The Irish Banking Crisis – reviewing the Honohan Report

Part 3: Future Imperfect

Joe Carter 

7 August 2010

As we have briefly noted in the first two parts of our review, the measures available to Irish regulators were not used and even had they been we have good reason to doubt their effectiveness.  The world-wide bank bail outs have only increased the problems faced by regulators briefed to ensure financial stability.  The number of banks have reduced, and will do so in Ireland, making the ‘too big to fail’ problem even bigger.  The argument that the implied state guarantee to banks has encouraged reckless lending, the ‘moral hazard’ argument, has only gotten worse.  If the Irish State is prepared to see its debt increase by a factor of four in order to save the banks from openly acknowledged incompetence, greed, stupidity and lawlessness, just what practices could the bankers get up to which would induce the State to make them accountable for their own excesses?  The latest crisis has wedded states to the financial sector even more than before.  They have committed and they must continue to do so.

The bottom line is that effective regulation hits the bottom line; it reduces profitability, and while this is rational at the economy wide level it is obviously not so for each individual financial institution.  So how could such regulation be imposed when exactly the same argument about micro-rationality and macro-irrationality is one of the fundamental criticisms of the entire capitalist system?  Increased regulation will increase costs, raising the cost of raising capital not only for the banks but for their customers.  To a great degree what has happened is the transfer of debt from the private sector, including the banks, to states.  Given no real acknowledgement that ‘financial innovation’ lay behind much of the recent collapse the incentives are in place for banks to exploit this newly created debt to their own advantage.  Already the sight of financial institutions speculating against public debt, while it was states which saved their bacon, has been sickening.  Not because we have any sympathy for the capitalist states involved but because working class and middle class taxpayers are paying.

Another possible route to further financial instability is the need to raise interest rates in some countries, such as Britain, to avoid the inflation whose fuse has been lit by the monetary measures introduced to save the financial system.  This will further hit states in debt and also non-financial businesses which may easily see their interest bills jump 100% or more given the low rates the increase will start from.  In order to continue to raise funds the banks of other countries may follow suit.  All these factors will particularly impinge on Ireland, reflecting once again its weakness.  One possible line of development therefore is the gradual disappearance of an ‘Irish’ banking system and the consequent increasing irrelevance of Irish regulation.  This process has begun with the proposed sell-off of Allied Irish foreign acquisitions and may finish with their acquisition by foreign banks.  Of course for this to happen these banks would first have to be put in a position to be worth buying, and this assumes success in the current bail out plus no double dip recession that would bankrupt the state and banks.  But then again perhaps after this event the whole state and its banks could be bought much more cheaply.  We have started already on this road with the new group set up by the government to see how, and how much, the State’s semi-state companies could be sold for.

Measures

A shopping list of regulatory measures that might go some way to reducing risk and the possibility of financial instability has been proposed but the likelihood of their implementation currently looks remote.   A global treaty for international financial regulation would reduce the ‘beggar thy neighbour’ costs imposed by competition to reduce the burden of regulation and a regulatory ‘race to the bottom’.  This is unlikely not just because of the difficulties in regulating very different financial systems but because competition to entice foreign finance operators, through promising a light regulatory approach, is not something which states fear others will engage in, and would not do otherwise, but is something in which they actively engage in order to gain an advantage.  The Irish are to the forefront in this even while they pooh-pooh any comparison with Iceland which adopted this approach, leading to disaster.  In this they simply follow the lobbying of foreign banks; German banks have already lobbied against regulatory measure proposed for the International Financial Services Centre in Dublin.

A second possible step is explicit recognition of the costs involved in guaranteeing the banks.  On this score the probability of this being done in Ireland approaches zero.  If anything was more controversial in the Honohan report than the locus of the crisis it was his judgement of the Government’s blanket guarantee scheme.  The Finance Minister Brian Lenihan hailed it as the cheapest in the world at the time and this view is still widespread, even as the resultant costs of saving the banks have soared almost exponentially.  The NAMA vehicle to do this has been created as a special purpose one in order to avoid explicit accounting for the cost.  Above all, an explicit accounting for the bill would threaten totally the legitimacy of getting the majority of the population to pay it.

A third measure has been to increase the capital reserves of the banks to ensure that they can withstand the results of their own recklessness.  Some problems with this have already been noted.  It must be further observed that the British bank Northern Rock collapsed weeks after it claimed it had so much capital it was giving its ‘surplus’ to its shareholders.   The EU has just carried out a stress test of its largest banks to reassure investors that they are solvent.  These have been widely ridiculed as being woefully inadequate.  Commentators have easily demonstrated that the tests failed in any meaningful way to model easily foreseeable stresses that the banks might face.  Yet the reaction of ‘the markets’ has been positive.  This does not mean these commentators are wrong.  It is just one more example of the irrationality of the financial markets.  It will be only a matter of time before these same markets speculate against the weakest European banks.

The tests were not to reassure depositors or taxpayers that they would not have to bail out these banks but to reassure their owners and shareholders that they won’t be called upon to provide significant extra capital.  Even while testing the banks the objective is to protect them.  The Irish banks were repeatedly described as well capitalised, as were some of the big banks that went bust in the United States, and the IMF has produced a report showing that the capital ratios of failing and successful banks showed no significant difference in the period immediately preceding the crisis event. 

The third world debt crisis in the 1980s already raised the problem of lack of capital.  Today much controversy surrounds the accounting treatment of investments held by the banks with criticism of the ‘mark to market’ approach of financial auditors.  What this means is that the investments held by the banks are valued at what they could be sold for.  Not a very difficult concept to grasp or to object to, but the profound failure of the capitalist system is demonstrated by the fact that this is controversial and controversial because some have claimed it is sometimes impossible to do.  During the height of the credit crunch banks would not lend to each other because they didn’t know what toxic assets were sitting on the books of those they lent to that might force them into insolvency, taking their money with them.  These assets not only included securities that only a very few could understand but assets that no one was prepared to buy because of suspicion.  Since you cannot have a market price for something no one is prepared to buy how could you value it and include it in the books of the banks?  This failure to agree a price, or a method for accountants to determine a price, exposes capitalism to a devastating critique because it is precisely the claim of capitalism that markets are the only mechanism which can set efficient prices and socialism fails precisely because it cannot do this.

So how can the value of what the banks hold be accurately assessed when either the security held cannot be understood or valued or the real asset it rests on cannot be sold, like the empty houses or half finished property developments in Ireland?  On top of this one has to factor in the straight forward lies of the bankers.  For example, executives from Anglo-Irish bank made a presentation before the Department of Finance days before the bank guarantee in September 2008 claiming that only 0.5 per cent of its loans were impaired!  In reality if they had said that perhaps 0.5 per cent were perfectly sound they would have been much, much nearer the truth. 

Politics

A further suggestion is the ‘depoliticising’ of finance.   In order to achieve this it is proposed that the big banks be broken up and often suggested that the investment banking business, which is more risky, should be separated from the ‘utility banking’ operations.  This was previously carried out in the US after the financial collapse of 1929.  The banks however have grown in power since then.  The recent financial reforms by Obama have been described by Charles Geisst, a professor of finance, as ‘business as usual’ and none of the banks central to the crisis have been broken up; in fact they have gotten bigger.   The Dodd-Frank bill, named after its main authors in the US Congress who are both big recipients of bankers’ political donations, also fails to seriously restrict banks’ trading in derivatives or their engagement in proprietary trading.  This means that they can engage in speculation on their own behalf while advising clients on where to put their money.  If you naively believe that the banks couldn’t advise clients to buy pieces of crap the banks are otherwise trying to get rid of then you haven’t yet woken up to what has been going on.

The political power of finance has been demonstrated everywhere from the US, to Britain, the EU and Ireland where the state has sunk itself deeply into debt to bail out banks which are actually impossible to save.  Even the Honohan report notes and doubts the wisdom of ‘leaving senior management in place’ after it guaranteed their disastrous lending practices, something that could only encourage them to take more risks but this time explicitly with taxpayers money behind them.   The terms of the blanket guarantee were framed not so that new lending could be facilitated, which might only have required the guarantee of new bank funding, but to guarantee all bank financing, including that most clearly earning a return because it was supposed to be taking some form of risk.  The ‘transparency’ of this blanket bail out was justified on the grounds that anything less than this simple solution ‘might cause confusion when markets opened.’   Honohan makes it clear that the guarantee could not be justified in terms of its stated purpose of simply restoring liquidity to the banking system. 

A final proposal is simply to let the bankers pay for their recklessness by letting them fail.  Those that lent most wisely will survive and through a process of capitalist evolution the best banks will survive and thrive.  The counter to this is that bad debts will bring down good debts and bad banks will bring down good ones in a process of contagion that would destroy whole sections of the economy that would otherwise be perfectly solvent and successful in the future.  Letting the market take its natural course will therefore inevitably result in a new Great Depression not unlike that of the 1930s which today would not only bankrupt businesses and economies but also bankrupt whole states.  The threat to social stability would be too great.

Only the policy of saving the banks and engaging in looser monetary and fiscal policy, lower interest rates, central bank lending and printing money plus running budget deficits, has thus far saved the world economy from just such a threat.  Once again the argument, deployable by both sides, is that higher capital reserves could reduce the threat or impact of contagion.  The arguments of the previous parts of this article nevertheless still apply.  It might also be noted that even if banks were broken up nothing would be achieved if all the smaller banks indulged in the herd like behaviour of the Irish and engaged in exactly the same reckless policies, all chasing the same profits.  Breaking up the banks doesn’t address the cause of any financial crisis and to the extent it encourages competition among the banks it encourages imprudent lending.  Again the Irish experience lends support to this view.  If the crisis is big enough then the amount of increased capital being discussed is simply not enough.

For some analysts many regulatory proposals simply make the situation worse by proving that the implicit state guarantee of bankers’ recklessness is a real one.  This simply encourages similar recklessness in the future.  Indeed the argument is not only that this policy is self defeating but that all the organisations involved in sponsoring and carrying it out are part of the problem – the IMF that bails out countries (actually bailing out the banks), the European Central Bank (doing the same thing) the Fed in the US etc.

The cost of this policy is now simply incredible; two authors estimate it at $65 trillion, roughly 2.5 times total GDP of North America and Europe.   But not only is it incredible, it is unsupportable; in the end it must either lead to a dramatic crisis or the vast amount of debt that this guarantee supports must be brought down in a more manageable process.  Either way it must lead to a reduction in the level of growth in the economy, in other words a real reduction in profits, until the creation of real value is sufficient to support expansion of credit once again.  Once more however what is rational at the level of the economy is not at all the dynamics which operate at the individual firm where growth and maximisation of profit is the prime objective.

Learning

But surely, it must be argued, those in charge of the banks can see what has nearly happened; it is not in their interest for it to happen again; surely therefore they will heed the obvious advice to stop the reckless practices they indulged in in the past?  This is indeed the final argument put forward, often by those not a million miles away from personal responsibility for the latest mess.  In a mea culpa article in ‘The Irish Times’ Jim O’Leary, former journalist, economist, bank director, employee of a stock broking firm and member of a social partnership body (he personifies almost all the guilty parties in one!), says that ‘on a more optimistic note, the most powerful defence against a repeat of the current crisis, at least in the medium term (by which I mean a generation or so), is the fact it has just occurred.  The crisis and its consequences will live in the memory of borrowers and lenders, and will loom large in the risk models of the latter for many years.’ 

The unfortunate fact is that the history of financial crises speaks against such a judgement, summed up in the title of a book we noted before ‘This Time is Different.’  Nor can it be taken for granted that the bankers are actually not as stupid as they sometimes appear from the outside.  This is a question one continually asks oneself reading the Honohan report and it is one that presents itself again in O’Leary’s article.  He notes that in Allied Irish bank, the biggest in the state, there was a ‘period during which extraordinary efforts were made to transform the way the bank dealt with risk – and the board’s agenda was thickly populated with risk-related items.’  This attention to risk arose precisely, as O’Leary notes, because of a previous crisis in 2002.  Yet not only did it not take a generation to ‘forget it’ but the process of risk analysis itself is presented by O’Leary as one reason why it didn’t work – because the non-executive directors such as himself thought it was all being taken care of by others.  Not only that but the banks as a whole ‘didn’t understand the risk being taken, and were not much assisted in doing so by the tools being used.’ 

Let us remember this was not a crisis due to new complex derivative securities supported by mathematical calculations only a computer could process.  This was an old fashioned property bubble in which money was leant to people already up to their necks in debt, with next to no real collateral, engaged in a business in which dozens of others were involved, in a market clearly heading for a cliff.

The authorities had a crisis manual but it turned out to be useless in an actual crisis.   They were in the process of writing a new one but this didn’t survive the crisis either.   The banks paid out dividends even as they were going bankrupt, the last payment four days before the guarantee.  They told the Government everything was well even after the guarantee.  The government acted as if this was true and no attempt was made to quantify just how much might be expected to be paid out as a result of the guarantee.  The Honohan report can conclude not much more than that ‘given the perceived lack of a solvency problem at Anglo (or the other banks) on balance a guarantee seems to have been the best approach.’   It is rather as if, presenting oneself to an accident and emergency department with a severed leg, one were to be happy to receive a few paracetamol to help get rid of the migraine.

Honohan dismisses the importance of  the complete stupidity or mendacity of the government’s approach, for it was either one or the other - claiming ignorance of the true state of affairs of the banks might simply be viewed as a variant of the former, by claiming that the related issue of excluding Anglo-Irish from the guarantee ‘is of academic interest only.’ 

In fact it is extremely doubtful that even the claim to ignorance could be sustained, especially in the case of Anglo-Irish, since the state’s own pension funding body refused to place significant or long lasting investments in the bank because of its concerns.  Instead Honohan can only say that the government should ‘probably’ have known the true state of affairs but that really it ‘probably’ made no significant difference to policy anyway.   The government knew that Anglo was bust and its friends in PWC were commissioned to produce a report that would cover this fact up.

Answers

We can therefore see that what little autonomy the Irish state and its finance system has to mitigate the potential of further crises is likely to result not in the introduction of some measures that might actually do so but in an approach that will probably make the problem worse and the effects of any new world-wide or European crises more severe.  The Irish state is much more likely to continue a light touch regulatory approach in an attempt to win a bigger share of mobile financial capital.  The problems of cronyism and corruption are not primarily personal or contingent features of the political system but a reflection of a system that consists of disbursement of patronage because it does not dispose of real power.  The government’s response to the crisis has demonstrated this more than the creation of the crisis itself.

At the international level the political power of financial capital has been confirmed in the US and the EU.  All the problems identified as giving rise to the problem of financial instability have not been reduced and in some ways have worsened.  This includes the creation of even bigger banks that are now not only too big too fail but possibly too big to save.  What increased regulation there is will be evaded.  Because the regulated sector will inevitably have lower profitability than the unregulated money will flow into the latter, this is how capitalism works.  Regulation may simply ensure that banks keep a foot in both camps, which means the whole system will remain endangered by the most reckless.   Mobile financial investment will move from one jurisdiction to another stimulating the competition among states to capture it, at least momentarily, and encouraging the regulatory race to the bottom; a race the Irish state has practice in.

The ultimate problem facing the idea that any sort of regulation can prevent crises under capitalism is thus not the individual greed, incompetence, corruption or stupidity of the banks, regulators or governments but in the irrationality of the system itself.  It is undoubtedly true that bankers will have read all the articles, books and commentary on how the financial crisis was caused and the steps necessary to limit its possibility in the future but this cannot be the prime dictator of their behaviour.  As during the boom, if profits are being made there is no point in an individual bank saying that a new bubble is being created.  There are profits to be made and making profits is what it is all about.  If you do not make these profits one of two things might happen.  Either you will go bust before the boom collapses, in which case your far-sightedness has achieved you nothing, or you will have lower reserves with which to weather the bust.

Once again it will be a case of predicting just when to get in and when to get out of the market.  Unfortunately this is predicated on the market booming and bursting as it has just done.  The approach of the US Fed and its chairman Alan Greenspan was not that there was not bubble but that it was better to clear up the mess afterwards than to try to prevent it in the first place. This was simply recognition that cyclical booms and slumps are part and parcel of capitalism.  If we didn’t have them we wouldn’t have capitalism.  The conclusion is obvious but it is not to anyone’s taste, at least not among those empowered to regulate.  To regulate the system assumes the system in the first place and it is the latter which is the fundamental problem.