Was the early food the late poison? Foreign banks and the retail credit market during Ireland's financial crisis

1. INTRODUCTION 'Progress would not have been the rarity it is if the early food had not been the late poison. ' Walter Bagehot, Physics and Politics, ch. 2, sct. 3 (1872). Can Bagehot's hypothesis on the development of social and political institutions in ancient civilisations hold for the banking system in Ireland? For the best part of thirty years, Ireland has been home to an extremely open and large financial sector (2,180 per cent of 2012 GDP), of which the banking system makes up approximately one-third. The early benefits of this openness were reflected in a rise of skilled employment in the banking sector, a more competitive domestic banking market and an ability to exploit the funding opportunities arising from the rapid globalisation of finance and the advent of monetary union. However the experience since 2008 has not been as favourable, as the direct and indirect costs of resolving the problems stemming from the excessive expansion of the banking system in the years preceding the domestic and international financial crises have been extremely large by historic standards. In this paper we examine the resident banking system at a dis-aggregate level over the decade, analysing how Irish and non-Irish owned banks evolved in advance of, and during, the domestic and international crises. In doing so we investigate the extent to which foreign ownership, one aspect of the openness of the banking system, has contributed to the development of the domestic credit market. Foreign participation in the domestic banking system has been an area of study in international finance for decades, with the theoretical benefits and costs of financial deepening and integration being subject to numerous empirical analyses. Among the costs of foreign participation is the potential for foreign banks to add instability to the domestic credit market, contributing to excessive credit growth during booms and excessive contractions during downturns. In this paper we analyse whether foreign bank participation in Ireland's retail credit market has been "costly" in terms of an excessive reduction in bank credit during the crisis and the channels through which that cost is realised. We also discuss the potential for policy recent policy developments in terms of banking union in the EU to minimise such costs generally. Our paper makes two primary contributions. First, using confidential data collected by the Central Bank of Ireland for monetary statistics purposes we identify three categories of banks based on their ownership and business models (Irish-owned institutions; non-Irish retail institutions; and IFSC institutions). We analyse the aggregate balance sheets of these bank categories over the 2003-2013 period, broken down by the key asset and liability instruments across different counterparties and geographical splits, and show how their characteristics are important when examining aggregate trends in the banking system with reference to the domestic economy. Second, we add to the empirical literature on foreign bank credit allocation in host markets and on the Irish financial crisis. We do this by examining the drivers of the different response evident in the data by Irish and foreign owned banks in the retail loan market in the context of the literature on multinational banks and the specific policy context and developments in the EU. In aggregate, we find a similar profile to developments in NFC lending by Irish and non-Irish banks over the period, whereas the non-Irish retail banking group reduced their lending to Irish households more so than Irish banks during the crisis. Using bank-level micro data in our econometric analysis we control for an array of common and bank specific demand and supply factors and show that foreign ownership was a key determinant in the different response of Irish and non-Irish retail banks in terms of lending to households during the crisis. We also highlight the channels through which this differential emerged: parent group liquidity considerations and conditions related to the recapitalisation of foreign banks by their home government. …