Monday 26 September 2016

Have we missed our last opportunity for banking reform?

Rory Gillen

Published 26/07/2015 | 02:30

We are not the first country that did not understand money and risk — and as a consequence, suffered a financial crisis
We are not the first country that did not understand money and risk — and as a consequence, suffered a financial crisis

How very refreshing to see Toshiba executives resigning en masse last week when found to have cooked the books in one of Japan's legendary companies.

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No one should accuse the Irish politicians and bankers who presided over the nation's fiscal and banking bust of dishonesty - but what a tonic it would be to hear them admit what we all know: that they were incompetent.

We are not the first country that did not understand money and risk - and as a consequence, suffered a financial crisis. In fact, history is littered with examples.

With a fixed exchange rate system after the introduction of the euro in 1999, European banks didn't price the risk of lending to Ireland correctly - and our banks were able to suck in finance from Europe at cheap rates.

They then lent this borrowed money on - against grossly overvalued property assets, and to developers that were too dependent on debt rather than having a more appropriate mix of equity and debt.

The Regulator - who was supposed to understand money, banking and risk - simply didn't have a clue. Do we really need a banking inquiry to tell us this?

They say a tragedy should never be wasted. And an area where I feel the potential for reform has been wasted is in the Central Bank's mortgage market reforms of 2014.

Many ordinary house owners have suffered significantly for the past seven to eight years. This occurred, and will occur again - as most people do not know how to value an asset or assess risk.

And if they can't do that, then how can they know what price to pay for a home, and how much debt to take on?

In contrast, I feel the mortgage system in the US better protects the ordinary person.

There, banks lend against the property and not to the person. The banks are charged with valuing the asset - and they generally do not have recourse to the borrower.

In implementing their reforms, the Irish Central Bank has tried to lower the risk for all parties in the Irish mortgage market by restricting the amount of credit one can attain on a property. But this is a woefully blunt approach, as it does not distinguish between the person with resources and the person without.

So now we have banks declining to provide credit to many who can easily handle a higher proportion of debt on a property (due to a better quality of income or a myriad of different factors).

A system that forces the banks to assess the credit risk of one buyer versus another leads to a better functioning credit market. It forces banks to price the risk.

And is that not what banks are there to do - to assess the risk in individual mortgage applications?

This approach leads to credit being more costly for one borrower versus another. But the price of credit (that is, debt) should vary with the risk. The insurance market works this way, so why not banking?

Approach the mortgage market this way and you dispense with the need for a large portion of the regulators now employed; you force the banks to take the consequences if they price risk incorrectly; and you free the ordinary person in society from being persecuted for a lifetime for not knowing how to value an asset. What a lost opportunity for meaningful reform!

A chasm separates clock builders and time-tellers

Three big technology giants reported their second quarter results last week, with Apple and IBM turning in disappointing figures, though Google returned to favour with decent numbers - and more importantly, talk of more discipline in how it redeploys its vast cash flows.

After all, there's not much point in generating a 30pc return on capital if you fritter it all away on a constant stream of Tomorrow's World projects. Don't you find it amazing that Google has yet to pay a dividend to shareholders?

That said, in a world where there are clock builders and time-tellers, I'd rather own the clock builder. A time-teller can assist you to tell the time while he is around, but the clock builder is better as he builds the clock from which anyone can tell the time.

Google's search engine is indispensable.

Likewise, IBM has being doing business with 70pc of the Fortune 500 companies for decades.

Both look like business models that will survive, companies where future managers should just slot into where current management leaves off.

IBM may be having some near-term difficulties in exiting its traditional hardware businesses and transitioning to cloud, big data and analytics software support services - but it should get its fair share of this evolving business from customers it has been dealing with for decades.

Apple, on the other hand, looks more like the time-teller. It appears to me that management has to continually invent new products as old ones become obsolete. And the master time-teller, Steve Jobs, is no longer there! The clock is ticking...

Gold and the bloodless verdict of the market

Gold is hard money and nothing more than that. In a world swimming in central bank-created paper money, you'd think the gold price would be riding high as the only currency that cannot be printed ad infinitum.

Paper money printing has generally led to inflation, and the alternative hard currency - gold - has been a good protector against such inflation over the millennia.

But last week the gold price broke to new lows in a downtrend that started nearly four years ago. I guess the relevant question now could be: is inflation a threat or not?

The argument in favour of inflation is that money printing by central banks has never worked in history - and that as economies recover, all that excess money that has been printed by the central banks will create inflation, much as it always has done in the past.

Of course, inflation is needed, given the debt load in most economies. A necessary start, in my view, is an increase in incomes for many in society - so the recent plans to increase the minimum wage in the United States, the UK and Ireland is a move in the right direction.

After all, how else can people pay back debt and cover rising costs (rents in particular) if incomes don't rise?

But the effort must be across borders if one country is not to lose competitiveness versus another. Tricky!

The argument against inflation is that the real money printing occurred between 2003 and 2007, when the banks in the developed world over-lent to property. The resultant global credit crisis unleashed a huge credit contraction in the western banking system, which of course was deflationary.

With quantitative easing, central banks have simply offset the credit contraction and inflation fears are overdone.

As the saying goes last week's "bloodless verdict of the market" suggests no inflation.

Not yet anyhow.

Rory Gillen is author of 'Three Steps to Investment Success' and founder of GillenMarkets, a subscription-based online investment newsletter. See more at

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