New bank chief to take over a work in progress
The country needs a financial sector structured to support the rest of the economy
Published 25/10/2015 | 02:30
Patrick Honohan will be leaving the Central Bank in December in considerably better condition than it was back in September 2009 when he arrived in Dame Street. He has had to devote much of his term as Central Bank governor to firefighting. The fires may not be decisively extinguished but the reputation of the Bank has been restored. His successor, Philip Lane, will wish to do more than consolidate what has been achieved.
The country needs a financial sector structured to support the rest of the economy without exposing it to excessive risk. Such restructuring as has occurred has been driven by events rather than by policy. One of the big lessons of the crisis is that managing an economy without a currency places heavy demands on the efficacy of financial regulation and supervision. There have been changes but there is more to be done.
The failures at the Central Bank and at the office of the Financial Regulator have been addressed in two ways. The Bank has reabsorbed the regulation function, whose separation into a distinct unit in May 2003 was a blunder and may have contributed to the subsequent weaknesses. The Bank has strengthened its in-house capacity and expanded staff numbers substantially while some of its supervisory headaches have been taken off its hands by the European Central Bank. The four largest Irish banks, including AIB and Bank of Ireland, are now supervised from Frankfurt.
The Eurozone, notwithstanding the partial centralisation of bank supervision, has not evolved into a fully-fledged banking union. Responsibility for bank resolution, that is, for dealing with banks that go bust, remains potentially a liability of national governments. There has been no progress at all towards centralised deposit insurance. Thus the Eurozone remains a common currency area rather than a proper monetary union, where the location of a bank's headquarters would not matter. This means that small countries should avoid having very big banks, since they are at hazard if things go wrong. The two main Irish banks remain, even after passing along a large slice of their dud loans to the taxpayer via Nama, quite large relative to the size of the Irish economy. While the ECB has taken responsibility for their supervision, it will not be picking up the tab if they get into trouble again.
One of the reasons why the Irish banks still have sizeable balance sheets is that they remain the principal mortgage lenders. Indeed mortgages are an even bigger slice of their balance sheets today than they were pre-crisis since the assets they have been shedding are mainly non-mortgage loans. Since mortgages are long-term (the standard product is still a 25-year variable rate offering) the maturity mismatch on their books is extreme. At one time the retail commercial banks were not much involved in residential mortgage lending in either Ireland or the UK. Somebody has to provide housing finance but it should not be assumed that routing it through the main retail banks is the only, or the safest, option for the future.
In a country with a dysfunctional housing market and a dogged political unwillingness to face supply constrictions, there is a permanent temptation to use cheap and plentiful mortgage credit to paper over the cracks. The most depressing episode in Patrick Honohan's tenure was the amount of pushback he had to endure when he insisted on tighter loan-to-value ratios and loan-to-income tests for new mortgages. The lack of housing supply in the areas of highest demand is not a problem any central bank should feel required to address for the convenience of politicians.
New rules for the adequacy of bank capital (the excess of assets over liabilities) have emerged internationally but it is open to a country to seek higher ratios from banks for whose solvency it remains responsible. If things should go wrong again, it is bank capital that provides the ability to absorb losses. It is surprising that the Irish banks, with the seeming endorsement of the authorities, are already talking about the restoration of dividends to shareholders, which deplete capital.
The return of profitability at the main banks owes much to accounting rules and to some regulatory indulgence. The banks have not been required to take impairment charges on their large burden of tracker mortgages and weak competition has allowed them to cross-subsidise the lucky holders of trackers by charging extra for variable-rate loans. In effect, the banks have been allowed to levy a kind of tax on captive customers, retaining the proceeds to fund the loss-making trackers and to show overall profits. This indulgence needs to be phased out at some stage and a ban on dividends, including dividends to the State, for a few years would be a start. It would be nice to have some renewed competition in banking but it is not easy for the authorities to bring that about.
Had it not been for the sheer scale of the Irish banking bust, one of the largest relative to the size of the economy ever to occur anywhere, there would currently be an Oireachtas inquiry into the insurance industry. Under the radar there have been two spectacular insurance failures, at Quinn and Setanta. Both will be a charge on policyholders for many years to come. In the case of Setanta the bill washed up in Ireland even though the company was supervised in Malta. Some other insurers in Ireland also survived near-fatal experiences. Banks go bust mainly because their assets (loans) go sour and are found to be worth less than their liabilities. With insurers it is the other way round. Insurance companies generate pots of cash (premiums) up front and are always liquid. But they must pay out claims over an extended period, sometimes many years into the future, and are solvent only if they make prudent provisions for liabilities. Insurers almost always go bust in the same way - claims provisions have not been adequate. The recent banking failures were the first cases in Ireland of big banks going wallop. Not so with the insurance failures - there were two bad insurance busts back in the 1980s and the record of insurance supervision has been poor. The next Irish financial disaster does not have to be a bank. The new Central Bank governor, Philip Lane, has been involved in a number of academic initiatives designed to move the Eurozone towards a less fragile structure, for example through some form of common Eurobond. There is substantial resistance, particularly from the German government, to a thorough-going redesign of the common currency area and the academics have not made much headway. To date only small Eurozone members (Greece, Ireland, Portugal and Cyprus in that order) have got into serious trouble. Since a proper monetary union has not been agreed it is always possible that the next casualty will be large enough (Italy and Spain are the popular candidates) to either force the needed changes or scupper the entire project. Of course it is also possible that the muddle-through policy will work, without either a proper monetary union or a disorderly break-up. There will be a well-stocked in-tray for Patrick Honohan's successor in December.