To
understand where the Irish banking system currently stands, one has to look at
the Irish economy’s evolution since 2000 and the integral role that monetary
and financial institutions played in that evolution. Only by taking into
account what happened in this period, can we fully appreciate the current
predicament of the balance sheets of the same institutions.
In
2000, Ireland’s economic indicators were among the best of the developed
economies. Unemployment was at a historically low 4%, the average industrial income
had reached the euro equivalent of €22,000[1],
on a par with Luxembourg as the highest per-capita income in Europe.[2]
and the Irish economy was experiencing export-led growth of near 10% per year.
Honohan (2010) notes: “a combination of higher population, higher income and
lower actual and especially prospective mortgage interest rates provided a
straightforward upward shift in the willingness and ability to pay for housing.”
The
maximum loan-to-value ratios required by banks in Ireland continued to fall
until 2006 as banks sought to gain market share in a competitive mortgage
lending market. One bank in particular led the charge and has since become the enfant terrible of the Irish banking
system[3]:
Anglo Irish Bank. To put into context the growth recorded by Anglo Irish Bank,
one can get an idea from looking at their market share. In ten years, it moved
from from 3% to 18%[4].
At this stage, it is our contention that leaders of the other Irish banks
should have turned to the central bank and warned them about Anglo; Instead,
they engaged in a competitive battle to provide loans to developers, exacerbating
a large financial problem.
The
Irish Financial regulatory system of that period was termed by one New York
Times article as “the Wild West of European finance.”[5]
Lax enforcement of banking standards meant that by 2006, over 60% of loans to
first-time buyers had loan-to-value ratios in excess of 90%. The remainder were
receiving 100% loans. Bizarrely, for an indicator which had risen almost
exponentially, banks were carrying out stress tests to factor in a 20% drop in
house prices (Honohan “What went wrong”, 2009).
Ireland’s
loan books were financing the housing boom largely by foreign borrowings and the
Irish housing market was quickly becoming over-priced. Banks sought lending (and
borrowing) opportunities elsewhere, almost always focusing on real estate. As
they did so, they exposed themselves to property bubbles elsewhere,
particularly the UK.
Real
residential property prices peaked in 2006, at which time property-related
lending account for over two-thirds of banks loans. Shares in Irish banks,
hitherto the best performers on the Irish Stock Exchange, peaked in early 2007
[insert nice figure for share price then and now] and now came under scrutiny
as the international banking crisis took hold. As
an aside, by 2006, Ireland built half as many houses as the United Kingdom,
which has a population fifteen times as large[6]. By
early 2008, Honohan (2010) notes: “net foreign borrowings by Irish banks had
jumped to over 60% of GDP from 10% in 2003.” When the credit crunch hit in the
second half of 2008, Anglo Irish Bank was unable to secure funding and turned
to the Irish government for solvency.
The
government sought to calm markets by extending a blanket guarantee for all
loans and deposits in Irish banks from September 2008 in what then Finance
Minister, Brian Lenihan termed, “the cheapest bail-out in the world.[7]”
The government – which itself was now suffering from decreasing tax revenues –
couldn’t afford such a guarantee if it was eventually required and bond markets
recognized this. Spreads on Irish government bonds increased in a continuing
spiral of economic uncertainty surrounding the country and its banking
institutions.
On
January 15th 2009, the government nationalized Anglo Irish Bank
–with the eventual intention of winding it down - as it became clear that it
would never function as a bank again, given both the state of its balance sheet
and the loss of credibility[8].
Less than a month later, Irish Life and Permanent revealed that it had
deposited €7 billion in Anglo Irish Bank in September 2008 as a favour to the
CEO. Almost simultaneously, the government takes 25% stakes in each of Bank of
Ireland and Allied Irish Bank. Days later, Anglo Irish’s annual report showed
that it had previously lent €451m to ten separate customers on the basis that
they would buy shares in the bank to prop up the share-price.
The
Irish banking system was experiencing something approaching a meltdown. After
some discussion between the Government and the agents of the said institutions,
it was decided to form a “bad bank” entity to be titled the National Asset
Management Agency (NAMA).
NAMA
NAMA
was formed in April 2009 as a means to place all of the bank’s bad assets in
one portfolio. The thought was that if the balance sheets were cleared up of
these assets, confidence would be restored to investors in the Irish banking
system. There was considerable back and forth debate at the time about how to
value the assets now that Ireland and the World at large was facing severe
liquidity problems. The largest share of assets on the balance sheet of NAMA
was commercial property (with a nominal value of €80 billion) but it also
included items such art collections and vintage furniture. It was decided that
the banks would be given between 67% and 80% of what they paid for the assets.
The government was also facing allegations that it was further enriching banks with
public money.
NAMA
allowed the government to focus on the discrepancy between what the banks had
paid for property and what the property was now valued at. In September 2010,
the Central Bank said that the bailout for Anglo Irish Bank alone could be up
to €34 billion from an earlier estimate of €23 billion. When such figures are
put in context of Ireland’s GDP, it is of little surprise that the major
ratings agencies downgraded Ireland’s outlook to “negative,” forcing up
borrowing rates. A breakdown of the NAMA loans by origin shows the
international nature of much of the debt.
Percentage of NAMA loans by origin (“assumed” €77 billion):
1. 66.8% in Irish republic.
2. 20.7 in Great Britain.
3. 6.2% in Northern Ireland.
4. 2.7% in the United States.
5. 1.4% in Germany.
6. 0.7% in Portugal and in France
7. 0.2% Czech Republic, Italy and Spain.
8. 0.3% in others.
Source: NAMA
Given
the above bank debt, which had now been taken on by the taxpayer, Ireland
couldn’t practically go to the markets to borrow money with the lending rates
it was being offered on funding markets. The IMF arrived in Dublin on November
18th, 2010.
The Troika Bailout
The
IMF arrived -in tandem with the ECB and European Commission -at a time when the
Irish Government had all but exhausted its efforts to bail out the banks.
Accepting a bailout totalling €85 billion seemed the only remaining option to
avoid default. The bailout in question totalled €85 billion, including €10
billion set aside for the banks, with a €25 billion contingency.[9]
The IMF quoted the aims of the bailout as follows[10]:
1. Identify
the banks which remain viable and return them to health through downsizing and
reorganization.
2. Recapitalized
banks and encourage them to rely on deposit inflows and market-based funding.
3. Strengthen
bank supervision and introduce a comprehensive bank resolution framework.
|
Table 1: Timeline of Irish Government interventions
in the banking sector
|
|||
|
Date
|
Event
|
Amount
|
% of GDP4
|
|
2008
|
Guarantee of the
banking sector
|
€352 bn guaranteed
|
191.7
|
|
2009
|
Nationalisation of
Anglo Irish Bank
|
Nil
|
Nil
|
|
2009
|
Capital injections
into BoI (Acquisition of preference shares for cash)
|
€3.5 bn
|
2.2
|
|
2009
|
Capital injections
into AIB (Acquisition of preference shares for cash)
|
€3.5 bn
|
2.2
|
|
2009
|
Capital injections
into Anglo (Acquisition of equity for cash)
|
€4 bn
|
2.5
|
|
2010
|
NAMA established
|
€28.7 bn
guaranteed
|
18.6
|
|
2010
|
Capital injections
into Anglo (Injection of promissory note)
|
€25.3 bn
|
16.4
|
|
2010
|
Nationalisation of
EBS and INBS
|
Nil
|
nil
|
|
2010
|
Capital injections
into EBS (Acquisition of equity)
|
€0.875 bn
|
0.6
|
|
2010
|
Capital injections
into INBS (Injection of promissory note)
|
€5.4 bn
|
3.5
|
|
2010
|
Restructuring of
Anglo and INBS
|
Nil
|
nil
|
|
2010
|
Capital injections
into AIB (Acquisition of equity for cash)
|
€3.7 bn
|
2.4
|
|
2011
|
Capital injections
to meet PCAR stress test results5
|
€17.6 bn
|
11.2
|
The
troika loans, it was agreed, would have a timeframe of 16 years and an interest
rate of over 5%. Opinions varied on the terms of the deal, but crucially, it
meant that Ireland did not have to return to the markets in the short term
(until 2013), that its immediate solvency requirements were secured and that
balance sheets in the banking system were in a healthier state relative to how
they had been two years before. Before going further with details on how the
Troika deal will be put into effect, we shall take a look at banking regulation
and the role it should play (and indeed, the role it should have played) in the Irish banking
system.
Regulation
is an effort exerted
by an authoritative agency to influence the behavioural patterns of economic agents to a certain,
pre-defined condition. This effort can assume the forms of standard setting,
information gathering and monitoring.
Financial
regulation is critical because banks play a very important role in the economy
through efficiently allocating resources; increasing capital formation;
stimulating productivity growth and acting as a repository of national savings.
The Irish
Central Bank, the regulation authoritative agency, was created in 1942. Firstly
with the task of safeguarding the integrity of the currency, the ICB later
acquired the role of protector to the banking system, introducing strict credit
restrictions on bank lending, deposit requirements on net capital inflows and
liquidity ratios for licensed banks. Extending the authoritative acting made
the Irish banking system the most “intensely regulated” in all developed
countries.
In the
1990s, Ireland assisted to the de-regulation phenomenon, when many of the
regulatory provisions, which were designed to protect the stability, were
either removed or relaxed. The relationship between the regulator and banks was
“particularly close and inappropriate” and the Central Bank was “too mindful of
the concerns of the banks, and too attentive to their pleas and lobbying”
Banks had
“green light” to operate with little regulatory oversight, exercising a profit
maximization approach by ramping up their credit outflows. The majority of this
expansion was property related, either through the financing of commercial developments
or by the provision of mortgage credit to the personal sector, conducting to
the real estate bubble mentioned before.
Banks
funded this lending through disproportionately high borrowing from the ECB, as
their deposit accounts could not keep pace with the huge growth in lending.
There were other factors supporting the
bubble beside the lower regulation intensity like tax incentives for property
development, rising income levels and pent up demand for housing.
The bursting of the real estate bubble caused the
destruction of the capital base of banks and years of steady progress and
integrity have been eroded in a few years. There was clearly a regulatory failure
and the government response
was a more intensive
supervisory regime. Senior Management at banks failed to develop appropriate
risk management structures so the objective of future reforms will be
strengthening the competence of senior personnel at banks to detect and forestall occurrences of imprudent
risk taking.
In
March of 2011, the Central Bank of Ireland put a set of procedures in place
called the Financial Measures Programme (“FMP”), which sets out to implement
the obligations for Ireland’s banks agreed between the Irish Government and the
EC, the IMF and the ECB (herewith referred to as “the Troika”). The programme
falls under three broad categories:
-
What is termed an “independent loan loss
assessment exercise,” which is an audit of the banks’ outstanding loans.
-
An annual stress test of the capital
resources of the domestic banks under a given stress scenario set by the
Central Bank of Ireland.
-
Establish funding targets for banks to
reduce leverage in the Irish banking system, reduce banks’ reliance on
short-term funding and ensure convergence to Basel III liquidity standards.
The
capital requirements listed above are calculated on the basis of the following:
-
Estimating loan-life and three-year
losses under base and adverse scenarios.
-
Modelling the impact of these losses on
balance sheets and P&L accounts.
The
Central Bank has been careful to apply such judgements in a conservative
manner, and
Claim
to have drawn on “expert accountants to inform and validate these judgements”.
Provisioning
for potential future loan losses The Central Bank's calculation of projected
losses under the stress case ensures
that banks will hold capital to meet potential future losses (even if they are
to occur only in a severely stressed macroeconomic context) at an early
stage. This goes well beyond provisions
required under existing accounting standards.
Below
is a diagram which explains how the Central Bank used the adverse (stress)
macroeconomic loan loss assessments from the independent assessors to build
appropriately conservative projected provisions for the banks. The Central
bank, it should be noted, has put capital buffers in place on top of the
recommended amounts to provide comfort concerning post 2013 losses as an additional
layer of conservatism.
As
part of the restructuring, the assessors have advised the government to raise a
significant amount of extra capital to “clean up” the balance sheets of the
four Irish banks being examined.
The
table below is what the assessors recommend, constituting a total of €18.7
billion. The recommendation is that the banks maintain core tier 1 capital
(“CT1”) of €10.5 billion before the government adds their discretionary buffer
of €5.3 billion. The
banks, under this proposal will have enough capital on the assets of their
balance sheets to satisfy Basel III, which was released some months before on
September 12, 2010.
The Central Bank
of Ireland has overall responsibility for the regulation and supervision of
Credit Institutions authorised in Ireland. The objectives in supervising
Credit Institutions are:
-
To foster a stable
banking system.
-
To provide a degree of
protection to depositors with individual credit institutions.
The Irish banking
system is dominated by two banks, Allied Irish Bank and Bank of Ireland, who
together hold over 55% of the domestic banking market. Other players on the
market include EBS, Permanent TSB and the Irish Bank Resolution Corporation
(sprung from the merger of Anglo Irish Bank and Irish Nationwide[11]).
|
Aggregate Banking Data: Covered
Insitutions
|
||
|
Date
|
31/12/2010
|
30/09/2010
|
|
|
€'000's
|
€'000's
|
|
Total Assets
|
455,600,661
|
482,753,544
|
|
Loans to customers
|
293,961,794
|
329,360,712
|
|
Available for Sale assets
|
87,336,268
|
55,957,970
|
|
Loans to Central Bank/Cash
|
11,421,052
|
9,317,653
|
|
Interbank Lending
|
14,278,158
|
15,593,387
|
|
Other Assets
|
78,603,389
|
72,523,822
|
|
Total Liabilities
|
434,684,252
|
458,329,370
|
|
Customer Deposits
|
169,442,677
|
203,364,051
|
|
Debt Securities
|
62,516,958
|
66,900,032
|
|
Subordinated Debt
|
9,812,195
|
13,146,785
|
|
Interbank Borrowing
|
167,831,781
|
148,394,866
|
|
Other Liabilities
|
27,081,641
|
26,523,636
|
|
Equity & Reserves
|
20,916,409
|
24,424,174
|
|
Total Liabilities & Reserves
|
4,556,600,661
|
482,753,544
|
|
Source: Central Bank
|
||
Since 2009, the Irish authorities have provided the banking sector
with capital injections amounting to €64 billion, equivalent to 41 per cent of
Irish GDP. These have taken a number of different forms including: preference
shares, ordinary shares and promissory notes. This section discusses the
treatment of these capital injections in the Irish Government finances.
As of
December 31st, 2010, the loan book of the four main Irish banks
looked as follows:
Loan Book of Irish
Banks (€m)
|
Product
|
AIB
|
BOI
|
ILP
|
EBS
|
Total
|
|
Residential Mortgages
|
31,014
|
59,941
|
33,872
|
15,891
|
140,718
|
|
Corporate
|
20,723
|
22,815
|
33,872
|
0
|
43,538
|
|
SME
|
19,229
|
17,305
|
0
|
0
|
36,534
|
|
CRE
|
17,124
|
20,414
|
2,049
|
841
|
40,428
|
|
Non-mortgage Consumer and Other
|
5,621
|
5,444
|
1,655
|
0
|
12,271
|
|
Total
|
93,712
|
125,919
|
37,576
|
16,372
|
273,938
|
Source:
www.centralbank.ie
One of the
main goals of the Financial Measures Programme (outlined elsewhere in this
report), is to stabilize the Irish banks. This requires that they become
smaller in terms of their loan books. The above figures suggest a loan to
deposit ratio (LDR) of 180%. The governments’ aim, in tandem with the Troika,
is to reduce this figure to 122.5%, requiring funding to the amount of around
€70 billion.
Deposits in Banks operating in
Ireland
The
picture for Ireland’s bank deposits is currently alarming. In a 12 month period
to September 2011, all bank deposits fell from near €900 billion to €600
billion. The beginning of the outflow of these deposits began at approximately
the same time as the guarantee for deposits in Irish banks expired, providing a
clear correlation for the reason behind the phenomenon. Around half of the
deposits were made by non-residents and had never been effective in the Irish
economy.
As
we have already stated, however, the funding of Irish banks doesn’t just come
from private sector deposits as it used to. The banks are now mainly funded by
Irish government money and Eurosystem deposits, a situation which will likely
continue for many years to come, unless some debt forgiveness agreement is
reached at EU level.
The Central Bank of Ireland is also responsible for
regulating monetary and financial institutions in Ireland. While the vast
majority of these institutions have avoided the spotlight because they have
avoided the hubris of the collapse of the Irish economy, they nevertheless play
an important role in the Irish banking system.
The IFSC (Irish Financial Services Centre) is a
cluster just outside of Central Dublin, where these institutions are based. The
IFSC was formed in 1987 (ironically, after the Irish government of the time had
sought EU approval)[12]as
part of the Financial Services Act of Ireland. The initial aim was to create
employment in Ireland by offering incentives (including a special 10% tax rate)
to certified international companies who agreed to set up operations in the
IFSC.
With the favourable tax regime in place, hundreds of
blue-chip financial firms were attracted to Dublin. Despite most not offering
much employment (no strings were attached to using Dublin as a corporate
tax-haven, which meant that most firms in the IFSC became shell or special
purpose vehicles), the IFSC now employs over 14,000 people primarily in
back-office services for major international banks and insurance firms.
The IFSC website reads: “More than 500
operations are approved to trade in under the IFSC programme. The centre is
host to half of the world's top 50 banks and to half of the top 20 insurance
companies. Merrill Lynch, Sumitomo Bank, ABN Amro, Citibank, AIG, JP Morgan
(Chase), Commerzbank, BNP Paribas and EMRO are just some of the big-name
operations that have chosen to locate in the area.”
“Ireland’s banks will be
significantly smaller in future.”
Brian
Cowen, then Ireland Prime Minister, November 22nd, 2010[13].
More
than one recent report has hailed the progress of the Irish banking system and
the economy at large. The so-called Troika of the EC, ECB and IMF released a
statement on October 20th, which said: “Deleveraging
of the banking sector is progressing as planned, despite challenging conditions
and banks have secured term funding reflecting improved confidence. Further
progress in these areas is needed to allow banks to fulfil their essential role
in the economy.”
Despite
what the Troika suggest and meagre growth figures experienced by the Irish
economy, an alternative scenario is that Ireland is in fact, insolvent. It owes
more money than it can realistically pay back. By official estimates, by 2015,
Ireland will have a national debt of about €200 billion. High profile Irish
economists such as Morgan Kelly have predicted that that debt will reach
upwards of €240 billion, with the banking component being close to €100
billion.
When
two Danish banks failed in early 2011, their senior bondholders were burned.
This raised funding costs for the entire banking system in Denmark[14].
The savings for Ireland of burning bondholders – from an EC and ECB perspective
– would be offset by an increase in funding costs across the board in the
Eurozone. However, the current political uncertainty surrounding the Euro,
Greece and even Ireland, suggest a less optimistic perspective for the Irish
banking system, at least in the medium term.
It
is our prognosis that a solution needs to be found for the mortgage crisis
hanging over Ireland before the banking system mends itself. Mortgage lending
in Ireland in 2011 has reached its lowest level since 1971,[15]
which is an even starker figure when one considers how much the Irish economy
has grown in the intervening years and that the population of Ireland has grown
by about 50% in the same period. This isn’t a voluntary move on banks’ behalf
in that mortgages are being offered – it’s that the general population doesn’t
want to invest in property after what has happened in Ireland. The result is
falling property prices[16],
increased negative equity for private homeowners and less mortgage-lending
opportunities for the Irish banking system, which traditionally uses about 5-7%
of its loan book for mortgages.
On
August 29th 2011, the Central Bank released a quarterly report on
mortgage arrears (which serves as a proxy for the default-rate on the Irish
banking systems’ loans), which showed the fastest increase yet in the fraction
of mortgages that are more than 90 days in arrears. The figures arising from
the report, according to one economist, “raise questions about whether the type
of light restructurings that the Irish banks have been applying to distressed
mortgages are sufficient to deal with the problem.”
Alternative scenarios for the Irish
Banking System
The
stress tests carried out by the government and their independent assessors
account for one course of action (albeit, one course of action in varying
economic conditions) for the Irish banking system: that is, that all
outstanding loans, both junior and senior, are paid in the future. Of course,
this is a little like the example of Net Present Value; it fails to take into
account the several other options (or situations) that can confront the Irish
banking system, the Irish government and the Troika.
An
organization called “New Beginning” has been established in Ireland by a group
of legal firms, who contend that Irish citizens are bearing too much of the
burden of the debt in the Irish banking system. At present, it’s not clear what
form of easing of consumer debt that they are proposing. A meeting was held
with the Department of Finance in mid-October and at the time of writing, the
transcript has not been released. Given that the Department of Finance is
answerable to the Troika, not much can happen in the short term with any
proposal put forward by this organization.
There
is a movement towards so-called “debt forgiveness” in Ireland (quotations marks
in place because alleviating the debt of one citizen effectively raises the
debt of another). None of the methods of doing so thus far have been
satisfactory to the government. It is possible that the Troika will be
convinced – provided the euro is saved – that “haircuts” will be allowed on
some of the debt, particularly that of junior bondholders.
Further
still down the line, it is not difficult to see a foreign banking corporation
taking at least a minority share in one or both of Allied Irish Bank and Bank
of Ireland[17].
By integrating its loan book into that of a far bigger bank, an Irish bank
could gain a better credit rating almost overnight, allowing it to go back to
international money markets and start providing credit to the Irish economy
again. Any foreign banks would likely want to wait for the inevitable de-sizing
before this occurs, however.
Whatever
course the Irish banking system takes, it is sure that its current composition
will change dramatically in the coming years. Changing domestic legislation,
Basel III and funding requirements will ensure that this is the case.
Bibliography
Websites:
Reports:
Central
Bank of Ireland 3rd Quarterly Report, 2011
Central
Bank of Ireland, “The Financial Measures Program Report,” 2011
“The
Irish Banking Crisis: Regulatory and Financial Policy 2003 to 2008,” A Report
to the Minister of Finance by the Governor of the Central Bank
“Misjudging
Risk: Causes of the systemic banking crisis in Ireland,” Report of the
Commission of Investigation into the Banking Sector of Ireland, March 2011.
Academic
Papers:
Honohan,
P., 2009, “What went wrong in Ireland?” Trinity College Dublin/World Bank
Kelly,
M., 2011, “A Note on the Size Distribution of Irish Mortgages,” UCD Economics Department
Working Paper WP11/17
Audio:
The
Hugh Butler Lecture series: Morgan Kelly. August 2011.
[1]
www.cso.ie
[2]
Preliminary Report into Ireland’s Banking Crisis, 2009
[3]
Before becoming the enfant terrible, Anglo Irish Bank was awarded the title
“Best Bank in the World, 2007” by Banker Magazine. On accepting the award,
Anglo Irish Bank chief executive David Drumm said: “We have a strategy that has
remained clear and focused.”
[4]
Honohan, 2009
[5] “Insurers’ Trails lead to
Dublin,” New York Times, 01/04/2005
[6] Morgan Kelly, The Hugh Butler
Lecture, August 2011
[7] “Irish bailout cheapest in
world, says Lenihan,” Irish Times, 10/10/2008
[8] The Irish Times featured an
article, which said that Anglo Irish Bankers were either “exceptionally bad
golfers or extremely generous to customers,” after it emerged that they had
spent over €200,000 on golf balls between 2006 and 2008.
[10] IMF.org
[11] On announcing the name-change,
the Irish Minister of Finance, Michael Noonan said that the name-change was to
remove "the
negative international references associated with the appalling failings of
both institutions and their previous managements” Cited in the Department of Finance Website, July 2011.
[12]
www.ifsc.ie
[13]
http://www.irishtimes.com/newspaper/ireland/2010/1122/1224283834707.html
[14] “Rationale behind ECB opposition
to burning bondholders,” Irish Times, 23/09/2011
[16] Property prices in Ireland had
the second steepest falls in the world in 2010.
[17] “Foreign takeover of Ireland’s
banks is now a real solution,” Irish Independent, 18/11/2010
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