Patrick Honohan: Economic stability issues
Opening statement by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the
Joint Committee on Economic Regulatory Affairs, Dublin, 10 November 2010.
* * *
Thanks for inviting me to discuss issues of economic stability with you here today. I am
accompanied by Bernard Sheridan, Assistant Director General in charge of Consumer
Protection at the Bank, and Anne-Marie McKiernan head of the newly created Risk
Department.
The topic could not be more relevant as I need hardly remark and, although it is specifically
financial stability that is the most explicit part of our remit at the Central Bank, we also have
as one of our main explicit objectives, as set out by the Oireachtas in the Central Bank
Reform Act that was passed just a few months ago, "the provision of analysis and comment
to support national economic policy development." It is in this spirit that I approach our
discussion today.
Clearly this is a time of considerable risk and balance sheet stress in Ireland. Banks,
households, firms and the Government have all been under pressure and what will inevitably
be a lengthy period of balance sheet repair involving consolidation of net spending is in
progress.
I begin with the banks, whose behaviour has been central to the situation that has emerged
both because of their own losses, but also because of the fact that the property price and
construction bubble, which they fuelled with credit, created vulnerabilities in the financial
position of other sectors including the Government.
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 aimed at making them less
vulnerable to confidence shocks or adverse sentiment. The scale on which capital has been
replenished is very large, though the favourable 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, as
I have been reminding foreign observers 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.
I will not rehearse here the details of the scale on which capital has been injected into the
banks with which members of the Committee will be fully aware. It is important that relevant
foreign investors have this information at their finger tips so that they can run their slide-rule
over these figures so that they can see the extent to which buffers have been created to
absorb not only the loan-losses that can be fully expected to occur, but also to take account
of any additional loan-losses over-and-above what has been projected as likely over the
coming couple of years. I sense a concern in the market that some other problems might be
hiding somewhere. Possibly this concern is due to the way in which the later NAMA loan
tranches turned out to involve more severe haircuts than the first lot. Specifically though,
attention has naturally focused on the residential mortgage book, and the scale of the loan-
losses that need to be allowed for here. Although the actual accounting provisions taken by
the banks on this portfolio are small, the Central Bank has insisted that allowance be made
for much higher loan losses. The stress case loan-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. 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.
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.
Presumably over-capitalizing the banks could 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 issues for the banks relate to the working out of the portfolio imbalances that had
accumulated by 2008, specifically the very large loan-to-deposit ratio entailing borrowing
abroad. Much of this exposure to rollover and withdrawal risk has been transformed into a
claim of the ECB. Over time this block of legacy indebtedness will be run off, a process that
could be assisted by sale of securitized parts of the portfolio.
Let me turn to the need to stem the deterioration in the Government's balance sheet and
return it to a contained convergent path. Much ink has been spilled on this matter in recent
days and weeks and I do not need to provide much background.
For the record, let me state that I strongly endorse the Government's decision to set out a
multi-year budgetary plan. The need to announce and implement a clear and fully specified
plan to bring the public finances onto a credibly convergent path of debt dynamics is of the
utmost importance in order to restore domestic and international confidence and thereby
unblock growth dynamics and restore access at reasonable cost to international capital
markets. I also regard the parameters as being within the credible range and a good basis for
rebuilding confidence.
Household and business balance sheets are also stressed. I have already referred to the
over-indebtedness of some households, not least those affected by the increase in
unemployment. Working through these issues is something on which the Central Bank has
specific responsibilities to ensure that distressed households are dealt with properly by the
banks, and my colleague Matthew Elderfield, who has participated in the Expert Group on
Mortgage Arrears has spoken on these matters recently. I don't need to add anything to what
he has said, except perhaps to emphasize and reiterate that, when I have used the word
"manageable" in recent times, in relation to the costs of bank recapitalization, I have of
course been referring to the overall fiscal program. It is an important message for me to
transmit to investors drawing their attention to the fact that these costs are clearly not
"unmanageable". I have evidently not being referring to the consequences of the downturn
and the fiscal measures already taken or contemplated on individual households: it would be
more than impertinent for me to do so.
Finally, there is the question of the business sector and here I think more work is also
needed on restructuring the finances of many small firms whose underlying viable business
is threatened by the overhand of property-related debt that they accumulated on the side, so
to speak. This is a challenging work out job for the banks to tackle, and it needs to be done
expeditiously in order to ensure that viable businesses are not overwhelmed but can instead
resume their contribution to the economic recovery.