independent

Monday 21 April 2014

Time we cut our banking cloth to fit our measure

The Irish banking system has historically been totally unfit for purpose

European Central Bank President Mario Draghi. Photo: Reuters
European Central Bank President Mario Draghi

Since the liquidity crisis at Anglo Irish Bank in September 2008 was resolved (temporarily) through the ill-advised blanket bank guarantee, the Irish authorities have been fire-fighting the collapse of the Irish banking system.

Notwithstanding the prodigious quantities sprayed (of money rather than water) on the inferno, several banks have been consumed in the flames and are no more. The few still standing have seen their shareholders wiped out and are still repairing their balance sheets. In the belief that the worst may be over, it is now time to survey what is left of the Irish banking system, and to consider whether it will prove an adequate support to economic recovery. If all goes to plan, Ireland will need a solvent and competitive banking system focused on serving the retail customer, particularly the household, farming and small business sectors which cannot access external banking markets.

For a small country committed (or condemned) to membership of the eurozone common currency area, the ideal is a domestic banking system big enough to support the real economy but small enough to avoid exposing state finances to excessive bank bailout costs. Whether small countries should seek to host large offshore banking centres is a separate question. If the host must bear direct or indirect exposure to rescue costs, the attractions are seriously diminished.

In a proper monetary union, bank supervision would be centralised along with the costs of resolving failed banks, and retail bank deposits would be insured through a central scheme. The eurozone is not a proper monetary union in this sense. A partially centralised system of bank supervision has reluctantly been agreed but is not yet operational. Liability for bank resolution and deposit insurance remains national. If another bank in a eurozone country has to be rescued, that country's treasury, however overstretched, is exposed.

There is no centralised backstop, as there is in a proper monetary union such as the United States. Since the Irish Exchequer is already seriously over-burdened with debt, including debt incurred bailing out unsecured creditors of bust Irish banks, restraining the size of the domestic banking sector, and hence of any future rescue liability, is a policy priority.

Despite the transfer of dud loans to NAMA, the sale of various non-core businesses and the restriction of credit supply in the domestic market, the three surviving domestic banks remain sizeable relative to the scale of the Irish economy. On a consolidated basis, their liabilities equal about 200 per cent of Ireland's national income.

It is an under-statement to observe that Ireland was over-supplied with banking capacity in 2008. The following domestic banks have disappeared entirely: Anglo Irish, at one stage almost as big as AIB and Bank of Ireland, has vanished; Irish Nationwide, a building society cum property development bank, also vanished; and Educational Building Society, whose remnants were absorbed into AIB. Of the foreign-owned retail banks, only Ulster remains in anything like its previous incarnation. Bank of Scotland (Ireland) has been closed down; National Irish, which belonged to Danske Bank, has withdrawn entirely from branch and retail banking; Rabobank, which operated the ACC network, has done the same. What's left? In the retail market, there are just five players offering current accounts, mortgages and deposit products. These are the three Irish-based banks AIB, Bank of Ireland and Permanent-TSB, plus the UK-based Ulster Bank, all with national branch networks, and the Belgian-based KBC.

In the corporate market both Danske and Rabobank retain a presence as does the UK bank Barclays. These banks understandably focus on the larger firms, including semi-state companies. But small businesses and households are captive to the dwindling number of banks still offering retail service. There has been speculation that Ulster might consider curtailing, or even withdrawing, its retail operations in Ireland. This would leave most small businesses to the tender mercies of an AIB/Bank of Ireland duopoly, since the third domestic bank, Permanent-TSB, remains essentially a mortgage bank and has not built a strong small business presence through its branches. Thus the authorities have a strong interest in keeping Ulster Bank in the Irish market. Having 'enjoyed' excess competition through the bubble, there is now a risk Irish banking customers face too little.

The three surviving Irish banks rely excessively on the mortgage business. For Permanent-TSB, almost all loans and advances are either mortgages or property-related. The bank's balance sheet still reflects its origins as a building society. But even with AIB and Bank of Ireland, supposedly broad-based commercial banks, mortgage and other property-related lending accounts for almost three-quarters of their total loan book. This is an unhealthy concentration of risk and is not reducing, despite low levels of mortgage advances in recent years. Forbearance measures which include 'interest-only' deals exacerbate the problem through slowing the run-off of mortgage debt. Mortgages are anyway long-lived assets, typically 25 or 30 years. For deposit-funded institutions this involves a big maturity mismatch: the banks attract mainly short-term funds, so with assets tied up in illiquid form for very long periods they are vulnerable to periodic funding crises. It is not prudent for deposit-funded institutions to have an excessive reliance on mortgage lending.

In the peak bubble year of 2006, lending for house purchase in Ireland reached the extraordinary figure of €28bn. Last year, it was about €3bn. If house-building returns to a more sustainable rate of perhaps 25 to 30,000 units per annum, there would be a need for mortgage finance of possibly €8bn or more. Adding such amounts to the asset side of bank balance sheets would extend indefinitely the existing over-reliance on mortgage lending.

Some means needs to be found to finance home ownership on a more sustainable basis, and that means getting it off bank balance sheets. The building societies financed most Irish borrowing for home ownership until the 1990s when their tax and regulatory privileges were removed. They are gone and are not coming back. Deposit-funded credit unions are not an alternative either.

One attractive option is the Danish system of mortgage finance, where mortgages are packaged into securities and removed from bank balance

sheets, into the hands of long-term investors who bear the credit risk. The mortgages could be originated by brokers other than banks, a model which has its own problems, or banks could continue to originate but would retain only a small portion of the credit risk.

There could be a market, at least temporarily, for these securities (called ABS, for 'asset-backed securities') in the form of the European Central Bank. At his press conference on Thursday last, ECB President Mario Draghi was quizzed about the possibility of quantitative easing. This is where a central bank which has already cut interest rates close to zero, resorts to direct purchase of securities in order to ease credit conditions further. He said: "We think that a revitalisation of a certain type of ABS, a so-called plain vanilla ABS, capable of packaging together loans, bank loans, capable of being rated, priced and traded would be a very important instrument for revitalising credit flows and for our own monetary policy.'

The existing stock of tracker mortgages on the balance sheets of the Irish banks would be a natural candidate for president Draghi's quantitative easing programme when it comes, since they conveniently charge an interest rate directly related to the ECB's own policy rate.

Shifting the bulk of existing and future mortgage lending off the books of the banks would help shrink their balance sheets further, reducing the exposure of the Irish Exchequer to any future bank resolution costs. It would also help turn the two main lenders back into commercial banks, with lending spread across a variety of risk categories including the critical SME sector. Their experience as hybrid building-societies-cum-property-hedge-funds has not been a happy one.

A thorough and comprehensive inquiry into the failure of lending policies across the Irish banking system in the decade up to 2008 would help the reorientation of bank lending skills in the required direction. The Irish experience should be a rich source of lessons in how things can go wrong even in a long-established and traditionally conservative banking system. The forthcoming Oireachtas inquiry could help lay the foundations for a stronger credit system through conducting a bank-by-bank examination of precisely what management practices brought down the Irish banks.

Irish Independent

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