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Banking Crisis

A Contrary View

Some media personalities and political pundits have over-stated the case for placing the blame for Ireland’s current economic mess on the government’s recent policy decisions.  The two big recent decisions of the Irish government (insured deposits and new bank capital) appear to me quite defensible.  If I may bring some controversy to the blog, here are three statements making the media rounds that I think are false:

1.  The primary cause of the Irish economic crisis was bad decisions by Irish policymakers and banks.

The statement above is false since the primary cause of the Irish economic crisis is the US-generated global credit crisis. This credit crisis in turn was caused by disastrously bad decisions by US policymakers (Congress, the quasi-state agency Fannie Mae, the SEC and Federal Reserve) and the U.S. finance industry (mortgage originators, ratings agencies, investment and commercial banks).  The too-weak oversight by the Irish central bank and financial regulator left the Irish bank sector very vulnerable to an external shock, as did the Irish government through its tax-and-spend policies, but these are both secondary not primary causes of the economic crisis.  It is a counterfactual and impossible to scientifically test, but I speculate that in the absence of the U.S. credit crisis, the Irish economy would have experience a somewhat bumpy “soft landing” from its 2002-2005 excesses. Without the US-generated crash, the 2009 situation would have been nothing like what we are in.

2.  The government decision on September 30th to insure all bank deposits was obviously foolhardy and inconsistent with careful economic analysis.

This statement is false since it might possibly have been foolhardy but that is not obvious. As Brunnermeier notes in his recent JEP article, the 2007-8 credit crisis brought a new type of bank run, what he calls an “investment bank run.”  This is a bank run between institutions, where banks lose trust in one another and the relatively strong banks attempt to cut all credit ties to the weaker ones. As the Lehmann Brothers disaster shows, this can be a very destructive type of bank run due to the complex interlocking relationships between large banks.  Going back to the classic Diamond-Dybvig model, a bank run can be stopped by the monetary authority providing or promising monetized liquidity to all depositors.  As soon as the depositors realize that this monetized liquidity is available, the bank run ends.  There is a long-term moral hazard problem of course, but bank runs can be stopped in this way, and it usually works in practice.  So the government’s action was consistent with reasonable economic analysis of the situation.  Unfortunately Diamond and Dybvig wrote their paper before the advent of the Euro, so they do not explain what happens when the national government does not control monetary reserves.  Still, it seems a defensible policy move under the circumstances.

3. The capital injection into the two big banks is wasted and/or inadequate since they are obviously worthless on a net-value basis.  The current share prices are just the speculative value of an out-of-the-money call option.   

The second sentence of this statement might be true (Patrick Honohan made this point earlier on the blog) but the first sentence seems false.   Relatively big banks in small economies probably have considerable economic value even when their market value is near zero or effectively negative on a net basis.  The two big banks will pull through their current “negative value state” and eventually return to being profit-making institutions, with appropriate government support during the current crisis.  Banks are almost always insolvent on the basis of current liquidation value.  The fundamental nature of a bank is that it is a device for changing liquid deposits into illiquid loans.   Government capital support for the banks at this stage seems defensible.  The alternative of full nationalization of all the banks (not just the rogue bank Anglo Irish) carries too many risks for the economy.

16 replies on “A Contrary View”

In Diamond-Dybvig, the critical point is that the banking system assets have their full value when held to maturity so the bank run is a pure liquidity crisis, not insolvency. Does anyone think that troubled Irish banking system assets have that characteristic?

It is clear that the current crisis in Ireland has many causes.

The financial crisis is of course to a great (?) extent external (though not entirely) but we are in a much bigger mess, and this other part of the crisis is home made. In that context it is quite valid to wonder if other/better policies could have been adopted.

One of the big distinguishing features of our crisis is that the exchequer is in a terrible state. That has little to do with the US crisis. Instead it has a lot to do with the heavy reliance on construction related taxes (a large chunk of corporation tax also came from financial services – I suspect that there is not much coming in from there for a while) and a rapid expansion of public service employment and current expenditure. I don’t think we can blame the US for that. Nor should anyone pretend that there were no warnings – while 3 years ago nobody predicted the kind of deep crisis we are in now, quite a few raised the issue of the housing market and rapid growth in public expenditure. There is no evidence that these warnings were heeded.

What about the failures in banking regulation? Surely those are homemade too?

The Irish economy ‘went off the rails’ a long time ago (in my opinion sometime around 2003) and that has little to do with the US. Have a look at the sources of recent growth – largely construction, public sector, financial services and retail. Construction was bound to contract (crash) and you can’t keep on expanding the public service indefinitely so those two sources of growth were unsustainable (and were known to be so). We know what happened to third one!

I am shocked by your analysis in point no. 1

The Irish economic crisis is primarily our own making. The US crisis just revealed that the emporer had no clothes, it pulled the trigger but it didn’t load the gun.

There can be “disastrously bad decisions by US policymakers and the U.S. finance industry” as a root cause in the US but not in Ireland? I’m sorry, but that’s BS.

If lending was restricted to a low multiple of income, it’s pretty safe to say that we would not be in this crisis. If lending was restricted to a maximum of 80% of the value of a home, we would not be in this position.

One would imagine that this, in turn, would lead to banks looking for other revenue streams such as investment in business rather than the one way bet they had taken as they were sure to get a better return on property.

Consumption & investment would have been further diversified throughout the nation rather than focused on property.

Sure, we were exposed to low interest rates by the ECB that were beyond our control, but this could have been countered by the restrictions I mentioned. We would not be suffering to the extent at present and will in the near future.

This crisis is of our own making, it originated here, it’s Irish. Ireland is different. We, as a nation, did no have to follow the irresponsible practices of others. Just because the US put their hand in the fire, doesn’t mean our policymakers & banks had to.

Point 1 above is on shaky ground because if that was true the Canadian banks should be in deep trouble now because of Canada’s massive exposure to the US economy. However, the six major Canadian banks had their lobbying efforts for laxer regulation resisted by the Federal Government and TD Bank got out of derivatives just in time, when newly appointed CEO Ed Clark realised the guys supervising the derivatives traders had no clue how they worked.

In short, even in a slump good instincts in regulation and management save banks.

A timely piece, Greg.

Perhaps, though, you understate the degree to which the scale of the Irish construction boom and of foreign borrowing to finance it have contributed to our problems — an interesting and unresolved question is how to decompose our problems into home-grown vs globally caused. For sure they are not simply additive factors.

On the guarantee, I agree that an extensive depositor guarantee was made more or less inevitable by the failure in September 2008 of Anglo-Irish bank. But it was still a flawed action:

(i) I would not have guaranteed subordinated debt;
(ii) I would have taken the opportunity at that time to place Anglo into administration;
(iii) I would have made more use of the long-standing network of communication and collaboration between central banks in Europe to get whatever assistance might have been available, and to avoid the kind of damaging international reaction that occurred.

I’m not sure the timing of events supports your view, Greg. Real house prices in Ireland peaked in 2006:Q4. By the time the first wave of the international crisis hit in August 2007, real prices were already down 5 percent from the peak and nominal prices were dropping. Expectations of future prices had turned. The bubble had burst. By the time LB went belly-up in September 2008, the property crash here was well underway. As you say, counterfactuals are hard, but it sure looks like the we were going to have a hard landing, irrespective of what happened abroad. But, of course, nowhere near as hard as what is developing.

You note that “[t]he alternative of full nationalization of all the banks (not just the rogue bank Anglo Irish) carries too many risks for the economy.” Could you be more specific about what additonal risks for the economy nationalisation would give rise to, over and above the risks we already face?

I also disagree emphatically with point (1). The extent to which the Irish economy had become reliant on construction and property related activity was alarming and the crash totally predictable. This in turn was very much down to Irish policymakers making bad Irish policy (lack of use tax on land, Euro interest rates, legal framework for planning and apartment dwelling, one off housing etc.)

It is almost impossible to imagine any situation in which a soft landing could have come about.

It is even worth considering that perhaps our crash would have been all the more fiery had the global economy moved the opposite way in 2007/2008, because at least now we are cushioned by falling import prices and falling energy prices: whereas in a global boom our competitiveness would have been just as eroded and imports would have stayed dear.

The Irish Bust may have been delayed if the US credit crunch had not arrived. Sadly it’s likely it would have been even worse when it eventually came. Ireland was coming to its Minsky Moment sooner or later when the entire financial speculative frenzy was going to end in tears. Hyman Minsky advanced the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crisis.

It was always going to be difficult for businesses and individuals to avoid the temptation of easy and cheap credit (debt!) but the Irish policy makers threw oil on the fire with its tax breaks, lax financial regulation and rubbishing of anyone who had the temerity to question the wisdom of the speculative frenzy.
Sadly we may have plenty of time (too much) to figure out the reasons for the recent “madness” .
“Men, it has been well said, … go mad in herds, while they only recover their senses slowly, and one by one.” Charles Mackay 1841

I have been waiting to see if someone was going to mention Reinhart and Rogoff. Since they haven’t, it might as well be me. We were due for a pretty big crisis no matter what.

Here are some quotes from the 2003 IMF report I linked to some while ago. The last point deserves particular consideration IMO.

“The spectacular increase in house prices and credit to households over the past several years inevitably raises the risk that prices may unwind, possibly abruptly, especially if unemployment were to rise further

“Care would need to be taken that measures do not postpone the adjustment of house prices, given the risk of an even sharper unwinding later on

“The authorities were concerned about risks to banks from rapid house price and credit growth, but noted that high levels of capitalization and profits provided an adequate cushion to absorb the effects of potential shocks without systemic distress

“Staff agreed with the authorities’ concerns about risks in mortgage lending, particularly from a rise in unemployment and from differential risks within mortgage loan portfolios. Staff also noted that the concentration of large exposures to commercial property loans as well as insurance industry risks merited close attention.

“The authorities were concerned that persistently higher wage and price inflation would worsen competitiveness as the euro strengthened and external demand weakened…

“Staff cautioned against relying entirely on favourable economic conditions to eliminate the structural deficit…the structural revenue ratio could decline further…For instance a deceleration in housing turnover would adversely affect indirect taxes and stamp duties. More generally, tax revenue could decline if the house price boom unwound quickly.”

Kevin, Glad you’re still digging back into the IMF archives. So Sharmini Coorey got it right. She talked to a wider range of outside opinion than did her successor as mission chief for Ireland.

The interesting impression is that (if bank behaviour is anyhting to go by) prudential warning fatigue seems to have set in soon after that report was released in mid-2003.

More from the IMF Archives for 1999 indicates that outside observers were concerned about precisely what our policy-makers and regulators actively encouraged and tolerated during the last 10 years
“In light of the rapid growth in credit and strong housing price increases, a number of Directors expressed concern about the risks of an asset price bubble and the potential vulnerability of the banking system. Directors stressed the need to enhance the forward-looking aspects of regulatory policy and, in this regard, welcomed the supervisory authorities’ recent initiative to assess the financial system’s vulnerability to specified macroeconomic shocks. They felt that a peer review, particularly by supervisors from a country that had undergone a real estate boom, might be helpful” http://www.imf.org/external/np/sec/pn/1999/pn9979.htm
Was the suggested peer review ever done?
Judging by the decisions on banking since September last, it is not clear that options had been developed working our what response there could be to the (inevitable) failure of Irish policy on relying on house construction and property as primary forces in “development”/”economic” growth. Perhaps there were some lone voices in the Dept of Finance or the Central Bank. Since 1999, many others have issued cautionary comments on Irish economic policy eg. EU, OECD and some “unpatriotic lulas” who live and work here.
Long before the credit crunch, we were force-growing the seeds of our current economic situation.

Alan Ahearne is certainly correct that the slowdown in Ireland was well underway before the US credit crisis shook world markets since prices were falling after Q4 2006. There is not only the evidence for a property market slowdown Alan mentions, but also, as Colum McCarthy noted at the DEW workshop, quarterly income began falling or flattening in early 2007. One could speculate that in other circumstances this 2006-7 slowdown might have served as the beginning of a “bumpy landing” for Ireland rather than the “crash landing” which followed the US-induced Irish credit crisis.

I agree wholeheartedly with many of the comments regarding the very poor bank regulation in Ireland, the weak oversight by the Central Bank which endangered Ireland’s financial stability, and the profligate tax and spend policies of the Irish government during the period of irrational exuberance. In the absence of the US credit crisis would these many bad policies have led to a crash or just a bumpy downturn? It is impossible to know for sure and perhaps futile to speculate.

My own concern is that too extreme a depiction of the pre-crash environment in Ireland will lead to over-treating of the problems, and a government cure worse than the disease. If these problems are addressed in a constructive and balanced way, there is a good possibility that Ireland can emerge from the current recession with a much improved finance and business regulatory system (I am less optimistic about any tax-and-spend improvements).

I accept Patrcik Honohan’s point that the deposit insurance scheme was more or less inevitable, but was flawed in its implementation.

Alan Ahearne asks me to be more specific what risks nationalization (of all the main banks) would give rise to over and above the risks we already face. My concern with AIB and BOI nationalization centres on their credit control and funds allocation while in state ownership. The dominant political party in the current government has long and very close ties to the property industry. The Irish taxpayer through its deposit guarantee scheme is now the residual claimant on all bank assets, and in particular a massive overhang of bad property loans to very sharp and politically-powerful developers. The banks need to collect on these loans wisely but ruthlessly, bankrupting whoever needs to be bankrupted, and credibly threatening with financial ruin any developer who does not cooperate in maximum repayment. This is not a job for civil servants reporting up to a Fianna Fail government.

Gregory: This is a good piece and I agree with your overall assessment. I have to say I do think A.Aherne is partly correct on the guarantee scheme relating to dated sub-debt, I would have excluded this for sure but I would not have but any bank into administration as this would have made the entire process useless. If we spend all our time reviewing that went wrong in Ireland we must also examine and compare with our countries. Working in a German bank (and previously with a Scandi bank) I can say they have different problems but sadly no less severe relative to Ireland. The saving grace for the Irish banking system is that they are not also sitting on trillions of paper transactions (neg.basis trades, CDO2, monoline wrapped rubbish….) Many European banks have to contend not only with weak real estate assets (which are at least tangible and worth something) but they also have mountains of worthless paper assets that are completely worthless and will never be worth anything. The write-downs yet to come from these mainlly German and British banks will be eye watering and will cause the whole system to fail or be nationalised. Finally I strongly dissagree with your views on agressive debt collection – not from a social perspective. From experience in other countries I say that this route is self defeating and will make a bad situation very much worse. Trust me. Thanks for your article Gregory.

Thanks very much Karl for the encouraging words. Your experience regarding best practice in debt collection is interesting. This is something about which I have no experience and have seen little in the economics research literature on it (Patrick Honohan touched upon it briefly in one of his recent papers). I read a book recently called The Builders by Frank MacDonald — it is full of long passages on recent Irish property deals and planning fights that left me as an economist speed-reading, there was not that much economics in it. But two points came across from the book that have relevance to the current banking crisis: 1. these large developers are very sharp and aggressive about money matters and 2. almost all of them have extremely close (in many cases second-generation) ties to Fianna Fail. I am not trying to score political points (and this blog page is not the appropriate forum for that) against Fianna Fail but all fair-minded people will admit that their relationship with the property industry has been problematic. I take your point that a softly-softly approach might be best but worry what might happen in the case of a nationalized bank squared up against these property developers. Having read the Frank MacDonald book I suspect that many of these developers, as we speak, are hiding assets and cash flow in overseas shell company structures. Who should be in charge of collecting and how should it be undertaken? What about the case of Anglo, where I suspect that the loan provisions and security arrangements are likely to have been done quite poorly?

Karl: Not to make this an “our banks are worse then your banks” argument, but there is a key difference between Irish banks and German (and British Swiss) banks. German, Swiss and the larger British banks loaded up on the toxic securitized paper from the US. Irish bank concentrated on old fashioned loans that they retained on their balance sheet.

There is a big difference in the accounting for holding of CMOs and other asset-backed securities vs. holding of old fashioned loans. CMOs etc are market to market (or marked to model, now that no market exists). This means that a good part of the losses on this stuff have already been taken. Loans are not marked to market; instead, management make a guess of the expected losses and make a provision, i.e., book a loss, for it. Most of these losses have not yet been taken. In the case of Ireland, probably only a small fraction have been taken.

You are right that the coming credit losses at German banks will be eye watering. But, those at Irish banks will be truly horrendous.

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