David McWilliams: How banking collapse turned into dramatic hostage crisis

June 26 2013 04:05 AM

THE brilliant English economist John Stuart Mill, writing in the 1860s, noted that "a crash doesn't destroy wealth, it merely reflects the extent to which wealth has already been destroyed by stupid investments made during the preceding boom".

Mill's way of looking at financial crises, examining the period well before the bubble burst, when the boom masked the progressive destruction of wealth, remains the most constructive way to look at any financial crash, including the great Irish banking/property crash.

Let us not forget that every bank in Ireland went bust. It didn't matter whether the banks were locally or foreign run and owned. They all indulged in reckless lending and they were all bailed out.

To date there hasn't really been a satisfactory answer as to how exactly this happened deep inside each bank and why there didn't seem to be even one dissenting bank. Nor is there any real answer as to why the Central Bank and the regulator ignored all the warning signs, or why those few who did warn and publically stressed the dangers of all this reckless lending were scorned and vilified.

The endgame of banking crises all over the world, if nothing is done in the boom to slow down lending, are bank collapses. These meltdowns are caused by bank runs. Those at the bottom of the queue – depositors – will lose everything without somebody plugging the hole in the banks.

The lesson from both the Great Depression and the Asian crisis is that a bank run is much more damaging to the economy, to employment, confidence and income than even the shock of the crash itself. The loss of deposits eliminates the wealth of the middle classes. If you doubt this can happen even when banking crises are managed, consider what has just happened to Cypriot depositors.

In recent years, the notion has been raised – at ECB level – that depositors are "lenders" to the bank and therefore, when banks wobble, the depositor should expect to lose money.

But this is a terribly mistaken interpretation of what goes through a person's head when they deposit money in a bank. Most people deposit money for safekeeping. You do this for the rainy day. Your savings are what you have when all the other bills are paid. It is your nest egg.

Yet, every time a loan was made, every time a bank in Ireland scrambled to extend money for some development or other, ordinary people's deposits were risked because more and more wealth was being destroyed.

Deposits were not sheltered. Even after the Northern Rock collapse and the collapse of Bear Sterns on St Patrick's Day 2008, neither the Irish financial regulator nor the Central Bank drew up a bank resolution mechanism to protect depositors in the event of a crash.

But how was the situation allowed to get so out of hand?

Bear in mind all the banks were at the same game. It wasn't just Anglo. AIB and Bank of Ireland doubled their loan books in the three or four years preceding the crash.

The other banks copied Anglo's lending approach by lending as much as possible, and they also followed Anglo's funding model, by borrowing as much money as possible in order to fuel the binge. This is where the infamous bondholders come in.

Obviously, when lenders to the banks are confident of getting their money back, they are prepared to lend for long periods. But they began to panic, triggered by a property market crash, and demanded their cash back.

This mismatch between liabilities (what the banks owe) and assets (what the banks have lent out) is often why banks go bust. They lend out for very long maturities but they are financed by very short maturities.

So, when a crash comes, they can't call in their loans (their assets) because they are illiquid and lent for, say, 20 years, but the people they owe money to (their liabilities) can ask for their money back the very next day. The fragile nature of a bank's balance sheet means that wise and vigilant regulation is paramount.

Failure to oversee the system meant that when the panic came, the authorities were not faced with good and bad policy options. All the options were bad. It is a question as to which option was the least bad.

Once a banking boom leads to a banking bust, the entire drama becomes like a hostage situation. On the one side you have the kidnappers – the bankers – who threaten that if they are not bailed-out they will shoot the hostage, meaning the economy and the deposits in the bank. They threaten the authorities as follows: if you don't do as we say, we will allow a bank run and your people will lose their savings and your economy will stall because your payments system will break down. The ransom is the size, type and duration of the bailout.

The government which has already suffered a monumental intelligence failure as the regulators and the central bank have failed abjectly, faces a choice: are the kidnappers bluffing or do they have a nuclear option which they are willing to use?

This is what the Irish Government faced in September 2008. It was a hostage crisis. And we know from the Anglo tapes that the attitude of the kidnappers ranged from the cavalier to the sociopathic.

While outside governments such as Germany and the UK may have said "you shouldn't deal with kidnappers" or "we wouldn't have done it that way", in terms of concrete plans there was nothing coming from the ECB.

The guarantee was temporary to stop the flood of money leaving the country in panic. Once the panic had subsided, it ought to have been rescinded and followed by a resolution mechanism whereby bondholders were picked off one by one in an orderly fashion.

Why this didn't happen in the subsequent months/years remains a mystery, particularly when it became obvious that the bankers were lying about the extent of the losses.

Would it have been a runner to do nothing in September 2008, call the kidnappers'/bankers' bluff and risk a run on the banks where depositors would have lost everything?

The Irish banking crisis didn't start in September 2008; it started years earlier when bank after bank abandoned prudence and risked everything for short-term profits and personal bonuses. It ended up as a hostage situation with kidnapper/bankers threatening the economy and deposits, leading to the state guarantee. This option was the consequence not the cause of the financial meltdown.

By David McWilliams