Financial Regulation and Compliance

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What Caused the Irish Banking Crisis?
Article in Journal of Financial Regulation and Compliance · July 2010
DOI: 10.1108/13581981011060808 · Source: RePEc
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K.P.V. O’Sullivan
University of Limerick
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Electronic copy available at: http://ssrn.com/abstract=1888342
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What caused the Irish banking crisis?
K.P.V. O‟Sullivan
Department of Government
London School of Economics
Houghton Street
London WC2A 2AE, UK.
Telephone: +44 (0) 20 7955 7553
Email: k.p.o’sullivan@lse.ac.uk or kpvosullivan@gmail.com
Tom Kennedy
Kemmy Business School,
University of Limerick, Ireland
Address: Kemmy Business School, University of Limerick, Limerick, Ireland
Telephone: 353 61 202125,
Email: tom.kennedy@ul.ie
Electronic copy available at: http://ssrn.com/abstract=1888342
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Abstract
Purpose – This paper explores the Irish banking crisis. It attempts to explain how
various factors contributed to a collapse in asset prices, an economic recession and the
near failure of the banking system. The paper will seek to document the dangers of
pro-cyclical monetary and government policies, particularly in an environment of
benign financial regulation and pent-up demand for credit.
Design/methodology/approach – The paper will map the Irish banking crisis against
its general background. It will describe the roots of the crisis, with particular attention
given to government and monetary policies, the practices of the financial regulator
and banks during the property bubble, together with the difficulties associated with
the international sub-prime crisis.
Findings – While the global financial crisis exacerbated matters, the banking crisis in
Ireland was largely a home grown phenomenon. The crisis stemmed from the collapse
of the domestic property sector and subsequent contraction in national output. Its root
cause can be found in the inadequate risk management practices of the Irish banks and
the failure of the financial regulator to supervise these practices effectively.
Originality/ value – This paper documents the “celtic tiger” phenomenon of the last
decade: the Irish economic and property miracle, its sharp decline, and the sub-prime
crisis. It delineates one of the most severe banking and economic crisis in a developed
country since the great depression with a number of key policy lessons for rapidly
expanding economies.
Keywords Banks – Banking crisis, Ireland, Regulation
Paper type – Research paper
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1. Introduction
The banking system provides the fulcrum around which the economy turns. It
underpins the efficient allocation of capital stock, provides essential transaction and
intermediation services and funds the development of new businesses and
technologies in the wider economy (Harper and Chan, 2003). As seen with recent
events in 2008, banking crises can depress economic growth, increase unemployment
and destabilise the wider economy. Rogoff and Reinhart (2009) suggest that following
a severe financial crisis, gross domestic product (GDP) per person falls by an average
of 9% in two years, the unemployment rate increases by 7% and house prices fall by
approximately one third in real terms and take about five years reach its nadir.
Concomitantly, real government debt grows by an average of 86% in countries
afflicted by financial crises, reflecting a collapse in tax receipts due to a reduction in
economic activity (Rogoff and Reinhart, 2009). Therefore, downturns following a
banking crisis are typically long and deep (Gup, 1999). Consequently, it is necessary
to understand how these crises develop, in order to limit the probability of such events
reoccurring.
In 2008, Ireland experienced its worst financial crisis to date. While this phenomenon
was not unique to Ireland at that time, the speed and severity of the Irish experience
makes it an interesting case study. This paper attempts to show how macroeconomic
conditions contributed to a systematic failure of the banking system and how a rapid
growth in the Irish economy stimulated a property boom. This together with an
increasing population, historically low interest rates and expansive fiscal regime,
contributed to the property boom becoming a bubble. In effect, a liberalised
regulatory banking system enabled credit to fuel an already overheated property
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market which ultimately gave rise to a crash rather than the anticipated soft landing.
The resultant sharp decline in house prices led to an increase in credit defaults in the
bank‟s property-exposed loan books and, allied to the freezing of international money
markets, gave rise to major funding difficulties for banks in Ireland. Consequently,
the Irish government in September 2008, had to take the unprecedented and somewhat
controversial decision to rescue its financial system by issuing a blanket guarantee of
all its debt obligations. This was followed by the nationalisation of Ireland‟s third
largest bank, a €7 billion recapitalisation of its two main financial institutions and the
creation of a type of “bad bank” (National Asset Management Agency) to manage the
billions of nonperforming or toxic loans in the banking system.
This paper is structured as follows. Section 2 provides the theoretical framework by
examining the determinants of international banking failures with special reference to
the Swedish financial crisis in the early 1990s. Section 3 investigates the
expansionary phase of the Irish economy between 1997 and 2007. In particular, it
describes how the property boom became an asset price bubble as prices and the
production of house units escalated. The next section presents the monetary and
public policy framework which facilitated the Irish property bubble. Section 5
describes the Irish regulatory environment and delineates its liberalisation and
adoption of principle based regulation (PBR). Section 6 describes the changing nature
of banking practices during the property bubble. Section 7 documents the current state
of the Irish economy and the challenges facing the banking system. Finally, the paper
concludes with a discussion of the key conclusions and recommendations.
2. Determinants of International Banking Failures
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Recent experience suggests that financial systems are prone to periods of instability
and market failure. Since the 1990s (and particularly in 2008), the scale and frequency
of banking failures have been common, large and expensive. Eichengreen and Bordo
(2008) have identified 139 financial crises between 1973 and 1997 compared with a
total of only 38 between 1945 and 1971. The majority of banking failures in the recent
past have been associated with adverse macroeconomic conditions, such as: cyclical
downturns in output, difficult trading conditions and fluctuations in property prices
(Caprio and Kingebiel, 1996; Lindgren et al., 1996; Kaminsky and Reinhart, 1996;
Demirguc-Kunt and Detragiache, 1998; Gorton, 1988). The latter is the main
triggering agent causing banking fragility and ultimately systemic crisis (Woods,
2007; Berg, 1998; Gup, 1999). For example, a Federal Deposit Insurance Corporation
study in 1997, concluded that price changes in commercial property markets was the
main cause of losses at financial institutions during the US banking crises in the 1980s
and early 1990s. Nevertheless, the practices of banks, regulators and the government
ex-ante can be seen as the root cause of the majority of financial crises. Drage et al.
(1998); Llewellyn (2000); Altman (2009) suggest that many banking failures in the
last 20 years have been, in part, a product of a lack of government intervention.
Similarly, others (Benston and Kaufman, 1994; Dowd, 1996) have attributed the
Asian and Nordic financial crises of the 1990s to the indirectly malign effects of
regulatory frameworks and inappropriate banking practices.
The Swedish banking crisis is a good example of a property induced banking crisis
and provides an interesting perspective given its similarities with Ireland‟s
experiences in 2008. Historically, credit markets in Sweden were heavily regulated.
The Riksbanken [Swedish Central Bank] set the rate of interest and the size of capital
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flows within the economy (Jonung, 2008). Lending ceilings, placement requirements
and interest regulations created an environment of excess demand for credit (Drees
and Pazarbasioglu, 1998; Berg, 1998). A lack of competition within the banking
sector (Woods, 2007) contributed to the tight credit conditions as banks were highly
cautious when assessing risk. Furthermore, financial institutions in Sweden were
intensely scrutinized by the Riksbanken to ensure prudent behaviour was maintained
(Englund, 1999).
In the early 1980s, the Swedish financial system underwent a period of significant
deregulation. Firstly, liquidity ratios were abolished in 1983, followed by the removal
of interest and lending ceilings two years later. These factors stimulated an increase in
competition amongst banks. Overall lending increased by 73% in real terms (Englund,
1999) as risk management criteria were loosened by banks to maintain market share.
In the five years following the liberalisation of Sweden‟s financial market, mortgage
lenders increased the maximum loan-to-value ratio from 75% to 90%. The expansion
of credit in the economy was supported by low or even negative real interest rates
(Englund and Vihriälä, 2007) and a tax system that favoured borrowing (Bäckström,
1997). Banks also started to enter new and more risky markets to take advantage of
positive conditions. Loans were increasingly used to fund highly-leveraged
commercial property investments. However, mortgage lending saw the greatest
increase, growing by 129% over a five year period, following liberalisation (Englund,
1999). This allowed banks and mortgage institutions to expand rapidly and post
significant profits.