Financial Stability & Euro Adoption: Lessons from Ireland? Max Watson Fellow of Wolfson College, Oxford Research Director, John Howell & Co Ltd

Outline

1. 2. 3. 4. 5. 6.

Why Ireland? Global and euro setting Financial trends in Ireland Bank governance issues Domestic policies Lessons for others?

Why Ireland? Ireland was the ‘poster child’ of EU convergence, rising from poorest (1973) to 2nd richest EU member After euro adoption it underwent a severe financial boom & bust, triggered proximately by global crisis, with blanket bank guarantee & major intervention Why did Ireland suffer so badly: what are lessons? Regling-Watson report commissioned by Minister Lenihan in Feb. 2010 to analyse global and domestic sources of crisis and explain to Irish parliament

Global Conditions Long-term interest rates in percent*

Broad money and GDP*

Source: OECD *Long-term government bond yields (10 years). Weighted average of the US, Japan and Euro Area.

*Nominal GDP converted at constant PPP and broad money (M3) in the US, Japan and Euro Area.

Euro Area Conditions Real short-term interest rates*

Source: OECD *3-month interbank interest rates deflated by the harmonised index of consumer prices.

Loan-to-Deposit Ratios 250%

200% 2004 150%

2005 2006

100%

2007 2008

50%

0% Ireland

Source: IMF

Portugal

Spain

Global and Euro Setting This setting featured a confluence of •

easy global monetary, fiscal & financial setting

•

euro monetary conditions were easy relative to Ireland’s cyclical position

•

EU/euro boost to financial integration in terms of wholesale market funding and competition

•

lower risk premia accompanying euro adoption

•

Basel trend to rely on market, ignore liquidity

Private Sector Credit 35% 30% 25% 20% 15% 10% 5% 0% 2003

2004

Source: Central Bank of Ireland Includes subsidiaries of foreign banks in Ireland Includes securitised residential mortgages

2005

2006

2007

2008

External Balance

Relative Unit Labour Costs*

Source: OECD * Unit labour costs compared to Euro Area, total economy, double export weights

Financial Trends in Ireland A rapid expansion of credit and a shift into current account deficit were a natural result An expansion of credit specifically to the property sector was also to be expected (as euro area factors amplified trends evident in many global markets) A competitiveness loss with the rest of the euro area was the equilibrium mechanism to slow this boom In this setting, the challenge for bank governance was to avoid excessive risk taking; while for fiscal and prudential policies it was to dampen the cycle

Compound Loan Growth 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Allied Irish Banks

Bank of Ireland

Anglo Irish Bank

*Loans are at group level and so include foreign lending as well as domestic lending Source: Annual Reports Bank of Ireland data are for the financial year ending March in the following year

Irish Nationwide

Irish Life and

Building Society

Permanent

Educational Building Society

Loan-to-Deposit Ratios 300%

250%

200% 2005

150%

2006 100%

50%

0% Allied Irish Bank

Bank of Ireland

Anglo Irish Bank

Irish Nationwide Building Society

Irish Life and Permanent

* Loan to deposit ratio calculated at group level, incl. foreign loans and deposits. Source. Annual Reports All data at December 2006, except Anglo Irish Bank data September 2006 and Bank of Ireland data March 2007

Educational Building Society

Loan to Value (Mortgages)

Loan-to-value for Irish residential mortgages, 2004-7 (Source: Central Bank of Ireland)

Commercial Property Loans 90 80 70 60 50 40 30 20 10

12.5 7.4 3.5

3.0

0 Allied Irish Banks

Bank of Ireland

Anglo Irish Bank

Irish Nationwide Building Society

Construction and property (% of total loans, 2006)

Construction and property (as a multiple of capital base, 2006)

*Data exclude residential mortgages and can thus be taken as representing the exposure of banks to commercial property in a broad sense. Source: Annual Reports 2006 Specifically the data are for: Allied Irish Banks and Irish Nationwide December 2006; Bank of Ireland March 2007; Anglo Irish Bank September 2007, estimated based on data in the 2008 annual report.

Bank Governance Issues Bank governance/audits failed in plain vanilla ways: •

internal safeguards overridden to preserve market share: LTVs on residential mortgages raised; exposures to commercial real estate dangerously high (& concentrated), especially with high cross-border funding; documentation of loans poor; remuneration incentive issues;

•

there were (more limited) severe governance abuses involving (e.g.) loans to directors and non-transparent liquidity management.

Public Expenditure 25 20 15 10 5 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-5

Current Spending

Nominal GDP

-10 Government Current Expenditure and Nominal GDP: Annual Changes (%) Source: O’Leary, Jim (2010), “External Surveillance of Irish Fiscal Policy during the Boom”,

Tax Revenues

Others* Capital Gains Tax Stamp Duties Corporation Tax Income Tax VAT and Excise

80% 60% 40% 20% 0%

19 90 19 91 19 92 19 93 19 94 19 9 19 5 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08

% of Tax R evenue

100%

*Customs, CAT, RPT, MVD, Ag. & Emp. Levies

Domestic Policies Fiscal policy missed transience of tax boosts; fastest spending in OECD. At micro level, eroded durable parts of tax base, subsidised commercial property. Mortgage deductibility, no property tax. Bank policy emphasised competition; supervisors acted on property & liquidity, but too little too late; failed on governance; did not inform policy-makers. Approach too hands-off, and staff/skills inadequate. Financial stability reports & FSSA saw soft landing. By 2006 commercial property loans, cyclical/fiscal dynamics, & governance problems ruled this out.

Lessons for Others? Euro a clear plus, but strong policy implications: •

fiscal & prudential policies must take more account of ‘mismatched’ monetary conditions

•

‘external’ imbalances matter under euro while fiscal & labour market policies are national; wholesale liquidity not indivisible even in € area: thus private sector imbalances matter

•

Cyclically Adjusted Balance needs fine-tuning with more indicators; tax swings need analysis; consider fiscal council, and expenditure rules

Lessons for Others (2) •

intrusive, not light touch, supervision needed; must probe macrofinancial risks: e.g., asset risk correlations & asset-liability interactions; centrale de risques can be valuable

•

stress tests have limitations: financial stability analysis must feature ‘contrarian’ scenarios

•

cross-border macro-pru risks are an EU issue

Some of these are global lessons; but crucial in euro run-up as risk premia fall / financial integration rises