John Hurley: Restoring stability to the banking system
Speech by Mr John Hurley, Governor of the Central Bank and Financial Services Authority of
Ireland, to ACI Ireland, Dublin, 10 June 2009.
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Introduction
Thank you for inviting me to speak to the Association again. When I last addressed the ACI it
was the autumn of 2007. We had by that time experienced the first months of market
volatility, which had started out as a problem centred on the US sub-prime market quickly
followed by global problems of declining liquidity and a sharp re-pricing of risk.
As we now are aware, we were, back then, only in the foothills of what has turned out to be a
financial crisis of very major proportions; one that has demanded, and continues to require,
an immense response from authorities worldwide. It is also a crisis with a particular domestic
resonance here, coinciding as it did with the correction in our own property and
constructionrelated sectors. As in other countries, the authorities here have taken extraordinary and
unprecedented measures to stabilise the banking system and the economy.
My address tonight will focus on events since September of last year when the turmoil
became a full-blown crisis and how authorities have responded since that time. It is clear that
that this crisis will drive significant changes both in terms of the structure of banking systems
as well as the regulatory regime and I will share some thoughts on these issues. Restoring
stability to the banking system is a necessary but, on its own, not a sufficient condition for
restoring health to the economy. I will conclude by commenting on the other key policy
challenges of restoring competitiveness and stabilising the public finances.
Financial market turbulence evolves into a crisis
The events of last September, centring around the failure of Lehman Brothers, were seminal,
after which governments and central banks everywhere had to intervene in an
unprecedented way and on a scale that was not conceivable beforehand. Beginning in
September, global interbank markets increasingly seized up, even at the very shortest
maturities. The severe shortage of liquidity impacted significantly on the operations of banks
everywhere. In response, policy makers across the world have taken exceptional steps
through direct financial sector interventions, as well as monetary and fiscal policy responses.
Recapitalisations, deposit guarantee extensions, the provision of credit and liquidity, and
programmes to deal with distressed assets were all undertaken to support financial
institutions, while central banks cut policy rates to historically low levels and have introduced
a range of non-conventional monetary policy measures.
The response of public authorities in Ireland
Notwithstanding the limited exposure to structured financial products of Irish banks, the
interaction of the global shock to financial markets with the pre-existing vulnerabilities in the
domestic economy triggered systemic repercussions here. A particular vulnerability here was
an overheated property market that had been financed through the banking sector, in large
part with funds raised on wholesale markets both at home and abroad. The immediate
systemic consequences of the shortage of liquidity for the domestic banking system have
been accompanied by the broader economic impact we are now experiencing.
The principal motivation behind all of the decisions that have been taken subsequently with
respect to the banking system has been to limit damage to the real economy from the
banking crisis. The banking sector plays a crucial role in the modern economy by acting as a
financial intermediary and ensuring that funds are distributed from those who wish to save to
those who wish to borrow. When this vital function is impaired, it can have severe effects on
economic activity. Downturns that are preceded by episodes of financial stress tend to be
longer in duration and, partly because of this, more severe than those caused by other
factors. Furthermore, when the financial stress is related to the banking sector in particular,
then the impact tends to be even more significant.
The approach adopted here in response to the crisis is consistent with the general approach
adopted by countries across the EU; namely, the initial introduction of a state guarantee for
banks' liabilities, followed by recapitalisation of banks to ensure viability and nationalisation
where warranted, and most recently, measures to address banks' non-performing
propertyrelated assets through the establishment of the National Asset Management Agency
(NAMA). A final necessary stage must address the optimum shape and structure of the
domestic banking sector that will be required to meet the needs of the economy in the years
ahead.
The State guarantee
By end-September of last year, the severe shortage of liquidity in global money markets was
impacting significantly on the operations of Irish banks. Funding pressures were exacerbated
by negative international investor sentiment, related to Irish banks' exposures to the property
sector, at a time when property prices and transaction volumes were declining following a
period of unprecedented increases. Daily liquidity reports were showing that the situation
was becoming increasingly strained.
Events came to a head on Monday 29th September when it was found necessary to
introduce a State guarantee for a range of domestic banks' liabilities. The objective of the
guarantee was to give sufficient time for our banks to stabilise their funding situation, by
providing the necessary confidence for international investors that would enable them to
continue lending to Irish banks in the fraught environment at that time, thereby relieving
short-term funding constraints and preventing a drain of liquidity. To maintain the confidence
of international wholesale markets on which Irish banks are heavily dependent, it was
essential that the guarantee be pitched at a level that ensured success. The guarantee
resulted in an immediate improvement in the liquidity situation. Subsequently, a large number
of countries, including at least 14 other European countries, introduced guarantee schemes
in order to obviate the same risks, although the type, and maturity, of liabilities covered has
differed according to different circumstances and judgements made in individual countries.
Recapitalisation
It was recognised at the time that the guarantee was not a long-term solution and that it
would still be necessary to determine if additional capital would be necessary for Irish banks.
On the basis of supervisory information, Irish banks met their regulatory requirements.
Across Europe, however, international markets were expecting higher core Tier 1 capital
ratios than before the crisis. A number of countries, including Ireland, took the decision to
recapitalise banks on this basis. A further consideration in the Irish case was market
participants' expectations of significant write-downs on property-related assets that would eat
into existing capital. The severity of the downturn in the economy was also a factor in
recapitalisation here. While Irish banks, unlike many of their international peers, were not
exposed to securities based on US subprime mortgages, the exposure that attracted concern
in the Irish case was our system's over-exposure to property-related loans. There was great
uncertainty about the ultimate impact of the unwinding of an overheated property market on
the quality of banks' assets. There was also concern that banks might attempt to improve
their capital positions only by curtailing the supply of credit. Historical experience from other
countries shows that this type of dynamic would potentially have had severe and lasting
negative repercussions for the economy and the financial sector and needed to be avoided
After consultation between all the relevant authorities, a decision was taken to recapitalise
our largest domestic banks following due diligence on these banks' exposures. The banks
were also required to make a commitment to increase lending capacity to small and
mediumsized firms and first-time buyers. Following the emergence of unacceptable governance
issues, Anglo Irish Bank was taken into public ownership to protect the stability of our wider
financial system.
Non-performing assets on banks' balance sheets
International commentators, such as the IMF in its Global Financial Stability Report, suggest
that the challenge now for many countries is to address banks' balance sheets - specifically,
to identify and deal with impaired assets - as a necessary step in recovering from the crisis.
Our domestic banks have substantial exposures to land and development loans, which
creates uncertainty about their capital positions and, ultimately, affects their ability to provide
credit to the real economy.
It is in this context that the Government has decided to establish the National Asset
Management Agency. The intention is to transfer the land and development books and
appropriate associated exposures to NAMA in return for government bonds. It is essential
that this is done; it is a critical stage in the process to renew confidence in the banking
sector. The correct pricing of these assets is a most important issue and must balance value
for the taxpayer with restoring the capacity of the banking sector to support the real
economy.
The Eurosystem response
Alongside the various domestic initiatives outlined above, the Central Bank has continued to
respond to the crisis as a member of the Eurosystem. The Governing Council of the ECB has
reduced its key policy interest rate by 325 basis points cumulatively since last October. This
has had a very significant effect in lowering borrowing costs for households and firms across
the euro area, including in Ireland. There has been a pick-up in investor sentiment over the
last number of months and this partly reflects economic indicators, which have been
somewhat more positive both in Europe and globally. Nevertheless, this follows a very sharp
contraction in euro area GDP in the first three months of the year and the more recent data,
for the most part, point to a further - but smaller - decline in activity in the second quarter.
The recovery is likely to be gradual and extended, however, given the nature and scale of the
crisis we have experienced. As a result, monetary policy will have to remain accommodative
for as long as is required and will only be adjusted when there are definite signs of a
significant improvement. As regards prices, euro area inflation is expected to turn temporarily
negative for a period this year but to return to positive territory again thereafter. I would like to
emphasise that, over the medium term, indicators of inflation expectations remain very much
in line with the Governing Council's definition of price stability. This reflects the Eurosystem's
credibility.
The Governing Council's response to the crisis has been exceptional and has also included
innovative non-conventional measures, particularly in terms of liquidity provision. Banks are
currently able to access unlimited liquidity against suitable collateral at a fixed rate for up to
six months, and later this month they will be able to do so for an even longer period, up to 12
months. This has been of enormous benefit to Irish banks and to the euro area banking
sector in general. At its last meeting, the Governing Council announced the details of a
programme to purchase around €60 billion of euro-denominated covered bonds issued in the
euro area, which will help an important market, and again will be of benefit to banks and
support credit provision. The European covered bond market is currently stalled and the
programme will help stimulate the market, as it increases demand for the instruments in
question, making new issuance attractive for banks. Covered bonds form an important
funding channel for the main Irish banks.
What does the future hold for banking systems generally?
While it remains unclear when the crisis will end and what its ultimate effects will be, recent
signs of recovery remind us that we need to look at the type of financial system that we want
to see emerge when the crisis is over. This holds at national, EU and global levels.
The ongoing crisis underlines the need to adopt a system-wide approach to regulation and
supervision. The proposals of the de Larosière report are particularly pertinent on this point.
A feature of the current crisis has been that, while the build-up of pressures at a macro, or
system-wide, level was widely recognised when it was happening, the publication of these
concerns, which was the internationally accepted way for central banks to convey their
concerns, was not effective. This was the case both internationally and in Ireland. It is
essential, therefore, that we bridge the gap between financial stability, or macro-prudential
supervision, on the one hand and micro-prudential, or traditional supervision, on the other. In
this context, the European Commission has proposed a new supervisory framework for the
EU based on the de Larosière proposals. The proposal for new structures recognises
explicitly the need for macro-prudential risk assessments in order to identify emerging
vulnerabilities in the financial system and issue risk warnings but also, crucially, the necessity
to follow these with policy actions when appropriate. While the details of the proposed new
EU framework still need to be ironed out, I strongly support the direction proposed. I
welcome also the recent announcement here providing for full integration and co-ordination
within the Central Bank of responsibilities for both financial stability and micro-prudential
supervision. These new domestic arrangements would fit very well with the proposed new
European framework.
The current crisis has made it clear that risk management practices across all parts of the
financial sector need to be improved significantly. One of the key aspects that must be
addressed is ensuring that the regulatory framework does not magnify the cyclicality already
inherent in the financial system, as it has during the current crisis. In this context, it is
essential that we develop mechanisms and procedures to ensure that banks accumulate
resources in good times to act as a cushion when the cycle turns. Clearly, accounting
standards play an important part here, and I welcome initiatives being undertaken both at the
IASB and the Basel Committee to improve reporting in order to reduce cyclicality. The
restructuring of remuneration packages is another important issue related to risk
management practices, and the re-alignment of incentives to prioritise long-term
sustainability above short-term profitability is necessary.
Structure of Irish banking sector
In the light of all that has happened, we need to examine the structure of the domestic
banking system. When the crisis comes to an end the structure and shape of our banking
system will be different. This is likely to be an international trend. In Ireland, the very
existence of NAMA will in itself be central to this. The banks that emerge from that process
may well be smaller but better prepared for the new environment. This should allow for a
more focused and consolidated banking sector. We need to ensure that the banking system
that emerges is one that is there to serve the future needs of the economy.
The global financial services industry is going through a period of radical change as a result
of the financial crisis. At this stage, it is not clear what will be the ultimate impact on the
industry. The international financial sector operating in Ireland is obviously not immune to
these global developments. However, there is a broad range of activities located in the IFSC,
which as a whole has withstood the crisis reasonably well, and I am confident that the IFSC
will continue to make a very significant contribution to the Irish economy.
Economic assessment
While huge efforts have been put in to stabilising the financial sector, we also need to act to
restore stability in other areas. More generally, it is vital that we act credibly and quickly to
confront the very significant challenges that we face and chart a path that will in time ensure
a sustainable recovery in economic growth. Over the past two decades, Ireland has
demonstrated a strong ability to exploit its advantages - in the form of flexible markets, a
competitive economy and a highly-skilled and educated labour force - to generate growth. In
more recent times, these strengths have come to be masked by increased costs and by the
fact that economic activity had become unbalanced. We had become too dependent on
largely construction-driven growth in domestic demand. Among other things, this pattern of
growth entailed an overdependence on property-related transaction taxes. The inevitable
downturn in construction activities then gave rise to an extremely sharp and severe
deterioration in the public finances, the scale of which has exceeded even that of the
downturn in economic growth. The importance of taking effective and immediate steps to
improve cost competitiveness and address fiscal imbalances cannot be overstated.
Economy-wide productivity gains have been very modest and labour costs have been
relatively high in recent years compared to our main trading partners. This deterioration must
be addressed if we are to return to a sustainable growth path. A strategy to restore
competitiveness must encompass action on a number of fronts including pay and non-pay
costs, infrastructure improvements which support productivity growth, the enhancement of
competition in sheltered sectors, continuing to encourage innovation and R&D activity and
enhancing the skill levels of the labour force.
In particular, a flexible approach to wage developments is essential. More recently, in the
face of the sharp contraction in economic activity, many firms have taken action to reduce
their costs including the negotiation of reductions in wage rates, with a view to protecting
employment. While this has undoubtedly been painful for those concerned, it nevertheless
reflects encouraging evidence of the flexibility and realism that is needed if the economy is to
maintain the maximum possible number of jobs in the short-term while placing Ireland in a
favourable position to benefit from an eventual recovery in world demand. This type of
flexibility must embrace all sectors of the economy.
The deterioration in the fiscal position has been a cause for serious concern. The
Government has agreed with the European Commission to correct our Excessive Deficit
position by 2013. The Government's introduction of a public sector pension levy and the
Supplementary Budget are steps they have taken to this end. It is important that the target
agreed with the European Commission be met.
Future lower medium-term growth potential means that cyclical recovery will not solve our
fiscal problems. The Commission on Taxation and the Special Group on Public Service
Numbers and Expenditure Programmes, which are currently underway, will have a key role
to play in identifying measures that will improve the budgetary situation in coming years,
These measures are necessary to restore confidence, deal with financing concerns and
underpin the medium-term growth potential of the economy.
Conclusions
In summary, we remain in a very difficult and challenging environment. The very significant
global downturn, as evidenced for instance by the IMF in their latest global economic
forecasts, coupled with our own economic difficulties, is impacting significantly on Irish
households and businesses. On a human level, the contraction in the economy is impacting
directly on households' incomes and resulting in very significant levels of unemployment.
Sound economic management and timely decision making to deal with the unfolding situation
are therefore essential. In this context, it is critical that continuing action is taken to both
improve the economy's competitiveness and address the deterioration in the fiscal position. It
is also vital to ensure that stability is restored to the banking sector as quickly as possible
and I have outlined the actions already taken in this regard. If we address all these
challenges head-on, the economy has the potential to grow solidly again in the medium term
and the process of reducing our significant levels of unemployment can begin.