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Irish banks had been national businesses for decades, set up to serve local and national enterprises. However, by the mid to late 1990s, the bigger banks were establishing an international presence; AIB bought into Bank Zachodni in Poland and Bank of Ireland bought Bristol and West in the UK. As Ireland’s economy began to grow, National Australia Bank entered into the retail market. The International Financial Services Centre (IFSC) opened in Dublin which also provided a location for the emerging global non-retail financial business.
Klaus Regling & Max Watson said in ‘A1 Preliminary Report on The Sources of Ireland’s Banking Crisis’:
“From the late 1990s onwards, the world economy was characterised by relatively high growth, low headline inflation, strong liquidity creation, and low interest rates. The literature has named this period ‘The Great Moderation,‘ which can be explained by the positive effects of globalisation, technological progress and productivity increases, and the stronger credibility of most central banks around the world, which had become independent from political interference, facilitating a stabilisation of inflation expectations.”1
Ireland’s profile in world banking and world financial services expanded rapidly and, by the early 2000s, was well established.
Throughout the early 2000s, trade between the US and China grew, resulting in a surplus in favour of China. The Chinese Government recycled much of the new and surplus money back into the US by investing in US treasuries (Government bonds). In turn, the US Federal Reserve (Central Bank) invested the bond monies in US banks and insurance companies for a higher return. A high-risk loop of mutual inter-dependencies stretching from Chinese investors to US householders had formed, with every party in the loop hoping to profit.
David Duffy, Chief Executive Officer, AIB, said:
“… It’s a once in a generation circumstance where the availability of a huge amount of liquidity including retail bank liquidity which wasn’t available before in the sense that it was made available as well as geopolitical events where China, in order to grow, was very much a supporter of a cheap cost of capital through its purchasing of US debt despite the overall levels of debt. …the US consumer became very heavily indebted and that was a contributor to the property boom.”2
The creation of the Euro and the growth of the Chinese economy both affected the world economy. Professor Philip Lane, Professor of International Macroeconomics and Director of the Institute of International Integration Studies in Trinity College Dublin, explained some of the international background:
“China was growing so quickly that it was important in the late 1990s, but by the mid-2000s it was very important. That had trading effects, although maybe less so here. For example, the economies of Portugal, Greece, Italy and so on were quite affected by the rise of cheap imports from China. Financially, the surpluses coming out of China were essentially flowing into the US financial system. Low interest rates in the US prompted, for example, the rise of securitisation in US financial markets and European banks were active in the US system. Therefore, there was a deep connection between what was going on in the US in the mid-2000s and what was going on in Europe. A lot of that was being intermediated through banks. European banks were important in linking the US financial system to the European financial system.”3
David Duffy also said in his evidence to the Joint Committee:
“That cheap money was allowing every market to chase property and when it collapsed in the sub-prime and then was further influenced by allowing banks to go bankrupt in the US, there were many more banks were very close to going bankrupt. So the extraordinary measures of the US Government at the time, both negative and positive, if you put all of those together, it is an exceptional period of time. Ireland’s problem was that we were very badly positioned to react to that given our concentration.”4
From around 2003, the Irish started to invest a very high proportion of national income and personal income in property.5 This was enabled by the ready availability of cheap money on the wholesale money markets.
Brendan McDonagh, CEO of NAMA said:
“I think, when you look at the … again, at the growth in the balance sheets of the banks between 2003 and 2008 … the banks were lending, but they were effectively lending to a longer-term asset class, which was property, but they were funded by short-term cheap, wholesale money market deposits. So, they were borrowing at, you know, one month, three month, six months at around 2% … a lot of it, you know, German money coming into Ireland, looking for a home. And, you know, once the crisis happened, all those depositors withdrew, took their money back and the banks were left long on assets but short on cash.”6
A number of factors within the single currency context contributed to the liquidity crunch preceding the economic crash of 2008, principally:
1. EU monetary union and control of monetary policy
The free movement of capital and its attendant benefits provided a critical rationale for the introduction of the euro. The EU’s developed and expanding status bolstered available liquidity. European investors began to look favourably on Ireland, given its impressive economic performance throughout much of the 1990s and into the mid-2000s.7 A major expansion in liquidity in Ireland was the result.
“…Prior to monetary union, Ireland and Spain had probably under-invested in housing as we had a higher cost of capital than in countries like Germany or France. Given the demographic profile, we needed to invest in housing. In permitting a more rapid adjustment to the housing stock, the lower cost of capital was beneficial. However, it was the failure to appropriately control this surge in investment which eventually proved fatal…”8
2. Design faults of the Euro
The Eurozone was an economic and monetary union that lacked a banking union. The Stability and Growth Pact continued only certain aspects of the convergence criteria, considering that others would be successfully addressed by the European System of Central Banks (ESCB) and European Central Bank (ECB). In the absence of the exchange rate and the domestic interest rate, the behaviour of the Irish economy was allowed to change in ways that would not have been previously possible due to external pressures placed on the punt as the real effective exchange rate deteriorated.
Professor John FitzGerald, Research Professor at the Economic and Social Research Institute (ESRI), told us:
“You do not have the interest rate tool to manage an economy or to manage inflation and, in particular, asset market bubbles. You have to use other instruments, that is, fiscal policy. It was something which we did not anticipate or talk about. It is clear from the literature before monetary union, people were barking up the wrong tree about the problems of monetary union, not just in Ireland but elsewhere that one needs to use fiscal policy to manage housing market bubbles.”9
In the absence of a banking union, where free capital flows were facilitated by the new currency system, Ireland needed to modify its approach to policy formation in the fiscal and monetary spaces. The gaps between the convergence criteria and entry into the Eurozone on 1 January 1999 were sizeable refer to following table. The reference criteria were:
The criteria of an optimal currency area highlights the importance of consolidated fiscal policy across members of the currency zone and the importance of fiscal transfers, as well as labour mobility. These facts were present but considered of the utmost importance in the Irish context. The Irish approach to fiscal policy was coloured by the experience of the 1980s and the fiscal consolidation that took place as part of the protracted recession, and Ireland’s labour market was nearing full employment at the time. According to John FitzGerald:
“…there was a need to use fiscal policy in a different way. In terms of the economics literature, the use of fiscal policy to manage the cycle had gone out of fashion, as the Senator is probably aware, saying fine tuning is not possible. This is not fine tuning, this is stopping disaster by using fiscal policy differently. Hopefully we have learned our lesson.”10
| Inflation (%) | Long-term interest rates (%) | Deficit ratio (%) | Debt/GDP (%) | ERM two-year membership | |
|
Austria |
1.1 |
5.6 |
2.5 |
66.1 |
yes |
|
Belgium |
1.4 |
5.7 |
2.1 |
122.2 |
yes |
|
Denmark |
1.9 |
6.2 |
-0.7 |
65.1 |
yes |
|
Finland |
1.3 |
5.9 |
0.9 |
55.8 |
no |
|
France |
1.2 |
5.5 |
3.0 |
58.0 |
yes |
|
Germany |
1.4 |
5.6 |
2.7 |
61.3 |
yes |
|
Greece |
5.2 |
9.8 |
4.0 |
108.7 |
no |
|
Ireland |
1.2 |
6.2 |
-0.9 |
66.3 |
yes |
|
Italy |
1.8 |
6.7 |
2.7 |
121.6 |
no |
|
Luxembourg |
1.4 |
5.6 |
-1.7 |
6.7 |
yes |
|
Netherlands |
1.8 |
5.5 |
1.4 |
72.1 |
yes |
|
Portugal |
1.8 |
6.2 |
2.5 |
62.0 |
yes |
|
Spain |
1.8 |
6.3 |
2.6 |
68.8 |
yes |
|
Sweden |
1.9 |
6.5 |
0.8 |
76.6 |
no |
|
United Kingdom |
1.8 |
7.0 |
1.9 |
53.4 |
no |
|
1998 reference values |
2.7 |
7.8 |
3.0 |
60.0 |
|
|
Greece (2000) |
2.0 |
6.4 |
1.6 |
104.4 |
yes |
|
2000 reference values |
2.4 |
7.2 |
3.0 |
60.0 |
|
|
Source: European Commission Convergence Reports, 1998 and 2000 |
|||||
Source: Centre for Economic Policy Research.11
3. Foreign exchange risk eliminated
The introduction of the Euro eliminated foreign exchange currency risk across the majority of EU Member States. That provided a platform for access to cheap liquidity by financial institutions from large client deposit bases in different countries. It also helped foster a perception outside the EU that the risks of euro Member States were pegged to that of the best performers, notably Germany with its AAA status. Thus, for certain types of investors, a 10 year Irish bond paying annual interest of 2% was more attractive than a 10 year German bond paying annual interest of 1%. In such a scenario, the short-term gain and risk would trump the longer-term gain and risk, even though the scale, structure, markets and risks of the Irish and German economies were vastly different.
As was stated in the Nyberg Report:
“…The Irish economy and Irish financial institutions were, furthermore, exposed to the expansionary financial incentives associated with membership of the Euro area. The disappearance of exchange risk and the absence of euro-wide inflationary pressures caused a significant reduction in interest rates, compared to the Irish Punt historic rates, while there was virtually unfettered access to funding from European and other capital markets (Figure 1.2). At the same time competition increased via new non-Irish entrants into domestic financial markets…”12
The EU financial institutions used the new Euro denominated liquidity to invest in bond offerings from the Irish financial institutions for an incremental return. The Irish institutions lent to developers who in turn invested in property and construction, seeking to obtain an even higher return. Some investors formed syndicates (group of borrowers pooling monies together) to invest in tax designated and non-tax designated property-related ventures. Householders, along with investors, also borrowed monies to purchase housing and second properties.
Brendan McDonagh said:
“…While some of the lending was to professional, well-managed entities, much of it was to individuals or syndicates whose primary business was not property developments, or who became involved in property developments relatively late in the cycle”13 and went on to say “They were new arrivals, a lot of the professional class. A lot of the professional class got into syndicates, particularly to buy land, and particularly to buy land mainly in … a lot of it in regional Ireland…”14
4. Interest rate harmonisation
Under European Monetary Union (EMU), the ECB sets interest rates to meet the needs of the Eurozone economy as a whole. This resulted in an interest rate which, for many years in the run-up to the crisis, was set at a level which was too low for Ireland. That resulted in a low or, at times, negative real interest rate for Ireland, further aggravating the boom. For countries experiencing low growth or recession, the opposite effect occurred.15
David Doyle, former Secretary General, Department of Finance, said:
“…Prior to the establishment of the ECB the Irish Central Bank was fully responsible for monetary policy and financial stability and regulation. It set interest rates at a level that were appropriate to the specific conditions of the Irish Economy. It lost this authority following the entry into the Euro. The ECB did not appear to regard the question of curbing asset prices or excessive credit growth through the interest rate mechanism as appropriate, viewing this as a matter for the domestic central banks and regulators…”16
Bertie Ahern, former Taoiseach, said:
“…We were … able gradually to remove incentives from the property market but membership of the euro meant that we were unable to raise interest rates. Accordingly… according to the IMF report in the summer of 2009, the housing boom was caused mainly by cheap credit due to low interest rates, along with rising incomes and a strong demand for housing…”17
An IMF Staff Report contained the following:
“The boom years stored up immense problems. Following a decade of export- and FDI (foreign direct investment) led growth supported by broad-based productivity gains, from about 2003 on the Irish economy embarked on a domestic boom underpinned by lax lending. Stiff competition for market share from foreign-owned as well as domestic banks pushed underwriting standards lower, and the feedback effect of rising collateral values fuelled the leveraging process. Rapidly rising property prices also drove high fixed investment in commercial and residential property, and a positive wealth effect fed private consumption, raising incomes and employment. Wages and prices rose, eroding competitiveness and compressing real interest rates. The integration of the Irish financial system into the broader euro area financial landscape, as well as the apparently strong fiscal position of the sovereign, gave Irish banks unfettered access to wholesale funding that turbocharged their asset expansion.”18
During the Context Phase of the public hearings, the Joint Committee heard evidence from Peter Nyberg, Rob Wright, Patrick Honohan and Klaus Regling, all of whom had completed reviews of the crisis. The key findings of these reports as they related to the banks were as follows:
The Joint Committee wanted to establish, through evidence given by bank executives and board members, the extent to which the findings outlined above were the reasons for the collapse of the banking industry in Ireland. In particular the Committee examined the following key areas:
The Joint Committee then examined how these key issues were dealt with within the banks and focused on lending practices.
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