Patrick Honohan: Financial regulation - risk and reward
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, at the International
Financial Services Summit 2010, Dublin, 10 November 2010.
* * *
The topic of this morning's session fits nicely with what I want to say about the way forward
for the Irish banks.
To the extent that the global banking and wider financial market collapse of late 2008
reflected both a sharp upward revision in market estimates of risk, combined with a sharp
downward movement in risk appetite, it is not surprising that the global regulatory response
has been in the direction of seeking to shift risk to where such reassessments and changing
appetites can do less damage. That entails de-risking the banking sector (as well as
widening the scope of prudential regulation at least to some extent).
I like to list the main sources of social risk from banking as credit, liquidity and complexity
risk, as well as the constant tension of misalignment of private incentives with social welfare.
The policy responses that have been adopted and proposed, both in international fora and in
national regulatory policies here in Ireland and in most other jurisdictions have sought to deal
with these four risk sources. For each there is a classical regulatory tool - some dating back
to the Great Depression or before - and these tools have been intensified or ramped up
where they were still in operation, dusted down and modernized where they had fallen into
disuse during the long period of deregulation which accompanied the macroeconomic lull
from the late 1980s known as the Great Moderation.
Thus, to meet heightened credit risk, there have for years been capital requirements; to meet
liquidity risk there were liquidity ratio requirements; to meet complexity risk there have been
incentive risk
restrictions on scope of activity; and to meet there is prudential supervision.
The Basel 3 and Financial Stability Board discussions have focused on the first two of these.
The greater reliance on going concern capital instruments, the higher overall risk-ratios, the
counter-cyclical mechanisms and the more restrictive definitions of capital all move in the
direction of better absorption of credit risk and other risks relating to asset values.
The two liquidity ratios, one to lengthen the time over which short-term outflows can be
reliably met and the other to reduce the scale of maturity transformation on a medium-term
basis, clearly roll-back the egregious liquidity risks that were being taken four and five years
ago.
Complexity risk has also been addressed in discussions that range from the "Volcker Rule",
seeking to prohibit own-account or proprietary trading by regulated banks, to the suggestions
from the Bank of England that narrow-banking should form the heart of the protected and
regulated banking sector. (Complexity has not really been a major issue for the Irish banks
and we have not had to address many issues of this type outside of the export-oriented
IFSC).
Finally, intensified, intrusive supervision is on the daily agenda of every regulator I have
spoken to.
Ireland - the problem
All of this discussion is of much more than theoretical interest in Ireland, where it can be said
that the banks as a group went into the downturn more exposed than most other systems,
and have correspondingly had to cope with worse loan-losses than most.
The regulatory response over the past few quarters in Ireland has been fully in line with the
need to de-risk the banks and make them less vulnerable to confidence shocks or adverse
sentiment. The scale on which capital has been replenished is very large, though the
favorable impact on investor confidence has not yet been as strong as might be hoped for.
Much of the reason for the slow return in confidence lies in the parallel weakness of the fiscal
situation - a weakness which also has its roots in the credit-driven property bubble which
lulled the managers of the public finances into a false sense of security ending up with a tax
and spending structure highly vulnerable to the downturn.
With the government finances so stretched, the additional burden of recapitalizing the banks
has reduced fiscal headroom and contributed to the concern of the financial markets. Still, I
would like to remind you that this recapitalization burden is often over-stated as a contributor
to the required fiscal adjustment. Indeed, the interest cost of servicing the notes injected to
recapitalize the banks only accounts for about one-tenth of the fiscal adjustment now in
prospect over the next four years.1
The plan
Since it became evident last year that heavy loan-losses were inevitable at the banks, and
that the Government was going to meet the losses arising from the bursting of the
construction and property bubble, the plan has been to divide and conquer the risks by
putting the banks - as institutions - firmly back on their feet without being dependent on
either future assistance or threats from government; thereby freeing the government finances
from the apparent threat of bank-imposed costs.
Achieving this separation requires actions to reduce and shift risk, so that, for example, the
banks are seen to be well-capitalized and sufficiently de-risked in terms of their loan
portfolios. It also requires market participants to be convinced that this action has been
effective and sufficient. So far, not least because of the rest of the fiscal burden remaining
such a challenging problem, investors are not yet fully convinced.
Important steps in the process are still under way but nearing completion, namely (i) the
purchases by NAMA of the big property-backed loans and (ii) the achievement - despite the
very sizable loan losses crystallized by these purchases - of much higher capital ratios.
These capital ratios are calibrated to ensure that core tier 1 capital remains above 8 per cent
through to 2012 (7 per cent equity) for the main Irish-controlled banks, taking into account
the inevitability that the non-NAMA book will incur additional losses not yet brought to book
during that time. (The new capital injected would keep the banks above 4 per cent core tier 1
even in a severe stress scenario contemplated by the Central Bank and involving much
higher loan losses across the loan book than are currently expected by the banks.) The
higher capital ratios have been achieved partly through the sale of sizable non-core assets at
prices above book as well as by the acquisition of equity stakes by the National Pension
Reserve Fund and (in the case of Bank of Ireland) by the private sector.
Scale of losses dealt with by the capital injections
I'm not sure that it is widely recognized just how big the actual and prospective loan-losses
taken account of in the recapitalization of retail banks in Ireland has been. In fact, if we
include the losses of the 6 main foreign owned banks active in the domestic market, of which
the largest have been Ulster (an RBS subsidiary) and BOSI (a subsidiary of Lloyds) as well
as all six of the banks that were guaranteed at the end of September 2008, and if we include
all loan losses that have been provided for in the accounts of the banks since 2007, as well
as the Central Bank's base case of the prospective losses through to 2012 (against the
expectation of which the current capital requirements have been set), the total loan losses
come to no less than €85 billion, or about 55 per cent of this year's GDP. In addition to the
State's share in injecting funds to meet these estimated losses (which has already been
announced and widely discussed), the remainder has in effect, been absorbed by the
shareholders. I mention this not so much to emphasize the scale of the problem as to dispel
any impression that the policy and shareholder response in restoring capital levels might
have grossly low-balled loss estimates.
Yet investor confidence has been slow to recover fully. In part, this doubtless reflects the
conventional observation that credit and confidence are lost quickly and recovered much
more slowly. It will not have helped that the laborious process mandated for NAMA loan
valuations have taken such a long time and that the first NAMA haircuts, high though they
were, unexpectedly proved to be less harsh on average than the rest, leading to a sequence
of bad news events. Undoubtedly, the severity of these haircuts has led some observers to
read across to the non-NAMA book (and indeed the Central Bank has applied such a
readacross on a bank-by-bank basis in respect of the property loans in the €5-€20 million
category that are no longer NAMA-bound, and banks are being required to hold that much
more capital).
A read across also from concerns in the US that American banks could experience further
loan-losses given the slow recovery of the property market there may also have caused
observers to question the adequacy of loan-loss provisions in the Irish residential mortgage
books especially given the downward revisions in some of the medium term macro forecasts
for employment and GDP growth in Ireland (even though the stress case expected loss ratio
to 2012 of 5 per cent used by the Central Bank for the Irish residential loan books to
determine required capital levels is well outside historic experience in Ireland). Despite
recent trends in arrears and reschedulings, there is as yet no hard indication that the stress
levels would be exceeded. Undoubtedly there are many stressed households with
burdensome mortgage debts, not least in the buy-to-let category; the policy challenges that
this presents in terms of achieving workable and fair solutions are more complex than the
mere issue of the likely loan-losses that might be involved, for which (as I have mentioned)
an allowance well in excess of the banks' own accounting provisions has already been
made.
Winning investor confidence
In anticipation of next year's update of the PCAR exercise, the Central Bank is embarking on
a more granular analysis of the this part of the portfolio in particular to track its evolving
performance and determine whether the expected loss amounts remain sufficient.
This is a long-term book and its lifetime performance will not be precisely known for many
years, nevertheless, it is important to have early awareness as possible of any deterioration
resulting from the evolving macroeconomic conditions, and take any necessary
consequential regulatory steps.
Accelerating Basel 3 agenda
As the Basel 3 programme is implemented for Ireland, both in terms of capital and liquidity,
and supported by the intensified supervision process which we have been putting in place,
the underpinnings of investor confidence will be strengthened. Bank boards and
management will be already thinking along these lines. The faster this can be achieved, the
better, and - though that is more easily said than done - it is clearly desirable to aim for a
earlier restoration of confidence.
Capital: Already the 7 per cent equity requirement imposed by the Central Bank resonates
with the same percentage built into Basel 3, though the Basel definition of capital is rather
more stringent. Presumably over-capitalizing the banks would also help build confidence, but
this is not something which the State can be lightly asked to do, given the pressures on its
finances. Indeed, the market's perception of the stressed condition of the Sovereign is surely
weighing also on the banks in terms of interest costs and ready access to funding; just as the
banking problems have weighed on the Sovereign.
Liquidity: In order to meet the Basel liquidity ratios, the banks will, over time, have to either
find new sources of long-term funding, or - more likely - dispose of some of their assets.
Packaging sizable blocks of, say, residential mortgages and selling them to international
investment funds (while continuing to administer the loans at the retail level) is one
conceivable way of achieving the Basel long-term stable funding ratio in a way that allows
the banks to de-risk further by funding a much higher proportion of their remaining asset
portfolio with their own retail and corporate customer deposits, and not be so dependent as
they are at present on short-term wholesale funding including central bank funding. To be
sure, any such operation would certainly have to be designed in such a way that the new
structures did not bring additional moral hazard with them. Achieving such sales at realistic
prices in the current market climate - with market participants distrustful of all forms of
Residential Mortgage Backed Security would likely require some form of credit enhancement.
As such, involvement of external equity in such a transaction would likely be necessary.
Indeed, from a national point of view, the entry of foreign purchasers for some or all of the
banks would help transfer both credit and liquidity risk to those in a better position to bear
them. This is not as far-fetched a scenario as it might appear to some; astute bankers
recognize that there is profitable banking business to be done in Ireland in the years to come,
though they will differ on the optimal timing and pricing of entry.
We'll be contributing to an intensified effort to identify viable measures along these lines to
select and implement the most cost-effective of them, as it is clear that all will benefit from
greater market confidence in the financial situation of the banks as in the sovereign.
Towards a virtuous circle
This is a virtuous circle we are seeking to enter and exploit. Even if moving towards a
stronger banking system in terms of capital and liquidity has entailed costly outlays for the
State, it is a prerequisite for ensuring the credit of the State.
Likewise, healthier public finances are indispensible for keeping interest costs and ensuring
that the banks have ready access to market funding. In the end, I believe it is the prospects
for effective fiscal adjustment against the background of the global macroeconomic recovery
that will most directly determine the degree to which investors will be fully convinced that the
banks have been de-risked and strengthened in the manner envisaged by the Basel 3
process, and thus able to contribute more effectively themselves to the consolidation of that
recovery. Besides, even if there is a negative initial demand effect, healthy government
finances are - like healthy banks - needed for job creation and economic recovery.