Morgan Kelly’s paper can be found here: http://www.ucd.ie/t4cms/wp09.32.pdf
On a personal level: my daughter was just born 3 days ago so I don’t have sufficient time to give a proper response to his paper but the following is one area that I feel he’s overstated the downside risk. I don’t believe there is no downside risk only that it isn’t as great as he presents it to be.
The issue is with this quote:
“From being almost entirely funded by domestic deposits in 1997, by 2008 over half of Irish bank lending was funded by wholesale borrowers through bonds and inter-bank borrowing. This well of easy credit has now run dry. In the words of Bank of England Governor Mervyn King: “But the age of innocence—when banks lent to each other unsecured for three months or longer at only a slight premium to expected policy rates—will not quickly, or ever, return.”4 As foreign lenders have become nervous of Irish banks, their place has increasingly been taken by borrowing from the European Central Bank and short-term borrowing in the inter-bank market. Payments from NAMA will allow Irish banks to reduce their borrowing by a trivial amount. Without continued government guarantees of their borrowing and, more problematically, continued ECB forbearance, the operations of the Irish banks do not appear viable. Borrowing in wholesale markets at 5.6 per cent5 to fund mortgages yielding 3.5 per cent is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets by repaying debt and returning to their earlier state of being funded mostly by deposits.
From being almost entirely funded by domestic deposits in 1997, by 2008 over half of Irish bank lending was funded by wholesale borrowers through bonds and inter-bank borrowing. This well of easy credit has now run dry. In the words of Bank of England Governor Mervyn King: “But the age of innocence—when banks lent to each other unsecured for three months or longer at only a slight premium to expected policy rates—will not quickly, or ever, return.”4 As foreign lenders have become nervous of Irish banks, their place has increasingly been taken by borrowing from the European Central Bank and short-term borrowing in the inter-bank market. Payments from NAMA will allow Irish banks to reduce their borrowing by a trivial amount. Without continued government guarantees of their borrowing and, more problematically, continued ECB forbearance, the operations of the Irish banks do not appear viable. Borrowing in wholesale markets at 5.6 per cent5 to fund mortgages yielding 3.5 per cent is nota sustainable activity, and Irish banks face no choice but to shrink their balance sheets by repaying debt and returning to their earlier state of being funded mostly by deposits.”
Essentially, Irish banks will be forced to go back to a deposit only model where their current levels of assets vastly outstrips their current level of liabilities so they’ll have to trim the asset side of their balance sheet. Because much of these assets are long term assets that are difficult to liquidate (if not impossible in some cases), the Irish banks will be forced to cut back on new lending and “rolling over” old lending. Thus very very bad for the Irish economy.
The problems I see with this are:
a) The idea that wholesale funding won’t be made available to Irish banks at attractive rates if there is an obvious availability of good investment opportunities being left go seems to run against basic economic logic. Short term mismatches between available credit and potential demand for credit do occur but is there good evidence to suggest that such short term fluctuations can become long term in a country? The examples of the Latin Debt crises and South-East Asian crises would say no.
b) Mortgage rates aren’t fixed at 3.5%. Most commentary on the residential market that I’ve read indicates that variable rate mortgages are the norm not fixed or tracker mortgages. If wholesale money costs more, mortgage rates will be forced upwards. The issue comes from whether one believes that wholesale money will decrease for Irish banks or not. I’d argue that we’re seeing the high point for the medium term right now with respect to the difference from the ECB rate over the past year and a half not the norm for the next 5 – 10 years. Market confidence is weak, risk aversion is high and so on. This isn’t a new market norm though, we’re simply in a global recession with a nastier national recession, of course wholesale money is going to be expensive for Irish banks right now but that doesn’t mean it will necessarily stay this way over the medium term! Higher mortgage rates bring problems for the banks, but this is inevitable given the abnormally low ECB rate.
c) The problem of the level of mortgage debt versus GDP/GNP is undoubtedly a real and very worrying problem. There are some aspects of it that are less apocalyptic though compared to the problems seen in the US. First, bankruptcy law is very different here and encourages the debtor to avoid default at all costs in a falling market versus in the US where no-recourse loans make walking away from debt easy. Second, we thankfully only had minimal activity in the sub prime market and minimal “no paperwork” mortgages and similar. While we do have too much mortgage debt, that debt is generally sitting on the laps of people with goodly sized incomes. Yes these incomes are now under threat but we have nothing close to the problem we would have if lending practices had been as loose as they were in the US. Finally, those that hold the mortgages income streams are far closer to the borrower than in the US with CDOs. This closer banking relationship should allow for a smaller default rate through banks being able to offer easier terms if temporary repayment difficulties are encountered. This isn’t a panacea and Irish banks will have to deal with defaults but we might be spared the meltdown that the US property market saw.
Overall, I agree that the Irish banks will have serious problems to deal with in both the short and medium term. I don’t agree that the downside risk on this side of things (i.e. wholesale market funding especially) is as bad as this paper would have us believe. Then we are dealing with large unknowns here and perhaps I’m being overly optimistic but I think I have history on my side with regard to credit inflows after banking crises and recessions.
The Mercer report summary can be found in here: http://www.mercer.ie/summary.htm?siteLanguage=100&idContent=1366355
One particular line leaps out at me:
“The organisations in the survey are primarily subsidiaries of multinational corporations and large Irish companies and represent some of the largest private sector employers in Ireland.
Their sample is skewed towards large multinationals and similar Irish companies thus their study is skewed towards export based companies and suffers from the problem I outlined above.”
There is a stark division in the Irish economy between primarily export based companies and those that service the internal market primarily. Our exports have held up fairly well versus the drop in internal demand which is unsurprising given out much more severe recessionary problems. The sample used in the Mercer report will by its nature overemphasize the export sector given its focus on multinationals and larger Irish firms. This report has been used to justify resistance to the Public Sector pay cuts but its sample is unsuitable as a sample of the population of companies based here or put simply, we wouldn’t expect the wage policies of large companies exporting goods and services abroad to be the same as the wage policies found in smaller companies serving local and national markets where there’s been a much sharper drop in demand. As a survey of multinational and large firm behaviour the survey is appropriate (and this appears to be what its authors intended to do with it) but it has been quoted as a rule of thumb for the Irish economy blindly and without caveats and this kind of misuse of statistics is something that should be below national commentators but it appears it isn’t unfortunately, not that I’m surprised.
In particular if you see this quote: “70% of companies reported that they reduced payroll costs in 2009. On average these were reduced by 11%.” being applied to the general state of Irish companies you’ll know that this isn’t the real picture!
“Capitalism should reward good behaviour” – David McWilliams forgets that banks aren’t like other businesses
David McWilliams on Frontline tonight (RTE 14/12/09), in relation to the Irish banking crisis, stated something along the lines of:
“We’ve forgotten what capitalism is supposed to be about: Capitalism should reward good behaviour and punish bad behaviour”
This is initially very compelling. It appeals to our sense of justice and appeals to the ideal of the hard working man being rewarded by the market for his efforts. Reality though is far more complex. First, the markets are amoral. They don’t care how good or bad you are, your business fails or succeeds by a combination of hard work and ultimately luck. This isn’t very appealing, the idea of the entrepreneur who after months of dedication and hard work gets put out of business by a stroke of bad luck or bad timing seems harsh and uncaring but such is the reality of a modern economy. Fairness doesn’t come into it, if it did then we wouldn’t really need the Public Sector now would we? Secondly banks aren’t like ordinary businesses, they can’t be thought of in the normal logic of the free market where viable businesses thrive and poor businesses fail. Allowing a bank to fail has many more consequences than allowing a car dealership or a chain of coffee shops to fail. When a normal business fails there is misery and loss but it’s limited to the suppliers of that business (who mightn’t be repaid in full for monies owed to them), the owners of the business (who lose whatever time and money they’ve invested in the business) and the employees who lose their jobs. It’s not nice but it isn’t systematically dangerous generally speaking.
A bank is different. A bank in simplistic terms acts as a conduit between other economic entities for the transfer and storage of money. It also lends money out to economic entities and allows (in theory) for the matching of long term debts like mortgages and business loans with short term deposits (i.e. current accounts for both businesses and individuals). If a bank fails it brings down all this and a sufficiently large bank will affect everyone in some way, i.e. I may bank at AIB but the company that pays my wage might bank with BoI so if BoI comes down I won’t get paid and the company I work for might go under, so I’m not protected by personally banking with a different bank.
A bank in extremely loose terms is an entity that takes deposits and loans them out in some way. Now there are non-bank financial entities that act as de facto banks in essence but this is a separate problem and thankfully not one Ireland has to deal with.
We can’t allow bank failure because of three reasons:
a) It’s a really bad thing if a major part of the financial infrastructure of the economy collapses. A lot of people lose money and there is chaos and if there is a deposit guarantee scheme the State has to pay out a lot of money instantly. Imagine suddenly not getting paid next week, not being able to access any of your money in accounts and your credit cards not working. It really wouldn’t be pretty. Now imagine all the businesses being in that position, not being able to lodge money, able to pay wages and so on. It’d be a lot worse than anything we’ve seen so far, a lot worse. People who can remember the banking strike can tell you what it’s like when you know your money is safe! And that was in a time when people still dealt mostly in cash or by cheque. It would be far worse if it happened now with our reliance on debit and credit cards. In short, the financial infrastructure, particularly the major clearing banks (banks with a lot of depositors who deal with a lot of normal business transactions like AIB, Bank of Ireland, PermanentTSB etc) need to be protected almost at any cost.
b) If one bank fails it can undermine confidence in other banks and start a bank run on them (all it takes is a rumour to start that “AIB will be next” to start a bank run if the public are already nervous about bank stability as was shown in the Great Depression in the 1930’s). Now the problem with any bank is this, it will never have enough money to hand to pay out all depositors if they all withdraw their money at once. Now this isn’t a problem normally because this almost never happens under normal business conditions. A bank run is where this does happen and this can bring down any bank if the bank run isn’t stopped! It doesn’t matter how sensible a bank has been, if there’s a bank run on it, it can be brought under. This is crucially important to understand. People are very predictable in some ways, if everyone else is doing it then we feel compelled to do it too and if a large enough group of people start queuing outside AIB/whatever looking for that money that queue is guaranteed to get longer especially if the online banking services they provide go down (as happened with Northern Rock!). If a bank is left fail it can only be let happen when you can be pretty damn sure it won’t start a domino effect and this is very hard to know in advance.
c) The other problem is like the second one but is concerned with long term confidence and stability. If a major Irish (clearing) bank failed it would scar a generation with the losses suffered. It would undermine the future workings of banks by reducing our ability to trust that our money will be safe and if we don’t trust that our money is safe then bank runs can suddenly start (this is why we have deposit guarantee schemes by the way, not for the sake of borrowers!). The problem is guarantee schemes are a gamble, so long as confidence in banks remains high, they don’t cost any money. As soon as a bank fails they cost a lot of money. There was a time, in the States, where some banks financed their own insurance style schemes to protect against bank runs (if one of the group suffered a bank run the other banks would band together to make sure that bank had enough cash to meet demand and by doing so hopefully avert bank runs before they even happened because if people believe that the other banks will fund the bank during a bank run they won’t bother to queue outside it for money and because of this no bank run happens etc). The issue was this, a second group of banks started in operation which didn’t pay into these schemes and because they didn’t pay into them they could offer savers a higher rate of interest on deposits and so on making them more attractive to savers while the stability exuded by the system of insurance by banks rubbed off on them a bit because the average man on the street isn’t going to be that well informed on which banks are in and which banks are out of such a scheme. In short it’s the free rider problem and so the State needs to enforce the guarantee scheme on all banks or it won’t work.
The other half of this is stability of the overall economy. Instability can mean outsiders won’t lend to our banks and people in the country might opt for shares, bonds or whatever instead of deposit accounts or more problematically invest their money abroad in order to avoid the Irish banking system/economy altogether (for a good treatment of capital flight from economies in crisis in the latter half of the 20th century see Paul Krugman’s recently reissued book The Return of Depression Economics). This reduces the pool of potential loanable funds. This reduces the level of investment in the economy, now this is only a problem if there is a shortage of liquidity in the system (i.e. good businesses with sound business plans can’t get loans like what’s apparently happening at the moment according to Small and Medium Firms Association and others). Stability encourages confidence in the system, confidence in the system averts the possibility of bank runs that could bring down otherwise healthy banks and further than this confidence increases the liquidity available in a country by allowing for investment inflows to occur.
So in short we can’t leave the banks’ collapse, no matter how badly the managers of these banks may have screwed up. This is infuriating on a personal level for most people, myself included, but we don’t have a choice. Arguably the Government should have gone for temporary nationalisation rather than NAMA (as has been argued by many well regarded Irish Economists) but people need to realise and to be told that what we’re debating is how best to save the banks not whether to save them and cries of “There’s money for the bankers but no money to keep public wages high” are missing the point. We’ve no choice but to bail out the banks. To let them fail would be far too dangerous and risky to contemplate. It’s galling but whoever said life was fair anyway?