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. 17

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. 18

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. 19

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. 20

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. 21

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. 22

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. 23

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. 24

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. 25

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 inGulliver’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. 26