Patrick Honohan: The importance of sound information in assessing the
health of the Irish banking sector
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the Chartered
Accountants Ireland, Dublin, 23 November 2010.
* * *
There is a letter in the archives of the World Bank in Washington DC on the letterhead of the
Shelbourne Hotel, Dublin, dated Saturday, June 7, 1958. Benjamin King writes back to
headquarters on his mission to Ireland. This was the first ever such mission sent by either of
the Bretton Woods Institutions (the World Bank and the International Monetary Fund) since
Ireland had joined both of them in the previous year. King was in Dublin at the invitation of
the Secretary of the Department of Finance, T.K. Whitaker, who had asked the World Bank
to help by carrying out a review of the Irish economy with a view to a possible borrowing
programme for Ireland from the Bank.
But King found that much analysis had already been carried out by the Irish administration.
Indeed, he had been perusing a draft of the document that would change the course of Irish
policy towards its economic engagement with the rest of the World. "I have asked Whitaker",
he writes, "to send you by airmail his report "Economic Development". It is over 200 pages
and seems pretty good to me." And it's not just a document of factual analysis, but addresses
challenging policy issues. He notes that "it is also quite tough (in a velvet-glove sort of way)
with some old-established practices". With this document, King believes that Ireland would
be already "halfway toward [having] a sensible program".
Ireland did not in fact borrow immediately from the World Bank but eventually it borrowed a
total of US$ 150 million between 1969 and 1975 for a variety of projects, ranging from power
generation, to agriculture, to education. The last World Bank loan to Ireland, to support the
then ICC (now BOSI - alas closing at the end of this year) in promoting regional
development and employment, was approved in August 1975.
The resonances from this 52-year old letter are particularly sonorous this week, as an IMF
team scrutinizes another Irish plan and maps out another international programme of
borrowing by Ireland (with the additional support on this occasion of European institutions).
The 1958 economic policy shift launched a move towards increasing internationalization and
- to use a word not yet in use back then - globalization for Ireland. To be sure, Ireland had
long been an open economy, but one whose international economic relationships were
predominantly with Britain and its former empire (and, for migration, with the United States).
Since independence, both domestic politics and the international economic and military
environment had encouraged higher barriers to trade and investment. Now these were to be
progressively dismantled as Ireland opened up to a wider and deeper engagement with the
global economy.
One key dimension of this opening up is of course trade: exports as a percentage of GDP
grew from 24 per cent in 1960 to an astonishing 101.5 per cent in 2011 (as forecast), placing
Ireland in a very select league of countries (Malaysia and Singapore being the other ones of
significance) for which exports exceed GDP. The pattern of exports also shifted.
Predominantly agricultural in the 1950s, today (while agriculture and agribusiness-based
exports are far from negligible) exports are dominated by manufactures and services. The
shift to globalization was accompanied eventually by a rapid and more or less complete
convergence in living standards to the highest levels of Western Europe. Once a laggard,
whose relative position had slipped since independence, Ireland became seen as a
European growth leader - even though much of the growth in the 1990s was really a
catchup to the production frontier as enough jobs were at last being generated to employ
essentially all of those who wanted work and sucked in returned emigrants and new
immigrants as well.
Speaking to an audience of accountants, I must naturally remind you, though, of the
accounting and measurement challenges that have been presented by the extraordinarily
globalized nature of the Irish economy as it evolved over the years. These include national
accounting - which I know is not so much the professional concern of this audience today -
and also corporate accounting and reporting. For it was not only the volume of exports that
was remarkable, it was their character, largely produced by foreign owned multinational
corporations and with a high profit component reflecting returns on R&D and other
investments accruing to the owners and not to Irish residents. That distinctive pattern of
globalization meant that the most common measure of economic performance - GDP - is
quite misleading for Ireland, exceeding as it does by over 25 per cent the aggregate statistic
which better measures the national component of production, GNP. Though GNP growth
was certainly very strong in the period from 1994-2007, and reached a very high level in per
person terms, growth rates and levels of GNP have been much lower than GDP. Indeed in
the recent downturn, quarterly GNP has fallen 20 per cent peak to trough - much more than
GDP. A mistaken national accounting focus on GDP thus risks exaggerating the strength of
the Irish economy.
There are knock-on effects of the distinctive globalized structure of the Irish economy on
other accounting measures of performance. With the structural shift towards high-productivity
sectors during the 1990s and again since 2007, unit labour costs tend to fall even if wage
costs for any individual firm or industry are increasing. Because of this shifting composition
effect, as has been well-known for decades, but is routinely forgotten by superficial analysts,
unit labour costs are a false friend in judging competitiveness developments for Ireland.
Measurement and accounting are of crucial importance at times of structural change. Careful
scrutiny is needed to ensure that policy choices are quantitatively well-judged. These matters
will no doubt retain their importance throughout the period of the recovery programme now
being discussed with the IMF, the EU Commission and the ECB.
Banking is a main focus of these discussions. This is not the time or the place to go into
comprehensive detail on the elements being included in the programme to improve further
the resilience of the banks and restoring greater market confidence in their long-term.
Instead let me continue to weave the globalization and accounting dimensions to the Irish
banking story. Actually, important aspects of the banking crisis are themselves a part of the
globalization story. Probably almost enough has by now been said about poor loan appraisal
practices and the consequences of the bubble mentality, but of course that would not have
added up to anything of great consequence had it not been for the access, through the
globalized banking system, to vast sums that could be borrowed from abroad. To be sure
here too the banks had been internationally integrated for a couple of centuries. They
sourced funds in times of need from the Bank of England, but more normally placed very
substantial funds on deposit in the London money market, given that Irish land and
professional classes were net savers and the banks unenthusiastic in the past about lending
too much locally.
Well we all know what happened from 2003 when the banks wanted to keep feeding the
property and construction boom. The run-up in net foreign borrowing was spectacular, and its
contraction equally sharp (as foreign lenders declined to roll-over into an economy with a
property bust and then also a stressed Sovereign). Deleveraging this exposed funding
position through structural measures is a key goal of current banking policy as has been
mentioned elsewhere.
Apart from the pressure on the Sovereign, the capital position of the banks has, as is
wellknown, been placed under pressure by actual and especially prospective loan losses.
Naturally, long-term lenders to banks need assurance as to the adequacy of the banks'
capital position and this means not only that the banks' capital has had to be increased - and
this has been done on a very large scale over the past two years - but that investors need
more and better information about the portfolio of the banks.
The lengthy process of determining the NAMA-related loan losses and the time taken in
some cases to meet the Central Bank's capital target set out in the Prudential Capital
Adequacy Review PCAR announcement of March 30, 2010, and revised at the end of
September, has tended to muddy communication around the capital adequacy of the Irish
banks. There is market concern about tail risk in the banks‟ portfolios. This, together with
the heightened market uncertainty prevailing since the end of April, certainly argues for
higher percentage capital targets. And, while the external experts have found no fault with
the methodology used for this year's PCAR stress test, the next exercise, which takes place
early in 2011, will both dig deeper where possible, and take account of evolving economic
and loan performance developments and prospects over the year. As already indicated in the
past couple of days, it is clear that addressing both the capital ratios and the PCAR exercise
will be key elements of the programme being negotiated at present with the EU Commission
and the IMF in liaison with the ECB.
Capital is an indispensable multi-purpose buffer against unexpected risks, though it is costly,
especially for dealing with tail risks. There is another dimension along which tail risk can be
lowered, thereby further increasing confidence of investors on a less costly basis. This falls
into your area as accountants, because I am talking about accounting and other information
disclosed to the market.
I have already railed elsewhere against the backward-looking loan-loss provisioning
practices encouraged by International Financial Reporting Standards (IFRS) and still all too
pervasive in the reporting by most of the Irish banks. I find it unsatisfactory that expected
losses in many parts of the portfolio are clearly higher than the provisions already taken,
because I fear that this evident and in some cases explicit discrepancy may awaken doubts
in the minds of investors as to the relevance of other aspects of the reported accounts.
But banks could build confidence by going further, to disclose much more information to the
market. Probably disclosure practices by Irish banks were formed during good times, when
share prices were high and most of the market analysts following Irish banks were equity
analysts.
Credit analysts are different from equity analysts. When stock prices are high, questions of
loan losses and defaults are not on people's minds. The equity analyst is looking at growth
potential, market share evolution, the competitive environment as it influences spreads, cost
control and so on. When stock prices are low, we have moved into a different region of
probabilities: the underlying source of volatility of CDS and subordinated debt spreads is
what needs to be analyzed and it is the credit analyst that comes to the fore.
Different information flows are relevant to the credit analysts, and this sort of information has
been provided by the Irish banks only in a limited way and not uniformly as between different
banks.
There is a lot of information that could be provided. For instance, for the residential mortgage
book, which has been much discussed recently, one could imagine much more extensive
disclosures about the size distribution, broken down into a variety of sectoral and other
classifications. Information on the aging and migration of loans between different
performance buckets would also help. Bottom line: the banks might do well to call in the
leading credit analysts and find out what information would be of greatest use to them in
identifying and quantifying tail risks. And then provide it.
For, if there is no information, the credit analyst tends to assume the worst. They think: "if the
actual situation were good, would the bank not have been at pains to disclose it?" Since it is
not disclosed, it must be bad. At present, regulators have been gathering more and more
information of this type, and the size and quality of the information set available to the
regulators has been improving by leaps and bounds. Communicating more information to the
market would not only enlist the expertise of market credit analysts in a way helpful to all, but
could lower the cost of term borrowing as investors regain confidence. We plan to explore
this aspect further with the banks; they have much to gain and formal regulation here may
not be needed.
As the information flow to the market improves both in quantity and quality, and especially
when the economy improves and the news contained in the information is getting better, we
will hopefully move towards the euthanasia of the Irish bank credit analyst (though not of
course of the accountants!).
More important, and more broadly, restoration of market confidence in the banks and in the
finances of the Irish state will step by step be rebuilt by these and other measures to be
contained in the programme on which negotiations have begun. This effort will help set the
course of economic and financial policy on a more secure path leading to reduced
uncertainty and a return to a sustainable path of employment growth and economic activity.
We will have a slimmed down banking system that is much better placed to serve the needs
of the economy into the future. While all of this will take some time to be worked through, we
can be reassured by the announcements of recent days that the banking system retains the
support, not only of the Central Bank of Ireland, but of the European Institutions.
The globalization unleashed by Whitaker's initiatives in the 1950s generated great benefits
and lifted living standards over the following two generations. Analysing the distinctive
structure of the economy that it created requires careful analysis of good accounting data,
both national and private. Some distortions have undoubtedly resulted in the process of
globalization, not least the excessive dependence in the last number of years on foreign
borrowing and its consequences. These distortions reflect the phenomenal ability of
globalization to generate a rapid amplification of changes that would occur slowly in a closed
and inward-looking economy and society. The rapid leap forward of the Celtic Tiger period
was a favourable amplification; the credit and construction bubble a disastrous one. This
perspective suggests that, once we find our stride again, with the renewed help of the
international and European partners with which we joined in 1957, 1973 and 1999, a
favourable amplification will restore prosperity, albeit of a more sober variety.