Patrick Honohan: The new micro-prudential regime for banks
Opening statement by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the
Oireachtas (National Parliament) Joint Committee on Finance, Public Expenditure and
Reform, Dublin, 28 May 2015.
* * *
It is just six months since I had the last opportunity to engage with the Committee. On that
occasion, my introductory remarks focused on three main areas, namely (i) the
macroprudential measures on which the Bank had just published a consultation paper;
(ii) the transfer of ultimate responsibility for the micro-prudential supervision of the main
banks to the Single Supervisory Mechanism of the ECB, which had just taken effect; and
(iii) the level of mortgage interest rates, which was already attracting increasing attention
from the Bank given its consumer protection mission.
In the intervening period we have, as members of the committee are well aware, concluded
the macroprudential consultation and introduced the calibrated loan-to-value and
loan-toincome restrictions for mortgage lending. We continue to monitor the impact and
effectiveness of these and are not dissatisfied with subsequent developments in that market.
The new micro-prudential regime for banks is settling-in well. The transition has been
smooth, exemplified by the results of the ECB's Comprehensive Assessment of the banks at
entry, which confirmed the merits of the asset quality review previously conducted by the
Bank. The modest additional capital requirement for PTSB, triggered by the higher capital
standard set for the ECB's Comprehensive Assessment, was raised in the private market.
The concerns I expressed around the standard variable rate in November foreshadowed a
wider public focus on this issue, reflecting the widening spread between Irish mortgage rates
and those in many other parts of the euro area. The Bank has conducted a good deal of
research on the topic (some of which previously published) and a summary of some of this
was included in the document which was prepared at the request of the Minister for Finance
and published last week.
Since the crisis, banks' SVR rates have moved higher than previously relative to the banks'
cost of funds and arguably higher than a fair-minded customer might have reasonably
expected. This development was manifest in a number of Eurozone countries but the
divergence has become particularly large in Ireland. Is this compliant with the contract that
the customers signed? Is it consistent with good business practice for the long-term
relationship? Is it good for the overall recovery of the economy on which the banks depend
for their long-term success?
Admittedly, it is essential for the survival of banks that they achieve a sufficient return on the
investment of funds, including equity (much of it owned by the Government, by the way). If
not, they will not be able to achieve and maintain the growing requirement for capital
adequacy in the years ahead. The profitability goal has to take account of long-term
considerations, and of the risks involved in lending, especially the actual and prospective
losses on non-performing mortgage loans.
Nonetheless, personally, I would welcome a reduction in bank SVR rates in current
circumstances as a benefit to the economy at large. Were it not for the firm conviction that
the introduction of administrative control on interest rates in Ireland would be bad for the
country as a whole in the medium term - notably because of its stultifying effect on bank
efficiency and its chilling effect on the entry of other banks - there could be a case for some
government intervention.
The SVR contract
The SVR type of contract was the mainstay of Irish mortgage lending for decades. It had the
advantage of being adjustable in response to changing conditions, and as such insulated the
lender from sharp rise in the cost of funding.1 As such, it avoided the devastating squeeze on
profitability which led to the insolvency of a large part of the US Savings and Loans industry
in the 1980s. But the wording of most SVR contracts meant that borrowers are vulnerable,
not only to changing funding costs, but to many other types of influence which the lender
judges to warrant a change in rates. The SVR was increasingly replaced for new lending by
the tracker mortgage, especially in the boom. This much more tightly defined interest rate
contract protected the borrower against any interest rate changes other than those occurring
to the ECB policy rate (which is a rate at which the ECB lends a small amount of the funds
required by euro area banks and which is adjusted to help ensure that the ECB meets its
monetary policy objectives, principally with regard to euro area inflation). Whereas, pre-crisis,
the Irish banks were easily able to secure deposit and bond funding at close to the ECB
policy rate, their ability to do so since the crisis has been constrained (though recently
improving). Because of this (and because the spreads they set above the ECB rate were too
low to cover the loan losses that were to come), the tracker contract has been extremely
costly for the State and the other shareholders of the banks. For this reason, the banks
stopped offering tracker mortgages.
A different/new contractual arrangement that linked the floating rate on new mortgages to
actual funding costs of the banks could be designed in such a way as to achieve the original
aims of the tracker without retaining the vulnerability of the ECB policy-rate linked tracker. (Of
course the spread would have to cover the costs and risks of lending.) But such contracts are
not currently offered.
Given the wording of the SVR contract, I assume that borrowers agreed to SVR terms largely
because they trusted the banks to behave in a fair manner with regard to interest rate
adjustments. And for decades it seems that this trust was, by and large, not misplaced. Is
this still the case? There is clearly justification for some of the increase that has occurred in
the spread, which was too low in the past. Relevant factors include: the persistent drag on
their viability from the combination of a large tracker book and the fact that funding costs are
much higher than the ECB policy rate; the dramatic increase in non-performing mortgage
loans and the need there has been to make large provisions against loan losses; and the
sharply increased capital requirements on banks have all threatened the viability of mortgage
lending for the banks. In a general way, defenders of the banks can point to these factors as
providing some justification for higher spreads on SVRs. Still, such arguments are rather
open-ended, and, in the absence of a transparent, clear and quantified policy on the part of
the banks, can be seen as excuses for charging whatever the market will bear rather than
being a fair application of the contract consistent with a borrower's reasonable expectation.
Under these circumstances, the SVR borrower's main protection is competition: the fact that,
by setting its SVR rate too high, any bank stands to lose business (whether new business or
switchers) to competitors. Whereas this protection was effective pre-crisis, the level of
competition currently is too low. Ensuring that official policy does not inadvertently deter
competition and entry of banks to the market is thus vital for the long-term health of the
economy.
The Central Bank wrote to each of the banks in February to ask for a clear statement of each
bank's pricing behaviour around SVRs. In their responses, none of the banks have so far
provided what I would regard as a clear and quantified statement of their policy with respect
to adjustments of the SVR interest rate.
In my opinion, good business practice of the banks would demand that they make upward
adjustments to SVR rates only following clear and objective changes in prevailing business
conditions (not only funding costs); good business practice would also call on them to lower
SVR rates when the same conditions move in the opposite direction. To regain the trust of
their customers, I believe that the banks should move to publishing a clear and quantified
statement of their SVR interest rate policy. Since they do not seem to have such a policy,
they will need to develop one. If necessary, drawing on its legislative powers for consumer
protection, the Central Bank will codify such a requirement formally, but this should not be
necessary.
Broader considerations
While insisting on transparency may seem to be an insufficient official response to the
manner in which the spread of SVR rates has drifted up, I would insist on my words of
caution against the enacting of legislation that would provide for officially-administered
lending rates. Nothing could be more likely to curtail and discourage entry of new competitors
into Irish banking, and without the possibility of such entry, I cannot see that banking can
recover the operational efficiency and competitive pricing that is essential for Ireland in the
long run. For the sake of modestly lower SVRs for a few quarters, a much larger and
quasipermanent albeit somewhat invisible loss would be incurred by the customers of the banking
system in Ireland. Well-capitalised banks operating more competitively will, in the end, offer
lower rates and better service.
Besides, close administrative control of interest rates would not be easily compatible with the
principle of an open market economy with free competition which has underpinned the
considerable increase in national prosperity over the past half century in Ireland (and which
of course is enshrined in the European Union Treaty). This is not a matter to be taken lightly
or opportunistically for what would clearly be at best a transitory advantage.
The health and ability of the banks to contribute to the needed services to the economy
certainly requires them to operate on a profitable basis.2 Also, they are required by the terms
of the business plans which they agreed in order to receive the sanction of the European
Commission DGCOMP for the State Aid they received, to reach a net interest margin of 2 per
cent. Given they are constrained by contracts on the trackers, there is only a limited range of
options for achieving this. Only then can they build and hold sufficient capital to be compliant
with international regulations, to be fully financially autonomous and not dependent on an
implicit backstop of the State, to have the resilience to deal with future shocks and to serve
customers properly. Their recent return to profitability is modest and significantly dependent
on provision write-backs rather than normal business profitability.
The crisis continues to have serious legacy issues that cannot be resolved easily or
painlessly. To mention just one example, ensuring that borrowers whose loans have been
sold to unregulated firms do continue to obtain the consumer protections that they previously
had is a concern which the Bank has been to the fore in advocating. I am glad to see this
reflected in legislation (on which the Bank has actively advised) currently being enacted by
the Oireachtas.
Without detracting from the importance of appropriate pricing on the SVR loans, I should not
conclude without emphasising that delays and uncertainties surrounding the resolution of
non-performing loans remains a much more acute problem. The latter problem is of course
one which we have discussed in this Committee repeatedly and on which progress remains
damagingly slow.