John Hurley: Recent issues in financial stability
Address by Mr John Hurley, Governor of the Central Bank & Financial Services Authority of
Ireland, to the Institute of Internal Auditors, Dublin, 18 April 2008.
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Introduction
Ladies and Gentlemen,
It is a pleasure to be back speaking to members of the Irish District Society of the Institute of
Internal Auditors on the occasion of your 20th Annual Conference. I would like to thank your
chairman, Fintan Geraghty, for the invitation to speak today.
A few years ago, before I became Governor of the Central Bank and Financial Services
Authority of Ireland, I had the honour to make the opening remarks on the eve of your
conference. Throughout my working life, I have always been conscious of the importance of
the Internal Audit role.
In my address this morning, I will comment on recent issues in financial stability, focussing
on developments in international financial markets and the outlook for both international
growth and the domestic economy. I will also briefly comment on the pivotal role that the
auditing and accounting professions have in enhancing the resilience of financial markets.
I see that the focus of this year's conference is on the challenges facing the profession in
delivering assurance to stakeholders on the effectiveness of risk controls in a changing and
turbulent environment. The Central Bank and Financial Services Authority like all major
organisations, financial and other, places significant reliance on reports and opinions by
external and internal auditors in relation to corporate governance and internal controls. We
have established close relationships with accountancy and auditing bodies in the context of
supervising regulated entities. As you know, the principles-based approach to financial
regulation in this country places a lot of reliance on financial organisations to adopt and
adhere to the highest standards. Auditors and compliance personnel have a key role to play
in this system. Under financial services legislation, auditors are now required to report certain
matters to the Financial Regulator, such as material defects in financial systems and controls
or in accounting records. While the respective orientations differ, auditors, and internal
auditors in particular, can provide valuable independent assurance on many other issues.
I would like to turn now to the main focus of my address this morning, namely, recent issues
in financial stability.
What is financial stability?
Let me start by defining what we mean by financial stability. Financial stability exists when
the various parts of the financial system such as payments and settlements systems,
financial markets and financial intermediaries such as banks can operate smoothly and
without interruption and with each part resilient to shocks. A stable financial system is able to
absorb adverse shocks. The maintenance of a stable financial system is fundamentally
important to the operation of the economy. For example, it facilitates the provision of credit,
the security of depositors' funds and the smooth operation of payments systems. Serious
financial instability can manifest itself in terms of banking crises and recession and can be
very costly for any economy in terms of disruption and reduced output and employment.
Ireland is well placed in terms of the institutional arrangements that exist in relation to
financial stability. The Central Bank and Financial Services Authority is the organisation in
Ireland responsible for financial stability issues. When the Central Bank was restructured in
2003, the new body was designed with financial stability in mind with both the Central Bank
and the single Financial Regulator operating within the one organisation. Both of the
constituent parts work closely together to contribute to the maintenance of financial stability,
though their focus of interest differs. The role of the Central Bank relates to surveillance of
developments in the wider economy and the financial system as a whole, while the Financial
Regulator focuses on the prudential health of individual financial institutions, in addition to its
consumer protection mandate. Both perspectives are necessary to fully assess the risks to
stability and to take the necessary actions by way of mitigation. The real advantage of our
structure is the seamless sharing of expertise and information that comes from operating
under the one umbrella. Such co-operation strengthens our assessment capabilities and the
speed with which we can act. These institutional arrangements have been tested in recent
months, and I am happy to state that they have proved to be effective in dealing with the
recent financial market turbulence.
Our organisation contributes to maintaining financial stability in several ways. We maintain a
regular dialogue with the financial sector to exchange views on current and emerging issues.
In addition, as a member of the ECB's Governing Council, I participate in the formulation of
monetary policy and the setting of interest rates in the euro area. This has as its primary
objective the maintenance of low inflation which also contributes to financial stability.
Furthermore, the Central Bank has a key role in providing liquidity to Irish banks and we are
responsible for oversight of the payments and settlements systems. Our organisation is
continually assessing, and stands ready to deal with, emerging problems and potential
shocks to the financial system. There is the closest co-operation between the Central Bank
and Financial Regulator on financial stability issues. In particular, the Financial Regulator had
introduced a variety of measures, prior to the onset of the market turmoil, which led to the
financial services industry here being well placed to deal with the challenging environment.
Finally, we publish an annual Financial Stability Report. Our hope is that the wide-ranging
analysis in the Report conveys the importance of a stable financial system and encourages
discussion of the financial-stability environment among the general public, the business
community and the financial sector.
Recent issues in financial stability
On balance, our current assessment is that while the outlook for financial stability in Ireland
and globally has deteriorated in recent months, domestic financial institutions remain sound
and capable of absorbing shocks. There are a number of current and longer-term issues that
have a bearing on this assessment.
International financial markets
Ireland is an extremely open economy by international standards. Our relatively large trading
sector and the significant presence of foreign multinational firms and international financial
services companies means that our economy and its financial system are influenced
significantly by developments in the global economy and international financial markets. This
is why Ireland could not be immune from the current disruption in international financial
markets.
As to the origins of the current developments, the low interest rate environment has
undoubtedly played a part. With a steady availability of credit, and relatively low interest
rates, there was an increased desire on the part of investors to acquire assets earning a
higher return without, however, paying due regard to the associated higher risk associated
with this. In particular, during this time, the international banking sector had compensated for
falling margins on traditional business by investing in structured finance products or
originating collateralised debt obligations (CDOs) without fully taking on board the risks
inherent in these products. On the liabilities side, there was a move towards more volatile
wholesale funding sources such as issuance of debt securities, interbank loans,
securitisation and issuance of covered bonds. Banks also extended back-up credit lines to
structured investment vehicles (SIVs) or conduits whose business model was based largely
on the continued smooth operation of the asset-backed commercial paper market. These
developments exposed the international banks to a variety of risks such as possible losses
on their investments in structured products, losses on their retained tranches of CDOs, the
volatility of wholesale funding sources in adverse market conditions, and the risk of funding
contingent liabilities to SIVs and conduits for which some banks had made inadequate
provision.
I would stress that the domestic banking sector was largely insulated from these trends, in
part by the exceptional performance of the Irish economy over the last 15 years. Irish banks
shared the experience of their international peers in that margins on traditional business had
fallen over the longer term. However, because of the high level of demand in Ireland,
profitability was maintained without recourse to investing in structured products or conduits
as described earlier.
The re-pricing of risk in international financial markets and the associated turmoil was
triggered in mid-2007 when international investors became nervous about the underlying
value of their investments in assets that consisted of pools of US subprime mortgages.
These assets had been created under the "originate and distribute" model whereby
mortgages were issued to borrowers by an originator (i.e., a bank or broker) but were
subsequently packaged together and sold on to investors. An increasing number of these
mortgages have become non-performing since mid-2005. These losses became an
international problem, as many of the investors including banks that had bought these assets
were located outside the US. Uncertainty about the size and the identity of those investors
holding the losses gave rise to increased risk aversion in the marketplace and marking down
of the value of these types of assets.
The uncertainty rippled through a variety of financial markets and caused disruption. Arising
out of concerns about banks' exposures to risky assets, counterparty risk heightened and
problems began to spill over to the interbank market - where banks borrow from and lend to
each other. As a result, there was increased uncertainty in key markets where banks
traditionally raised funds. Disruption to funding markets is particularly problematic for all
banks since they regularly need to renew portions of their funding.
The bout of turbulence in international financial markets has persisted for longer than many
commentators would have predicted. Since mid-2007, there remain ongoing tensions in
international financial markets amid a steady flow of negative news. Through late-2007 and
into 2008, central banks - including the ECB - have continued to provide funds to promote a
smoother functioning of the interbank money market. However, the cost of term borrowing for
banks in this market has remained high. In addition, other longer-term bank funding markets
remain relatively closed, as banks continue to be reluctant to lend to one another other than
for short maturities, while many asset-backed securities, leveraged loan and structured credit
markets are virtually inactive. Term premia are expected to remain elevated for some time
because of wider problems in the financial system such as uncertainties regarding the
valuation of complex products, counterparty mistrust and continuing uncertainty about the
ultimate location of mounting losses on assets linked to the US subprime residential
mortgage sector.
International economic growth
Against the background of the problems in global financial markets, there have been
downward revisions of economic growth across many countries. This has occurred because
of concerns over the scale of the losses being incurred by the banking sector internationally
and the potential for knock-on effects in terms of a lower availability of funds for borrowers
and a higher cost of credit. Many surveys of banks' current credit standards indicate that they
have been tightened because of the financial market turbulence. On a practical level, this
means that it is more difficult to borrow funds for consumption and investment and, as a
consequence, globally there could be relatively less economic growth.
It is estimated by the International Monetary Fund that the global economy expanded by 4.9
per cent in 2007 and will grow by 3.7 per cent in 2008. This latter projection is significantly
lower than forecast last October. There are increased signs that the deterioration in the US
housing market is starting to spill over to the broader economy and the outlook for consumer
spending appears to have weakened. Many observers are of the view that the US economy
may experience little or no growth for some time.
Despite continuing problems in financial markets, the latest economic data remain consistent
with moderate but ongoing real GDP growth in the euro area. While growth is expected to
moderate somewhat from its 2007 rate, euro area economic activity is still expected to
continue to expand this year. However, the risks to this outlook would appear to be on the
downside. They arise from the significant uncertainty related to the problems that financial
markets are experiencing and the risks surrounding the global growth outlook. For instance,
the implications for growth stemming from developments in the United States remain highly
uncertain. The full implications of financial market developments for the US economy, and
subsequently for the global economy, may not be fully apparent yet. Hopefully, the initiatives
discussed by the G7 last weekend will help reduce these uncertainties.
Turning to price developments in the euro area, sharp increases in food and energy prices
have had a significant impact on the harmonised Eurosystem inflation rate in recent months,
pushing it well above 3 per cent. The headline rate is expected to moderate gradually over
the course of the year, but the risks to the outlook are clearly on the upside. Looking ahead,
the ECB Governing Council has signalled that it will continue to monitor very closely all
developments over the coming weeks.
Implications for the Irish economy
The outlook for the Irish economy in 2008 is undoubtedly more challenging now than was
envisaged last year. As a result, real GDP is projected to increase by 2.4 per cent while real
GNP is forecast to increase by 1.9 per cent in 2008. Although this is a much-reduced rate of
growth by the standards of our experience since the mid-1990s, it still remains a good
performance by international standards. The OECD confirmed this view in their latest
assessment of the Irish economy published this week. This noted that, despite the slowdown,
the economic fundamentals remain strong and it pointed to our skilled workforce, flexible
labour market, moderate taxation, business-friendly regulatory environment and our sound
fiscal position.
The key domestic issue is the marked decline in house-building activity expected in 2008. All
of the various leading indicators of housing supply are pointing to a reduction in activity. For
instance, completions recorded for January 2008 were the lowest since early-2003. The
Central Bank's latest estimate is for about 50,000 houses to be completed this year and
about 45,000 next year. This is a necessary adjustment to a more sustainable level of output.
However, it is having adverse knock-on effects in terms of job losses and lower consumption.
External demand will be affected this year by pressures on competitiveness and weaker
growth in Ireland's main trading partners. In recent years Ireland's competitiveness position
has deteriorated somewhat due to a combination of the appreciation of the euro, a domestic
price level which continues to remain stubbornly high - although inflation is projected to
reduce towards the end of the year, higher wages and non-labour costs relative to our
trading partners and a slowdown in productivity growth. Over the longer term, the key to
restoring competitiveness is containing domestic inflationary pressures, including the
evolution of pay, and to improve productivity growth. A number of policy measures are
relevant in this regard including boosting competition, reducing the regulatory burden on
business, investing in infrastructure, improving educational standards, encouraging R&D and
innovation, maintaining macroeconomic stability and increasing flexibility. In general, Ireland
needs to remain a good place to do business with policy settings supportive of enterprise,
investment and innovation.
The labour market has performed well over recent years and unemployment is at a level that
probably represents a position close to full employment for the Irish economy. The expected
slowdown in the economy this year, however, will have implications for the performance of
the labour market. Employment is expected to increase by just 0.5 per cent in the coming
year, which is less than the anticipated growth in the labour force and, therefore, the
unemployment rate could increase to 5.9 per cent. Despite the projected increase, our
unemployment rate is expected to remain below the European average. It may be worth
recalling that the labour market proved particularly resilient to the last significant downturn in
economic growth in 2001/2002.
Some pick up in economic growth is likely in 2009 on the basis that house-building activity
will stabilise or contract only modestly, and there will be some recovery in the global
economy. At this stage, growth in Irish GDP and GNP are forecast to recover to 3.6 per cent
and 3.2 per cent, respectively, in 2009.
Property prices and private-sector indebtedness
I would now like to turn to recent developments in the property market - both residential and
commercial.
We have come through a buoyant period in the residential market. In previous years, the
Central Bank expressed its concern about the persistently high rate of capital appreciation.
However, residential prices are now about 9 per cent lower than this time last year, although
there are tentative indications that the pace of decline in prices has eased somewhat. It is
important to bear in mind that these developments should be seen as part of a necessary
adjustment following many years of exceptional house price inflation. For instance, prices
rose by about 12 per cent in 2006 alone and by over 50 per cent between 2002 and 2006.
With respect to future price developments, as I stated recently, residential prices are now
returning to more realistic levels. I stated in 2006 that, at that time, a gap was opening up
between the price of residential property and the fundamentals supporting that position. This
gap is now in the process of closing. There are a number of factors that may help to stabilise
the market. On the supply side, developers have been very prompt in responding to declining
demand and we have seen national completions contract sharply. The underlying demand
for housing continues to remain strong, as evidenced by the fact that rents are continuing to
grow strongly (about 9 per cent per annum), although there is recent evidence of some
softening in rental growth. Affordability has begun to improve again due to lower house
prices and changes to stamp duty and mortgage interest relief. The combination of higher
rents and improvements in affordability may already be bringing the relative costs of buying
and renting closer, helping to re-establish equilibrium in the market. There are, of course,
risks stemming from the unsettled international financial market environment that could
negatively affect this scenario.
The rate of increase of prices in the commercial property sector is easing following
exceptional rates of appreciation in recent times. The continued uncertainty in the global
financial markets may be impacting on investor demand for commercial property by
increasing funding costs and tightening credit conditions. In addition, commercial property
tends to follow the economic cycle more closely than residential property, and near-term
developments in the real economy could be particularly important for the performance of the
commercial property market. Anecdotal evidence suggests that commercial property
investors are currently maintaining a cautious investment strategy and, consequently, capital
appreciation is expected to ease further in early-2008, as transaction activity slows.
The CBFSAI has been concerned for some time about the level of private-sector
indebtedness. There has been a welcome improvement with respect to these trends recently,
namely, the rate of credit growth has slowed and the rate of accumulation of private-sector
indebtedness has moderated accordingly. The most recently published figures indicate that
private-sector credit increased year-on-year by about 16 per cent compared with annual
rates in the region of 30 per cent in early-2006. It is expected that this downward trend will
continue into 2009. However, an important distinguishing feature of the Irish economy has
been that Irish households do not appear to have consumed their capital gains on housing to
any great extent and, accordingly, their consumption does not appear as reliant on credit as
is the case in many other countries which have experienced relatively large cumulative
increases in house prices. Two additional mitigating factors are the significant share of
households with no mortgage on their primary residence and the substantial net worth of
many households.
Overall assessment of financial stability
Notwithstanding the deterioration in the outlook for financial stability both here and abroad in
recent months, domestic financial institutions remain sound and capable of absorbing
shocks. The strength of the Irish economy is continuing to support the stability of the financial
system, and Ireland has a healthy domestic banking sector with good shock-absorption
capacity. Membership of the European economic and monetary union has increased our
ability to manage the challenging international environment.
The health of the banking sector remains robust according to the key indicators. The sector
is profitable and well capitalised. The level of non-performing loans remains low by historical
standards. Finally, the sector's funding arrangements are good. The Central Bank and
Financial Services Authority with the cooperation of the key domestic banks has regularly
stress-tested the banking sector. These exercises involve measuring the financial health of
the sector in difficult economic circumstances, and the results indicate that the sector has the
capacity to weather a significant slowdown. Notwithstanding the robust health of the sector,
the issues which I have outlined earlier pose challenges for the sector.
International banks have been negatively affected by recent events, both directly through
losses on their US subprime assets and through a variety of other indirect channels.
However, Irish banks have not had to absorb similar losses because the domestic banks
have no significant direct exposures to US subprime mortgages and very limited exposures
through investments and credit lines extended to other financial companies or special
purpose vehicles. The banks' provisional year-end results confirm that losses arising from
the US subprime issue are relatively small.
In light of the scale of the disruption in international financial markets, it was inevitable that
the domestic banking sector would find it more challenging to raise funds on a term basis.
However, Irish banks' liquidity arrangements are good and the sector is comfortably
satisfying the more robust prudential liquidity requirements put in place by the Financial
Regulator prior to recent events. In addition, Irish banks are well positioned to access central
bank funding, both because of the broad range of collateral acceptable in the Eurosystem for
obtaining these funds and the significant volume of this high-quality collateral available to
them.
Lessons - the way forward
Before concluding, I should say that the financial authorities and governments in many
countries are assessing how to turn the corner on the recent period both from a short-term
and medium-term perspective. At an EU level, ECOFIN has set out a roadmap for dealing
with such episodes of turbulence, while the Financial Stability Forum, which brings together
national authorities, international financial institutions, financial regulators and central
bankers, has reviewed the lessons from a global perspective and presented them at the G7
last weekend.
In the short term, all international commentators agree on the fundamental importance of
restoring confidence in the creditworthiness and financial health of banks. The prompt
disclosure by relevant banks of their exposures and associated losses would seem to be
crucial in this respect. In the medium term, the Financial Stability Forum (FSF) has identified
a number of broad policy areas where further action is required to increase the resilience of
the global financial system. These relate to enhanced transparency about banks' exposures
to structured products and off-balance sheet vehicles, improving the valuation of assets
when markets are illiquid, reviewing aspects of the new Capital Requirements Directive and
banks' management of liquidity risks, examining issues around market functioning including
the role of credit agencies, strengthening the authorities responsiveness to risks and, finally,
robust arrangements for dealing with stress in the financial system.
In relation to the initiative on transparency and disclosures, the auditing and accounting
professions have a key role in ensuring the clarity and integrity of data reported by financial
institutions. In the medium term, the Forum proposes that auditors help to develop principles
to be used as a basis for risk disclosures. Further, they are asked to engage in regular
discussions with both industry representatives and investors to discuss the key risks faced by
the financial sector and to identify the risk disclosures that could most usefully be made at
that time. Auditors have also been assigned a significant part to play in addressing potential
weaknesses in financial firms' valuation practices and disclosures, especially at times when
fair valuation is required but the relevant markets are illiquid. For instance, it has been
identified that firms that have performed relatively better during the turmoil had established,
prior to recent events, rigorous internal processes for the valuation of complex or potentially
illiquid securities. In contrast, those firms that performed relatively worse had weaker internal
processes. In the period ahead, auditors are being asked to work with financial institutions to
improve their valuation methodologies and to clarify the uncertainties associated with these.
This would contribute greatly to market confidence.
Conclusion
In conclusion, the Irish economy and its banking sector continue to demonstrate their
strength against the background of a challenging international environment. While the growth
rate of the economy is expected to slow this year, it will still represent a good performance by
international standards, and growth is expected to recover in 2009 and subsequent years.
Prices in the residential housing market are in the process of returning to more realistic
levels. The health of the domestic banking sector remains robust.
The likely duration of the difficult international environment is highly uncertain. Pending a
return to more normal conditions, we continue to monitor the situation very closely. We are
also actively involved in international efforts towards understanding the origins of these
events, drawing lessons that can be learned to help avoid a repeat of the turmoil and
implementing initiatives to improve the resilience of the international financial system. The
auditing and accounting professions have a pivotal role to play in that process.