John Hurley: Financial Stability Report 2004
Opening statement by Mr John Hurley, Governor of the Central Bank and Financial Services Authority
of Ireland, at the presentation of the Financial Stability Report 2004, Dublin, 21 September 2004.
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General introduction
I would like to welcome you to the publication of the Central Bank's first annual stand-alone report on
the stability of the financial system in Ireland.
The report is published in accordance with our mandate under the Central Bank and Financial
Services Authority of Ireland Act, 2003. Our mandate as a member of the European System of Central
Banks also requires us, in conjunction with the various national central banks, to contribute to financial
stability. Financial Stability Reports are an element in the discharge of this mandate.
This is the fourth report that we have published on financial stability issues but up until now the
analysis has been published as a chapter in our Annual Report. The publication of a stand-alone
report has allowed us to expand greatly the depth of analysis on financial stability issues. For the first
time, seven research articles complement this analysis with special attention being paid to the Irish
housing market and the results of the recent exercise in stress-testing of the banking system which we
undertook jointly with the Financial Services Regulator.
What is financial stability?
Financial stability exists where the various components of the financial system (financial markets,
payment and settlement systems and financial intermediation) function smoothly and without
interruption, with each component resilient to shock.
If financial institutions run into difficulties then other banks, businesses and consumers could be very
negatively affected. There have been many examples of financial crises in the past in various
countries that proved to be very costly in terms of economic disruption and lost growth. The primary
aim of financial stability analysis is to try to identify any factors that might lead to crises in the future.
This is a major task as each crisis tends to be very different from the previous one.
Background to the Report
The publication of this report in itself is a contribution towards the promotion of financial stability. It is
intended to increase awareness among all the players in the financial system of the various important
issues at stake to ensure the continued health of that system. There are two distinct approaches
adopted in this publication; first, to report on the current health of the Irish financial system and
second, to highlight the possible shocks which could hit the system and simulate, to the extent
possible, the likely impact of those shocks.
The nature of the exercise involved in financial stability analysis is quite distinct from the type required
for the other economic reports published by the Central Bank, such as our Quarterly Bulletins. We are
not forecasting that all or any of these shocks will occur, and we are not limiting our analysis to those
shocks that are most likely to occur, but we are looking at a broad range of possible shocks and
forming a view on the robustness of the system to withstand these shocks.
Key issues highlighted in the Report
In this short address I will confine my remarks mostly to four areas, namely property prices, credit
growth, stress-testing and the dimension of global risks. Frank Browne will provide further comments
in his presentation that will follow.
Property prices
From our examination of financial stability issues, the risk of an unanticipated and sudden fall in
residential property prices, accompanied by an increase in the default rate among mortgage holders,
is the risk that poses the greatest threat to the health of the banking system. However, the shock
absorption capacity of the banking system is currently adequate.
Regarding the question of whether or not house prices are overvalued, the analyses in the report give
quite mixed results. Some measures suggest that there is a significant overvaluation while others do
not provide evidence of overvaluation. However, what is more certain is that if house prices were to
continue to increase in double digit figures, the risk of a sharp correction would be more pronounced.
In this context, the present tentative indications of a gradual slowdown in house price inflation are to
be welcomed. This development is consistent with the large increase in supply and the decline in
rental income that has been evident for some time. Of course, it should be noted that, even if there is
no significant overvaluation in house prices, any sizeable deterioration in the fundamental
determinants of the market could still mean that house prices could fall significantly and this also
would have adverse implications for financial stability.
Credit growth to the household sector
As I said to you in July, credit growth continues to be a concern - especially credit for property-related
purposes. The continuation of current rates of credit growth to the household sector, well in excess of
the corresponding rates in other countries, will inevitably lead to a more highly indebted household
sector in this country. This underlines the need for both lenders and borrowers to stress-test every
borrower's ability to repay these debts, not just in the economically favourable circumstances that exist
today, but also in more challenging circumstances. In the context of credit growth, our focus has to be
on the medium- to long-term where increasing indebtedness increases the vulnerability of borrowers to
income and employment shocks in future years.
In discussing vulnerability, it is important to bear in mind the current low level of interest rates. There is
a danger that this may be causing some participants in the housing market to associate the adoption
of the euro with permanently low interest rates. Since most new mortgages have periods in excess of
twenty years, borrowers must take a long-term view of interest rates. Variable mortgage interest rates
(which represent the bulk of outstanding mortgages) reflect where the euro area economy is in the
short-term, but are unlikely to reflect where the economy will be in the medium to long term.
We are continuing to work closely with our colleagues in the Regulatory Authority, both in developing
our joint work on stress testing, and in following-up on the results of the mortgage lending study
undertaken last year. Specifically, the Authority requested a tightening up in relation to client income
verification and the funding of mortgage loan balances in order to ensure that loans are properly
secured and will be repaid in full. They are monitoring lending practices on an ongoing basis. In
addition, the Authority is, as part of a review of conduct of business rules, consulting with both industry
and consumers on the benefit of a measure requiring each lending institution to obtain from the
borrower, in writing, agreement of its assessment of the borrowers' ability to repay.
Stress-testing credit institutions
A stress test of the banking system was completed during the last 12 months. This involved the banks
simulating the impact on their financial positions of being hit by a severe recession. The outcome of
the exercise was positive. The financial position of the banking system, and each of the twelve credit
institution included in the test, proved very resilient to the simulated recession. However, these results
have to be qualified because the stress-testing techniques used are still being developed and may be
subject to a number of shortcomings.
International dimension
In any analysis of Irish financial stability, an assessment of international developments is a critical
factor. The extreme openness of the Irish economy makes it exceptionally vulnerable to shocks
emanating from abroad. Systemically threatening shocks are more likely to originate abroad than
within the Irish economy. The interaction of such shocks with any vulnerabilities that might be present
in the domestic financial system could result in systemic weakness. Unemployment as well as interest
rates, both crucial factors in an analysis of the financial health of the Irish economy, can rise as a
result of developments from outside the economy. Currently, there are several international
developments that have implications for the stability of the Irish economy and financial system. The
most important concerns are the large global imbalances, commodity price pressures and
expectations of monetary tightening globally.
Conclusion
Let me conclude this short address by stating what we hope to achieve by publishing our Annual
Financial Stability Report. First, we hope to identify potential risks in the Irish financial system and
second we will endeavour to raise the level of awareness of these risks by all economic agents,
including households and businesses. Finally, we propose to continue our ongoing dialogue with the
banks in the context of the findings of the report with the objective of arriving at a common
understanding of any developments that might suggest a risk to financial stability.