Saturday 27 May 2017

We must find banks' black box

I WAS on the Dart the other day when a young man, dressed in regulation ripped jeans, trainers and hoodie, plonked himself on the spare seat beside me. I noticed an indecipherable Chinese proverb tattooed on his inside forearm as he rifled through his bag -- and produced a well-thumbed edition of Andrew Ross Sorkin's Too Big to Fail.

His eyes darted from left to right, devouring the pages as if it was the latest thriller and he couldn't wait to find out "who did it".

Since when did a book recounting the collapse of boring investment banks on Wall Street have such an appeal?

It did seem that something fundamental had changed. New terms like "moral hazard" and "burn the bondholders" have moved beyond their technical origins and entered the common language.

Who would have thought that an obscure announcement by LCH Clearnet about an increase in the margin call of Irish government bonds would make the headlines on the RTE news? And in what parallel universe was it possible to imagine that a nation would hold its collective breath awaiting the outcome of the regulator's stress tests on the nation's banks?

But wait a moment. This seems like a movie that we have seen several times before. This is the fifth attempt to recapitalise the banks and the third set of stress tests. Instead of Groundhog Day this is more like Groundhog Year.

We have all become inured to the play in three acts. Act One: Denial of the full extent of the problems; Act Two: Flood the system with emergency liquidity accompanied by the drip-feeding of the banks with as little state capital as possible (the latest being Irish Life and Permanent); and finally, Act Three: Proclaim that the corner has been turned and that the situation is manageable.

The problem is that this pattern -- which commenced as far back as 2008 when Patrick Neary appeared on Prime Time declaring that this was a liquidity problem and that the Irish Banks were amongst the best-capitalised in the world -- is still not working.

On Friday, credit default swaps on Ireland, a gauge of the nation's creditworthiness, were still the second highest in the eurozone -- the sceptical markets have yet to be convinced. By continuing to rely on emergency liquidity for the foreseeable future and putting off dealing with the core solvency, debt restructuring and bank governance issues, we appear destined to keep producing the same negative result.

More generally, rather than being reassured by the provision of more capital for the Irish banks, existing depositors and creditors have used the rescue funds to exit their holdings. Meanwhile, new money remains sidelined by concerns about the debt overhang and the fear that the country cannot afford to repay the debts incurred by the banks.

A core issue for any banking system is "safety and soundness". In a normal world, this is something we should take for granted.

In the aviation industry "safety" is at a premium. We get on board an aircraft because we believe that there is a system of limits in place to make air travel safe. We have assurance that the pilot won't be too tired because there is a limit to the number of hours he or she can fly. We know there are limits to the weather conditions in which an aircraft will be allowed to land. Even after an air accident we will still get on board because we believe that there will be a painstaking and transparent inquiry into the causes of the accident with assurance that any lessons will be learned and applied immediately.

Contrast the public confidence in Irish aviation with the banking system -- where limits appear to have been more notable by their absence than by any restraint they may have imposed on bank lending.

In terms of the banking crash, after three years of searching, we are still waiting to find out if the black box containing the details of the internal workings of the bank's control systems has been discovered. Instead of the black box we have the third iteration of stress tests.

It was significant that on the day the Irish Government announced that our banks needed a further €24bn of capital, US Assistant Secretary of Treasury Timothy Massad announced that the US bank bailout programme had moved into profit. The US Tarp programme invested $245bn in US banks at the height of the crisis. On Thursday, $251bn in the form of capital repayments, dividends and interest had been repaid.

Massad stated that the objective was not to make a profit, but to stabilise the system. This result was achieved because the weakest parts of the banking system were eliminated and new stronger banking laws were enacted. This turnaround was also supported by a public and transparent investigation into the causes of the banking collapse and a replacement of the boards and management in the institutions participating in the scheme thereby restoring market and public confidence.

Unfortunately I fear that we have reached the stage where Thursday's declaration of the stress-test results is not as significant as it should have been.

The stress tests are really just more evidence of what we knew all along -- namely, the existing bank systems are not functioning normally. The repetition of stress tests is a symptom of the problem, not a solution to the problem. What really matters is whether actions can be taken which get ahead of the game and break the cycle.

Last week, the Department of Finance said that the actions of the Government and the Central Bank are to ensure that the banking system is functioning normally. No system can function normally when burdened by the massive debt overhang and relying on very short-term emergency funding.

In addition to stress tests, actions are needed to restore belief that the systems employed to measure and manage the banks are working with integrity, transparency and credibility.

We should learn some of the lessons from the US. Only then can we go hope to return to the normal world, where boring books on banking are banished from the Dart.

Shane Ross is on leave and will return next week

Sunday Indo Business

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