Patrick Honohan: International credit and financial market integration -
after the storm?
Opening remarks by Mr Patrick Honohan, Governor of the Central Bank & Financial Services
Authority of Ireland, at the 8th INFINITI Conference on International Finance, Trinity College,
Dublin, 14 June 2010.
* * *
It is a pleasure to open the 2010 INFINITI conference, an acronym I understand to mean
"international financial integration studies at Trinity". Research on international financial
policy issues has never been more important in Ireland and abroad than it is now. The Great
Financial Crisis has thrown up many key questions for research.
Our own experience in Ireland has many international financial ramifications. For, even if I
have been emphasising recently how much of Ireland's banking difficulties were home
grown, they have certainly occurred in an international context. Ireland is one of the most
globalised economies in the world - one indication: the ratio of exports to GDP approaching
one (which, by the way, you will realise is not a theoretical upper bound). And its property
price and construction bubble was financed to an important extent from abroad. Over a four
year period 2003-2008 net indebtedness of the banks to the rest of the world jumped from
10 per cent of GDP to over 60 per cent.
Interestingly, this foreign borrowing was not only used to finance the domestic property
bubble but also to finance property development abroad - mirroring a common phenomenon
of high income countries incurring foreign debt to acquire foreign equity - in this case equity
in the property market some of which did not perform too well.
And there was another international development that was important in igniting the property
boom. In line with Shiller's theory of how bubbles get going, a myth that a new economic era
was unfolding drove expectations. Thus there was not only an unrealistic expectation that the
Irish economy would grow beyond the sustainable level of output - close to the production
frontier and at full employment - which it had achieved in the Celtic Tiger period based on
sustainable improvements in competitiveness and efficiency. In addition, the sharp fall in
nominal and real interest rates on euro entry led many investors to exaggerate the degree to
which a higher capitalization rate would apply to long-lived assets such as property.
What new areas come to the fore now as topics for study? I would like to emphasise a
number of issues which relate to the interaction of fiscal and banking policy. The direction of
the interaction is two-way. Banks can affect the fiscal position, as in Ireland when first the
property-related transactions, capital gains and profits taxes generated by the bank-led
property bubble induced the government to become reliant on such transient forms of tax
revenue, creating a vulnerability in the fiscal position.
Likewise, when it became evident that there would be banking losses, the uncertain scale of
these losses hung over the public finances as a threat. At the Central Bank, we have dealt
with the latter problem by applying quite severe stress tests to the banks, and requiring them
to inject additional capital this year, with a view to ensuring that, after they have transferred
their big property loans to the National Asset Management Agency (which is purchasing
them at a price related to market value, and thus at a deep discount to book value), and after
they have absorbed further losses that can be expected as a result of the recession, they will
come through this loan-loss cycle with a comfortable buffer of core tier 1 capital - 8 per cent
in the base case, which itself is more pessimistic than that of the banks, and 4 per cent even
under a severe stress. When this recapitalisation is completed, the market will be able to
take comfort from the removal of the large uncertainty that was hanging over both the banks
and the government's accounts.
Conversely, the fiscal position can affect the banks, and we have seen this recently in
Europe with heightened market concerns about the fiscal situation in some countries have
spilled over to banks and sovereigns, in turn hampering the transmission of low monetary
policy rates throughout the euro area. Frozen interbank markets reflected what seemed an
overblown response to perceived fiscal risks.
We've seen an extensive policy response to tackle this. Not only quite sharp fiscal
adjustment measures, but a huge commitment of public funds - some €750 billion, which is
huge in relation, for example, to the outstanding stock of debt in the countries affected.
There's also the ECB's Securities Market Programme, directed at promptly unblocking
money market conditions.
Clearly, then, this interface between fiscal and banking conditions is a fruitful area of policy
research right now.
Let me just mention two specific issues within this. First, the Stability and Growth Pact, which
needs the addition of a focus on sustainability of the fiscal accounts, and not just on a
particular deficit or debt level. Ireland was not the only country for which the downturn had a
very unusually sharp and large impact on the deficit reflecting the unsustainability and
transient nature of a large part of the tax system, For me there is a lesson here from banking
regulation. Just as banks are required not only to make provision for expected loan losses in
their accounts, but also have to hold capital reserves to meet unexpected losses, the SGP
targets should make allowance for the risk that unexpected fall-offs in revenue may occur.
Finally, a word on the taxation of financial intermediaries, which is back on the policy agenda.
I see that Financial Transactions Taxes are being discussed again, though I suspect that the
conclusion will be that they do little for improving the efficiency or safety of the financial
system (they would have done nothing to discourage derivatives related to sub-prime
lending, for example), and also would not generate as much revenue as some suppose.
Nevertheless, it does seem possible to use some form of Pigouvian corrective taxation as a
kind of graduated type of regulation, potentially better than outright banning of products, and
a useful complement to the regulation-by-ratio that has become the norm over the past
quarter century.
With such a long list of researchable topics, I look forward to seeing a large international
attendance again at INFINITI, and I declare the 2010 conference open.