10 years on - What have we learned?
Remarks by Sharon Donnery, Deputy Governor of the
Central Bank of Ireland
Dublin Economics Workshop, Wexford
14 September 2018
Introduction
It is a great pleasure to be with you today, and I would like to
thank the organisers for arranging the event and inviting me
to participate on this panel.i
The Dublin Economics Workshop has always been a key policy
forum and September 2018 - ten years on - gives us a timely
opportunity to look back and consider not only what we have
learned - the Central Bank included - but also, what has been
achieved, and critically, what must yet be addressed.
The crisis affected every aspect of Irish society, of the Irish
economy, of the Irish banking system. A decade later,
significant numbers of people across the country are still
dealing with its legacies. Whilst it may be tempting to look at
the uniqueness of the Irish experience, taking a wider
perspective shows that "the last 400 years has been replete
with financial crises, which often followed increases in
supplies of credit, greater investor optimism, and more rapid
economic growth."ii This is not to minimise the Irish crisis and
its effects, merely to stress that history shows us that we must
always be on guard against the next potential crisis.
The story of the causes of the Irish crisis has been well told, so
iii
I will not repeat it here. The herding behaviour, groupthink,
speculative mania, and information gaps, have all been well
documented.iv Today, I would like to highlight what I see as
five key lessons. Whilst not unique to the Irish experience,
some are lessons which we in Ireland learned, to devastating
effect, the 'hard way'.
What I will say is that the overall governance, regulatory and
supervisory system is designed with lines of responsibility to
manage and mitigate risk effectively. In the banking and
financial sector, the primary responsibility for risk
management in individual financial institutions lies with their
executive management and boards of directors. This is
supported by internal audit and compliance functions within
the banks, and external auditors. Legislators set rules,
regulators define and implement the regulatory framework,
and supervisors oversee firms' behaviour, enforce this
framework and enforce sanctions in the case of
noncompliance.v Each plays a role in the system with its own
responsibilities.
"Systemic financial crises - both in Ireland and elsewhere - are
uncommon because they require such a large number of
simultaneous institutional and judgmental failures."vi
For central banks and regulatory authorities, and particularly
the Central Bank of Ireland, the crisis transformed everything
we do: our mandate, our organisation, our frameworks for
assessment, our policy instruments, our culture.
So whilst I will not try and be exhaustive today, as I said, I will
focus on five key lessons from both a domestic and European
perspective.
***
Lesson 1: we must act to mitigate the build-up of systemic
risk
Before the crisis, Irish banks built up a heavy reliance on
funding from wholesale markets and hence were more
vulnerable to a sudden stop. The crisis also laid bare the lack
of analytical frameworks to assess financial imbalances and
the lack of policy tools to mitigate them.vii Therefore, following
the crisis, the argument for new policy instruments to mitigate
risks to financial stability became compelling, and the
development of macroprudential policies and instruments
followed.viii
The ultimate objective of macroprudential policy is to mitigate
systemic risk, as major disturbances to the financial system
can disrupt the provision of financial services, which can have
serious negative consequences for the real economy.ix
In Ireland, the Central Bank was designated the National
Macroprudential Authority in 2014 and the introduction of
macroprudential policies by the Central Bank has been a key
step for promoting financial stability.x These tools aid the
Central Bank in building resilience for households and the
banking system, such that they can better withstand economic
shocks or adverse movements in credit or property prices.
The mortgage rules are now an established element of the
macro-financial landscape and have an important structural
dimension, with the aim of permanently dampening the
procyclicality of credit and house prices (relative to the
experience prior to the rules being in place).
The widespread public understanding for the Central Bank's
mortgage measures is positive. We are very conscious that the
deposit requirements are a heavy burden on many people
trying to build for their future. However, there is I think, a
public understanding that as hard as that is, these measures
are necessary and better than the alternative. Ultimately, they
are just as much about protecting households, as they are
about promoting stability.
From a broad cyclical perspective, ensuring resilience is built
early in the cycle is most effective - and this has informed the
timing and calibration of the mortgage measures and the
counter cyclical capital buffer (CCyB). This so-called CCyB is
another example of a tool that can build resilience in the
banking system to withstand future shocks. We recently
announced an increase in the CCyB to 1 per cent, which
becomes effective in July 2019.xi Structural systemic risk,
related to the "too-big" or "too complex" to fail phenomenon,
is mitigated by the Other Systemically Important Institutions
(O-SII) buffer, which has been set at rates up to 1.5 per cent
for the relevant institutions, with a phase-in period from 1 July
2019 to 1 July 2021.xii
One key point to note when looking back at the crisis is that
while the use of macroprudential tools may not have averted
the crisis a decade ago, the scale of the downturn in Ireland
could have been limited and the high cost to citizens reduced.
We must therefore continue to guard against complacency
and build up resilience across the system.
So in short, a key lesson from the crisis therefore was the
importance of developing credible counter-cyclical
macroprudential policy and strengthening micro-prudential
policy to mitigate systemic risk. This is what the Central Bank
has been doing for the last decade.
***
Lesson 2: all actors in the economy need to build resilience
As a small, particularly open economy, Ireland can be
significantly influenced by external events. Ireland has
benefitted greatly from our openness. However, the other
side of this coin is our vulnerability to external shocks, over
which we may have little control. We do not have to look far
for evidence of this. Over the past twenty-five years or so
growth in employment, incomes, consumption, domestic
investment, real estate prices and credit have been more
volatile in Ireland than in the euro area, the United Kingdom,
Sweden or Denmark.xiii The key to dealing with this
vulnerability is not to retreat from the global marketplace, but
to recognise that we need to be prepared for inevitable
downturns. In this context, building resilience, whether in
banks, at the individual, household, corporate, or national
level is key.
All stakeholders have their part to play in this process.
We have seen progress, for example, in household debt
statistics - Irish household debt as a proportion of disposable
income fell by 49.8 percentage points between Q1 2014 and
Q1 2018. However, despite this progress the legacy of the
crisis is still apparent, as Irish households continue to be the
fourth most indebted in the EU.xiv
From a national perspective, fiscal policy is one of the most
important policy levers available. One of the trade-offs of
joining a monetary union is the loss of an independent
monetary policy. This trade-off increases the relative
importance of fiscal policy, in addition to macroprudential
policy, as a lever that can be used to mitigate country specific
shocks in the way that a broad, union wide, monetary policy
cannot.
The fiscal position in Ireland in the years after joining the
economic and monetary union (EMU) appeared favourable.
The debt to GDP ratio continued to trend downward and the
budget showed a surplus. However, these headline figures
obscured a significant shift in the structure of tax revenues.
The share of revenue collected by income taxes fell, while the
share for property related taxes such as stamp duty and capital
gains tax increased.xv
Debt to GNI* - a measure which avoids the distortions
encountered when using GDP - stood at 28 per cent in 2007
and peaked at 158 per cent in 2012.xvi In 2017, debt to GNI*
stood at 111 per cent.
The adverse effects this tax structure had in the crisis years,
highlights the need for a broad-based and stable tax base,
rather than one dependent on windfall revenues. It also
exposed that using potentially transitory revenue items to
fund regular expenditure can exacerbate deteriorations in the
fiscal position during a downturn.
The recovery in the public finances has been dramatic relative
to the situation faced during the early crisis years. Significant
fiscal consolidation played a large part, as did some favourable
external factors, including unexpectedly positive growth and
low interest costs.xvii
These factors illustrate the need to strike a
cyclicallyappropriate fiscal balance to strengthen resilience and build
buffers to counteract future shocks.
The characteristics of Ireland, as an extremely open economy
with significant trade and financial linkages to the broader
international economy, as well as downside risks to the
economy, such as Brexit, add to this need.
So, the second key lesson is all actors in the economy need to
build resilience, be they individuals, households, corporates,
banks or indeed governments.
***
Lesson 3: in addition to the level of regulatory capital, the
type and quality matter
Turning specifically to the banking sector, whilst in Ireland,
aggregate capital resources of banks grew from 2000-2007,
and banks maintained their regulatory requirements, the
composition of capital changed materially. The proportion of
shareholder equity in the covered banks' capital decreased
significantly, with the balance being made up by subordinated
loan capital.xviii
Ordinary shares, however, were found to be the main
effective loss-absorbing instrument on a going concern basis.
In response to the crisis, European legislation was agreed to
create a safer financial sector. A key aspect is the
establishment of a more robust framework for setting
minimum capital requirements. The Capital Requirements
Regulation (CRR) and Capital Requirements Directive (CRD IV)
were agreed in 2013 and revised the capital requirements for
banks.
The framework provides for a Pillar I Requirement, which is
the regulatory minimum amount of capital that banks must
hold. This is a minimum total Capital Ratio of 8% of their Risk
Weighted Assets (RWA). As part of those revisions, the highest
quality capital, Common Equity Tier 1 (CET1), typical items of
which include ordinary shares and reserves, must now,
following various deductions and adjustments, correspond to
4.5% of RWA. Pillar II is an additional capital requirement that
may be applied to institutions by supervisors and is based on
the Supervisory Review and Evaluation Process (SREP). The
institution specific nature of Pillar II ensures that a bank's
capital is tailored to their individual business models and risk
profiles. In addition to the Pillar II capital requirement,
competent authorities may also set non-binding Pillar II capital
guidance that relevant banks will be expected to hold.
The Combined Buffer Requirement is the collective term for
the four capital buffers provided for in CRDIV. This includes the
aforementioned CCyB and O-SII buffer, as well as the Capital
Conservation Buffer and Systemic Risk buffer.
The Combined Buffers act firstly as a mechanism for
procyclical accumulation of capital, so that institutions can build a
store of supplementary own funds in 'good times' in order to
protect their regulatory minimum during periods of adverse
conditions. If a bank breaches the buffer, automatic
safeguards apply to limit the amount of dividends and bonus
payments it can make.
The key point here, however, is buffers must be made of CET1,
the highest quality capital.
And much progress has been made, since the end of 2014, the
fully loaded CET1 ratio of Significant Institutions in Ireland has
increased from 9.4 per cent to 17.7 per cent at end-2017.
So in short, the third key lesson from the crisis I want to
mention today was that, in addition to the level, the type and
quality of capital matter. Progress has been made in many
other areas too. My colleague Ed Sibley, Deputy Governor,
Prudential Regulation outlined in more detail the specific
regulatory and supervisory response, earlier this week.xix
***
Lesson 4: some banks will inevitably fail - we just have to be
better prepared
The level of public support to the banking system during the
crisis in the EU was staggering. In 2009, Member States
provided the equivalent of 7.3% of EU GDP, or EUR 906 billion
in liquidity support and guarantees to the financial sector.
Ireland stands out beyond any other Member State in terms
of the relative support it provided following the far-reaching
2008 decision to guarantee all liabilities and deposits. Beyond
liquidity and support, Member State governments provided
capital support amounting to 4.5% of EU GDP between 2008
and 2012. Ireland, for example spent the equivalent of 37.3%
of GDP recapitalising its banks over the period.xx
This motivated a fundamental change in how banks and
authorities prepare for and manage bank failure. In Ireland, as
a direct response to the crisis, we introduced the Credit
Institutions Resolution Act in 2011. In a European context, the
Bank Recovery and Resolution Directive (BRRD) now provides
authorities with common European rules for the recovery and
resolution of failing banks. When banks get into difficult
financial situations, the supervisor now has a number of early
intervention powers at its disposal. The BRRD also requires
each bank to prepare a recovery plan which outlines what it
will do if it gets into difficulty. The Central Bank of Ireland was
designated as the Irish National Resolution Authority in 2015.
In this context, the Bank is also part of the Single Resolution
Mechanism and we draw up firm-specific resolution plans with
the aim of enhancing the resolvability of the firms.
Central to the BRRD is that the authorities have a variety of
powers to try and minimise the cost to taxpayers of a bank
failure. Critically, the new framework introduces bail-in tools
and also aims to ensure that banks have a sufficient stock of
bail-inable liabilities. This is known as the minimum
requirement for own funds and eligible liabilities (MREL). In
short, the objective of this is to ensure that shareholders and
creditors bear the brunt of losses in bank failures, thus moving
from bail-out to bail-in. Ensuring banks have sufficient and
high quality MREL goes a long way to increasing their
goneconcern loss absorbing capacity.
So in short, the fourth key lesson is that some banks will
inevitably fail, to protect taxpayers we must actively prepare
for their failure and ensure that impediments to resolvability
are removed.
Major legislative and institutional changes took place to
ensure authorities are equipped with the tools that enhance
both the resilience and the resolvability of institutions, which
will be better prepared to deal with, and recover from, a crisis
situation. But ensuring the effectiveness of the framework
remains a challenge for the years to come.
***
Lesson 5: the need for cross-border authorities
The final lesson I wish to discuss today is the need for
crossborder authorities.
The crisis exposed the weaknesses and heterogeneity in
banking supervision across Member States. Of course, the
failures in banking supervision in Ireland have been
comprehensively examined and well documented, particularly
in the (2010) Honohan Report.xxi Some of the conclusions of
the report showed that the then 'Financial Regulator' relied
"excessively on a regulatory philosophy emphasising process
over outcomes," that "a greater degree of intrusiveness and
assertiveness" was required on the part of the regulator and
there was a need for "additional staff resources and
training."xxii
The crisis also exposed the weaknesses in the framework for
resolution - as I just discussed, but also the fundamental
mismatch between cross-border banking and domestic crisis
management, in addition to the lack of adequate, and
harmonised powers authorities had to deal with crises.
Prior to the crisis, the authorities, legal powers, objectives and
tools for crisis management and resolution varied
considerably across the EU. For example, in some cases the
relevant powers were derived from specific resolution or
insolvency frameworks for banks, while in others only the
general insolvency proceedings were available. In some cases,
Member State authorities had the power to transfer assets to
a third party purchaser by executive order, in others by judicial
proceedings, for example.xxiii These differences, coupled with
the lack of a harmonised approach to burden-sharing and a
weak framework for cooperation (in the form of voluntary
cross-border colleges/stability groups) made effective, rapid,
coordinated cross-border intervention very challenging.
In a monetary union, where subsidiaries were the main form
of cross-border banking holding almost EUR 4 trillion of assets
by 2006, the lack of incentives to cooperate and coordinate
compounded the lack of trust across the system.xxiv The well
documented collapse in the inter-bank market led to the need
for central banks to aggressively step in to provide liquidity in
order to prevent the collapse of the financial system.
The response to the crisis was a wholesale change in the
legislative framework, policy tools and the institutional
architecture for banking supervision and resolution. This
culminated most visibly with the establishment of the Single
Supervisory Mechanism (SSM) with the ECB in Frankfurt at its
centre, and the Single Resolution Mechanism (SRM) with the
Brussels based Single Resolution Board (SRB) at its centre.
So in short, the final lesson that became abundantly clear was
the need for cross-border authorities. A major institutional
overhaul of the architecture of Economic and Monetary Union
ensued to complement Banking Union. Key elements have
been addressed but the work is not yet complete.
If "stability" is the short-hand we use to describe the objective
of these changes, it is important to stress that we seek to
safeguard stability precisely because of its importance for
citizens. Building on this, the changes I outlined above have
been accompanied by a parallel, and interrelated, series of
changes to strengthen the consumer protection framework.
European legislation improved protection for consumers in
areas such as mortgage credit, payment services, insurance
distribution and investments. The Central Bank both
contributed to this work and strengthened the domestic
framework. This included the enhancement of the Consumer
Protection Code, the introduction of the Code of Conduct on
Mortgage Arrears, the SME Lending Code and subsequent
SME Lending Regulations, and more.
***
Conclusion
So, is it all sorted then? Clearly no, much remains to be done.
On the institutional side, the review of the European
Supervisory Authorities (ESAs) and ongoing debate on the
need for a European Deposit Insurance Scheme and a
panEuropean Anti Money Laundering (AML) authority show the
institutional architecture necessary to sustain Banking Union
is not yet complete and further work must be undertaken.
Enhancing the MREL targets based on the outcome of
resolvability assessments and developing a policy for transfer
strategies all remain ongoing initiatives.xxv Moreover, the
backstop to the Single Resolution Fund needs to be quickly
operationalised. Now that important steps have been taken to
address bank failure, the authorities will need to turn their
attention to other significant players in the financial sector
such as financial market infrastructure and insurance firms.
Turning to resilience, debt to GNI* in Ireland is still elevated
and remains above 100 per cent. As outlined by the Governor
of the Central Bank in a recent speech, given the particularly
favourable economic growth in recent years, the projection of
a general government deficit in 2019 does not appear to be a
sufficiently ambitious fiscal policy.xxvi
On the macroprudential side, building resilience most
effectively requires balancing timing, policy-mix and policy
calibration, depending on the nature of the systemic risk being
addressed. Technical work is ongoing to assess whether we
can strengthen the framework further.xxvii
However, much progress has been made.
And ten years on, it is important to take stock and
acknowledge this.
Banks are now jointly supervised and resolved by cross-border
institutions. Banks and authorities are better prepared for
bank failures, which should reduce the cost to taxpayers in the
future. The level, type and quality of regulatory capital has
increased and the loss-absorbing capacity of banks has
improved. We now actively intervene to address systemic risk
and pro-cyclicality in the system. Also, there is a cognisance to
Ireland's vulnerability as a small open economy and the need
for all sectors to build resilience.
We should keep the lessons from the crisis to the forefront of
our mind, in our work, in our thinking, and in our
communications. Then, our combined efforts to highlight and
address risks and build resilience will make the financial
system stronger and safer, thereby safeguarding stability and
protecting consumers.
Thank you
i
I would like to thank Mícheál O'Keeffe and Paul Reddan for their contributions to my remarks.
ii
See Aliber, R.Z. and Kindleberger, C.P., 2015. Manias, panics and crashes. Hoboken, pp. 340.
iii
See Lane, P.R., 2011. The Irish Crisis. CEPR Discussion Paper No. 8287.
Also see Fitzgerald, J., 2014. Ireland's recovery from crisis. CESifo Forum (Vol. 15, No. 2, pp. 8-13).
Also see Whelan, K., 2014. Ireland's economic crisis: The good, the bad and the ugly. Journal of
Macroeconomics, 39, pp.424-440.
iv
See Nyberg, P., 2011. Misjudging risk: Causes of the systemic banking crisis in Ireland. Ministry of Finance,
Dublin, March.
v
For an overview, see Lastra, R., 2003. The Governance Structure for Financial Supervision and Regulation in
Europe. Columbia Journal of European Law, 10(1), pp.49-68.
vi
See footnote (iv), pp 5.
vii
See 'Lessons from the past, safeguarding stability for the future,' address by Sharon Donnery, at the CEPR
Economic History Symposium 9 June 2016. Available here.
viii
See 'Macro-prudential policy: action in the face of uncertainty,' address by Sharon Donnery, at the Dublin
Economic Workshop Annual Economic Policy Conference 24 Sep 2016. Available here.
ix
See footnote (viii).
x
See A Macro-Prudential Framework for Ireland 2014.
xi
See Central Bank of Ireland Countercyclical capital buffer rate announcement, 5 July 2018.
xii
See Central Bank of Ireland Identification of Systemically Important Irish Institutions and
Announcement of Buffer Rates, 8 December 2015.
xiii
See Central Bank of Ireland table for Standard Deviation of Annual Growth Rates (%): 1991-2017.
xiv
See Central Bank of Ireland Quarterly Financial Accounts - Q1 2018.
xv
See Lane, P., 2010. A new fiscal framework for Ireland. Journal of the Statistical and Social Inquiry Society of
Ireland, 39, pp.144-165.
xvi
Modified GNI is an indicator that was recommended by the Economic Statistics Review Group and is
designed to exclude globalisation effects that are disproportionally impacting the measurement of the size of
the Irish economy.
xvii
See Smyth, D., 2017. The Recovery in the Public Finances in Ireland following the Financial Crisis. Journal of
the Statistical and Social Inquiry Society of Ireland, 46, pp.149-174.
xviii
See footnote (iv), pp 41.
xix
See 'The Banking Crisis - A Decade On,' address by Ed Sibley, at the Trinity College Dublin "Behind the
Headline" Series 12 Sep 2018. Available here.
xx
See European Commission State Aid Scorecard.
xxi
See Honohan, P., Donovan, D., Gorecki, P. and Mottiar, R., 2010. The Irish banking crisis: Regulatory and
financial stability policy 2003-2008, Report to the Minister for Finance.
xxii
In 2003, the Irish Financial Services Regulatory Authority (the 'Financial Regulator') was established within
the overall new structure of the Central Bank and Financial Services Authority of Ireland.
xxiii
See European Commission 2009.
xxiv
See EU Banking Structures October 2007. The subsidiary number reflects the EU rather than the euro area
specifically.
xxv
See Minimum Requirements for Own Funds and Eligible Liabilities (MREL).
xxvi
See 'Macro-Financial Policies for the Short Term and the Long Term,' address by Governor Philip R. Lane, at
the MacGill Summer School 27 July 2018. Available here.
xxvii
A Systemic Risk Buffer is one potential instrument allowed under CRR/CRD to mitigate non-cyclical systemic
risks, such as those related to exposure concentration.