Irish Economy Conference, Dublin, Jan 31st 2014 A Banking System for Economic Recovery

1. Irish Economy Conference, Dublin, Jan 31st 2014 A Banking System for Economic Recovery Colm McCarthy

2. Signs of Recovery • Employment data is improving • External environment, especially outside the Eurozone, is better • But there is still no hard evidence of a broad-based recovery.

3. The L-Shaped ‘Recovery’

4. Macro Prospects…….. • Sharp decline in activity seems to be over • Fiscal stance remains deflationary, credit availability weak • Through 2014 and 2015, nominal GDP unlikely to grow more than 4% per annum (CB Forecast) • While a recovery from 2014 is plausible, there is aclear debt sustainability problem

5. Domestic Demand Prospects • Since Ireland must run a BOP surplus for many years to come, domestic demand must be restrained. • This means consumption and fixed capital formation cannot grow too quickly. • Growth needs to be mainly export-driven.

6. What Infrastructure Deficit?

7. The Banking System • Domestic banks have closed, foreign banks have withdrawn • Balance sheet contraction continues • But the three ‘guaranteed’ banks still had consolidated assets > 200% of GNP in mid-2013

8. Housing Finance • At bubble peak in 2006, mortgage lending for house purchase reached €28 billion. • In 2013 below €3 billion. • 25 - 30K houses needs €8 billion, or more • At the end of a bust, credit requirements for asset transfers are additional.

9. The Contingent Liability • There will be no centralised Eurozone backstop for bank resolution, so the liability remains national. • No centralised deposit insurance means national liability for deposits in foreign-owned banks too? • Does sovereign sustainability require further bank balance sheet contraction?

10. Other Credit Demands • Finance also needed for inventory re-build, trade credit, working capital, dairy herd expansion. • Multinationals, large Irish companies, semi-states, have external credit access • Households and SMEs are captive.

11. Bank of Ireland • Assets 98% of GNP • Leverage 17 • If further 5% of loans lost, leverage = 42 • Price-to-Book 105% • Mortgages + property = 73% of all loans, 52% of all assets • Loan to deposits = 121%

12. AIB • Assets 88% of GNP • Leverage 11 • If further 5% of loans lost, leverage = 16 • Price-to-Book 684%!!!!!! • Mortgages + Property = 73% of all loans, 42% of all assets • Loan to deposits 106%

13. PTSB • Assets 28% of GNP • Leverage 15 • If further 5% of loans lost, leverage = 37 • Price-to-Book 127% • Mortgages + Property = 99% of all loans, 78% of all assets • Loan to deposits 157%

14. Not a New Problem…. • ‘The banking system is heavily exposed: the big Irish banks, such as Bank of Ireland and Allied Irish, are in effect mortgage banks, observes Colm McCarthy of DKM Economic Consultants. A property crash would badly hit their balance sheets.’ • The Economist, October 2004

15. Clearing or Mortgage Banks? • Until the mid-1980s, the Irish clearing banks did not carry large mortgage books. The asset duration mismatch was seen as unsuitable for deposit-funded institutions. • Mortgages were extended by specialist and tax-privileged building societies. • There are no more building societies, and credit unions are not a replacement

16. How to Fund Housing? • Bank balance sheets need less, not more, long-duration mismatches. • Covered bonds are not the answer, since they leave the liability with the bank, whatever the accounting treatment. • If a major increase in mortgage lending is needed, mortgage-backed securities in an originate-and-distribute model is better.

17. Banks and SMEs • Deposit-funded banks are a suitable vehicle for SME finance (not for equity!). • And paradoxically for builders/developers. • Bigger firms, and some medium-sized firms, will increasingly be accommodated via securities markets, and foreign banks.