Patrick Honohan: Two-way interdependence between the banking
system and the State
Address by Mr Patrick Honohan, Governor of the Central Bank & Financial Services
Authority of Ireland, to the Small Firms Association, Dublin, 11 May 2010.
* * *
I would like to take the opportunity of this occasion to speak to about the two-way
interdependence between the banking system and the State, which has been illustrated in
dramatic fashion in recent weeks.
Understanding and managing the elements of this interdependence is key to improving the
situation with regard to the cost and availability of credit, matters that are of central interest to
my hosts tonight, the Small Firms Association.
In brief, my message is twofold:
- First, continued consolidation of the public finances is key to ensuring a flow of
reasonably-priced liquidity to the banks and their customers;
- Second, the recapitalization of the banks, which we announced at the end of March,
is key to dispelling the cloud of ill-defined banking losses that has been hanging
over the public finances for many months.
The extraordinary events in European and international financial markets over the past few
days show clearly how a better flow of credit does not simply depend on the motivation and
skill of bank management.
Improvements in the flow of credit can only go hand-in-hand with the creation and
maintenance of firm foundations in terms of the capital reserves of the banks, the national
fiscal stance and national cost competitiveness.
Credit and finance generally depend crucially on confidence. And in a country as open as
Ireland - still a world champion in its degree of globalization - that confidence has to extend
to the global audience, especially those who have invested in Ireland, and those who will
continue to invest in Ireland. It also means confidence at home on the part of those - like my
audience today - whose actions can help restart investment and boost job creation, and
those whose job it is to help finance that restart.
This week and last the media focus has been on confidence in international financial
markets. Ireland has not been directly under the spotlight, but the fact that it has been just
off-stage is illustrated by what I would regard as wide spreads on Irish government debt,
which - albeit fluctuating - have been a feature for well over a year.
We have been here before. Through the 1980s and into the 1990s Irish interest rates were
kept far too high as a result of market pessimism. In effect, the Irish government was paying
lenders over the odds to compensate them for currency risks on a scale which never
materialized and which the government knew would not materialize. My estimate is that in
those days we paid 21⁄2 percentage points extra as a result of this unfounded pessimism over
a decade.
Over the past year and more it has been a similar story. Markets have been demanding a
premium for risks which the government knows are unfounded. This morning the spread of
Irish government 10 year bonds above the German benchmark was still more than
11⁄2 percentage points, despite a sharp narrowing following the measures announced over
the weekend.
One way or another, commercial bank lending rates also come to embody the risk premia
being paid by the national government. This is something that cannot be avoided. And that
- in broad terms - is why bank lending rates have been creeping up again in Ireland. (I won't
speak today about important details such as the cross-subsidization between tracker
mortgages and other lending.)
Given how intimately dependent bank lending rates are on the rates at which the government
can borrow, let me say a word about the government's borrowing costs and how those have
been affected by market sentiment in recent weeks.
Right across Europe, for the past several weeks, the fiscal pressures in the Greek economy
have been heightening investor concerns. This resulted in Greek debt being traded in
secondary markets at record yields. Despite the negotiation of a large financing package
sufficient to deal with the Greek government's borrowing needs for three years, and
assurances that Greek government debt would remain eligible to back commercial bank
access to liquidity at the ECB, market concerns remained high. Indeed, they tended to spill
over into the markets for the debt of other countries with high borrowing needs. The
functioning of interbank and other short-term markets was also hampered. Irish government
debt did not escape this pressure, though it was not the most affected.
The symptoms intensified during last week to the point where some financial markets seem
to have become quite dysfunctional. It was clear that decisive action was needed.
The action decided upon on Monday morning had three main goals:
- First, the path of fiscal adjustment right across the European Union needed to be
confirmed and for many countries reinforced.
- Second, there had to be confirmation that sufficient financial resources would be
available to enable countries taking convincing and sufficient fiscal adjustment
measures to accomplish this adjustment in a smooth manner.
- Third, to address the malfunctioning of securities markets and thereby to ensure the
effective conduct of monetary policy throughout the euro area, wholesale markets
for debt and deposits which were beginning to freeze, had to be freed up.
Progressively these actions taken over the weekend are having their intended effect. But the
lesson is not that we can all sit back and relax. The experience has shown how crucial it is to
stay on a disciplined course to correction of the public finances right across the euro area.
This is essential if the financial markets are to work more effectively and in particular resume
their key function of helping to finance the recovery including through lending to small firms.
Of course it is not just in the short-term markets that the banks and the Irish government
have been closely intertwined in recent times, both in reality and, especially, in the minds of
market participants. The banking losses, and recognition that the government would have to
fill any eventual hole, started to weigh on markets from soon after the banking guarantee was
put in place some 19 months ago.
I won't rake back in any detail today over the banking excesses that preceded the crisis of
September 2008.
The whole economy was boosted well beyond its sustainable path in the middle years of the
past decade. Some of the benefits of the boom were spread widely. But unfortunately an
even larger part of the boom was not only unsustainable but wholly illusory and resulted in
wasted resources as we see in half-finished and half-empty housing estates and office
blocks all over the country.
It's much tougher to adjust expectations down, especially when one has taken on
commitments on the basis of an inflated wage, unsustainably low income taxes, or - relevant
for small firms - a few years of inflated profits. Above all, many of those hit by unemployment
resulting from the crash - which of course has been partly due to the global downturn, but
was exacerbated by domestic events - are in a difficult and debilitating position.
Money borrowed by the banks from abroad and ploughed into grandiose developments now
has to be repaid by the banks.
Uncertainty about the capacity of the banks to make these repayments, and hence about the
scale of the likely call on the State to step in, has represented a cloud over the public
finances.
This is the other main channel of interdependence between the banks and government.
The prudential capital adequacy review whose results were announced on March 30 is going
a long way towards removing this cloud.
Over the previous few months, we at the Central Bank have been making a careful
assessment of the likely bank loan-losses that are in prospect over the next few years. This
is over and above the valuation work being carried out by NAMA, and which gives us a good
fix on the likely recoverable value of the larger property loans. We have been working on the
non-NAMA loans and figuring out their likely performance as they suffer from the impact of
the overall economic downturn - part of it of course attributable to the global crisis, and not
just to the bursting of our own bubble. This exercise involved working with the banks, but
challenging their estimates of loan-loss based on our own more realistic - some may say
pessimistic - credit analysis. (I am over-simplifying the exercise, as it also looked at other
elements of the profit and loss account over the coming years). The conclusions of this
exercise are worth emphasizing.
To my relief, and slight surprise, it turns out that most of the banks started the boom with
such a comfortable cushion of shareholders' funds that they would be able to repay their
debts on the basis of their own resources. This includes the two big banks. It is because of
this fact - that their shareholders' funds will remain positive through the cycle - that one of
them, Bank of Ireland, has already been able to tap the private market for an additional
equity injection. Of course they do need additional capital to move forward, but, as has
happened in the US and elsewhere, the government's capital injections of last year into
these two institutions looks like being well-remunerated.
This takes account of the low prices being paid - much lower than originally envisaged - for
the loans being transferred to NAMA. The NAMA purchases replace risky property-related
loans with risk-free NAMA bonds and are part of the process of putting them on a solid
foundation. By the way, knowledgeable experts on the property market assure me that, at the
low prices they have paid, that organization now has a good chance of breaking even over
the coming years, as indeed has been its stated intention all along.
Having calculated their likely future losses, we have now required the banks to rearrange
their affairs to ensure that they have ample capital reserves to ride out this period of losses.
They are responding with plans that raise additional capital reserves and reduce the scale of
their less central activities.
The recapitalization and restructuring of the banks will be accomplished by end year. They
will be stable and secure, capable of resuming their role in providing financial services to the
economy.
Just two of the banks losses go so deep as to burn through not only the whole of their capital
reserves but billions of the depositors and other lenders' money. As you know, these two are
Irish Nationwide Building Society (INBS) and Anglo Irish Bank. There's no point in my
wasting purple prose in condemning the conduct and results of these banks. The taxpayer
- and those in need of better public services - will be picking up the sizable tab for their
deficiencies.
What I do want to emphasize is that - huge though it is - the net deficiency of these two
banks does not impose a burden on the government's budget that could justify recent
interest rate yield spreads on Irish government bonds.
INBS accounts for about €21⁄2 billion in net budgetary costs. With the NAMA purchases not
yet completed, I can't quite narrow the Anglo figure down precisely. However, rounding up
recent estimates to be on the safe side, it would be a pessimist who would put the taxpayer's
net cost above €25 billion. That is a huge sum, and it's unconscionable that it could have
arisen. (I will have more to say about this in my report to the Minister for Finance at the end
of the month).
The main point today, then, is to stress that the cost is manageable. Shocking, if you want,
but manageable. I make no excuse for using that word. It is important that everyone, at home
and abroad, recognizes that this is a sum that is not a game-changer in terms of the public
finances. It represents about one year's borrowing requirement at current rates. It is not
destabilizing.
The plan is that, when this has been accomplished later in the year, the markets will come
more to realize that the banks' losses no longer represent any threat to the public finances,
and that this is no longer a factor that should cause them concerns about investing in Irish
government paper.
This will be good both for the banks' ability to mobilize loanable funds, and for the
government's ability to fund its continuing, though steadily contracting, borrowing
requirement.
After all, it is the underlying gap between tax revenue and government spending that
represents the main pressure on the government's finances and that has resulted in the bulk
of the recent heavy borrowing. Staying on course to reduce this underlying deficit is
absolutely crucial to ensuring that confidence in the public finances can be maintained and
strengthened.