxley Act, to more identifiable, individualised sanctions that increase tariffs such as jail terms and other matters, rather than just fines?

Professor William Black

Yes, one only gets deterrence when one affects the senior individuals who make the decisions.

Does that mean that when, in a court of law, there are convictions against senior financiers for very serious financial crimes, fines should be personally levied against their wealth and-or they should go to jail? Does the professor say that is more a deterrence than the massive fines that we have routinely heard get paid, from the banks, by shareholders to the US Government?

Professor William Black

Yes, it is not only more. It is the only potential effective deterrent and, yes, it has to involve jail sentences for criminality. In addition to the jail sentences for the 1,000 plus convictions, we had over 3,000 enforcement actions and roughly 600 civil suits. Our goal was that we would make sure no fraud proceeds remained with any senior official. We were not always successful obviously but we were broadly successful in those efforts.

The professor said that 40% of total corporate profit globally-----

Professor William Black

In the United States.

--- comes from the financial sector. If I am correct, the professor referred to the financial sector as a parasite.

Professor William Black

At those levels it becomes parasitical and actually weakens mainstream ---

Yes, because a parasite sucks the lifeblood of its usually unwilling host. The international financial press has reported that major private corporations in Europe have about €3 trillion, or $3.5 trillion, sitting in banks and presumably in other financial institutions, which they will not invest, while 25 million people are unemployed. Looking into the future, what could or should be done, in Professor Black's view, to make those funds, which he describes as parasitical, work for people, society and social regeneration?

Professor William Black

There is really good evidence on this in the United Kingdom context. We have talked about payment protection insurance, PPI, but when they made small business loans, they characteristically sold swaps - often very complex swaps - to small business people, which is an utter outrage. This is the whole theory of financial intermediation, where they always claim to be engines of growth and such but they became the opposite in many contexts. What should you do? You should crack down on this recipe because it systematically leads to funding bad projects as opposed to good projects that are going to lead a country into development.

In the figures that the Deputy gave for Europe, in particular, what we are seeing is austerity. This is one of the costs of austerity. Banks are going to lend to businesses when businesses want to hire more people. That is demand. When there is not a whole lot of demand from the business community for purchasing, banks sit on the cash. They will particularly sit on the cash in circumstances where we have massive bailouts of the banks, not through the formal bailout that we have been talking about today, but through this incredibly ultra-low interest rate regime. Basically, the banks are not just sitting on the money; they are arbitraging. If they buy a bond, often a foreign bond, the supposed productive is not to Ireland, Greece, Italy, Spain or even Germany; that money is going out to somebody else, probably in China.

It is beyond this committee's remit, but the austerity principles that Europe is following are just nonsensical to economists because they have managed to create a gratuitous depression. Greece, Spain and Italy are not in great recessions; they are in great depressions.

I will have to bring proceedings to a conclusion so I will invite Deputy Phelan to make a contribution and then we will have to conclude.

I have a number of quick questions for Professor Black, the first of which relates to auditors. Did his own investigations in the 1990s in the US lead to the prosecution or fining of auditors for their activities?

Professor William Black

We made criminal referrals against the major audit firms including Arthur Andersen - which no longer exists and so can be named here - for far more egregious things than what it did at Enron. That was a bridge too far for the justice Department but we did get over $1 billion in recoveries, in a much smaller crisis, from the big eight firms. We also removed and prohibited particular audit partners and kept them from doing things in the future.

In answer to an earlier question, the professor poured some cold water on Basel III. Does he think that the Basel process is capable of working or delivering results?

Professor William Black

No. The Basel process, with Basel II, was opened up to industry but not to public interests or consumers. This is where bankers and banks are at their absolute greatest comparative advantage. It is ultra sophisticated, supposedly, econometric analysis modelling and normal human beings cannot fight against this. We have seen what Basel II produced, which was not ultra-sophisticated results but preposterous results. Under US law, you would have been considered critically under-capitalised under the Basel II standard and be shut down immediately. Under Basel II you would have had three times your requirement. That is how ridiculous the Basel II process became. As I said, the only thing that saved us in the United States, even partially, was resistance by the Federal Deposit Insurance Corporation to the economists at the Federal Reserve who were the principal proponents of this insanely low marginal capital requirement.

I will bring this session to a conclusion now. I thank Professor Black for making the journey to Ireland and for sharing his extensive knowledge and experience with this inquiry. We will be bringing forward a number of recommendations for the future. We are not just looking at the past, but at what we can learn from it for the future. On behalf of this inquiry, I thank you for the time you have given us, for the experience you have shared with us and the added value that you have given to this inquiry. In terms of the drafting of our final report, we thank you for the matters you have brought to our attention for our consideration at that time. I now propose that we suspend the meeting for 15 minutes until just after 12 p.m., when we will resume with Mr. Nava.

Professor William Black

I have an Irish mother who would kick me if I did not thank the Chairman, members and staff for their assistance.

Where is your mother from?

Thank you very much Professor Black. We can discuss that over coffee.

Sitting suspended at 11.50 a.m. and resumed at 12.05 p.m.

Mr. Mario Nava

I welcome Mr. Mario Nava from the European Commission to discuss banking regulation, supervision and financial stability. Mr. Nava is currently the director of the regulation and prudential supervision of financial institutions directorate in the Financial Stability, Financial Services and Capital Markets Union Directorate General, formerly the Internal Markets and Services Directorate General. Mr. Nava has been in the European Commission since 1994. His previous posts include acting director for financial services policy and financial markets, member of the group of policy advisers to Commission President Romano Prodi and a member of Mario Monti's cabinet. He studied economics at Bocconi University and at Louvain and has a PhD in public finance from the London School of Economics. Alongside his work at the Commission, he is active in research and teaching. He is a visiting professor at Milan's Bocconi University and occasional lecturer in many universities across Europe.

I wish to advise the witness that by virtue of section 17(2)(l) of the Defamation Act 2009, witnesses are protected by absolute privilege in respect of their evidence to this committee. If the witness is directed by the Chairman to cease giving evidence on a particular matter and the witness continues to do so, the witness is entitled thereafter only to a qualified privilege in respect of his evidence. The witness is directed that only evidence connected with the subject matter of these proceedings is to be given and, as he has been informed previously, the committee is asking witnesses to refrain from discussing named individuals in this space of the inquiry. Members are reminded of the long-standing ruling of the Chair to the effect that members shall not comment on, criticise or make charges against a person outside the House or an official by name or in such a way as to make him or her identifiable.

I welcome Mr. Nava again and ask him to make his opening remarks.

Mr. Mario Nava

I wish the Chairman, Deputies and the Senator a good afternoon. I am very pleased and honoured to have been invited to the Oireachtas to assist this committee in its inquiry into the banking crisis. I have been asked to provide the European Commission's perspective on the fitness of the European Union regulatory framework for banks and the supervisory policies, systems and practices in the run-up to the financial crisis, the lessons learned and improvements made in the past two years.

The regulatory framework for banks in the EU has evolved considerably over the past 15 years. A number of factors have driven this evolution. These include the need for the EU Single Market, international developments, rapid changes in the banking sector and shortcomings in bank risk management and the regulatory and supervisory framework. The EU regulatory framework takes into account the global standards for prudential regulation and supervision set by the Basel committee on banking supervision. These standards have been updated several times since 1988, most recently in December 2010 when the Basel III standards were adopted. Each of these updates has been implemented in EU law.

In 2000, the EU regulatory framework followed the principle-based approach which was embodied in a minimum harmonisation. Directives were used as the main legislative instruments, setting minimum requirements for prudential supervision. Member states were required to transpose those directives into their respective national legislation.

The use of directives as the main legislative instruments and the minimum harmonisation principle gave member states a degree of flexibility in setting the regulatory framework for banks, as long as they did not go below the minimum standards required by the euro. However, in line with the principles-based approach to regulation, member states typically did not resort to implementing over-prescriptive rules which would provide specific and detailed guidance to supervisors for exercising their duties. During this same period, national supervisory authorities were responsible for applying and enforcing the prudential requirements set out in the directives, which empowered each national supervisory authority to take the steps it considered necessary to implement prudential measures to safeguard the resilience of the banks and to supervise the financial stability of the banking sector as a whole. National supervisors had a considerable degree of discretion to apply stricter requirements than the minimum standards set out by the directives. In other words, nothing in the directives prevented member states and their national supervisors from taking appropriate measures to reduce further the risk of a bank failing or risk to the stability of the financial system as a whole.

The crisis has taught us a great deal about the failure of some European banks to manage their risk prudently and of some national regulators and supervisors to exercise their powers with sufficient rigour. Many studies and reports have been produced to analyse the consequences of the principles-based approaches pursued by national regulators and how national supervisors exercised their oversight and enforcement duties in the pre-crisis period. Reliance on soft and light touch approaches and low supervisory intensity encouraged by the principles-based approach to regulation, inadequate resources and insufficient attention to banks' corporate governance systems represented the most prominent causes of the various supervisory failures observed in several member states. Too often, national supervisors took a narrow focus on credit risk and underestimated the importance of other risks, such as concentration risk, liquidity and funding risks. Too little attention was given to market prudential considerations and effective early warning mechanisms which could have helped national authorities to detect emerging risks early and prevent bubbles from growing.

The EU capital requirement directive, which is known in the jargon as the CRD, was adopted by the European Parliament and the Council in 2006. It required national supervisors to conduct a thorough assessment of the risk management systems and governance of the banks they supervised and to take measures corresponding to the specific risk profile of the banks in question. The directive also stipulated explicit requirements for management of liquidity and concentration risks as well as risks arising from exposures to real estate markets. If national supervisors had used those powers to the full extent, a number of major difficulties could have been prevented. Robust risk management in the governance structure in banks and an effective oversight and control system represented the two indispensable conditions for the success of principles-based regulation. In the absence of those two preconditions, the regulatory effect intended by the directive could not have been delivered.

These deficiencies also revealed important shortcomings in the governance of the institutional framework for supervision itself and it sparked a period of unprecedented reforms in the EU, backed by an international consensus on the causes of the financial crisis and responses needed to address it. The reforms, therefore, had two distinctive dimensions - the regulatory dimension and the institutional dimension. I will discuss them in turn.

On the regulatory side there has been, in line with international developments, a pronounced shift to a more rule based approach, introducing a more detailed guidance in the regulatory framework for the supervisors to ensure that they step up their supervisory scrutiny. As a result, the new regulatory requirements have been made more prescriptive, the coverage of risk has been expanded and the prudential treatment of those risks has been strengthened. These regulatory reforms were carried out in two phases. The first phase, which is called CRD 11 and CRD III, which were adopted in 2009 and 2010, respectively, introduced quick fixes for some of the most pressing deficiencies highlighted by the crisis, namely, liquidity management, large exposures, remuneration, management of securitisation, trading exposures and supervisory co-operation. For example, banks were required to develop robust strategies, policy, processes and systems for the identification, measurement, management and monitoring of liquidity risks and funding positions. In the interbank market, banks were not allowed to lend or place money with other banks beyond a certain amount to limit the risk of contagion, which also increased the diversity of borrowing banks' funding sources. National supervisors were required to review banks' remuneration policies and empowered to impose sanctions if these policies did not meet with the new requirement.

The second phase, which is probably the most well known and goes under the name of CRR/CRD IV in the jargon, was adopted in 2013 and represented a more fundamental revision of the regulatory framework, responding in particular to the review of international prudential standards in the Basel III framework. This includes new rules regarding the quality and quantity of banks' regulatory capital, more detailed and harmonised rules dealing with liquidity, funding risks and excessive leverage, and measures improving banks' corporate governance, including rules realigning incentives. Supervisors have obtained enhanced sanctioning powers and are required to carry out their duties in a more intrusive, intense and forward-looking manner. Particular attention was given to measures improving supervisors' capacity to take appropriate remedial action at an early stage by putting more emphasis on macro prudential consideration.

This latest revision also aims to establish a single rule book to respond to the need for a more harmonised set of rules across the Single Market, to provide a true level playing field on which EU banks can compete. The degree of flexibility previously granted to member states and national supervisors, as I mentioned earlier, had led to divergent transposition of EU rules into national law. This created opportunities for regulatory arbitrage and hampered legal clarity. To achieve greater convergence, various options and discretions have been removed. Most provisions have been moved into the regulation known as CRR and that becomes directly applicable.

Parallel with the new prudential measures to reduce the probability of a bank failure, measures were also necessary to minimise the impact of possible failures and to equip resolution authorities with effective tools to deal with those situations. The new harmonised bank resolution regime embodied in the bank recovery and resolution directive, adopted by the European Parliament and the Council in 2014, was introduced in recognition of the fact that the normal insolvency regimes were not well suited to deal with bank failures. It was also a response to the need to protect certain critical stakeholders, for example, deposit holders, in functions of a failing bank and to reduce moral hazard in banks.

This legislation includes a requirement for banks and resolution authorities to draw up a recovery and resolution plan, gives bank supervisors an expanded set of powers to enable them to intervene in cases where an institution faces financial distress, provides the resolution authorities with a credible set of resolution tools, including bail-in, and improves co-operation between the respective resolution authorities.

Another initiative which should be mentioned in this context is the Commission proposal on banking structural reform dealing with the systemic risk of too-big-to-fail banks heavily engaged in trading activities. The proposal, which is still under negotiation in the Council and in the European Parliament, would provide for a ban on proprietary trading and empower supervisors to separate banks' risky trading activities from their retail operations. That is the regulatory side.

On the institutional side, the crisis demonstrated the need to adapt the institutional framework for financial regulation and supervision to a fast moving and inter-connected banking industry. First, the institutional reforms revolved primarily around the creation of the European Banking Authority. Its creation was necessary to promote convergency of supervisory practices in the EU and to improve communication and mutual trust among supervisors. In addition, the European Systemic Risk Board was created to respond to the failure of the national competent supervisory authorities to anticipate adverse market prudential developments and to prevent the accumulation of excessive risk within the financial system.

Institutional reforms went a step further at the euro area level and led to the creation of a banking union. The crisis clearly showed that in addition to a common set of reinforced rules for our banks, a single and independent supervisor to enforce those rules was also essential. Thus, the Single Supervisory Mechanism was created, with a view to breaking the link between banks and sovereign and ensuring the highest standards of quality and impartiality of supervision.

While the European Central Bank, ECB, has taken over supervisory responsibility for the 120 largest banking groups in the euro area, day-to-day supervision of the smaller banks remains, for reason of efficiency, the task of national supervisors under the general guidance of the ECB.

The second, equally essential, element of the banking union is the single resolution mechanism. The single resolution board, the new single resolution body, will ensure that banks participating in the banking union are resourced, if necessary, in an efficient and centralised way, with minimum impact on taxpayers. The cost of any such resolution procedures will be paid for by the private sectors and backed by a single resolution fund financed by bank contributions.

To conclude, taken together, the reforms I have mentioned represent a significant strengthening of the regulatory and institutional framework underpinning the EU banking sector. It would be presumptuous to claim that these reforms have consigned financial and, in particular, banking crises to history. However, it is undeniable that, if properly enforced, these reforms equip supervisors and the resolution authorities with a more robust set of tools, making a future crisis less likely, and, if one were to happen, less costly. I thank the members and look forward to their questions and the debate.

I thank Mr. Nava for his opening statement. I would like to acknowledge that he has come here representing the European Commission, and I thank the Commission, as a significant EU institution, for its co-operation with the inquiry.

I note that Mr. Nava comes from Milan. In that regard, I might use a comparison to explain what the European Commission does. Milan is very famous for its football teams. If I could describe banks as football clubs and central banks as national football associations, is Mr. Nava's role in the Commission comparable to FIFA or to UEFA in terms of setting the rules?

Mr. Mario Nava

I come from Milan, the land of two famous football teams. I do not quite get the equation between the two, but I am very happy to explain our role.

Mr. Nava is interested more in banking than in soccer.

But would the UEFA-----

Mr. Mario Nava

I like the idea of trying to bring-----

We are more interested in speaking about soccer.

The Deputy will have his opportunity to speak.

Mr. Mario Nava

What we do is this. The European Commission is the body in charge of drafting legislation, so we draft legislation, particularly in the area of banking legislation. We get the legislation after having participated in the various discussions in the global forums. We then draft the legislation. The legislation that is drafted is brought to the Council and the Parliament. The Council and the Parliament have their ways of adopting legislation, but, broadly speaking, the Council works its own text and the Parliament works its own text. There are then meetings called trilogues at which the Council, Parliament and Commission try to find a common version of the text. Once the text is adopted and put in place, if it is a regulation it is directly applicable. If there is a directive, the Commission is still responsible for checking that the directives are well transposed - that is the technical word - into the national legislation. Essentially, that is our role. I would say it is a role of initiating the regulation and making sure, unless the regulation is directly applicable, that if the legislation needs transposing to the national legal systems, this transposition is correct and the Commission watches over that. Typically, one would say the Commission is the guardian of the treaty in doing that job.

I thank Mr. Nava. In summary, to use my own analogy, Mr. Nava is UEFA and he sets the rules for Europe in terms of banking institutions and national regulations.

I echo the Chairman's welcome to Mr. Nava and his football analogy. Many Irish people will be in Rome this weekend for rugby, and we have many happy memories of Italia '90, even "Toto" Schillaci. We got one back four years later when Ray Houghton got the goal. Terrific friendships were formed at that time, and I join the Chairman in welcoming Mr. Nava here.

Mr. Nava also represents a very important academic tradition in that the Italian school of economics, scienza delle finanze, includes eminent people in economics to which Richard Musgrave has drawn our attention, and Mr. Nava is in that tradition. I see references to these people in his academic works. One of them, Maffeo Pantaleoni, was a very good economist who was elected to the Italian Senate but died soon afterwards, so I am hoping not to follow that precedent.

Mr. Nava was very pessimistic at the end of his contribution when he said that it would be presumptuous to claim that these reforms have consigned financial crises, and banking crises in particular, to history. When is the next crisis due? Should those watching this on television be worried if somebody of Mr. Nava's knowledge and eminence says we have not got this correct yet?

Mr. Mario Nava

The Senator may take my last statement in various ways. I would say it was probably more of a British-style understatement. I did not want to come before the committee and claim that there will never be another crisis because I did not want to be proved wrong by what may happen and what we have not foreseen. However, it is very clear that with all the reforms we have done we looked in academic terms to the two important components of a crisis. One of these is the probability that a crisis will come, and we have put in place all possible mechanisms to reduce that probability by essentially ensuring better risk re-pricing. One way to look at the crisis is that the pricing of the risk in the banking institutions was not always correct, so we have put in place a number of regulations that allow for a more truthful risk re-pricing. However, it is important to understand that the project does not consist only of new rules on capital, concentration risk and liquidity, but also new rules on supervision and resolution, and resolution is what makes an eventual crisis have much less of an impact on taxpayers than anything else. Those are the two pillars we have addressed.

The Senator asked where I would see the next crisis coming from. That is part of the work that the Commission needs to do in the next five years. In his opening statement the Chairman asked what we could expect from the Commission in the next five years. He should not expect the same volume of regulation from the Commission in the next five years as he has seen in the past five years. That is very clear. What he should expect from the Commission in the next five years is much more reviewing of what we have done, evaluation, and calibration of all of that.

Let us be clear. The financial reform we carried out has allowed us regain financial stability. Financial stability at some moments seemed truly in peril. The work we did allowed us to regain financial stability not only on paper and by law but also in the markets. Bank capitalisation has increased massively following the new regulation. Because that was done and because we have regained financial stability, it is possible now to look at how this new financial stability and these financial reforms can contribute to the major objectives of the current Commission, which are growth and jobs. In a word, there is no growth without financial stability, but there is certainly no financial stability without growth. That is the type of thing we will look at in the next five years.

What does the truthful, risk-free pricing Mr. Nava mentioned mean in application? How do we get better performance from bankers than has been the case heretofore?

Mr. Mario Nava

One way of doing that is by increasing the capital requirements for the various activities. When the capital requirements are low, it may well be that the risk is not priced sufficiently. If we increase the capital requirement we may not get the exact risk pricing, but we certainly set a floor for risk pricing so that it is not too low.

There is one point I should make very clear. As the Senator knows, the objective here is not to eliminate risk because lesson No. 1 in economics is "no risk, no return". The objective is not at all to eliminate risk but to allow people to take risks in such a way that if something goes wrong they pay for it. They can take a risk but they assume the risk. The aim is to avoid people taking risks and then shovelling that risk onto someone else. That is the objective.

Why has it taken so long, given that the euro was established as a financial currency in 1999 and an actual currency in 2002? It is now 2015. Should these rules not have been in place when the currency was introduced?

Mr. Mario Nava

When the currency was introduced in 1998, a committee was set up for banking supervision at the euro area level. The committee was set up at the initiation of the then board member, Mr. Tommaso Padoa-Schioppa. Interestingly, the committee was chaired by the deputy governor of the Bank of England, Mr. Brian Quinn, who was also very involved in football. Once he retired from banking, he became chairman of Celtic Football Club in Glasgow which won many cups and leagues and so forth. The committee was set up in 1998 or 1999 and was tasked with examining the question of whether, together with a common currency, we should have common banking supervision.

Things take time, however, and as we say, Rome was not built in a day. I have a slide here which illustrates the key milestones. Obviously, in the initial period from 2002 to 2006 we had quite positive economic developments and clearly that meant less pressure. Not only did positive economic developments mean less pressure, however, they also hid the potential difficulties to a degree. It was only with the arrival of the crisis that we were able to see the shortcomings and deficiencies. Then, I would say that we acted quite rapidly, as fast as we could. I was very happy to read a report by the House of Lords yesterday which found that given the very difficult circumstances in which the European institutions had to act, they acted appropriately in general. The report states that the work they did was to be "admired". Clearly it takes time to pass a directive. I have explained the mechanism - the Commission drafts, the Council and Parliament adopt and so forth. To return to my slides, members will see that from 2006 onwards we have been very productive.

In response to the question of whether we could have foreseen the problems, it is more difficult to do so in good times.

In the context of the 2006 capital requirements directive, we have heard evidence that by that stage in Ireland the damage was already done so the fact that nothing happened between 2000 and 2006 was very serious. In Mr. Nava's presentation he said, with regard to EU directives before the crisis, that "nothing in the directives prevented member states and their national supervisors from taking appropriate measures to reduce further the risk of a bank failing or risks to the stability of the financial system as a whole". Was the EU just standing by at that stage? With regard to the EU capital requirements directive, he stated that "if national supervisors had used these powers to the full extent, a number of major difficulties could have been prevented". I think the crisis was out of control in Ireland by that stage and those missing years, between the creation of the currency in 1998 and 2006, are crucial. Did the EU know what the Irish Central Bank was doing at that time or that there was a crisis in Irish banking? Did it report adequately and sufficiently?

Mr. Mario Nava

I hope I have explained clearly in my opening statement that the directives were based on the principle of minimum harmonisation. The role of the Commission is not supervisory. The Commission's role, as I said in response to a question from the Chairman, is to initiate legislation, to see that the Council and Parliament adopts it and then to make sure that it is well transposed. The supervisors, however, do not have to report to the Commission. In those years there was clearly, with the minimum harmonisation rules, subsidiarity so there was no legal power by which the supervisors should report to the Commission about one or other of the banking rules.

Mr. Nava says that nothing prevented national authorities from taking appropriate measures. In retrospect and with hindsight, one might say that it is a pity that there was not somebody saying "By the way, you should ---

Do not lead the witness. Ask the witness if that was appropriate but do not make a judgment yourself, Senator.

I am just acknowledging what the witness said, that it was a period during which the responsibility was national.

Mr. Nava in his own book, Economics and Policies of an Enlarged Europe, has cast doubts on whether there were sufficient gains from a common currency, with the benefits to be a mere 0.5% of EU GDP in the mid-80s, while other authors put this figure at 1%. Ireland trades primarily outside the common currency area. Mr. Nava's view was that "the undoubted benefits achievable for the single market" through the effects of the single currency are probably "not enough to justify the endeavour of renouncing the national currency". Was that a consideration at the time? The euro project is doubted in Mr. Nava's book, published in 2005. We have had a single currency since 1999 and the nation was still in charge. In Mr. Nava's opinion, the benefits of a single currency were small. Could Ireland have solved the problems itself during that period?

Mr. Mario Nava

As I said, there was a single currency but there was not a single supervisory system. There were capital rules and those rules were based on the principle of minimum harmonisation, meaning that members could not go below the minimum thresholds but could reinforce them on the basis of their own needs. This ability to reinforce common laws on the basis of needs still exists in some areas today, for example, even under the maximum harmonisation approach, in real estate. Real estate is very different from one country to another. Real estate in Dublin is not the same as real estate in London or Paris. In real estate, lots of freedom has been left to the national supervisory authorities to take measures, typically macro-prudential measures, that might help.

In the period from 1999 to 2006 or 2007, the national supervisors had the responsibility, no doubt, for their own banking systems. Therefore, they also had the latitude, when considered necessary, either to go for more stringent rules or to do what is known in the jargon as Pillar II, which means supervision on a bilateral basis between the bank and the supervisors.

Or they could do supervision on a bilateral basis of a particular bank that was exposed to a particular sector, region or counter-party, and ask for more requirements. All of this was certainly in the hands of the national supervisors at that time, but I repeat that the national supervisors did not have to report to us in the Commission on what they were doing.

I will bring Senator Barrett in again later.

I thank the Chairman and Mr. Nava.

I welcome Mr. Nava. I wish to raise a couple of points. The first two pages of his testimony deal with the whole area of supervision, mostly in a European context. Mr. Nava said it was up to the regulators in the individual countries. In terms of risk management and effective early warning systems, how would he view the Irish system? To use football parlance again, was there a situation in which the offside rule, in terms of the way the banks were operating, was not being properly enforced by the referee - that is, the Irish regulator? Was it effectively being misinterpreted?

No leading questions may be asked. Otherwise, the Deputy will be offside.

Mr. Mario Nava

I thank the Deputy for the question. If I gave a response I would be contradicting what I have just said. The Commission was not at the receiving end of the analogies of the supervisors. Of course, we looked at it in the framework of controlling the national economies. I am aware that in two weeks' time another witness from the Commission will be discussing the issues with the national economy leading up to the crisis. We were not privy to those discussions that should have taken place between the national supervisor-----

But Mr. Nava said that if national supervisors had used their powers to the full extent a number of major difficulties could have been prevented.

Mr. Mario Nava

That is our statement, which we made clearly with insight.

Obviously, Mr. Nava was making a statement. In an Irish context, what would it be? Mr. Nava is here as a representative of the European Commission, but in an Irish context, can he elaborate on that statement?

On what the intentions were or could have been.

Mr. Mario Nava

If the issue is what interventions there could have been, I think that when a national supervisor sees some sector growing at an excessive pace or some particular counter-party to which the banks are excessively exposed, he or she - without referring in particular to one sector or the other, or one bank or the other - certainly has the power to intervene. Supervisors had the power to intervene in two possible ways: first, by stepping up the legal requirements that were provided as a minimum by the directive from Europe-----

Capital requirements.

Mr. Mario Nava

Yes, capital requirements. That was the first way. Second, in their supervisory discussions with the banks, they had the latitude to step up the requirement only for one particular bank or for a group of banks exposed to that particular risk without necessarily raising the legal requirement - that is, targeting one particular bank or one particular group of banks that were at risk. This is what the supervisors could have done. More detailed guidance on what supervisors could do came later. The realisation of the move from principal base, minimum harmonisation and subsidiarity and the need to give more guidance came with time, so there was nothing that prevented them from doing these things. Also, there was not very detailed guidance as to what they could do.

What about the interaction of the ECB with the individual central banks in each country? Was there no interaction in terms of an overview from the ECB?

Mr. Mario Nava

As far as I know, the ECB-----

The Deputy asked the question rather than saying what intervention-----

What oversight role, in the European context, would the ECB have had over individual central banks?

Mr. Mario Nava

We were discussing the ECB before. There was no supervisory responsibility until very recently, November 2014.

So any decisions taken by the ECB would be entirely down to its own decision-making process, and it would not in those circumstances be reliant on the decisions or advice its gets from the individual country's central bank?

Is that what Mr. Nava is saying?

For clarification purposes, is Mr. Nava saying that, effectively, the ECB and the Irish Central Bank operate independently of each other?

Mr. Mario Nava

I am sorry; that is not what I am saying. What I am saying is a different thing. What I am saying is that the ECB was the monitoring authority and had that responsibility. The Irish Central Bank was the exclusive supervisory authority until very recently. There were committees at those times at which all the supervisory authorities were put together - committees that were particularly useful for dealing with cross-border banks, where banks were active in more than one country and account must be taken of interactions between the different countries. That is what I am saying. The supervisory responsibility lay with the national authorities. There were committees and ways to bring supervision to the level of where economics was. The later move to the banking union - where banking union means central supervision - was dictated by the simple fact that the economics had moved ahead of the regulatory institutional framework. The banks were much more integrated than the regulators and the institutions were. We found ourselves where the European banking sector, which is a very large sector. As the committee is aware, the European banking sector alone, depending on the year, represents between 40% and 50% of the world banking sector and is about four times as big as the American banking sector. The European banking sector is very large and is very economically integrated. There are banks that are present in many countries, and often are more important in the host countries than in their original country.

In the limited time available to me, can I move on to something in which the European Commission is directly involved. I do not know if Mr. Nava had the opportunity to view the contribution of Professor Black, who appeared before the committee this morning. Professor Black spoke about the impact of Basel II and said its outcome was preposterous. He said that the level of capital required in Europe was a third less than what would have been required in the US. He said the US effectively requires three times the level of capital weighting reserves that would apply in Europe. Also, the Basel III agreement will allow banks to have loans - effectively assets - to customers of 33 times their core Tier 1 capital. It is similar to the leverage of Lehman Brothers prior to its bankruptcy. Can Mr. Nava give his view? As that is very much within his domain, how does he respond to Professor Black's criticism of Basel II?

Mr. Mario Nava

Definitely. The story I am trying to tell you this morning is a story of evolution. It is a story of trial and error and improvement over time.

With due respect, the trial and error has resulted in a situation in Ireland-----

Deputy O'Donnell-----

Mr. Nava speaks about trial and error-----

There are consequences on the ground.

-----but there are consequences on the ground for the Irish public because up to €64 billion of bankers' debt, which is on the public record, has come about, potentially, because of these trials and errors.

How does Mr. Nava respond to Professor Black's criticism this morning, which is in the public domain, that he regards Basel II, which falls under Mr. Nava's remit, as preposterous because the level of capital required is less than a third of what it would be in the US?

Mr. Mario Nava

What I was trying to say is that Basel II no longer applies. It has not existed since 2010. Now we have Basel III, which has multiplied the capital requirements, which means that not only within the remit of the European Commission, when we make the banking directives, but at a global level, there has been an awareness, or recognition, of the fact that the capital levels set by Basel II were too low. We moved to the capital level set by Basel III. What I have said before, and must repeat, is that once the capital level of Basel III came about, once the Commission proposed the capital requirement directive, which has been adopted by the Council and Parliament, the market reacted. This is a very important point-----

I need Mr. Nava to-----

The Deputy asked a lengthy question, so I will give the witness-----

I will let the witness respond, because the Deputy’s question was quite lengthy. Mr. Nava, please complete the answer. I will give you some time.

Mr. Mario Nava

The important thing is the "fully loaded" concept under Basel III. It refers to the requirements that will exist in 2018. Forget the regulators: the market today, and the numbers in the banks, ask that all banks live under the so-called fully loaded requirements. I take that as a recognition of the fact that the regulatory reform we put into law has been welcomed by the market. I am sorry to have taken so long.

The Deputy has four minutes.

This allows the same level of leverage that applied when Lehman Brothers went bankrupt. How does Mr. Nava respond to that?

Mr. Mario Nava

The leverage ratio is an indication of Basel, but it is not yet a binding law in Europe. It may be used from 2018. I am sure the committee knows that when we brought this concept of the leverage ratio to the Council and the Parliament, they added a little more, so it became leverage ratios, and then it added leverage ratios depending on the business model. It acknowledged the fact that the leverage ratio may be different depending on the business model. The leverage ratio as a binding law - not as a discussion between supervisor and banks, not as a Pillar II concept but as a binding law - will be there from 2018, and so I cannot anticipate today exactly what it will do.

Mr. Nava's submission states that “the Single Supervision Mechanism was created with a view to breaking the link between banks and sovereigns” so that effectively the taxpayer would not be on the hook. In what circumstances will the conditions be such - in an Irish context - that Europe can provide money to purchase shares in banks that the Irish Government has already recapitalised and put money into? Under what conditions will the European Stability Mechanism, ESM, step in and purchase the shares that the Irish Government had to purchase to put money in the Irish banks on behalf of the taxpayer?

Mr. Mario Nava

It is important to understand how the Single Supervision Mechanism, SSM, and the Single Resolution Mechanism, SRM, work. They dramatically reduce the probability that a country will be obliged to use public money. For example, the first articles of the SRM, which few people pay attention to, speak about resolution plans. The first articles try to de-dramatise the famous weekend of resolution and to make sure that at the moment of resolution, which will be a difficult moment, the resolution authorities, who have to intervene, know exactly what to do because they have planned what to do in advance. Those plans differ from one bank to another. That is the resolution plan. There is another point in the Bank Recovery and Resolution Directive that I quoted - the ability to contain losses.

In the limited time, I am aware-----

I will bring the Deputy back in at the end.

Please, Chairman; I want the questions I asked answered.

I will give the Deputy time later. He will have a chance to come back in at the end of the session.

No; I actually intervened because I want Mr. Nava to speak purely about the Irish context. In what circumstances could retrospective recapitalisation apply under the ESM?

Mr. Mario Nava

I am not here to speak about the Irish context. I am here to speak about the European legislation. What I know about the European legislation is that the potential retroactive application of the direct recapitalisation mechanism is decided on a case-by-case basis and by mutual agreement of all the ESM. In making this statement, which is a bit general and simple, and is to be found in the rules with no reference to any particular country, I am repeating what the rules say: on a case-by-case basis and with the general agreement of the ESM members.

I would like to come back to the idea of minimum harmonisation, which Mr. Nava spoke about in his opening statement. He said this provided the minimum requirements for the enacting of prudential supervision in each member state. To his knowledge, did any country enact less than the minimum requirements or attempt to enact less?

Mr. Mario Nava

No. There is a minimum level in the rules that a country cannot go below, although it can go above that level. The issue is not going below; it is going above. There has been a global movement away from giving a little guidance and giving only the principal base to a more rules-based system under which we tend to say much more of what countries could or should do. There is no issue with regard to countries going below the rules that have been set.

To Mr. Nava’s knowledge, did any country, at the beginning of the last decade and in the years leading up to 2006, when the directives were transposed, go above the minimum recommendation?

Mr. Mario Nava

If they wanted to, they could have done.

Is Mr. Nava aware that anyone did? The Commission follows this up.

Mr. Mario Nava

There are some countries which - when implementing, but especially when supervising, even in the absence of precise guidance for supervision - went for more intrusive practices. When it comes to supervision - I am really simplifying this to give the Deputy the idea - there are two types. One is a more intrusive type of supervision, with supervisors physically in the bank, going residential, checking the numbers. In other countries they had softer supervision and less day-by-day supervision. These were two schools. I am simplifying because there are intermediate positions. For clarity, these were two schools of supervision that we saw progressing in Europe in different countries. Maybe that is one of the reasons we recently came up with more guidance for what supervisors can and should do in particular circumstances.

As you watched this happening throughout the 2000s into 2006, and the crisis in 2008, did you find a correlation between those countries that had gone further than the minimum and the success or robustness of their banking system?

Mr. Mario Nava

Supervision certainly helps to contain risks, and more intrusive supervision, which results in better knowledge of banks' risk management and the internal measures they take, has helped. One can look for the correlation. The crisis was general in Europe but it is clear that it has hit some countries more than others.

We then come to 2006 and the capital requirements directive. Mr. Nava said in his opening statement that had these powers been used “to the full extent, a number of major difficulties could have been prevented.” He is not talking about one particular country. Is he saying the directive was not being properly implemented or followed?

Mr. Mario Nava

No, what I am saying is that the directives were transposed and the Commission checked over the transposition of all the directives. What I am saying is that there could have been moves by the national supervisors which were not prevented by the directive. They were not even guided and they were not prevented. The reason there was not a precise guidance is exactly because there were different situations in different countries and therefore subsidiarity applied and depending on the economic and banking situation in a given country, the response would have been different from the response in another country.

Is it fair to say that the 2006 capital requirement directive was sufficient but that the national authorities-----

Mr. Mario Nava

It is fair to say that the 2006 capital requirement directives implementing Basel I, were done in the spirit of the time which was the spirit of going mainly for principle-based regulation. It is not fair to say that we did not realise that it was not enough. I have made this argument before in reply to a question from Deputy O'Donnell, which was that indeed, Basel II was then essentially scrapped and Basel III came. As I said it has been a history of evolution where there has been a constant improvement of the regulation and the supervision by learning from crises that emerged.

I refer to something Mr. Nava mentioned earlier about credit concentration limits. Are we going to have harmonisation at EU level on credit concentration limits or will that be left to national authorities in new supervisory structures? I was not clear from Mr. Nava's earlier statement if there was going to be an EU-wide directive on credit concentration as part of new structures or whether it will be left to the national authorities.

Mr. Mario Nava

No, credit concentration is certainly part of the capital requirement directives. Credit concentration may be looked at in different ways, for example, moving from micro to macro. The most obvious mechanism of credit concentration is excessive concentration to a counter party; for example, a bank lends me too much or a bank lends too much to a particular company. There can be credit concentration to a sector whereby a bank lends too much to a sector. There can also be credit concentration to a region whereby a bank lends too much to exposed activities in that region. This is a movement from micro to macro. One of the things we learned from the crisis is that national supervisors were more on a micro level and for good reason. Among the institutions which were created in 2011 was the European Supervisory Risk Board. This board's specific task is to help countries to carry out macro-prudential supervision and to carry it out in the context of the Single Market. Definitely, credit concentration is an issue but what I am trying to say is that this issue has both micro and macro aspects. Therefore, this issue can be tackled either at the level of one single counter-party by one single supervisor or it can be tackled at higher level and can necessitate some co-ordination of the measures.

I was not clear on the answer. The responsibility for identifying those risks lies with the national supervisor.

Mr. Mario Nava

Now that we have the system of single supervision, the ECB is responsible for the 120 largest banks in Europe and it will be able to identify for those banks if there are risks of credit concentrations.

On Deputy Murphy's point, is there a suggestion or a recommendation that the ECB needs be moving to a more micro-prudential examination in this regard?

Mr. Mario Nava

The ECB is the supervisor for the 120 big banks so the ECB definitely does all the micro supervision for all the largest banks. With regard to the macro aspect, national macro-prudential authorities have been set up in the past two to three years. The ECB and the national macro-prudential authorities work together to determine the macro-prudential tools - the macro-prudential values.

Is it the Commission's view that the ECB will move towards a more micro-prudential examination?

Mr. Mario Nava

Micro, for sure, because the ECB is micro-prudentially responsible for the 120 banks.

I welcome Mr. Nava and I thank him for taking the time to attend the committee. Does the European Commission accept any responsibility for the regulatory framework within which the banking crisis developed in Ireland and elsewhere in Europe?

Mr. Mario Nava

I am not here to accept responsibility; I am a witness. What I have tried to explain is the way in which we have worked, in some cases, at full steam, to continuously improve the regulatory framework with respect to the evidence provided by the economy. I hinted at it before but I will say it again: Let us not forget that during the good years, during the period 2000 to 2006, it became difficult for the Commission to intervene and make suggestions because, typically, those interventions were returned on the grounds that things are going okay and there is not much need for them. The job I am describing to the committee and the work we do here is very much a regulatory job of observation of the places where the crisis can emerge. That is why I was pleased to be asked one of the initial questions which was my opinion of where the next crisis will come from. It is a job of monitoring, understanding and adapting the regulatory system to it.

I accept that. If Mr. Nava will not accept responsibility is it then a statement of fact that the European Commission was responsible for the regulatory framework and the setting of minimum regulatory standards in the member states? Is that a statement of fact?

Mr. Mario Nava

As I explained, the European Commission is the draft legislator but it is not a co-legislator in Europe. The legislation is then set by the Council and the Parliament because they are the co-legislators and they act on the basis of our draft legislation.

Senator Barrett alluded to the period of 2000, maybe even 2002 to 2006. We heard evidence from the Governor of our Central Bank that by 2006 and 2007, essentially the damage was done, in terms of the losses being inherently in the system. Was principle-based regulation a mistake during that period?

Mr. Mario Nava

I can provide a clear example. With Basel III we introduced a capital buffer which is called, "counter-cyclical capital buffer". That buffer increases the capital requirements when an economy is in good times. Basel III and the CRR, introduced this clear mechanism which made the capital requirement higher in good times. This was done in recognition of what the Deputy said, namely, that most of the excess leverage and most of the errors may actually happen in good times because in good times the economy is booming and so banks tended to lend more. It is interesting to note the ESRB report which stated that in spite of the fact that we are clearly now not in a boom period, all countries have set their counter-cyclical buffer at zero for the time being but in all countries there is the possibility that if the economy booms again, a country will move its counter-cyclical buffer. Currently, only one country has moved its buffer out from zero.

The Deputy makes the point that most of the banking errors are made in the good times because of the excess of lending. That point has been recognised very much, both at the global level in Basel and in our legislation in the CRDCRR, by the introduction of this counter-cyclical capital buffer which allows more capital requirements in the good times.

Mr. Nava referred in his statement to minimum standards below which countries could not go but they were allowed to set a higher standard of regulation.

Did Ireland meet the minimum standards of regulation during the period in question?

Mr. Mario Nava

Yes, of course. Everybody met the minimum standards.

Was that checked by the European Commission during those years?

Mr. Mario Nava

The European Commission checked that national law was accurately transposing the directive. That is what the European Commission checked. On this, there was no possibility of being wrong.

So the banking directive at EU level was adequately transposed into Irish law and in terms of oversight, was that the limit of the European Commission's role during those years? There was no additional supervision and the Commission's only job was to ensure that the directive was transposed into Irish law. What about the implementation of the law? Was that entirely a matter for domestic authorities or did the Commission have a role in that?

Mr. Mario Nava

The Commission has the legal role of verifying the two items of law and making sure that they are equivalent. It is responsible for ensuring that the national law transposes exactly what the European law says. At that point, the law then becomes a national matter; it is a national law which is verified by the national court, if needs be.

I will move on to the present time and the measures that have been put in place to prevent a future crisis, particularly the single resolution mechanism and, as part of that, the single resolution fund. Is that fund live as we speak?

Mr. Mario Nava

It is interesting that when we speak about the single resolution mechanism, everyone focuses their attention on the single resolution fund. The fund is unique and a first in European legislation and is deserving of attention but if one looks at the directive, one sees that this comes at the end. What comes before are resolution plans and especially important, the possibility of using private sources - bail-ins - in order to make sure that eventual losses are contained within stakeholders and do not spill over to taxpayers. The single resolution fund will be constructed over eight years. Final agreement on that was reached a little less than a year ago in the European Council and Parliament. It will be constructed over eight years and by the eighth year, it will be at its maximum level. It is being progressively constructed. I must stress the point, which is well known, that the single resolution fund is made up of private contributions from the banks and is not made up, in any way, shape or form, of public money.

Very quickly, on the June 2012 summit agreement regarding separating banking debt ---

I was going to let you move on with the single resolution fund but if you are opening a whole new line of questioning ----

It is a very quick question and it is not really about Ireland either.

Fine. Proceed.

Is the European Commission satisfied with the progress, or lack thereof, on the implementation of that June 2013 summit agreement?

Mr. Mario Nava

Sorry, which summit agreement?

The June 2012 communiqué from the European Council on the separation of banking debt from sovereign debt. Is the European Commission satisfied with progress in that regard?

Mr. Mario Nava

The Deputy is referring to the communiqué on 29 June 2012, which launched the banking union. On that date, the Heads of State and Government called for a breaking of the links and on 12 September, nine weeks later, the Commission put a proposal on the table for the single supervisory mechanism. So, over eight weeks during the summer we were able to produce what was asked for. We have taken major steps to break the links between banks and sovereigns. I would point to at least three: greater capital in the banks, the Single Supervisory Mechanism, and the Single Resolution Mechanism and the possibility of using bail-in tools to avoid any possibility of a link between the two again.

I want to round off something that Deputy McGrath raised with you, Mr. Nava. How much does the single resolution fund require to be operational?

Mr. Mario Nava

The single resolution fund is supposed to reach 1% of deposits, which has been estimated at €55 billion.

So €55 billion is the requirement of the fund. How much is in there at the moment?

Mr. Mario Nava

At the moment it is being constructed and is at about 12.5%. It is not exactly at that point, but it will be constructed over eight years and one can assume that it will go up, roughly, by 12.5% per year.

At present the fund would not be able to cope with a crisis if one were to happen in the short term. Is that correct?

Mr. Mario Nava

The fund is not meant to cope in the first place with a crisis. The Chairman is talking about the overall fund, which I have said will reach €55 billion. If one takes the assets of the European banking system, however, the figure is approximately €46 trillion, while the assets of the euro area amount to about €30 trillion. On the basis of those assets, bail-ins are possible and that is the second line of defence. The first line of defence comprises the higher capital requirements and the regulatory plan. Then comes the bail-in possibility and then, only at the very end, the fund. We need to move away from the idea that the fund alone will do it. What will do it are all of the measures combined - greater capital requirements, greater supervision, resolution plans and bail-in possibilities. That is really what will defend taxpayers.

Thank you, Mr. Nava. Deputy Phelan is next.

I welcome Mr. Nava to the meeting. In response to Deputy McGrath's question about the years when the crisis first hit here, Mr. Nava said that Ireland met the minimum standards that were laid out by the Commission.

Mr. Mario Nava

The law of Ireland met the minimum standards.

Does that not beg the question as to whether those minimum standards served any purpose, in light of what we know now in terms of what was going on in financial institutions in Ireland and elsewhere? What was the purpose of those standards?

Mr. Mario Nava

What I said, to be precise, was that the law of Ireland met the minimum standards. Does that beg the question as to whether the standards were too low? I think you have had a very explicit reply by the global institutions and the Commission to that question, given the fact that those standards have now been multiplied by three. In the space of a few years, the minimum standards were multiplied by three and on top of the minimum standards we now have other buffers, like the counter-cyclical buffers which we spoke about earlier. We also have another buffer which is called the capital conservation buffer which makes it impossible for the banks to distribute dividends unless they are comfortably above the minimum and there are also systemic risk buffers which protect them. Rather than speculating about whether the standards were too high or too low, I would say that the pragmatic reply is very clear. We have had an explicit reply that we needed higher standards.

I understand that but it is of very little consolation to the Irish taxpayer that the standards were increased subsequently. In your opening report - and I do not want to be insulting to what Mr. Nava said ---

Do not be insulting, please.

I am not going to be.

In his opening statement, he outlined a system of trial and error. There is a strongly held belief in Ireland that we have been at the thin end of the wedge, to use an Irish phrase, in terms of that trial and error process. While changes may have been made subsequently, regulation for which the Commission had an oversight responsibility was wholly inadequate and not fit for purpose until quite recently. It has since taken a more in-depth responsibility for the 120 biggest institutions.

Do you have a comment on that, Mr. Nava?

Mr. Mario Nava

The Commission is responsible for bringing forward the regulation and that is what it always does, in all instances. I do not think that the Commission can be said to have waited excessively long. Banking regulation is something which is discussed at a global level. At that global level, one must think of Basel I and Basel II. In global fora, the Commission has always followed that and has always been at the forefront of the debate. What has happened is a progressive move away from a national situation to a European situation. That is what has happened and that is what we have tried to gauge with regulation.

I understand but were any sanctions meted out to countries which did not meet the minimum standards prior to the development of the single supervisory mechanism?

I ask Mr. Nava to give examples of that.

Mr. Mario Nava

If directives are not properly transposed, then the Commission opens what is called an infringement procedure. That infringement procedure may lead to sanctions.

Mr. Mario Nava

I do not exactly remember. I am happy to submit something in writing on that if the committee wants.

I suspect the answer may be "No".

Mr. Mario Nava

As I said, I do not exactly remember, but I do not think so.

Since the Commission assumed responsibility for the largest 120 institutions-----

Mr. Mario Nava

Not the Commission, the ECB.

The ECB I should say. Have there been sanctions handed out to any of those institutions that might have infringed the minimum standards?

Mr. Mario Nava

We have to be clear on who infringes what.

The banks. Since the change to having the largest 120 directly supervised by the ECB have sanctions been imposed?

Mr. Mario Nava

Wait. We need to clarify one thing, if I may. Sanctions are when a country does not transpose correctly a piece of law called the directive. That is a sanction. If a bank goes below the minimum, the national supervisor withdraws the licence or accompanies the bank toward the process of resolution. That is what happens.

On the 120 banks, there is a big distinction between the country and the banks. On the 120 banks that were moved to the ECB, before being moved to the ECB, the Deputy may remember that the week before the stress test and the so-called comprehensive assessment of the assets were made. So the ECB "acquired" - I am sure it is not the right word - or got power to supervise those banks after having had a thorough assessment of their assets and liabilities. This is the exercise of the stress test and the banks data-----

I was using "sanction" in the widest possible sense and not specifically related to transposing.

I wish to clarify one thing. The Commission deals with national structures. Sanctions with individual banks is not a matter for the Commission; it is a matter for national supervisors.

Mr. Mario Nava

Absolutely.

It is a matter for the ECB for the largest 120 banks.

Earlier this morning Professor Black outlined that the United States had introduced a cap on the annual growth of bank balance sheets - I think he mentioned 25%. Is there any proposal at a European level to look at the level of growth in bank balance sheets annually and have a similar cap at a European level? In Ireland one of the banks in particular was growing at a much faster rate than 25%.

Mr. Mario Nava

There are no global standards to limit the growth of the banks. There is, however, a global standard that was asked before on the indebtedness of the bank - on the leverage of the bank. That is a static value; it is not a dynamic value. So there are no global standards or European standards to limit the growth but, having said all of that, it is exactly the job of the supervisors to understand what is driving the growth of a particular bank.

The situation the Deputy describes is a situation that is more, let us say, idiosyncratic - so referring more to a particular bank than a general situation. It is typically the job of the supervisor to look at one particular bank. In the case of that bank, if it observes a growth rate which may be due to the effect of having found a particularly good business sector or a growth rate which can probably not be sustained, that is the duty of the supervisor. There is no global idea for that cap.

Cuirim fáilte roimh Mr. Nava. I ask him to clarify the role of the Commission and the minimum requirements set for member states. Is it correct that the Commission sets the minimum standards through the process Mr. Nava outlined earlier? When the minimum standards were applied they were transposed into national law and the Commission stood back and did not check whether those minimum standards were being fulfilled.

Mr. Mario Nava

If I may be precise, it would be correct to say that the Commission proposed those minimum standards to the Council and Parliament. The Council and Parliament adopted the minimum standards. Then the Commission verified that the national law was in compliance with those minimum standards. So the Commission verified that the national law said that banks must have so much capital. Then once the law is there, it is for the national laws for the national supervisor to make sure the banks would respect that minimum standard.

Would it be correct to say at that stage the Commission washed its hands with regard to the application of the minimum standards?

There is an application of prejudgment in referring to washing hands.

Did the Commission stand off? It had no other involvement in the application of the minimum standards once they were transposed and it had been assured they had been transposed accurately into national law.

Mr. Mario Nava

We are the guardian of the treaty. So we make sure the treaty is respected, but we are not supervisors. It is not our role; it is not our competence to go and check the banks. We do not have the resources. We do not have the people. The Commission is not a supervisory agency.

What were the minimum standards in 2008 and 2009? What was the core tier 1 ratio for risk-rated assets at that stage? What was the percentage?

Mr. Mario Nava

At those times the overall ratio was 8%, both before and after Basel III, but before Basel III the 8% was more generously calculated by a composition of the core tier 1, which needed to be only 4% and tier 2. The great reform of Basel III was exactly to increase the amount of capital that can unequivocally and in any moment absorb losses.

Does the European Commission have a role in approving capital injections for banks under EU state rules?

Mr. Mario Nava

The European Commission has responsibilities over state aid.

It had to approve capital injections. More specifically on the request to inject capital into Anglo Irish Bank in January 2009, when the Irish Government informed the European Commission that Anglo Irish Bank was capitalised above the 8% rule, did the Commission have no obligation to check whether that was accurate?

Mr. Mario Nava

Chairman, I cannot-----

It is not Mr. Nava's area of expertise.

Mr. Mario Nava

It is not in my area of expertise. I do not deal with competition policy and most especially I cannot talk about particular cases.

I have looked at the European Commission's website regarding the letter sent to it on 14 January by the then Minister for Foreign Affairs, Deputy Martin, which stated that the regulator assured that Anglo Irish Bank was capitalised above the minimum rates. I appreciate this was a competition issue, but regarding the division Mr. Nava heads up, is it correct that there was no requirement to assess whether the bank was in compliance with the minimum capital requirements at the time?

Mr. Mario Nava

If I understand what the Deputy is asking, the division I lead is the division of regulation. So my duty is to check the law. The Deputy is asking a question that has to do with competition. What he is asking is the verification of the statement of whether that particular bank was above or below a particular number. That, I repeat, is a case-by-case issue which I am not competent to discuss and I cannot discuss.

I appreciate that.

Mr. Mario Nava

My department is a regulatory department and will look at law. We do not look at particular cases.

I wish to clarify this. Mr. Nava's department deals with regulation. The request by the Irish State sought approval for the guarantee, which the Commission approved in mid-October. Is it correct that the request for all of the capitalisations of the banks, which would have been approved by the Commission, did not need input from the department Mr. Nava heads up?

Mr. Mario Nava

The request was sent to the competition department.

The competition department does all the analyses the Deputy asked about and I do not want to speak about the analyses it did because I am not fully aware of them. Once it made the analyses, given that any decision of the Commission is collegial, it submitted them to the different departments.

A restructuring plan was required as part of the recapitalisation of Anglo Irish Bank. Does the competition arm of the Commission, as opposed to its regulation arm, deal with this issue?

Mr. Nava indicated he has read the report by the House of Lords on the response of the European institutions to the crisis which was published on 27 January. The report was not completely uncritical of the EU institutions. It includes a section on the politicisation of regulation and identifies a number of areas where it suggests regulation was politicised. In the period leading up to 2008, was politicisation of regulation or deregulation an issue in terms of national supervisors?

Mr. Mario Nava

The Deputy asked two questions. On the first question, the restructuring plan is discussed with the competition department. While discussing the restructuring plan, the competition department takes into account all the rules we have. There is no disconnect between the two. There is an apportioning of responsibilities. Each department is responsible for its own areas but we obviously take into account what the other departments do. It is not possible to have a restructuring plan which does not take into account the rules we have made.

The second question was on the politicisation of decisions. As I stated, the Commission brings a draft proposal, a draft capital requirement, to the table of the Council and Parliament. Let me cite a concrete example. The last draft capital requirement - the capital regulation requirement that is in application today - was brought to the table of the Council and Parliament in July 2011 and finally adopted in April 2013. The process lasted a little less than two years, which was quite a fast process for a document of 1,000 pages. The discussion in the Parliament and Council is done by those who are entitled to make law, who I understand are the legislators. I understand they are the political masters, the elected and appointed persons who make legislation. There may be an interpretation that one or other aspect is excessively political but, as a European citizen, I find it democratically correct that we have a clear process of adopting a law and it is adopted by political people.

The members of the committee are political people who have all been elected. They are the legislative power and they make legislation. I do not find it particularly strange that politicians make legislation. Actually, I think it is their duty to make legislation. In doing so, they may introduce political considerations because that is exactly the area in which politicians are involved. Let me give a concrete example. When the capital regulation requirement, CRR, went through the Council and Parliament, given the particularly difficult economic situation, the Council and Parliament introduced a rebate for the banks that were lending to small and medium enterprises. A rebate of about 25%, which was not in our proposal, was given on the back of a particularly difficult economic situation and the need to sustain the credit flow to small and medium enterprises. Was that a political decision? Yes, it was a political decision. Was it something the Council and Parliament had the right to do? As a European citizen, I would answer "Yes". I must also say that, as a European citizen, I take comfort in the fact that the politicians looked not only at the piece of paper we brought to the table but also looked outside the window and saw what were the needs.

On the minimum regulation laid down by the European Union, Mr. Nava states that member states "typically did not resort to overly restrictive rules". He also notes:

The degree of flexibility previously granted to member states and national supervisors, as mentioned above, had led to divergent transposition of EU rules into national law. This created opportunities for regulatory arbitrage...

To what is Deputy Higgins referring?

I am citing page 3 of Mr. Nava's opening statement.

Mr. Mario Nava

I recognise that.

Will Mr. Nava briefly explain, in the English language, what the term "regulatory arbitrage" means?

Mr. Mario Nava

"Regulatory arbitrage" means there are different rules in different places and those rules can be arbitraged. This means that the banks can shop, if one likes, in those rules and choose the place where they are more favourable. In a single market, this creates economic decisions which are based on rules rather than economic grounds and therefore introduces a distortion in the Single Market. It is exactly to avoid the possibility of using different rules in different places that we went towards the single rule book. The sentence the Deputy read comes immediately after a sentence on the creation of the single rule book, which is the capital requirement regulation. The logic of this regulation is exactly to avoid circumstances in which one has different rules in different places for the same activity. This would create an advantage in going to one place rather than another, which would not be compatible with the Single Market.

In one definition the term "regulatory arbitrage" is described as a practice whereby firms capitalise on loopholes in regulatory systems in order to circumvent unfavourable regulation. Did that happen?

Mr. Mario Nava

Once again, the fact that one has different rules in different places for the same activity - lending, for example - makes it possible, given the free circulation of capital in the Single Market, to go and shop in the place where more favourable rules are in place, according to the Deputy's definition.

Would very favourable taxation policy on the financial industry, for example, a much lower rate of taxation, qualify as regulatory arbitrage?

Mr. Mario Nava

No, my statement refers to regulatory arbitrage. What the Deputy is hinting at is the fact that there are other types of arbitrage. He is hinting at fiscal arbitrage, namely, the possibility that there are different fiscal regimes for similar types of activities, which determines the movement of firms.

Are regulatory and fiscal arbitrage related?

Mr. Mario Nava

They are two types of arbitrage. However, the implementation of the single rule book is only responsible for eliminating regulatory arbitrage. The other type of arbitrage goes back to the issue of fiscal laws. As the Deputy knows, fiscal laws in Europe have a different degree of harmonisation from banking laws. It is a completely different debate for which I do not have responsibility and which is not in my remit.

In the pre-crisis period, did Ireland have a reputation in the European Commission for regulatory arbitrage?

Mr. Mario Nava

Regulatory arbitrage is not an issue for a country but refers to the possibility available to firms to move to a given place. Once again, this is not an area where one moves by reputation. I do not feel I need to respond to that question.

I was a member of the European Parliament for a while. Mr. Nava is correct that the Parliament and Council sign off on legislation.

It is true to say that the Commission is very influential in the production of legislation. In that regard, what type of influences lead Mr. Nava to make proposals? Mr. Nava will probably be aware of the Corporate Europe Observatory, which is a type of watchdog of the European Union institutions. It states that the European Commission operates an open door policy to lobbyists from the finance industry and that there are 1,700 finance industry lobbyists who spend €120 million per annum in lobbying the EU institutions. In contrast, civil society spends only a fraction of that amount. Was the decision to set only minimum standards in the pre-crisis period influenced by such lobbying by financial institutions?

Mr. Mario Nava

In regard to what we do in relation to the transparency of debt, this Commission has made clear from the beginning that it wants to be super-transparent. There is a register, which is available, in which is recorded all meetings with consumer associations, stakeholder companies and so on.

With whom do they meet?

Mr. Mario Nava

A Commissioner or the director general.

But not staff. Is that true?

Mr. Mario Nava

Normally, the senior manager who is in contact with the companies or stakeholders attends. There is no staff contact level.

Between end 2013 and mid-2014 there were 400 meetings between finance industry representatives and the Commission. Is that usual? Is it excessive, or not?

Mr. Mario Nava

I cannot make that judgment. I can say, however, that if that number of meetings did take place they were in relation to different areas. Today we are speaking about banking. The Deputy will be aware other areas such as corporate governance, markets and so on come within our remit. The areas we regulate are many and different.

It is important to make the point that all those contacts are transparent. It is probably not correct to claim that any particular outcome - the Deputy referred to minimum harmonisation - comes from those contacts. The counter-proof, which I think is relatively solid, is that the minimum harmonisation logic prevailed at global level. Clearly then a global level logic was in place at the time of the banking directives. The move from banking directives to banking regulation, which led to the move from minimum standards to maximum harmonisation, was made in 2011 in recognition of the need to preserve the Single Market, to have a single rule book and to avoid arbitrage. I would not definitely link them.

I welcome Mr. Nava and thank him for taking the time to be with us. The Commission's role is the drafting of legislation as opposed to making decisions. Would it be fair to say that given the amount of new legislation drafted since the crisis, the Commission's work in regulation up to that point was disastrously unfit for purpose?

Senator MacSharry's contribution is very colourful but he should stick to asking questions.

I asked a question.

The Senator also answered it.

I did not. I asked if what I was suggesting would be fair or not.

Mr. Mario Nava

It would be fair to say that legislative production in the last five years as compared with the five years previous to that has changed. In the last five years we produced 41 pieces of legislation. In previous years we did not produce so much legislation. This is in recognition of different elements, including the state of the economy, the global consensus on banking legislation and so on. If the Senator's question is whether the Commission produced more legislation in the period from 2009 to 2014 than it did from 2004 to 2009, the answer is "Yes".

So Mr. Nava agrees.

Mr. Mario Nava

I agree with the Senator that we produced much more legislation between 2009 and 2014 than we did between 2004 and 2009. That is a fact.

I am pleased that it is. In the period running up to the crisis the Committee on Economic and Monetary Affairs of the European Parliament met many times. The then head of the European Central Bank, Jean Claude Trichet, would attend those meetings and answer questions. At that time Irish MEPs, most notably Mr. Eoin Ryan and Mr. Gay Mitchell, consistently raised with Mr. Trichet whether, because asset price inflation at that time was extremely worrying for countries like Ireland, it was prudent to be lowering interest rates. It was even suggested by some people at the time that this would not be sufficient. All of this information is available from the minutes of the meetings and as such there is nothing that is not in the public domain.

Mr. Trichet was very specific in pointing out at that time that Ireland was performing very well and that while the focus of the ECB was very much on price stability, asset price inflation should remain its main focus and mission. Has that changed? From the Commission's perspective, is there greater focus than heretofore on the effects of asset price inflation given what that led to, as opposed to the traditional ECB mission which is arguably more German-focused of price stability?

Mr. Mario Nava

On the ECB mission, it is not for me to comment on that. The ECB mission is clearly defined in Article 104 of the treaty. It is not for me to comment on whether the ECB-----

I will try to be more helpful. In the reality of asset price inflation contributing to the difficulties we have experienced over the past seven or eight years, what has the Commission drafted to ensure we are adequately monitoring this situation for European citizens?

Mr. Mario Nava

One of the most well known pieces of production by the Commission is the so-called country specific recommendations, which touch on every country in Europe, and include many and different considerations of the specific economies looked at, including asset pricing. If the Senator's question is whether the Commission is looking holistically at the economics of all countries then the response is "Yes". However, it might be more appropriate to ask that question of the director general who signs off on the country specific recommendations when he is here in two weeks time. As a contributor to those specific recommendations I can say consideration is given to all those issues. I cannot as I said comment on ECB policy.

As pointed out, decisions are made by the Council and Parliament rather than the Commission. Has the Commission drafted a position or suggestion that Ireland should allow a bank to fail?

Mr. Mario Nava

This is not within my remit.

My remit is, clearly, regulation. This is not within my remit; it is within the remit of the country specific recommendation. I do not exactly remember. When the person who made the country specific recommendation-----

To whom in the Commission would one put this question?

Mr. Mario Nava

This is an issue one finds in the country specific recommendation. It is not within my remit of regulation.

I appreciate that and I am sorry. I am just asking-----

The witness may not be able to answer the question.

I appreciate that. I certainly do not know who to ask. Could Mr. Nava suggest who might be more appropriate?

Mr. Mario Nava

In 15 days time the Directorate-General for Economic and Financial Affairs, which signs off country specific recommendations, will come before the committee.

On a scale of one to ten, how much confidence does Mr. Nava have in the regulation now in place?

Mr. Mario Nava

My confidence has increased, and if I may I will give two replies. On a scale of one to ten my confidence is at nine in the regulatory reform in place. At the opening of the Brisbane G20 summit, the chair of the Financial Stability Board stated regulatory reform is substantially complete and what remains are banks which are too big to fail. My confidence has increased threefold with the work of recent years.

In 2006 Mr. Nava would have said his confidence was at three.

Mr. Mario Nava

In 2006 and 2007, we realised when the crisis came that we had many things to do, and certainly we have done many things. It is not by chance, and it was mentioned by Deputy Phelan a moment ago, that we have produced 41 pieces of legislation in five years. Clearly at global level there was recognition that more needed to be done. In Europe, particularly in the euro area, we went beyond the global level by introducing two specific elements of banking union, namely, the single supervisory mechanism and the single resolution mechanism. These are game changers and massively increase the confidence we should have in the system.

In the drafting of the legislation and the preparation of those mechanisms, how many times, if at all, did Mr. Nava, his colleagues and his team speak with Professor Black, or listen to or appreciate the argument he has put forward about the way banks and bankers have behaved and what regulation he believes would be a game changer?

Mr. Mario Nava

I did not have the chance to hear Professor Black.

I do not mean here this morning, I mean in Mr. Nava's work in recent years.

Mr. Mario Nava

In the work of the past two or three years we spoke with and took evidence from the authors of all of the academic papers that were available. We looked at-----

Did that include Professor Black?

Mr. Mario Nava

I do not remember discussions with Professor Black.

Mr. Mario Nava

Probably not. I certainly did not have discussions with Professor Black. We had a seminar with Admati and Hellwig, who propose a much higher standard. We measured the various proposals at international fora. Frankly, it is important for banking regulation to remain in tune with what is global because the banking market is global. What drove us was, very clearly, the necessity to step up not only with regard to what was happening in the banks but also the supervisory mechanism and the resolution mechanism. I do not think we have come up with a system which cannot be defined as safe. We have come up with a system which is very safe and which has significantly reduced the likelihood of failure and the impact of any failures which may occur.

Given his criticism of the system previously, and his criticism of the current system, would it be useful for Mr. Nava and his colleagues to engage with Professor Black, at least to hear what he might have to say, not only at our hearing but in a broader context, because he is very specific that he does not have faith either in the system that was there or the system that is here now?

Mr. Mario Nava

The European Commission is one of the most open organisations with regard to listening to all those who want to contribute. I would definitely welcome Professor Black if he wants to engage with us and come to speak to us.

It was Mr. Nava's mechanism that changed supervisory responsibility for the 120 largest banking groups. If I understand it correctly from his statement, this supervision is now with the European Central Bank.

Mr. Mario Nava

That is correct.

What is the benefit of giving the 120 larger banks to the European Central Bank and setting the others in a separate place? Does that not give us more belief in the idea of banks being too big to fail and that they need extra special help, supervision or status?

Mr. Mario Nava

There are various ways to look at it and the easiest way is probably what I tried to hint at earlier. These banks are not all super big. There are banks from every country. Most of them have grown outside their countries and are active abroad. They are no longer national banks. If one wants the economics to be European, so to speak, then the vision of those who control the economics needs to be a European vision. It made a lot of sense to have equivalence between the level of supervision and the level of the banks' activities. In some countries there are very small local banks and it is questionable whether a supervisor in Frankfurt would be as efficient as a supervisor closer to the bank who knows it better. Such banks are clearly of a smaller dimension. However, one point which I did not make and I should have is that the ECB has the power to supervise any bank, no matter how small. The ECB is responsible for the 120 larger banks, which account for 75% of European assets, and it has the potential to be responsible for the joint supervision, along with the national supervisor, of any of the other banks, which represent the remaining 25% of the assets.

I welcome Mr. Nava and thank him for coming. What was the ultimate sanction for a bank which did not meet the capital requirements?

Mr. Mario Nava

It was withdrawal of the banking licence. If a licence is withdrawn, that is it.

Who withdrew the licence?

Mr. Mario Nava

At the time it was the national supervisors, and today it is the ECB with regard to the largest 120 banks.

Did any bank have its licence withdrawn under the initial Basel directive of 2000?

Mr. Mario Nava

A number of banks had their licences withdrawn, and the mechanism foresees that when a national supervisor takes a decision to withdraw a licence of one given bank, it communicates data to the European Commission and the European Banking Authority, which keeps a register of European banks which one can see at any time on its website. At present there are approximately 7,700 European banks.

Of how many banks which had their licences withdrawn is Mr. Nava aware?

Mr. Mario Nava

I cannot recall the number, but it has happened in the past few years. At some times, the number was higher and other times the number was lower. The information is publicly available.

What reasons would there be for the withdrawal of the banking licence apart from not meeting the Basel requirements?

Mr. Mario Nava

That has nothing to do with Basel; it does not meet the law. Basel are only guidelines and they are then transposed into law.

Mr. Mario Nava

Exactly. These affect the data. The breaching of the law cannot be recorded. The breaching of the capital requirements cannot be recorded and the bank has no possibility to go back above the line.

Does Mr. Nava's role involve analysis of the ratings agencies?

Mr. Mario Nava

Not specifically my role. The ratings agencies are done by the corporate governance department and, in terms of the agencies, the work that the Commission did over the past few years was essentially it wanted to make their decisions more transparent and to make sure their decisions were taken on the basis of justified elements and with proper advance warning justification and so on, but credit rating agencies do not come under my remit.

Do they come under the entire section Mr. Nava operates?

Mr. Mario Nava

No, they are in a parallel section where they deal with corporate governance.

Do the big four auditing firms come under Mr. Nava's section?

Mr. Mario Nava

No, I am afraid not. They are together with the credit rating agencies under that section.

Banks complained that they had to allocate too many staff to adhere to Basel rules, particularly Basel II. Were they reasonable?

Mr. Mario Nava

We have heard the statement many times that the compliance costs have increased. Let us say the increase is connected with the fact that the rules have increased. What I said, even in my statement, is that the two essential elements of a good financial sector which citizens can trust are good bank governance and their own ability to respect the rules and then check the rules. Without being able - because it is not my job - to judge whether an increase was too much or too little, it is clear that as there were more rules, banks were probably wise to step up their ability to comply with them.

The Bank for International Settlements conducted a survey recently. It gave a number of banks a model and asked them to comply with it. Much of the information they supplied was different because each bank has a separate risk modulation. How can that modelling anchored on that basis that a model was provided but many different answers came back?

Mr. Mario Nava

The Senator is referring to the risk modelling issue and this is a central issue that we need to address. Since Basel II moved to the concept of risk weighted assets and not unweighted assets, the rationale for data is that if you do not move to risk weighted assets, you implicitly assign the same risk to any activity you do and, obviously, that is not correct. Obviously, there are activities that are more risky than others and, therefore, assigning the same risk to any activities you do is not correct. The way forward is to try to model the risk. Then comes the risk modelling issue. The models are internal models of the banks but the supervisors verify the different models and we have initiatives both at the European level, at the EBA, and at the global level, the Basel committee or the BIS, to try to make sure that this modelling is not too far apart. I am happy to quote here that during the CRR approval, the parliament introduced the concept of benchmarking, essentially trying to benchmark and compare the models as much as possible.

The other extreme would be to go to a standardised model where it is equal for all and, again, that is probably too much of a simplified assumption.

Mr. Andy Haldane, the Bank of England chief economist, has a dog and frisbee theory. Is he off the mark?

Mr. Mario Nava

Mr. Andy Haldane is a colleague at the Basel committee. He puts in evidence the difficulty of having good risk modelling. Risk modelling is not easy. There have been a number of initiatives since that influential paper was written and I welcome initiatives that make risk modelling safer and in a way more comparable. The problem is that going for a too simplistic alternative to risk modelling, which is not risk weighted at all, is unsatisfactory.

I thank Mr. Nava for attending. In reply to Senator O'Keeffe's question, he said he was 90% happier than when he took up office. He then said it is presumptuous to claim that these reforms have consigned financial and particularly banking crises to history. He gave an optimistic view and I hope that will the case, but I refer to the legacy issues faced by the committee. Living standards data for Ireland were published last week. Every person in Ireland is €2,500 worse off since 2008. Mr. Nava can imagine what that does to a family of four. I am not satisfied that the correct approach was adopted in applying the principle of subsidiarity to bank regulation in the crucial period between 2000 and 2008. The euro was a project that should have been implemented at a higher level and not under this principle. We have to examine those legacy issues, including the debt that has been mentioned. Are there design faults in the euro? How would Mr. Nava tackle legacy issues? His reforms are too late for our constituents and the people of Greece, Portugal and Spain. They are eminent and worthy but mistakes were made and the people on the streets have paid massively for them. Our duty as legislators is to try to recoup their losses.

Mr. Mario Nava

I sympathise a lot with what the Senator said because the curse of the legislators and the regulators is that they have few instruments to tackle what he calls, appropriately, "legacy issues". What we can do is go forward. Now with 15-year insights, there is common recognition that they were flaws in the design, which we have tried to cope with and improve, but, unfortunately, the fact of the matter is that in a difficult job like mine, the job of regulation has this curse of being unable to deal with what has happened. We can make sure that it does not happen again, and that has been my statement. We try to make sure that it does not happen again but what has happened has happened and we need to find a way to make it least difficult for the people who have suffered a lot through it.

Mr. Nava referred to the single supervisory authority and the Single Resolution Mechanism Fund as game changers. When will the fund become active? Mr. Nava referred to €55 billion. At what level does it become active?

When will it reach the level of €55 billion? What is the timeframe?

If you have a supplementary-----

I would like an answer to those; I may have to ask a supplementary question.

You may not, because we may run out of time. Mr. Nava has to be gone by 2.20 p.m.

Mr. Mario Nava

The question is very similar to the one the Chairman put.

I just want full clarification.

Mr. Mario Nava

This is the first year where banks are contributing to that fund. The constitution of the fund will take eight years. It is more or less linear, at one eighth per year. That is the time it will take and it will take exactly eight years. Please retain what I said. That fund is only the very last line of defence.

I know, but the point is that the fund has to be at €55 billion before it becomes active.

Mr. Mario Nava

No, that is not what I said. I said it will arrive, in eight years, at €55 billion-----

That is the peak.

Mr. Mario Nava

-----but that is the top.

When can a country actively apply to that fund?

Mr. Mario Nava

That is exactly the type of decision the single regulatory mechanism, which the Deputy mentioned, takes. When a bank goes down, we have a resolution plan which will involve so much of bailing, equity taking and so on. If needed, the use of the resolution fund is a decision the single resolution mechanism will take on a case-by-case basis.

It is active, as of now.

Mr. Mario Nava

It is.

As we move to concluding, Mr. Nava may have some final comments he wishes to add. I want to deal with a couple of matters. I am not too sure if we have a matter concretised. In regard to the credit concentration limits which are coming down the track and on which the Commission is currently working, is there a recommendation on what banks have to have in terms of credit concentrations?

Mr. Mario Nava

The credit concentration issue is inside the CRR. It is part of the main regulatory environment of banks. It is no different from other risk.

The reason I am pinning you down on this is that this is an issue which this inquiry has been looking at and will continue to look at. In 1996 the Central Bank in Ireland, in its winter bulletin, gave very clear recommendations to specialist areas with regard to sectoral credit limits. By the early 2000s, it looked as though, particularly with the testimony which has come before this inquiry, those concentrational limits were no longer being overseen or enforced. It is questionable whether they were even being breached at that stage. At no time were the sectoral concentration limits lifted by the Central Bank. To use Governor Honohan's phrase, it was a dead letter. In your latest set of rule making, is the Commission setting out clear concentration limits? Can you tell us what the percentage is? Is it 25%?

Mr. Mario Nava

There are clearly large exposure limits, no more than I would give a percentage of the capital or assets. They, clearly, are limits that the supervisors ought to control, and they will. I was just about to say one thing before the Chairman clarified his question. This does not impede the supervisors if, in some particular cases, they see that for a bank there is excessive growth, as was hinted before, or a particular concentration at the macro level in a given sector or country, with different counterparts. It does not impede the issue of the concentration limit being part of the supervisory pillar.

We began with a football analogy and you introduced the football team Glasgow Celtic. Glasgow Rangers got itself into trouble because it obeyed some very basic accountancy rules in running a football club and ended up getting itself regulated into a new league. We have a situation where, because a football club becomes insolvent, a very measurable outcome happens. This is football. Bill Shankly might have said it is far more important than life, but banking is certainly a very important factor in life.

In Professor Black's testimony this morning and Professor Kane's testimony the week before, both stated there was £180 billion paid out in fines by American and European banks since 2008. These are banks that are breaching rules and regulations you are setting out. In euro terms, it is in excess of €200 billion. This inquiry is not just about looking at the past; it is about learning from the past. You concentrated on that this morning. It is about focusing going into the future.

In your presentation to the inquiry this morning, you talk about banks that are too big to fail and sanctions that would be applied. I think it was on page 3 of your report. You say that national supervisors were required to review remuneration policies, which are bonuses in laypersons' terms, and to impose sanctions if these policies did not meet the new requirements. You then go on to state that supervisors have obtained enhanced sanctioning powers going into the future, which are more intrusive and so on and so forth.

Are we ever going to arrive at a stage where the Commission will say it will continue with a fine-based system, but it will move into a legislative code which identifies bankers, as Senator O'Keeffe said, as opposed to banking institutions? Would there be strong recommendations in regard to the changes in the criminal code, where we would criminalise some of this behaviour as opposed to the sanction involving fining an institution?

Mr. Mario Nava

First of all, my forecast is that because of the increased efforts by the bank to comply with the rules and the increased personnel mentioned by Senator D'Arcy to comply with the rules, instances of the need to sanction banks will probably be reduced because it is very clear that we have stronger rules and banks are making efforts to respect that. The Chairman is referring to matters in addition to the current individual responsibilities of the people who are on the board. In a banking institution there are still individual responsibilities for the people on the board. On top of that, one could move, presumably, towards straight individual responsibilities and make the supervisor fully accountable. That is a debate which may take place at some point.

What we wanted to do with the construction of the new system we have constructed, which has capital rules, supervision and resolution, was to make sure that the instances where one needed to impose punishments were as few as possible. This was for one simple reason, namely, that one had more people within the banks checking and more effective supervision checking that. We tried to move away from a system where there is damage and one applies a sanction to recoup the damage, to one where there is no initial damage. There are lots of lights which tell one to be careful and it is risky to go somewhere.

To conclude, I can appreciate that your new rules would have the expectation that you would have less of the behaviour that causes banks to crash and that may result in fewer penalties. Maybe I am misinterpreting what you are saying. Are you saying that the Commission is not looking at increasing the tariff, which is the penalty in terms of moving from a fine to a criminal sanction? Is that not on its agenda after what has been probably the largest financial crisis globally in modern history?

Mr. Mario Nava

This has been the largest crisis in modern history. It has been dealt with at the level of national supervisors. Now we have European supervisors who are responsible for checking compliance with the law. The Chairman is asking a question about the future to which I am unable to respond. He asked whether we will have some more legislation stepping up sanctions. That is a question to which I am unable to respond and which the Commission will need to address.

An important point is that this year we will do a review of the SSM. At the end of this year, we will review what has happened during the first year of the centralised supervision. As I said at the beginning in response to the question, what countries can expect from us in the next five years is maximum alertness to different situations that may arise in regard to the economy, the banks and the supervisory mechanism. We will watch carefully to see what further rules are necessary.

Thank you, Mr. Nava. Is there anything further you wish to add or have you concluded?

Mr. Mario Nava

I have concluded. I thank the Chairman and the committee for listening to me and hope my contribution was helpful.

I thank Mr. Nava for his participation at this inquiry and I thank the European Commission for co-operating and engaging with the inquiry's hearings. I know Mr. Marco Buti will attend in a few weeks. Again, on behalf of all the members of the committee, I thank Mr. Nava for his valuable, informative and detailed engagement with the committee.

The joint committee went into private session at 2.25 p.m. and adjourned at 2.30 p.m. until 9.30 a.m. on Wednesday, 11 February 2015.
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