Address by Director of Credit Institutions and Insurance Supervision Fiona Muldoon to the MacGill Summer School

Restoring confidence in the financial system

Good afternoon, ladies and gentlemen, I am delighted to be in this beautiful part of the world to talk to you today on this very wide ranging topic. In thinking about the topic, I will focus on how the banking and regulatory reform that is already underway can help restore confidence in the Irish economy and in Irish financial institutions. In turn, this confidence which I believe is a necessary pre-condition for future growth will ensure that there are future alternatives to austerity so that we are facing a very different outlook by 2016.

That Ireland has had a banking collapse is not news and although we went into the banking crisis with very healthy levels of government debt of 25 per cent of GDP at the end of 2007 our public finances are now paying dearly for the many mistakes of the last decade. The current task now is the necessary and difficult work of putting together a business model for Ireland Inc. that expands on those parts of the economy not built on buying and selling houses and development land to each other at ever inflated prices. (Even ignoring the interest payments on debt), the State currently generates a net deficit or in common language spends more than it receives in taxes. These deficits in turn must be funded and the State will continue to be a net borrower for many years and certainly still in 2016. Much of the borrowing is met from the savings of others, whether intermediated by private financial institutions or - as has been necessarily the case in the past three years - by foreign (especially euro area) governments and other official agencies. That they continue to have confidence to do so is reasonably critical. To consider this point further: These ‘net savers’ thus comprise many groups: Domestic and foreign pension funds, sovereign wealth funds and foreign banks and even our own credit unions, all of these, are (or were) amongst the lenders to Irish banks whether through holdings of corporate paper, bank bonds or deposits. The ECB has also become a big lender to Irish banks since the crisis began. Similarly there are many households in Ireland as in any economy who are net savers and there is still significant wealth in Ireland. There is €233.7bn in deposits (other than from credit institutions) in the Irish banks both covered and non-covered and €11.6bn in the credit union sector. That we have both borrowers and savers here in Ireland is obvious and that people can be borrowers or savers at different stages of their lives is also obvious. And in the main it is true, that your saving (in whatever form) funds my borrowing and also true that the two have to exist together. Given the systemic nature of the banking business model, it is also the crux of the issues facing the ECB as it rewrites the banking rule book for the Single Supervisory Mechanism for pan-euro area bank supervision. And more importantly as it negotiates banking resolution and pan-European deposit guarantee schemes (the latter two of which deal with what will happen in the future when a bank fails and who will pay).

So we have established that savers and borrowers exist on either side at both country level and at household level. So far, so normal – the problem arises when every household and every country fearful of the future, decides to cut back together. So we all stop spending and everyone saves (or as is the case in many Irish households’ currently we pay down debt). But as your spending is my income, if we all decide to save or pay down debt together then everyone’s income shrinks and confidence is further eroded, leading to the negative feedback loop that has been a feature of domestic economic conditions in Ireland in recent years. Restoring confidence in publicly owned banks, in our collective economic future and in our own household balance sheets is a critical component of breaking this loop of ever decreasing circles.

It is further the case that the situation here in Ireland is also uneven with many affected more than others by the downturn. Those that can afford to spend lack the confidence to do so fearful of what the future may bring in terms of taxation, job losses or asset depreciation. And in Ireland it would seem, from an economic perspective we divide broadly into three groups and some of it along demographic lines. Those lucky enough to be able to should be encouraged to spend, those that can’t afford to spend need to cut back in order to pay increased taxes, adjust to new wage levels or pay down debt and those that are insolvent need to be dealt with fairly and quickly.

In all of this of course, savers’ interests are sometimes but not always fully aligned with borrowers’. This is as true at household as it is at country level. So, it is as true for German bondholders as it is for say individual savers in our own banks. Sometimes in our national debate on the mortgage crisis – one might think there is only the bank on the other side of the €140.8bn in mortgages on Irish bank balance sheets. A dispassionate observer listening to the national debate on radio or reading our newspapers might be forgiven for thinking that a bank lends out its own money. Even though many of the banks in the past acted like they had discovered modern alchemy and may have lent with a certain abandon. In Ireland, largely, our retail banks are savings and loans institutions. In fact, any such bank is just a somewhat complicated intermediary: they lend other people’s money in the expectation of repayment and are supposed conservative ‘gate-keepers’ in that regard. The financial regulator sits carefully overseeing its charges protecting the saver, the bank and thus the availability of credit into the system. That is the theory at least and we now know how this went for us in the last decade.

And if we are currently living through very tough times in order to pay now for what went wrong then – how do we lay down a marker for what we would like to be in 2016? How do we attempt to ensure that we are not looking back and rueing (with the wisdom of perfect hindsight) a different set of mistakes being made currently in the attempt to clean up?

In terms of those two very difficult questions, I offer the following:

1. There is no real alternative right now for the Irish Government to cutting back (its ability to do otherwise is constrained by the availability of foreign sources of funding). The real choices to be made are whether some areas should be cut more than others or in how much we cut and whether we get value for money in what we spend. That is a matter for democratically elected government and its electorate and I don’t intend to comment further on it except insofar as it relates to a proper and efficient financial regulator and what value for money in that sphere ought to look like.
2. Within the wider European Union of course there are real policy choices to be made and there are alternatives to austerity for creditor countries. In many respects a small island on the periphery of the big economies is as ever, subject to the fortunes of its larger more powerful neighbours. In addition, the speed of banking regulation reform will be crucial to finally break the sovereign/banking link. Although we can use our influence in Europe, this will be to a great extent beyond our control (as the big creditor countries will likely drive the speed of change).
3. Next, eventually the big economies of Europe and the US will start growing again (indeed there are signs this is already underway in the US) and we must be ready. While we don’t control when growth will happen in those places, we can get on and make sure that the clean up here at home is complete in order that there is meaningful real participation for the majority of consumers and businesses in any uplift when it comes. And as importantly, so that we grow the domestic economy as much as we can. In effect, we must have a credible functioning banking system where markets and consumers alike are confident that losses have washed through and that the credit system is stable. Ireland’s recovery cannot be declared complete without this. So this means that those who are currently mired in unrepayable debt must be dealt with and any that are not paying by choice or by design must be required to do so. This point is within our collective control and is fundamental to our recovery. By 2016, it is wholly accomplishable that mortgage and SME work out and resolution should be complete. We cannot allow a situation to continue that further limps along with businesses, households, banks and the country unable to move on.
4. Finally, we can continue to build a new regulatory system: The strength of our application to that task should protect or future proof the next asset bubble and can be a lasting positive from this last crisis if we resolve to make it so.

What does an effective regulator look like? How do we ensure that as a key public sector government body we deliver value for money within the public service? How do we as a regulator, assess the risks as presented and ensure we respond proportionately? Can we ensure that there is an effective credible deterrent against wrong doing? In respect of such questions, I believe the regulator will have some interests closely aligned with the well governed institutions that it regulates: these will be prudentially stable, well capitalised, conservatively run institutions. Should there be a problem with the rules that the regulator sets or the way that it applies these rules, there will be a reasoned, articulate, public interaction based on the facts and the issues and thereafter a working together to resolve the problem based on a common understanding of the objective of that regulation in the first place. It is too easy to criticise the regulatory burden; it is much harder, much more worthwhile, much more constructive to put forward specific and persuasive alternative proposals that recognise the nature, intent and purpose of such regulation and accomplish the same aim in a more efficient, risk based, proportionate or cost effective manner. In addition, the creation of jobs is central to many of Ireland’s policies and the awful costs of unemployment in human, social and economic terms are plain enough to see. However the well regulated financial services industry of the future will not be at odds with job creation in that industry and I believe many of the firms we regulate understand that the arguments in this space are a good deal more nuanced than we are sometimes led to believe. In 2016, the restored regulatory reputation for the jurisdiction in which they operate will be important to these firms in terms of selling their own brand, their stability and their products. The boards of our financial institutions will govern those same firms based on doing the right thing by their shareholders, their employees and the wider economy in which they operate, rather than make their decisions based on short term profits, market share or because they are forced to by external rules and regulations. I believe in that regard, the financial sector will need to undergo a fundamental cultural shift whereby it will view regulation and the law as the outside parameter of acceptable behaviour rather than an obstacle to be overcome, something that can be worked around or whose boundaries are there to be tested.

The regulator will be confident in its interaction with these firms. There will be respect for the different roles and the reasons for those roles on both sides; a respect that was noticeably absent in the replay of tapes from the era that got us to where we are today. Both sides will listen carefully to the other.

I have spoken before about how regulation is not a popularity contest. Indeed, I often say to staff that it is a difficult job with little discernible upside and noticeable by the public only in its absence or ineffectiveness. Parts of the industry will always dislike it intensely and many will believe that they know better. However, on the positive side, there are signs that many in the industry have seen and understood the change that is under way. I believe that there are many who want to engage constructively in the manner I outlined and who understand well how corporate culture and corporate governance must break irrevocably from past practice. Indeed, we have been gratified by the response of many in the industry to the undoubted difficulties of absorbing and implementing the many new regulations imposed as a result of our reform agenda (I would single out for particular mention the credit union sector, a group that comprises largely, small, community based organisations and has been subjected to a sea-change in regulatory approach over the last few years).

So this is my quick portrait of 2016 where all firms behave so well that our job is easy and our problems relatively few. At this time the regulatory agenda would again be properly driven by the business of prevention rather than cure (as it is now with the banks). However, in the absence of that regulatory nirvana, and dealing entirely in the real world, the best that can probably be hoped for is a sort of continuous truce: a sensible, assertive risk- based supervision of the firms and a considered application of the not inconsiderable powers held. This means a proportionate application of the codes and rules that both allows for natural evolution and progression in the industry coupled with the memory of an elephant: so that when the tide eventually turns or when another asset bubble develops (whether in property or somewhere else) or when there are calls raised again for lighter hands and relaxation of the rules that there are enough sensible folk around who remember just how wrong it can go and are independent minded enough to say ‘this is not a good idea’.

Between now and 2016, with the implementation of the Single Supervisory Mechanism in Europe, banking regulation will have under gone a fundamental change. In addition by 2016, here in Ireland, the banking sector, the regulator and various other Government agencies will have worked very hard for a further three years in order to clean up the mess that was created in the boom. And what I would like us to be here is realistic: it took us quite a long time to get to this point (longer indeed than it should have) and I am of the view that it is going to take some time to work us out of it. The banks now, at long last, have the operational capacity to deal with their own customers. Now begins the real work of dealing with them one by one. We can expect that there will be some reactions to that and indeed repercussions from it. That appears inevitable. We have set targets for the banks to try and force the pace so that ambitious but realistic progress is made. All of the banks have said publicly that they are on course to meet the first set of targets – 20 per cent offers of sustainable solutions to customers in arrears (of more than 90 days) by end Q2 2013. In that regard I expect that we will see them start at the outer end of the range on both sides: namely the easy cases that can be fixed with a modest term extension or other change in terms and the legal cases that are so deeply in arrears that repossession or voluntary surrender appears the most likely outcome. In addition, I think it is also reasonable to expect that there will be some variation and iteration in the process with different solutions, trial periods and some time to see what is working and what is not.

So it would seem in this regard, Ireland is set for a turbulent period over the next few months. Those households so mired in debt and unable to pay will need to confront that difficult fact and thereafter engage actively with their bank. There will be some who will unfortunately lose their homes, and some who will need to enter insolvency proceedings. But there will also be many of us who will have to continue to face the consequences of bad investment or financial decisions who will still have to pay up. Separating those two and keeping them separate is difficult but essential because it is all we can collectively afford given the size of the loan numbers outlined.

All of this is difficult, just as cleaning up any mess is difficult and it requires compassion for those fallen on hard times and an acceptance that they must be helped. However and here it gets more difficult yet, this compassion and realism needs to be mixed with real skills for uncovering those that may be trying it on. There will be those who are heavily in debt but who can still afford to pay and they will have to continue to do so. This ability to distinguish between, and separate, the response to these two distinct groups needs to be part of the toolkit for bankers, the legislature and the administrative and judicial systems that are dealing with these issues and indeed for wider society and its tolerance for that kind of behaviour.

Banks got it wrong in the past indisputably, but as it stands right now it is the public purse that has most to lose from ill-judged or incorrectly applied debtor leniency for those who would like to chance their arm or indeed those who feel there should be debt write down for all. Capital used indiscriminately or incorrectly to help those that don’t require it will not be available for those that do. Capital if used up incorrectly will run out and need to be replenished in order to underpin future growth. The sense of awful unfairness of all of this has, of course, enraged many of us and causes many to question why cutting back is even necessary in the first place but given the banks’ public ownership, it is simply a matter of economics. And in the end, as ever, money talks and isn’t that the thing? The thing that must be different by 2016 is a restored banking system in which we can all be confident and a clear mechanism for banking resolution when future generations confront a future banking crisis. Never again can we have the socialisation of losses and the privatisation of profits as the business model in banking. The moves towards banking union however slow and difficult provide the best hope that this expensive and difficult lesson is being learnt here in Ireland, and throughout Europe.