Irish Economy Conference, Dublin, Jan 31st 2014 Irish Economy Conference, Dublin, Jan 31st 2014

A Banking System for Economic A Banking System for Economic

RecoveryRecovery

Colm McCarthyColm McCarthy

Signs of RecoverySigns of Recovery

Employment data is improvingEmployment data is improving

External environment, especially outside External environment, especially outside the Eurozone, is betterthe Eurozone, is better

But there is still no hard evidence of a But there is still no hard evidence of a broad-based recovery.broad-based recovery.

The L-Shaped ‘Recovery’The L-Shaped ‘Recovery’

Macro Prospects……..Macro Prospects……..

Sharp decline in activity seems to be over Sharp decline in activity seems to be over

Fiscal stance remains deflationary, credit Fiscal stance remains deflationary, credit availability weakavailability weak

Through 2014 and 2015, nominal GDP unlikely Through 2014 and 2015, nominal GDP unlikely to grow more than 4% per annum (CB Forecast)to grow more than 4% per annum (CB Forecast)

While a recovery from 2014 is plausible, there is While a recovery from 2014 is plausible, there is a clear a clear debt sustainability problem debt sustainability problem

Domestic Demand ProspectsDomestic Demand Prospects

Since Ireland must run a BOP surplus for Since Ireland must run a BOP surplus for many years to come, domestic demand many years to come, domestic demand must be restrained.must be restrained.

This means consumption and fixed capital This means consumption and fixed capital formation cannot grow too quickly.formation cannot grow too quickly.

Growth needs to be mainly export-driven.Growth needs to be mainly export-driven.

What Infrastructure Deficit?What Infrastructure Deficit?

The Banking SystemThe Banking System

Domestic banks have closed, foreign Domestic banks have closed, foreign banks have withdrawnbanks have withdrawn

Balance sheet contraction continuesBalance sheet contraction continues

But the three ‘guaranteed’ banks still had But the three ‘guaranteed’ banks still had consolidated assets > 200% of GNP in consolidated assets > 200% of GNP in mid-2013 mid-2013

Housing FinanceHousing Finance

At bubble peak in 2006, mortgage lending for At bubble peak in 2006, mortgage lending for house purchase reached €28 billion.house purchase reached €28 billion.

In 2013 below €3 billion.In 2013 below €3 billion.

25 - 30K houses needs €8 billion, or more25 - 30K houses needs €8 billion, or more

At the end of a bust, credit requirements for At the end of a bust, credit requirements for asset transfers are additional.asset transfers are additional.

The Contingent LiabilityThe Contingent Liability

There will be no centralised Eurozone There will be no centralised Eurozone backstop for bank resolution, so the backstop for bank resolution, so the liability remains national.liability remains national.

No centralised deposit insurance means No centralised deposit insurance means national liability for deposits in foreign-national liability for deposits in foreign-owned banks too?owned banks too?

Does sovereign sustainability require Does sovereign sustainability require further bank balance sheet contraction? further bank balance sheet contraction?

Other Credit DemandsOther Credit Demands

Finance also needed for inventory re-build, Finance also needed for inventory re-build, trade credit, working capital, dairy herd trade credit, working capital, dairy herd expansion.expansion.

Multinationals, large Irish companies, Multinationals, large Irish companies,

semi-states, have external credit accesssemi-states, have external credit access

Households and SMEs are captive.Households and SMEs are captive.

Bank of IrelandBank of Ireland

Assets 98% of GNPAssets 98% of GNP Leverage 17Leverage 17 If further 5% of loans lost, leverage = 42If further 5% of loans lost, leverage = 42 Price-to-Book 105%Price-to-Book 105% Mortgages + property = 73% of all loans, Mortgages + property = 73% of all loans,

52% of all assets52% of all assets Loan to deposits = 121% Loan to deposits = 121%

AIBAIB

Assets 88% of GNPAssets 88% of GNP Leverage 11Leverage 11 If further 5% of loans lost, leverage = 16If further 5% of loans lost, leverage = 16 Price-to-Book 684%!!!!!!Price-to-Book 684%!!!!!! Mortgages + Property = 73% of all loans, Mortgages + Property = 73% of all loans,

42% of all assets42% of all assets Loan to deposits 106%Loan to deposits 106%

PTSBPTSB

Assets 28% of GNPAssets 28% of GNP Leverage 15Leverage 15 If further 5% of loans lost, leverage = 37 If further 5% of loans lost, leverage = 37 Price-to-Book 127%Price-to-Book 127% Mortgages + Property = 99% of all loans, Mortgages + Property = 99% of all loans,

78% of all assets78% of all assets Loan to deposits 157%Loan to deposits 157%

Not a New Problem….Not a New Problem….

‘‘The banking system is heavily exposed: The banking system is heavily exposed: the big Irish banks, such as Bank of the big Irish banks, such as Bank of Ireland and Allied Irish, are in effect Ireland and Allied Irish, are in effect mortgage banks, observes Colm McCarthy mortgage banks, observes Colm McCarthy of DKM Economic Consultants. A property of DKM Economic Consultants. A property crash would badly hit their balance crash would badly hit their balance sheets.’sheets.’

The Economist, October 2004The Economist, October 2004

Clearing or Mortgage Banks?Clearing or Mortgage Banks?

Until the mid-1980s, the Irish clearing Until the mid-1980s, the Irish clearing banks did not carry large mortgage books. banks did not carry large mortgage books. The asset duration mismatch was seen as The asset duration mismatch was seen as unsuitable for deposit-funded institutions.unsuitable for deposit-funded institutions.

Mortgages were extended by specialist Mortgages were extended by specialist and tax-privileged building societies.and tax-privileged building societies.

There are no more building societies, and There are no more building societies, and credit unions are not a replacementcredit unions are not a replacement

How to Fund Housing?How to Fund Housing?

Bank balance sheets need less, not more, Bank balance sheets need less, not more, long-duration mismatches.long-duration mismatches.

Covered bonds are not the answer, since Covered bonds are not the answer, since they leave the liability with the bank, they leave the liability with the bank, whatever the accounting treatment. whatever the accounting treatment.

If a major increase in mortgage lending is If a major increase in mortgage lending is needed, mortgage-backed securities in an needed, mortgage-backed securities in an originate-and-distribute model is better. originate-and-distribute model is better.

Banks and SMEsBanks and SMEs

Deposit-funded banks are a suitable Deposit-funded banks are a suitable vehicle for SME finance (not for equity!).vehicle for SME finance (not for equity!).

And paradoxically for builders/developers.And paradoxically for builders/developers.

Bigger firms, and some medium-sized Bigger firms, and some medium-sized firms, will increasingly be accommodated firms, will increasingly be accommodated via securities markets, and foreign banks. via securities markets, and foreign banks.