THE STATE OF THE BANKING SYSTEM

THE STATE OF THE BANKING SYSTEM

 Dr Donal Donovan, former Deputy Director IMF, co-author of ‘The Fall of the Celtic Tiger’

 

In my remarks today I would like to focus on three key interrelated issues: first, will the Irish banks need more capital and, if so, could this come from Europe?; second, the difficult question of dealing with mortgage arrears and third, the “new lending” question”.

On the first issue, following the 2011 PCAR exercise, the domestic banks were adjudged by all to be very well capitalised, given the stress tests that were done at that time.  What is the position now?  Although the current macro situation is within the limits (only just) of the  adverse range of the scenario underlying those stress tests, in reality the question is more complicated.  In short, there are a lot of “moving parts” involved in establishing whether banks need more capital and a clear answer will not emerge until the new European supervisory authority conducts the exercise for all the affected European banks in early 2014.   Indeed , the precise methodology to be used  in this exercise, as well as the capital “standards” that will be required, are  yet to be firmly established.  So, we will just have to wait and see.

What if new capital is needed?  Might it come from the ESM?  There are two issues here.  First, since the July 2012 EU summit, the Irish leadership have held out the hope that the ESM would be willing, not only to inject possible additional capital that might be required,  but also to “retroactively” replace some of the capital injected earlier by the Irish government.  Assuming the ESM funds were not guaranteed by the Irish government, this would lead to a saving to the Irish tax payer.

However, this idea seems very unlikely to come about. Even immediately after the July 2012 summit, representatives of the “northern” creditor countries insisted that the language in the summit communiqué, contrary to the interpretation of the Irish side, implied no such commitment.  They have argued that, since the national regulatory authority was responsible for the banks’ mistakes, national sovereigns are responsible for paying the bill – this might only change after a pan–European regulator is assigned responsibility in the future.  This episode suggests that decisions on communiqué language, taken at 4 am in the morning – as occurred in this instance – are unreliable and will very often be subject to different interpretations.

The question of the ESM funding “additional” capital could, however, be another matter.  This, in principle, has not been rejected by any means although the details, the associated conditions and the financial capacity of the ESM, are aspects that are far from having been worked out.  It is possible that a clear picture will emerge only after the stress tests referred to above are done in early 2014.

Turning to a second major issue, dealing with mortgage arrears, this is clearly a large problem and it is unclear whether its magnitude is stabilizing or not as we speak.  The Central Bank and the government have all been pushing the banks quite hard to act more decisively to address the issue.  Why is this?  Is it just the case that, since the banks were provided with extra capital in anticipation of mortgage losses, they should now provision more aggressively?

This is certainly an important element – cleaning up the banks’ balance sheets.  But the benefits go beyond an accounting exercise. First, banks are currently devoting a very large amount of their time and resources to “hounding” – if that is not too strong a word – non-complying customers.  It is time for more definitive approaches to be adopted so that these bank resources can be diverted to more useful activities such as helping encourage new worthwhile lending.  Second, at some stage it will be desirable to sell the state’s equity in the banks and recoup some funds for the taxpayers. However, prospective buyers are likely to shy away from expressing an interest unless they can be assured that the true financial position of the banks vis-à-vis the arrears issue has been definitively established.  Finally, from a broader economic perspective, the prospect of a “fresh start” for many borrowers – particularly those who are, or hope to be, engaged in small business – can have an important confidence boosting impact.

Moves by the banks against “strategic defaulters” and those who refuse to engage constructively with the banks may prove controversial, especially if repossessions – hitherto almost unheard of in Ireland – become more common. However, unless the prospect of repossession exists, the whole concept of mortgage lending is fundamentally undermined as the lender would have no underlying security for the loan.  It is most likely that a very high proportion of repossessions will involve buy to let investors or those living in large family homes the debt on which is far beyond their capacity to service.

The banks have also been severely criticized for an unwillingness to engage in new lending. True, the pendulum has probably swung too far in the opposite direction, compared to the “no questions asked”, reckless lending spree of earlier years. This is quite common after banking crises. However, it is not entirely clear whether the lack of actual lending is largely due to the banks applying overly stringent borrowing criteria or reflects an underlying lack of demand for sound bankable projects.  The evidence, for example, from work done by the CBI and the IMF, is not conclusive on this score.  My own feeling is that we are unlikely to see any major expansion in lending until overall confidence in the economy starts to pick up.

Finally, as a postscript, I confess to being somewhat disappointed that a representative of the banks is not present at today’s session (I assume they were asked?). Those in charge of the banks now are not those responsible for the crisis. They are “our banks “ (by and large owned by the taxpayer) and how they address the difficult problems they face will have important implications for all of us.  A constructive, open public dialogue that involves the banks on all these issues would be very beneficial.

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