Background to Financial Crisis
The worldwide financial crisis which commenced in 2007 followed a period of over 10 years of relatively low inflation and interest rates. In the United States, interest rates were maintained at a low rate, following the bursting of the so called “dot.com” bubble. In Europe, interest rates were maintained low, while Germany emerged from a period of recession and d slow growth caused by the effects of unification. Asset prices began to rise rapidly, particularly in Ireland.
Trade imbalances between the United States and in particular China which maintain its currency at an artificially low level, created enormous surpluses which were invested in low-risk securities reducing their yield to historic levels. The plentiful liquidity enabled investors to seek higher returns as yields or returns on safe conventional fixed interest assets, reached historically low levels. Monies were allocated to inappropriately risky assets with the objective of seeking higher returns, apparently without proper recognition of the risk factors attaching to them.
Bank funding, which had lately relied almost entirely on the deposits, came to rely increasingly on debt securities and other sources of funding due to increased innovation and intermediation in money markets. The innovation of securitisation enabled banks to lend greater quantities of money, by packaging and selling their loan assets as securities. This facilitated ever increasing lending and led to degradation in lending standards.
Background to Financial Crisis USA
Securitisation in the United States and governmental housing policy encouraged the growth of so-called “sub-prime” real estate lending. Lenders reduced underwriting standards because were not retaining ownership of the loans. Many loans were underwritten on the basis of collusion and fraud by intermediaries and lenders. Rating agencies rated securities highly based on flawed risk analysis. Bank bonuses and profitability was directly linked to increased lending. It was believed that the market would automatically price risks. Failures of the type that occurred, were assumed by risk models to be highly unlikely.
In mid-2007, the United States Federal Reserve Bank finally increased interest rates after nearly four years of historically low rates. This quickly exposed the frailty of many housing loans and the securities based on them. Default rates increased rapidly on the housing loans Even the top prime layers of asset-backed securities, which were assumed to carry tiny risk and be equivalent to high investment grade were quickly exposed as highly risky and flawed. These securitised assets were held by financial institutions worldwide.
In the United States, institutions began to lose confidence in the financial strength of other institutions, whose ability to repay might be undermined by the possibility or fact of holding so called “toxic assets”. Impairment of housing and other packaged risky loans (generically, so called collateralised debt obligations) accelerated. A downward spiral occurred in their value.
In Europe, more and more lenders became reliant on short-term lending from other financial institutions as increasing financial sophistication and intermediation reduced the availability of deposits. The presence of toxic assets on balance sheet and general evaporations of confidence in the value banking assets led to a lack of confidence in counterparties in the banking market.
Collapse of Major Instituions and Credit Crunch
Northern Rock, a North of England mortgage bank which had grown exponentially in reliance on the inter bank market, became the subject to the first UK or Irish bank run since the middle of the 19th century, when depositors lost faith in its ability to meet its obligations. At the same time, a following property market in Europe and the United States further undermined confidence in the mortgages and loans, constituting the banks’ asset and backing their ability to repay customer deposits and other liabilities.
In the United States two private, but state promoted mortgage entities, Fannie Mae and Freddie Mac which purchased the securities, particularly housing loans of smaller banks, were placed into insolvency protection and required United States Government support. The global investment bank, Bear Stearns collapsed in March 2008 and was sold to a rival in a hastily organised sale.
In September 2008 in the United States, Lehman Brothers a giant investment bank was placed in insolvency protection and the United States Federal Reserve chose not to intervene. The immediate consequence was a sharp collapse in confidence between financial institutions and a world wide funding crisis. The inter-bank market froze as the “credit crunch”, which had been brewing for over a year, became almost total.
The effects of the credit crunch were felt worldwide. In a short period of weeks, in September to October 2008, Governments worldwide took dramatic and unprecedented steps to prevent the collapse of the financial system.
Background to Crisis in Ireland
Ireland joined the Euro system in 1999 and immediately benefited from a significant fall in interest rates. For the previous 20 years of the Punt’s existence, interest rates had remained high, due to a range of factors, not least the recurrent devaluations of the Irish punt, which led to a risk premium relative to major currencies.
In the early years of the Euro, the European Central Bank maintained interest base rates at historically low levels, at a time when Ireland’s monetary policy tightening. A housing price boom of historic proportions commenced in the mid-1990s. It ultimately saw house prices increasing by a factor of three to four while development land price increased exponentially on the expectation of ever increasing housing prices.
The sudden availability of cheap lending, failures of supervision and risk management, flawed regulation and a booming economy saw an enormous increase in the balance sheets (lending) of Irish banks. Initially, this was financed by domestic deposits, but by the early part of the 2000s, Irish banks resorted to the international financial markets just to supply funds for their rapidly expanding loan books.
Property Bubble
Due to a combination of historical, cultural and demographic reasons, a large surplus of savings was available in European banks and these were channelled through the mechanisms of securities, bonds and inter-bank lending to Irish banks, which were believed to be low risk. The enormous infusion of money stimulated an asset price bubble in all classes of property. Developed land prices reached astronomical proportions. Most asset prices were out of the range of historical price earnings ratio by multiples, driven principally by the willingness of banks to lend.
The Irish property bubble was exacerbated by loose monetary policy by the European Central Bank combined with expansionary budget measures, which positively encouraged investment in land. This included a development tax rate for individuals of 20 percent combined with a range of property and capital allowance schemes which incentivised ostensibly beneficial development such as hotels, nursing home, commercial and residential property in regeneration areas on the basis of tax allowances which sheltered investors income tax liability. The result, however, was to create perverse incentives and subsidies for the development and construction projects, with little economic justification once the initial tax benefit expired.
Banks Balance Sheets Expanded
By the early, to mid-2000s a number of banks had greatly expanded their balance sheet by greatly increased lending funded by debt securities and interbank lending. Governance standards were weak and credit underwriting standards deteriorated sharply. A decade of sustained rises in the price of property and related assets, created overconfidence in the sustainability of asset prices.
The banks which lent most were increasingly profitable with increasing share price and increasing market share. The other, formerly more conservative banks, concerned at the expansion of their rivals themselves lessened credit standards in the early to mid-2000s in an attempt to catch up with the apparently successful model of some other banks.
2008 Crisis
In late 2006 expected stamp duty changes led to a sudden dampening in the residential property market. The expected stamp duty changes did not emerge, but buyers began to postponed purchases, leading to a build-up of properties for sale. Through 2007 and 2008, many developers with large exposures, were unable to sell properties at the previous rate. Many working capital loans for developers were restructured on a temporary basis, to keep them performing, at least in formal terms.
The banks’ share prices began to fall, reflecting increased uncertainty regarding future profitability. This quickly exacerbated as a realisation gradually took hold that the banks’ liabilities (including their deposits) were backed largely by property based loans, much of it development property, in which the market was beginning to fall dramatically or simply freeze as the very few buyers apprehended accelerating future price falls.
In this mix, the freezing of international financial markets accelerated a steadily brewing crisis into an out and out risk of a bank run in Ireland. In 2008 the prices of the share prices of the main banks fell dramatically and depositor confidence began to erode. After the collapse of the Lehman Brothers, the bank guarantee limit of €20,000 was increased to €100,000 and extended to the entire deposit, rather than 90 percent, to a maximum €20,000.
Bank Guarantee
By 29 September 2008, it appeared that the accelerating withdrawal of corporate deposits would lead to an out and out bank run and the collapse of Anglo Irish Bank. The risk of the collapse of one major bank. which with interbank lending and issues of confidence, might quickly spread to all Irish bank, led to a hastily announced Government decision that it would guarantee the deposits and most of the liabilities of the key Irish domestic banks. This was later increased to a number of other non-resident banks. The State took on contingent liability of almost €400 Billion.
The decision to guarantee the liabilities of the banks remains extremely controversial. The banking system was facing a very severe crisis by the end of September 2008. The State announced the measure as a temporary protection due to illiquidity due to the international funding problems. However, it rapidly became clear, that the enormous concentration of the banks’ assets in domestic property assets at historically unjustifiable prices raised the serious questions over the solvency of the guaranteed banks.
Capitalisation of Banks
Other European countries had capitalised their banks. It was claimed that the guarantee would obviate the need for capital. However, by December 2008 the first capitalisation scheme was announced involving the investment of €2 Billion, in each of Allied Irish Bank and Bank of Ireland at an 8 percent return and €1.5 Billon in Anglo Irish bank at 10 percent.
Further bank capitalisation was required in early 2009 from the National Pension Reserve. €7 Billion was invested in guaranteed banks by way of preference shares at a fixed dividend of 8 percent. The Department of Finance took the power to appoint 25 percent of the directors and was given 25 percent of the voting rights in respect of certain key matters. The preference shares entitled the State to purchase up to 25 percent of the share capital. It was desired not to nationalise the banks.
Anglo Irish Bank’s position grew increasingly weak and it was nationalised in January 2009. The Anglo Irish Bank Corporation Act 2009 took the bank into state ownership. All of its assets were transferred to the Minister for Finance and the value of its shares were to be assessed. This did not occur, the shares being patently worth zero.
NAMA
The failure of the State guarantee and the recapitalisation to restart bank lending, the desire to avoid nationalisation and the possibility of accessing ECB funding, lead to the proposal on foot of a report by Peter Bacon to the establishment of the National Asset Management Agency. The purpose of the Agency was to buy the “bad” assets from the guaranteed banks, using State debt, which could be used by the banks to draw down cash from the ECB. It was thought at first, that NAMA might overpay by a very significant factor for the bank assets in order to prevent nationalisation. However, the decision required approval under the EU state aid rules, which require more realistic severe discounts, than initially proposed.
The National Asset Management Agency Act became law in November 2009. It proposed to acquire the development assets and assets linked to them over a certain value, held by the six main participating institutions (Bank of Ireland, AIB, Anglo Irish Bank, INBS, EBS and Irish Life and Permanent, TSB). A threshold of €25 million was adopted. The acquisition of loans was not linked to their performance. Once a development loan was part of the portfolio, that loan and associated loans to the borrower, were acquired by NAMA.
NAMA applied a discount on the price paid relative to the face value of the loans, based on the value of the underlying loan and security, the quality of paperwork and security and other risk factors. It acquired the benefit of both the loan and the security backing it, including guarantees. Assets were taken into NAMA at their long-term economic value as assessed. By the end of 2010, NAMA had acquired €71 Billion of loans for a total price €30 Billion.
By mid 2010, the Irish banks’ positions still remained fragile, as they sought have to de-lever and seek repayment of loans. This in turn had an adverse effect on the economy. In March 2010, the State issued a series of promissory notes of annual value €3 billion over 10 years, to fund Anglo Irish Bank. Its insolvency had increased by the greater than expected discounts applied by NAMA in acquiring assets and continual outflow of deposits and repayment of other liabilities, without any ability to re-fund.
State Solvency Impaired
Meanwhile, a growing lack of confidence in the Irish banks led to a significant outflows of deposits which was replaced by emergency lending from the ECB on the basis of liberal assessment of the value of their collateral. Banks had increasing resort to the Irish Central Bank under an exceptional liquidity assistance programme, which issued cash as part of the ECB system of back on a lower quality collateral.
On 30th September 2010, the Minister for Finance announced a package of measures in relation to the banks. It was announced that the total cost of Anglo Irish Bank would be of the order of €30 billion. Further injections of capital were made into AIB, acquiring 90 percent of its shares, effectively nationalising. €2.7 billion went into Irish Nationwide while nothing further was injected into Bank of Ireland.
By 2010, Ireland had run budget deficits of historic proportions due to the collapse in tax revenue since 2007. Combined with the enormous injection of money into the bank, it became apparent that the State itself may not be able to finance itself. The cost of Irish State funding on the Bond and related markets throughout 2010 and by September 2010 Irish lending rates exceeded seven percent, well beyond long-term sustainability.
IMF and Recapitalisation
At the end of November 2010, the State, under pressure from the European Union and with evident inability to fund itself beyond a number of months, entered in a joint EU/ ECB/IMF program of assistance by which €85 billion would be advanced of which, €17.5 billion was contributed by the State, from the National Pension Reserve Fund. There was a €35 billion facility to support the Irish banking system. €10 billion was made available for immediate recapitalisation with a further €25 billion of contingency fund. The balance of the fund was to meet the State’s budget deficits. The State was obliged to undertake a package of measures to reduce its deficits and loans to target levels by 2015.
Part of the requirements included a new Prudential Capital Assessment Review (PCAR) and Prudential Liquidity Assessment Review (PLAR) to be carried out by the Central Bank on all credit institutions. The institutions were to reduce their lending in order to reduce their extreme reliance on ECB short-term funding. The banking market was to be downsized substantially, from the levels which it had reached in 2008.
Bank Reorganisation
Legislation was required to resolve the position with insolvent credit institutions. The Credit Institutions (Stabilisation) Act 2010 enabled the Minister for Finance to make a direction to restructure institutions in a manner overriding most conventional company law mechanism. The direction order could be made subject to confirmation by the High Court. A very short period was allowed in which to challenge the decision by way of review.
By wrapping the Governmental direction in a High Court mandate, the ability to challenge the action was severely curtailed. Under this mechanism, the remaining deposits of approximately €8.6 billion in Anglo Irish Bank were transferred to AIB and the €3.6 billion in Irish Nationwide were transferred to Irish Life and Permanent. In October 2011, Anglo Irish Bank Corporation absorbed Irish Nationwide Building Society and its name was changed to Irish Bank Resolution Corporation Limited.
The new banking strategy requires two pillar banks. Bank of Ireland is to be separated into core and non-core sectors. €30 billion assets are to be sold by 2013. The Northern Ireland and UK Post Office business are to be retained.
AIB merged with EBS and become a domestic focused bank. AIB acquired EBS in July 2011. It was required to de-lever €20 billion of assets by 2013. Irish Life and Permanent continue in existence and the State acquired 99 percent of its shareholding under the 2010 act.
Aftermath
The Basel rules proved hopelessly ineffective in the financial crisis. The Basel III system grew out of the failures of the Basel II in the economic banking and financial crisis. It raised the required equity relative to risk-weighted assets progressively by 2015.
Banks were required to have additional capital buffers to withstand adverse shocks. The total equity capital is to be increased and tier 1 capital is to increase from 4 to 6 percent. The definition of capital was amended.
The financial crisis has reminded regulators that the critical role of banking in the economy is such that banks ought not to be allowed to take risks and be subject to moral hazard. International standards have recommended the modification of the systems of remuneration linked to undue risk-taking.
Mechanisms have been recommended for the resolution of insolvency in financial institutions without destabilizing the financial system. Strategically important financial institutions should have increased capacity to withstand risk due to their systematic importance. They should be more intensely supervised.