The Irish Financial Crises: Lesson From Weakness to Building Resilience

Deputy Governor of Central bank of Ireland, Sharon Donnery on her speech to Dublin Economics workshop dated 14th September 2018 addressed, what lesson Ireland learned after the financial crisis of 2008 where she mentioned that the reason behind the crisis was “A large number of simultaneous institutional and judgemental failures”. There are many reports presented after the financial crisis addressing the source of the crisis. Honohan and Walsh (2010) have mentioned that the reason behind the crisis was reduced interest rates, an increase in funding to markets where credit rates are cheap and risky loans for commercial properties.

Nyberg (2011) have explained how financial institutions failed in risk awareness, management failure, cooperation between authorities and policies violation. Sibley (2018) mentioned that by late 2010 Ireland’s fiscal position was unsustainable and the government agreed to enter into EU IMF support programme and even after 10 years from the crisis non-performing loans are under distress in banking system. After the crisis central bank has undergone various changes such as regulatory and governance change, organisational change, structural change and cultural change.

This report will look into the problems for crisis and the steps taken by Irish economy to overcome from the situation.

After the boom and bust situation in Ireland, the governance and regulatory system took the responsibility to mitigate the effect of the financial crisis. Donnery (2018) in her speech mentioned that the change in the legislative framework, policy tools, and institutional architecture responded banking supervision. The major reason behind not able to sustain during the crisis was household loans issued by banks.

As mentioned by Regling and Watson (2010), there was an increasing trend in the lending rate of the Irish banking sector from 2003 which made the banking system vulnerable. In 2014, Central Bank introduced macro-prudential policy tool to mitigate systematic risk, financial stability and resilience in household and banking (Donnery, 2018). Grace, T., Hallissey, N. and Woods, M (2015) mentioned that the goal behind implementing macro-prudential policy is to regulate individual firms, resilience mainly in banking sector and reduce destabilising imbalance within financial system. It is possible that individually banks are sound but their collective actions can create imbalance within economy for example risky business strategies to maximise business returns and boost profits. The two tools of micro-prudential policy namely capital instruments and liquidity instruments which can increase resilience to shock.

Capital instruments include counter cyclical capital buffer (CCyB), systematic risk buffer, sectoral capital reporting and leverage ratio reporting whereas liquidity instruments deals with lean to deposit ratio, Time varying liquidity funding ratio and Net stable funding ratio. Capital tools will help the banks to maintain higher capital for increased loss absorbing capacity whereas liquidity tool can compliment credit dampening effects of counter cyclical capital buffer and reduce reliance on vulnerable non-core funding. They further mentioned that monetary policy can reduce effectiveness of macro-prudential policy if policies are in conflicting nature objectives. The implementation of macro-prudential policy can affect other policies and the instrument is still new for an economy to analyse the effects however there are long term positive effects of macro-prudential policy and therefore implementation challenges are worthwhile for improvement in welfare. As per latest report of central bank of Ireland (2019) to build the resilience in banking cyclical systematic risk, central bank announced 1% CCyB rate. The step is taken for the future downturn.

The Single Supervisory Mechanism (SSM) came into operation in 2014 where European Central Bank will have supervisory powers over banks. The role of Single Supervisory Mechanism is to assess institutional risk profile, solvency, liquidity and recovery planning of an institution and anti-money laundering. Sibley (2018) mentioned that with the help of SSM it is possible to drive for the consistency and intensity of banking supervision. Single Resolution Mechanism (SRM) which is single resolution board is applied to SSM covered banks. As mentioned in annual performance report, the main objective of SRM is to reduce overall risk in the banking sector and implementing financial regulation reform in EU following the crisis.

After the crisis, due to restructuring in mortgages, non-performing loans declined from €85bn in 2013 to €25bn by 2017 in which 87% of the remaining loans are meeting the terms of restructuring (Sibley, 2018). Donnery (2018) have stated that household debt to disposable income has been fell by 49.8% between 2014 Q1 to 2018 Q. Central Bank focused on mortgage arrears resolution for fair borrowing with help of consumer protection framework and also making sure that banks are holding enough capital, provisions and operational arrears resolution strategies (Sibley, 2018). The mortgage measure of the counter-cyclical capital buffer is resilience in the financial system for future shocks sustainability (Donnery, 2018) and Annual report 2017). The central bank have also maintained Other Systematically Important institutions buffer as resilience to domestic economy financial institution failure. Even though the debt percentages of household are reducing, Ireland still is the 4th most indebted in EU however this policy tools is to avoid the future systematic risk (Donnery, 2018). The central bank report of 2019, have mentioned that macro-prudential mortgage have loan to value and loan to income limit. The mortgage measure is globally promoting overall resilience in bank mortgage. Whereas the (Other systematically important institution) O-SII buffer measure will the probability and impact of failure. After crisis EU macro-prudential framework have established systematic risk buffer under Capital Requirement Directive (CRD) IV. The report further mentioned that European systematic risk board should further attention to tighter liquidity stress testing, harmonised reporting framework, liquidity management tool and supervisory requirement and better use of leverage limit. EU has setup a banking supervision committee called Basel Committee which looks into capital requirement and capital standards. On March 2018, Basel Committee released changes in the policy which includes minimum capital requirement for market risk.

The European legislation revised a framework for minimum capital requirement since, in the case of Anglo Irish Bank, the governance failure played a major role, for example non-implementation of risk evaluation procedures. The bank was dependent on wholesale funding which is more volatile and made them vulnerable to their own solvency (Nyberg 2011). Regling and Watson (2010) stated that credit to commercial real estate created a boom in Ireland however that put bank capital heavily into a risk whereas under-resourced approached in supervision considering as good governance, ignored minimum capital requirement (Honohan & Walsh 2010). Donnery (2018) addressed the two pillars of revised minimum capital ratio under which the first pillar is that banks will hold 8% of Risk-weighted assets (RWA) as regulatory minimum capital and 4.5% of RWA for highest quality capital such as ordinary shares and reserves. Whereas, the second pillar is an additional capital requirement for institutions by supervisors in which capital will be restricted to individual business model and risk.

When Ireland joined economic and monetary union, there was a loss of independent monetary policy (Donnery 2018) however it benefitted Ireland in their fiscal position because of common monetary policy and single currency which is Euro. This change in legislative framework led to decreasing debt to GDP ratio and shifted budgets into surplus. However, the tax structure was seen misbalanced and the revenue was more generated from property tax and capital gain taxes. The effect of misbalance was observed in the period of crisis and indicated the need for a stable tax system. In a report of parliamentary budget office (2018), it is mentioned that implementation of Counter-Cyclical fiscal policy will reduce economic activity by increasing taxes when the economy is normal and vice versa. This has been identified as a priority for the government as resilience to future shocks. It is also mentioned that during the budget crisis, Ireland was in the corrective arm to fix fiscal imbalance targeting 3% deficit to GDP ratio and 60% debt to GDP ratio. In 2016 they left corrective arm and entered into preventive arm where the target is structural budget balance and expenditure benchmark.

The lack of supervision and ineffective management was one of the reasons behind failure in banking governance. The micro prudential supervision gave rise to financial stability concerns and it was found that supervision division of banking was under-staffed. The property lending division was handled by retailed division instead of corporate division. Bank of Ireland did not have a credit committee and group committee was dealing with major housing loans whereas in the case of AIB, the supervision was poor because of high business growth and inadequate IT systems (Nyberg, 2011). However, after the crisis Central Bank become more assertive, outcome-based, controlled arrangement and analytical approach towards supervision. Central Bank came with Probability Risk and Impact System (PRISM) in 2011 for supervisory governance and consumer protection. The supervisory role of PRISM is to conduct inspections, analysis of returns submitted to Central Bank, Risk-Rating of Firm. This systematic risk based supervision will act as a means for assessing different types of risks. The central bank’s Consumer focused PRISM model is for the protection framework for the consumer’s best interest considering effective fit and proper being critical component. Fitness related to qualification, experience and knowledge for controlled functions. PRISM is not only about analysis risk but ensuring that mitigating actions will be taken for any kind of risk like credit risk, market risk, operational risk, insurance risk, capital risk, liquidity risk, governance risk, business model risk, environmental risk and conduct risk. It is also mentioned that risk evaluation had potential weakness; however central bank incorporated quality assurance measures. The quality assurance deals with management oversight, management oversight, drafts highlighting flaws, risk mitigation programme, supervisory risk committee and supervision support (Central Bank, February 2016). Sibley (2018) mentioned that earlier there was a rule of huge reliance on the banks and banking management however the current scenario states that the rules are now more assertive & outcome focused.

Consumer protection code came into effect in 2007 and amended in 2012. Consumer protection was at risk when the Irish financial institutions were focused on property lending competitions and foreign banks funding access. As stated by Director of Consumer Protection, McEvoy (2019), mortgage arrears lowered the level of trust in financial institutions. She further mentioned that the misconduct was about money laundering, LIBOR rigging, fees for no services and so on in which the biggest scandal was about denial for mortgage tracker to customer or putting then on wrong rate. To recover the lending money, Central Bank launched the Tracker Mortgage Examination in 2015 which revealed overarching. As a result the banks have to compensate the consumers and as of now €665 million is refunded by banks. Central Bank also came with the reform proposal called Individual Accountability Framework as standards for staff to act honestly, ethically and with integrity. She further mentioned that the cultural change strategy will benefit the consumer protection which will ensure that change will be long term. Central bank published Consumer Protection Risk Assessment (CPRA) to monitor and enforce compliance. The Consumer Protection Directorate is to ensure that consumer interest in financial services is safeguarded. Its responsibility is authorisation of individuals and firms in retail sector and compliance monitor. Prudential regulation pillar as mentioned in Central bank annual performance report (2017) is responsible for supervision of bank, lending institutions, asset management and insurance undertaking industry. The role of this pillar is to protect consumers by looking into firm’s financial resource sufficiency, well governed, effective risk management, long-term business model, and resilience structure. New provisions get added to the consumer protection code and as per the latest addendum, enhance transparency in mortgage switching framework. Mortgage switching includes mainly; in place process between regulated parties, legal process and engagement between regulated parties as so on.

The reports on banking crisis in Ireland pointed out that the reason behind crisis was the oversight of corporate governance in financial institution. Regling and Watson (2010) mentioned that it was not that corporate governance was not existed before the crisis but problem was in the implementation of that. They gave example of nationalisation of Anglo Irish Bank. Central bank also reviewed largest banks; AIB and BOI for governance and risk management standards. Disclosures of director’s loan, window-dressing of balance sheet, purchase of own shares by financial institutions are the some of the things which violated corporate governance. Report issued by joint committee of inquiry into banking crisis (2016) mentioned that central bank issued paper on June 2010 on a new approach on banking supervision addressing guiding governance for financial institutions, fitness and probity requirement for directors and remuneration standard. It further mentioned that on December 2011, Elderfield introduced new statutory regulation requirements for entry into and removal from senior position within entity regulated by central bank. Sibley (2018) mentioned that there is successful improvement in sound banking system, governance and risk management arrangements and Irish banks now demand for quantity and quality capital as resilience against shocks. McEvoy (2019) has stated that the standards they aspire should reflect from the business through corporate governance structure to individual accountability and risk management to people management. Central bank has set out corporate governance code for different segments of financial institutions for example, Captive insurance and reinsurance undertaking, credit institutions, investment firms and market operators.

The problem of “Herding” was came into notice at the time of crisis investigation, in which investor and bank implicitly follow each other with little knowledge and analysis. The motive behind this is to earn smaller profits, share holders pressure or expected returns from management. The prudence was missing to ensure that the deals were beneficial or not. Investor’s heavy reliance on property investment and banks risky lending was the main issue behind crisis (Nyberg 2011). To protect the interest of investors European Securities and Market Authority (ESMA) took certain initiatives like, clear and relevant information to investor, provide product of a need to investor and as per investment objectives and provide priority to customer interest. EU regulation of financial market enforced new legislation in 2007 called Markets in Financial Instruments Directive (MiFID) and on 2018 it was replaced by MiFID II by revised rules. Denise Murray (2017) mentioned that the MiFID II is applicable to investment firms, broker dealers, credit institutions authorised to carry MiFID II activities, and wealth managers. He further explained that under MiFID II, European supervisory authorities will have a power to restrict or prohibit sale of any financial instrument which can cause serious concerns to investor interest, intervention in marketing of any kind of investment product and restrict any type of activities carried out by firms under MiFID II legislation. MiFID II empowered ESMA to propose Regulatory Technical Standards and Implementing Technical Standards. This will give the transparency in respect of Shares, depository receipts, Exchange traded funds, bonds and other similar financial instruments. The European Market Infrastructure Regulation (EMIR) is for the over the counter (OTC) derivatives and Financial and Non-financial counterparties for risk-mitigating techniques, reporting and closing OTC derivative. Central bank in association with other regulatory authorities is taking a major step for investor’s protection and their education.

Conclusion

The regime took after the financial crisis in Ireland is notable. The central bank and other regulatory committees took the necessary steps to lift the financial position at a level where the economy is looking for resilience system to upgrade. It is not that Ireland has completely recovered from the scars of crisis but the restoring system is working successfully and looking for resilience for future shocks. As mentioned by Donnery (2018) increase in the minimum requirement of funds and policies for transfer agencies are the current initiatives. This will not only keep banking regulations under control of central banks but the risk management and consumer protection will be operational. She further mentioned that apart from banks, other financial institutions like insurance and financial markets infrastructure need attention.

It’s been 10 year from the financial crisis and Irish economy got a lesson and strength for future challenges. Successful application and amendment in Regulatory framework, governance code, risk mitigating techniques, analytical framework and outcome focus supervision will build resilience for future downturn.

References

  1. Sible, E. (2018) The Banking Crisis – A Decade on. Available at: https://www.centralbank.ie/news/article/the-banking-crisis-a-decade-on-ES12Sept2018
  2. Donnery, S. (2018) 10 years on – what have we learned?- Deputy Governor Sharon Donnery. Available at: https://centralbank.ie/news/article/10-years-on-what-have-we-learned—deputy-governor-donnery-14-september-2018
  3. Parliamentary Budget office (2018) Potential Output, the Output Gap and Associated Key Issues for Fiscal Policy-making in Ireland. Available at: https://data.oireachtas.ie/ie/oireachtas/parliamentaryBudgetOffice/2018/2018-05-14_potential-output-the-output-gap-and-associated-key-issues-for-fiscal-policy-making-in-ireland_en.pdf
  4. Introduction to PRISM. Available at: https://www.centralbank.ie/regulation/how-we-regulate/supervision/prism
  5. Supervision Process for Electronic Money Institutions. Available at: https://www.centralbank.ie/regulation/industry-market-sectors/electronic-money-institutions/supervision-process
  6. (2016)PRISM Explained – How the Central Bank of Ireland is Implementing Risk-Based Regulation. Available at: https://www.centralbank.ie/docs/default-source/regulation/supervision/prism/gns-4-1-2-2-5-prism-explained-feb-2016.pdf?sfvrsn=2
  7. McEvoy, G. (2019) Good Worth Working For: Driving Banks to Deliver Effective Culture – Gráinne McEvoy, Director of Consumer Protection. Available at: https://www.centralbank.ie/news/article/speech-grainne-mcevoy-NY-Fed-04-june-2019
  8. (2016)Report of the Joint Committee of Inquiry into the Banking Crisis. Available at: https://inquiries.oireachtas.ie/banking/volume-1-report/appendix-11/
  9. Murray, D. (2017) MiFID II – Keynote Speech, PwC Breakfast Briefing “MiFID II – Are you Ready?” Available at: https://www.centralbank.ie/docs/default-source/regulation/industry-market-sectors/investment-firms/mifid-firms/170628-denise-murray.pdf?sfvrsn=6
  10. Investor Protection. Available at: https://www.esma.europa.eu/regulation/mifid-ii-and-investor-protection
  11. EMIR Regulation. Available at: https://www.centralbank.ie/regulation/industry-market-sectors/securities-markets/emir-regulation
  12. Grace, T., Hallissey, N., Woods, M., (2015) The Instruments of Macro-prudential Policy. Available at: https://www.centralbank.ie/docs/default-source/financial-system/financial-stability/macroprudential-policy/gns-2-1-1the-instruments-of-mpru.pdf?sfvrsn=2
  13. Addendum to the Consumer Protection Code 2012 (2018) Available at: https://www.centralbank.ie/docs/default-source/regulation/consumer-protection/other-codes-of-conduct/addendum-to-consumer-protection-code-2012—june-2018.pdf?sfvrsn=6
  14. Central Bank if Ireland (2019) financial stability review 2019. Available at: https://www.centralbank.ie/docs/default-source/publications/financial-stability-review/financial-stability-review-2019-i.pdf#page=59
  15. Annual Report (2017) Central Bank of Ireland.
  16. Annual Performance statement (2017) Central Bank of Ireland.
  17. Honohan (2010), The Irish Banking Crisis Regulatory and Financial Stability Policy
  18. Nyberg (2011) Misjudging risk: Causes of the Systematic Banking Crisis in Ireland.
  19. Regling, k., and Watson, M. (2010) A Preliminary Report on the Source of Ireland Banking Crisis.
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