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Professor John Cotter comments on crises in the banking sector

Date: 29 May 2009

Author: Professor John Cotter, Director of the Centre for Financial Markets and Associate Professor in Finance at the School of Business, University College Dublin

Irish financial system in crises:

Each economy has suffered a unique variant of the global financial crises. This column details Ireland’s financial crises and the perilous situation facing the banking and property sectors. It describes the drivers of the financial crises and the response of Government. It identifies weak policies especially in the early stages of the crises. However recent decision making has improved somewhat which bodes well for the future.

Crises in the banking sector and attempts to refinance:
Similar to other economies two sectors of the Irish economy have been seriously affected by the global crises. As well as the housing sector the health of the whole financial system has been seriously questioned. Irish banks were highly leveraged on property, and as their value collapses (and very difficult to price) it furthers the pressure on the banking system.

While it is understandable to make mistakes during crises the Irish Government made some fundamental errors in how it handled the worsening of the financial system. To give an example: late last September led to the introduction of the Irish Government Bank Guarantee Scheme whose primary aim was to allay fears that the deposits at Irish banks would not have sufficient assets to cover them. This scheme was introduced as a fait accompli with sketchy information given. Throughout the crises the information set has been very poor impacting negatively on resulting decisions taken.

It looks like the Government has agreed to guarantee the liabilities of approximately €400bn (over two times annual GDP) and charge a small fee - €1bn over the two years of the scheme - for doing so. Unlike other international schemes this was a blanket guarantee covering all liabilities. Six Irish institutions were covered with no attempt to distinguish the relative probabilities of each bank calling in the guarantee. Since then it has become very clear that there are large risk imbalances associated with each bank’s covered liabilities.

This guarantee scheme are similar to pension guarantee schemes (see Marcus, 1987) represented a (very) cheap option being sold by the Irish government on behalf of taxpayers so as to cover an inability of Irish banks to cover their liabilities due to insufficient assets (loans heavily immersed in property).

No attempt was made to avoid adverse selection: all banks were covered with no distinction made on the relative risk of each bank and their subsequent potential for the option being exercised.

Moreover, there does not seem to be any attempt to control the moral hazard of those banks insured by the scheme. The government has been very slow to control the activities of the banks and their management and information only appears to be forthcoming when further government support is required.

Some would go further and argue that the information set that the guarantee scheme was based on was cloudy at the very least, and potentially incorrect where the valuation of the banks assets could not be truly ascertained. You could argue that in a crisis a poor evolution of information is common and as a result decision making is detrimentally affected. However, this does not excuse the weak attempts at extracting relevant and correct information from the banks.

It was suggested around the guarantee scheme that Irish banks were healthy as they had assets of €480bn that exceeded liabilities. However as these assets are heavily sourced from property loans it calls into question the state of the banks, and this is especially true for those with a strong dependency on commercial and residential real estate.

Earlier mistakes feeding into current decision making on banks
Recently financial support for the Irish financial institutions has been done under the guise of providing support for institutions of systemic importance. But there are six of them (and given the fact that they do not consider themselves to be systemic given their behaviour and how they provide information to the government) for such a small economy it seems a strange interpretation of the term. Also it is becoming very clear that some of their assets are really bad with little value and a large proportion declining rapidly. It may be time to be stricter in our definition of who the government provides systemic support to.

Since the guarantee scheme we have had a recapitalisation scheme in December where money allowed for supporting three banks. By mid-January it was decided that the recapitalisation scheme for one of the banks covered, Anglo Irish Banks, was insufficient and it was nationalised. There is a major information deficit here with further recapitalisation being required by the same banks (who received sufficient funding!) just a just short time earlier. There is also a corporate governance problem for the banks that in the first instance, would not apply prudent decision making, and in more recent times, seems to be more about personal survival than facing upto the problems facing the banks.

Given the lack of capital for many of the banks there has recently been a debate on whether temporary nationalisation is required or whether their assets will be taken over by the government at some appropriate value. The government has chosen the latter approach and have set up the National Assets Management Agency (NAMA) whose function is to buy the assets (to the suggested value of €80-90bn) of distressed banks.

This is a very high risk strategy being undertaken by the Government. It strongly depends on getting correct valuations of the assets being covered as these are property related which are falling in value with no sign that they reached the bottom of the trend. It is also highly dependent on the correct information being given to NAMA and given what we have seen of the banking sector in recent months there would be very little evidence of this.

Note I mentioned that a debate has taken place. Although not everyone is in agreement with the decisions now being made it is an improvement on how government has been responding to the financial crises in its early days. Then there was either straight denial or attempts to bully the decision making process.

Dysfunctional property market
A main driver of the financial crises is related to property. Overall the property market – both residential and commercial real estate – can be considered highly dysfunctional. Take for example residential property: average prices increased by 270% in the ten years through June 2006. This created a boom in the property sector with those involved becoming very prominent in terms of wealth creation and decision making in the economy. Since its peak in February 2007 the market has fallen by approximately 20%, although, fortunately this decline has been reasonably staggered with price movements of around 1% per month. However, very few would forecast that the market has reached its trough.

The dysfunctional property market was supported and facilitated by policies and activities of both Government and the banking sector. Government directly benefited from the transaction stamp duty and capital gains from price appreciations. Moreover, policies supported the property sector as an important source of economic growth. Banks growth and profitability soared (one of the most well known is Anglo Irish Bank that increased almost 10-fold in market capitalisation from 2000 to 2007) and their property loan portfolio was identified as the main source of their successes. Also, Government through the regulatory bodies (mainly the Irish Regulator) had a soft supervisory stance that involved weak surveillance and monitoring of the banks’ property based loan portfolio.

We are still at an early stage of working through the unravelling of the dysfunctional property market. At present there appears to be little pressure being put by government on both banks and developers to ensure that the property loan books realise their maximum value.

The Irish subrime
Just like the US many would blame the financial leverage associated with the housing sector. And we even had our own subprime market although it is distinct from the US one (and we did not have our financial firms investing heavily in these products in secondary markets). The Irish subprime, unlike the US, did not originate from providing loans to individuals to purchase single units with poor credit. Rather it involved providing loans to property developers to build multi-unit blocks. So in primary markets you had a small number of players borrowing relatively large amounts.

However the Irish subprime has many of the characteristics of its US counterpart: the credit history of the borrower was not substantiated with respect to the amount borrowed, poor supervision of the process and high debt to assets ratios. It was the size of these loans that led to them being very high risk given what underpinned the value of the multi-units.

Stock market performance
Turning to equities, the Irish Equity market has performed dismally, driven by the large declines in financial firms who historically dominate the market. Year on Year the market fell by 66% in 2008 following a decline of 26% in 2007 and thus far the market has continued to decline in 2009 being down by 6% at the end of the first quarter. This is in stark contrast to earlier in the decade when the market outperformed many international counterparts (Cotter, 2004).

From this smaller aggregate market the influence of bank stocks has reduced from almost 40% of total market capitalisation at the start of 2008 to less than 10% in 2009.

Worryingly the market is showing all the signs of being uncompetitive and this is coming from a very small base where thin trading was always a key characteristic. Today there are very few promising features with almost non-existent primary market activity, much reduced turnover and a dwindling number of listed firms. Regardless of the recognition that many of these features are a result of the global financial crises questions of the future of the market are becoming increasingly vocal.

Bond market performance:
A much closer eye is now being cast towards the Irish bond market given the Government’s requirement to raise new finance through debt issues. The analysis has been mixed but there may be more hope starting to emerge in terms of the economy’s credit worthiness and its ability to obtain further funding.

Whilst serious concerns have been raised about the spreads between Irish bonds compared to their Euro counterparts (yields were almost twice for Irish Bonds compared to German ones) this spread appears to be narrowing as time progresses. The credit default swap spreads have also narrowed.

Of equal concern is the reduction in credit rating from AAA from leading agencies. Although to counteract this, the Department of Finance and the Government’s asset and liability management agency, NTMA, are pressing the flesh in European markets in an attempt to minimise the bad publicity relating to Ireland’s poor credit worthiness. Overall the NTMA has successfully been able to issue new bonds on a number of occasions in 2009 although with weak demand and low associated coverage.

Overall the ability of the Irish Government to raise finance through debt issuance is starting to see more positive results as time progresses.

Macroeconomic indicators and the overall picture
There is no doubt that the Irish economy has taken a large hit from the global financial crises. Many of the economic indicators have worsened considerably with forecasts suggesting that things will get worse before they get better.

Economic activity has collapsed with the economy expected to decline by over 9% in 2009 (the largest in the Eurozone). This follows a contraction of almost 5% in 2008.

The state of the economy is understandable given its textbook description of a Small Open Economy (SOE). We became quite uncompetitive in export markets at the start of this decade through uncompetitive salaries and trading in strong currency markets (our two largest markets are the US and the UK). This lack of competitiveness has, if anything, increased in recent times with the appreciation of the Euro against both Sterling and the Dollar. Trading in the Euro has been criticised in this context, but there is general agreement that the systematic external pressures from membership of the Eurozone will help to develop and enforce economic policies in the long term that benefit the economy.

During the economic boom policy makers lost their focus on the importance of export markets as domestic demand rocketed through the property bubble and it is now very clear and worrying that we may not be able to exploit the SOE features of the economy when world economic growth takes off again especially given the forecasts for our input costs and the currencies in which we trade.

On a daily basis the population are feeling the human costs of the Irish version of the crises: Unemployment rose gradually from 4.5% to 6.1% during 2008 but it has recently soared and more than doubled to 13.2% by April of this year. The forecasts suggest that it will continue to rise with almost 1 in 5 out of work next year.

Public finances (that were driven by the property boom) have become extremely unhealthy with the most optimistic forecasts of budgetary deficits in excess of 10% of the economy’s GDP. This has tied the hands of policy makers in trying to boost government expenditure and domestic demand.

Moreover our very healthy debt situation from a couple of years ago has understandably deteriorated considerably as the Government continues to borrow to finance its activities. Our debt to GDP has risen and is expected to double by then end of 2009 with a further deterioration expected in 2010.

However we do have a National pension fund (sovereign wealth fund) that was financed whilst we experienced our strong growth. The use of this pension fund is critical as Government has shown their willingness to support our ailing economy. Hopefully it will not be used to finance the bail out of our banking and property sectors.

Taking all these indicators has led many to question the wriggle room the Irish economy has in trying to kickstart the economy. Given the very poor public finances the increased debt is not being earmarked to bolster the economy. In addition, increasing taxes with reduced government expenditure could imply that, even with increased international demand, we are unable to get the economy growing when the world economy starts to rebound.

What we do have are positive characteristics that are in place since before the crises (eg. low corporation taxes and an educated English speaking workforce) (Honohan and Walsh, 2002). Hopefully they will help attract new engines of growth.

Overall the Irish economy has suffered extensively from the financial crises. Whilst we are not near the end of the cries there is some evidence that the poor state of the economy will start to improve.

Acknowledgements: Thanks to Karl Whelan.

References
Cotter, John (2004), “Viability of the Irish Equity Market”, Irish Banking Review, Summer, 42-54.
Honohan, Patrick and Brendan Walsh (2002). “Catching Up With the Leaders: The Irish Hare,” Brookings Papers on Economic Activity, (1):1-77.
Marcus, Alan (1987), “Corporate Pension Policy and the Value of PBGC Insurance”, in Bodie, Z, Shoven, J, and Wise, D (eds), Issues in Pension Economics, University of Chicago Press, Chicago, 49-76.

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Professor John Cotter comments on crises in the banking sector

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