Patrick Honohan: Investigating banking failures in Ireland
Introductory statement by Mr Patrick Honohan, Governor of the Central Bank & Financial
Services Authority of Ireland, to the Joint Oireachtas Committee on Finance and the Public
Service, Dublin, 15 June 2010.
* * *
Following publication of my report to the Minister for Finance I promised to come back to the
Committee to discuss the report and the question of the further stages envisaged for
investigating the banking failures. In preparing my report, I had the benefit of a very effective
team which was rapidly assembled to make sure that the job could be adequately addressed
in the limited time available. The members of the team are listed in the report and I would just
like to mention here the contribution of Rafique Mottiar, who is with me here today, Donal
Donovan and Paul Gorecki, who led the team, as well as Nodhlag Cadden and Suzanne
Pepper (also with me today) who organised the logistics and background work.
I can remind the Committee that the context for these reports is that "the Government
considers it essential to thoroughly examine the conduct of the banking sector in recent
years in order to arrive at a fuller understanding of the root causes of the systemic failures
that led to the need for extraordinary support from the State to the domestic banking system."
The Government has envisaged a two stage approach to the investigation, the first stage of
which involved "preliminary reports" potentially providing a basis for the Government and the
Oireachtas to prepare the terms of reference for the second stage, to involve the
establishment of a statutory commission of investigation.
The report I have prepared in response to the Minister for Finance's request is on "the
respective functions of the Central Bank and Financial Regulator ... in assessing and
responding to risks to the stability of individual institutions as well as to the banking system
as a whole". Although the report was described as "preliminary" I believe with my team, it has
been possible to establish a fairly clear and comprehensive understanding of the matters in
question. I believe that clear and unambiguous conclusions have been reached on most of
the issues on which I was asked to comment, and I feel that there will not be any substantial
need for further factual investigations regarding the performance of the Central Bank and
Financial Regulator in these matters.
In preparing the Report, an in-depth review of the powers, responsibilities, philosophy,
mandate, resources, policies and actions of the Central Bank and Financial Regulator was
first carried out on the basis of: (i) publicly available sources such as Annual Reports,
Strategy Statements, Financial Stability Reports, proceedings of the Oireachtas, and
speeches; and (ii) minutes and Board papers of the Central Bank and Financial Regulator as
well as extensive internal files, principally of the Financial Regulator.
Documentary material only takes one so far. In order to obtain additional background
information as well as elicit views of key officials, an extensive series of interviews were
undertaken running to about 120 hours; all persons requested to attend an interview did so.
All of the directors of the CBFSAI and the Regulatory Authority as well as all senior
management, managers and deputy managers in relevant units of the CBFSAI during 2003-
2008 were interviewed. In addition, several other officials of the CBFSAI provided invaluable
assistance on a number of important issues. In addition, to obtain a fuller picture, interviews
were also conducted with a number of senior officials of the Department of Finance, the
NTMA, the former Financial Services Ombudsman and three former bankers.
There are legal constraints on the detail which can be published on individual credit
institutions, but I have sought to disclose as much detail as possible within these constraints.
That has meant concealing or scrambling the identities of individual banks in many places,
but I do not think that this has materially hampered the presentation or interfered with the
possibility of explaining what went wrong.
The committee already discussed last week the work of Klaus Regling and Max Watson.
Their report overlapped to some extent with mine, in that they devoted some attention to
bank regulation and financial stability policy. They also discussed at some length
macroeconomic and fiscal policy on which my report had relatively little to say. There was, I
feel a substantial degree of concordance between the two reports.
To repeat the main conclusions of my report, it points first and foremost to prima facie
evidence of a comprehensive failure of bank management and direction to maintain safe and
sound banking practices.
This failure of bank management was not sufficiently countered by regulatory and financial
stability policy, for three main reasons.
First, a regulatory approach which was excessively deferential and accommodating;
insufficiently challenging and not persistent enough.
Second, under-resourced bank supervision that, by relying on good governance and
riskmanagement procedures, neglected quantitative assessment and the need to ensure
sufficient capital to absorb the growing property-related risks.
Third, an unwillingness by the CBFSAI to take on board sufficiently the real risk of a looming
problem and act with sufficient decisiveness and force to head it off in time.
The report also points to the contributory role of macroeconomic and budgetary policies
which contributed significantly to the economic overheating, relying to a clearly unsustainable
extent on the construction sector and other transient sources for Government revenue (and
encouraging the property boom via various incentives geared at the construction sector). A
less accommodating and procyclical policy would have greatly reduced the need for
preventive action from the CBFSAI.
When I appeared before another Oireachtas committee in December I said, "We understand
some of what happened, but some of it is still hard to understand". I think that we now know
a lot more about the dimensions of the crisis on which my report has focused, leaving
relatively little to be explored at the factual level by the proposed statutory commission of
investigation.
As far as other areas which deserve further study are concerned, in the same general
territory, but just outside the terms of reference for my report, I feel that we still don't know
enough about the risk management and decision processes in the major banks, and how
they failed to avoid disaster. I believe it would be useful to commission independent reviews
of risk management and governance of these matters for at least the two big banks - this
can be a useful exercise on a forward looking basis anyway, but looking at the period 2003-
2008 would be key for the present purposes.
The potential role of accounting and auditing professionals is another matter that deserves
additional factual exploration. It may be that this particular aspect should be deferred until
after more of the NAMA purchases have been completed, as (judging from the evidence
provided to this committee in April by Brendan McDonagh) the due diligence for these
purchases seems to have revealed some issues around loan documentation.
Finally there may also be a case for commissioning a study of the operations of the mortgage
intermediaries in loan origination during the boom period.
At the Central Bank, we have learnt our lesson and are already putting in place new
procedures and arrangements that take account of that, and we will be making further
announcements on this in the coming weeks.
Ric Battellino: Aspects of Australia's finances
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Financial
Executives International of Australia, Sydney, 15 June 2010.
* * *
Given the financial orientation of this group, I thought I would focus my remarks today on
some aspects of Australia's finances. In particular, I want to deal with three questions that
often come up when I talk to analysts and bankers from overseas. These are:

are Australian households over-geared?
 does Australia have too much foreign debt? and

do Australian banks rely too much on foreign wholesale funding?
Before I move on to these questions, I should note that, in my experience, foreigners never
ask about government debt in Australia, or corporate debt for that matter. It is not hard to
understand why, as both government and corporate debt in Australia are low by international
standards.
Household debt
Let me then start with household debt.
The Reserve Bank monitors developments in household debt very closely as they have
significant implications for the economy.
Glenn Stevens summarised the Bank's view on this last week when he noted that, while
households had coped well with current levels of debt, it would not be wise for there to be
further big increases in household indebtedness.
As you know, household debt has risen significantly faster than household income since the
early 1990s. At that time, households on average had debt equal to half a year's disposable
income; by 2006, debt had risen to around one and a half years' income. Since then,
however, the ratio of debt to income has stabilised (Graph 1).
Most of the rise was due to housing debt, including debt used to fund investment properties.
Other household debt, which includes credit card debt, car loans, margin loans and so on,
has not changed much relative to income over the period.
The current household debt ratio in Australia is similar to that in most developed countries
(Graph 2).1 Significant exceptions are Germany and France, where the ratios are lower, at
around one year's income, and the Netherlands, where the ratio is much higher - almost
21⁄2 years' income - due to the tax incentives for households to stay geared up.
All countries have experienced rises in household debt ratios over recent decades. Clearly,
therefore, the forces that drove the rise in household debt ratios were not unique to Australia.
The two biggest contributing factors were financial deregulation and the structural decline in
interest rates.
One of the consequences of financial deregulation was that the availability of credit to
households greatly increased. Up to the 1980s, the various controls on the financial sector
meant that the ability of households to obtain credit was constrained. Even obtaining a
housing loan was relatively difficult. However, after financial regulations were eased around
the globe, many new financial products were developed specifically for households, and
particularly relating to housing finance. Households found it was much easier to get a loan.
Most loans products have worked well, though some have caused significant problems;
subprime loans in the United States are the clearest example.
The level of interest rates in most developed economies in the past decade has been about
half that in the decade to 1995. This structural decline in interest rates has facilitated the
increase in household debt ratios because it reduced debt-servicing costs (Table 1).
Households have therefore found that they can now service more debt than used to be the
case.
Has the rise in household debt left households over-exposed financially? In trying to judge
this, there are a few considerations to take into account.
First, at the same time as the household debt ratio has risen, so too have the assets held by
households. Some commentators might dismiss this as simply reflecting the fact that the
additional debt has been used to inflate asset values. There is some basis for this in relation
to housing assets but, even if we exclude housing and focus only on households' financial
assets, the statement is still true. Financial assets held by households have risen to the
equivalent of 2.75 years of household income, up from 1.75 years' income in the early 1990s.
Second, the available data suggest that the increased debt has mostly been taken on by
households which are in the strongest position to service it. For example, if we look at the
distribution of debt by income, we can see that the big increases in household debt over the
past decade have been at the high end of the income distribution (Graph 3). Households in
the top two income quintiles account for 75 per cent of all outstanding household debt (Graph
4). In contrast, households in the bottom two income quintiles account for only 10 per cent of
household debt.
If we look at the distribution of debt by age of household, we see that the increased debt has
mainly been taken on by middle-aged households. The proportion of 35-65 year olds with
debt increased significantly through to 2008, as households have been more inclined to trade
up to bigger or better located houses, and to buy investment properties. Households under
35 years of age (i.e. the group that would typically encompass first-home owners), in
contrast, have seen a fall in the proportion with debt (Graph 5).
Another factor that has contributed to the resilience of household finances is that, by and
large, the debt has not been used to increase consumption. Apart from some brief periods,
household consumption has not been unusually elevated during this period of rising debt.
Rather, the debt has mainly been used to acquire assets.
Perhaps the best, and most direct, indicator of households' capacity to support the increase
in debt is the arrears rates on loans. This remains very low in Australia. The current arrears
rate is around 0.7 per cent. This is one of the lowest rates among developed economies
(Graph 6). Other data also suggest that households' aggregate debt-servicing capacity is
quite strong: in recent years more than half of owner-occupiers have been ahead of schedule
on the repayments on the loan they took out to buy their property.
Within this relatively benign aggregate figure, pockets of stress have emerged from time to
time. We saw this clearly in the south-western suburbs of Sydney following the sharp run-up
in Sydney house prices over 2002 and 2003. More recently there are some signs of
increased housing stress in south-east Queensland and Western Australia, again following
sharp rises in house prices in these areas.
Another segment of the market that will bear close watching is first-home owners. They have
accounted for an unusually high proportion of housing purchases over the past couple of
years - around 40 per cent. This has reflected the incentives created by various first-home
owner concessions. Most of these purchases have been funded by floating rate mortgages,
and the average loan to valuation ratio is relatively high, at around 90 per cent. Clearly, this
group will be very sensitive to changes in interest rates.
In summary, if we look at the way the increase in household debt has been distributed, what
households have done with the money, and the arrears rates on loans, it is reasonable to
conclude that the household sector has the capacity to support the current level of debt.
Having said that, the higher the level of debt the more vulnerable households are to shocks
that might affect the economy. We at the Reserve Bank therefore welcome the fact that the
household debt ratio has flattened out in recent years and, as Glenn Stevens remarked last
week, there would be benefits in that stability continuing.
Foreign debt
Let me now turn to the question of Australia's foreign debt.
Following the floating of the exchange rate and the removal of capital controls in the early
1980s, both foreign investment in Australia and Australian investment abroad increased
sharply as the Australian economy became more integrated into the global financial system
(Graph 7). In net terms, capital inflows increased from around 2 per cent of GDP to around
4 per cent, and, in the latest decade, to an average of almost 5 per cent of GDP. The current
account deficit widened correspondingly, since with a floating exchange rate the current
account and capital account balances must be equal and offsetting, both being determined
simultaneously through the interaction of a wide range of economic and financial forces.
The pick-up in net capital inflow meant that the ratio of net foreign liabilities to GDP rose.
From around 20 per cent in 1980, it rose to around 50 per cent by 1995. It then flattened out
for a decade, but in recent years the further increase in net capital inflow has seen the
foreign debt ratio rise again (Graph 8).
Expressing foreign liabilities relative to GDP is, perhaps, the most common way in which
people analyse them. For emerging markets, this measure has been shown to have some
association with vulnerability to balance of payments crises. This is because emerging
market economies often have a fixed or managed exchange rate and their foreign liabilities
tend to be denominated in foreign currency, rather than domestic currency. In such instances
a rise in the ratio of foreign liabilities to GDP does indicate increased vulnerability as it
signals an increase in the country's foreign exchange risk and liquidity risk.
For a developed economy that can borrow overseas in its own currency, and which has a
floating exchange rate, the significance of a rise in the ratio of foreign liabilities to GDP is less
clear. It also needs to be kept in mind that, as economies develop, most financial variables
rise relative to GDP. This seems to be a consequence of financial deepening. Expressing net
foreign liabilities as a percentage of the total financing in the economy is, perhaps, more
relevant, since it gives some indication of the proportion of the economy's funding that is
coming from offshore. In Australia, this ratio has remained relatively steady since the late
1980s, at a little over 20 per cent.
Foreign liabilities can also be measured relative to the physical capital stock of the country,
giving an indication of the proportion of the capital stock being funded by foreigners. This
ratio, too, has been relatively steady in Australia since the late 1980s, at around 10 per cent.
One could argue that housing assets should be excluded from this latter measure, since
foreigners' participation in the housing market is relatively limited. On that basis, the ratio
rose somewhat in the early 1990s, but has been relatively steady since.
In short, these measures do not suggest the build-up of any significant disequilibrium in the
economy resulting from foreign liabilities.
For developed economies with a floating exchange rate and the capacity to borrow offshore
in their own currency, the risk from rising foreign liabilities is not that they will cause a
traditional balance of payments crisis, but that they will undermine financial stability. The
process by which this can happen typically starts with a country, for one or more reasons,
becoming attractive to foreign investors. Capital floods in, overwhelming the capacity of the
economy to use it productively. Credit is misallocated and eventually there is some form of a
domestic financial crisis. This type of crisis can occur even in highly sophisticated
economies, as illustrated by the recent sub-prime crisis in the United States.
The policy challenge for countries in this situation is to ensure that the ready availability of
offshore funds does not end up distorting or weakening the financial side of the economy.
As the recipient of large amounts of offshore funds for much of the post-float period, Australia
has had to remain alert to these challenges. By and large, it has been able to successfully
absorb significant amounts of offshore capital over many years. There are several factors
that have contributed to this:

First, the country's foreign liabilities are virtually all either in Australian dollars or
hedged back to Australian dollars.2 Australia is able to do this because foreign
investors are happy to hold a certain proportion of their assets denominated in
Australian dollars. This means that Australian borrowers do not face foreign
exchange risk on the capital sourced from overseas. Therefore, if sentiment turns
and the exchange rate falls, domestic borrowers are largely unaffected. The large
swings in the exchange rate of the Australian dollar that have occurred over the past
couple of decades in no way threatened the corporate and financial sectors.

Second, the offshore capital that has flowed into Australia has been used essentially
to fund high levels of investment. Australia uses foreign capital not because its
national saving ratio is low, but because its investment ratio is high by the standards
of developed economies (Table 2). In the past decade, for example, the national
savings rate in Australia has averaged 22 per cent, much the same as in Europe
and well above the figure of 15 per cent in the US and UK. Over the same period,
the investment ratio in Australia averaged 27 per cent, whereas in most developed
economies it has averaged around 20 per cent. This high ratio of investment to GDP
is, I believe, an indication that Australia is using foreign capital productively, and
sustaining the capacity of the country to service that capital.

Third, credit standards, by and large, have remained robust and the amount of
capital wasted through bad loans has remained limited.
Foreign borrowing by banks
Within Australia's total foreign liabilities, the proportion accounted for by the foreign
borrowing of Australian banks has increased. Virtually all this rise took place through the
decade of the 1990s. Banks accounted for a little over 20 per cent of Australia's foreign
liabilities in 1990 but, by 2001, this had risen to around 40 per cent. It has not changed much
in the past decade (Graph 9).
Part of this trend was the result of banks adjusting their balance sheets following financial
deregulation and the growth of financial markets. These developments gave banks the
opportunity to move from deposit funding to various forms of funding through markets, as a
way of diversifying funding sources or reducing funding costs (Graph 10).
The growth of the superannuation industry, following government decisions to promote
compulsory superannuation, probably contributed to this trend. Firstly, it meant households
became less inclined to hold their savings as bank deposits, and second, the pool of funds
created by superannuation increased demand for securities such as bank securities.
Within this trend away from deposits to funding through securities markets, there were also
forces that resulted in banks increasing their use of offshore funding. As an example, a
substantial proportion - about 20 per cent - of superannuation savings flow offshore, mainly
into foreign equities. This reduces the pool of savings available domestically to banks and,
other things equal, increases the amount of offshore funding banks need to undertake.
It is also an inescapable fact that, with Australia running a current account deficit, some
funding for the economy needs to come from offshore. Households, by and large, cannot
borrow offshore and the government sector has not had much need for offshore funding.
That leaves the corporate and the financial sectors. Of these, the financial sector has a
comparative advantage in offshore borrowing, because of the relatively high credit rating of
Australian banks, both compared with Australian corporations and, in recent years, with
banks in other countries.
Banks in Australia have therefore established a significant role in intermediating the flow of
funds from overseas to Australia. Banks in countries where there are surplus savings, such
as those in Europe, play a similar role, though in reverse; they channel funds from domestic
savers to offshore.
There is a natural tendency to believe that it is riskier for banks to borrow offshore than to
lend offshore. Events over the past few years, however, have shown that one activity is not
intrinsically more risky than the other. It is a matter of how the risks are managed. In the lead
up to the financial crisis, for example, European banks were running very significant risks
through their offshore lending, not only in terms of the credit quality of the US assets they
were buying, but also in terms of the short-term nature of some of the funding transactions
that supported those assets. The US dollar shortages that keep recurring in global money
markets are manifestation of those funding risks. These risks were largely unrecognised and,
it seems, not very well managed.
The Australian banks have long recognised the risks that come from their business model,
and, in my experience, are very focused on understanding those risks and managing them.
This contributed to their relatively good performance through the global financial crisis.
Conclusion
You may have noticed that I have not given categorical answers to the three questions I
listed at the start of my talk. This is because I don't think it is possible to give simple "yes" or
"no" answers to these questions.
However, looking at a broad range of financial data, and considering the fact that the
Australian economy and financial system have exhibited a high degree of stability over many
years, despite the many global events that have tested their resilience, is, I think, grounds for
confidence that the economic and financial structure that has evolved in Australia is
sustainable.