Irish Central Bank declared its impotence before launch of the euro; Why Spain's biggest banks survived huge housing boom
By Michael Hennigan, Founder and Editor of Finfacts
Sep 7, 2009 - 5:07 AM

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European Central Bank president, Jean-Claude Trichet, cutting the cake at the 10th anniversary celebrations of the ECB, on June 02, 2008. Trichet said: "Europeans have achieved what was deemed impossible, what had never been tried. As Tocqueville said: 'L’histoire est une galerie de tableaux dans laquelle il y a peu d’originaux et beaucoup de copies.' 'History is a gallery of pictures in which there are few originals and many copies.' The single currency of Europe is indeed an original, according to Tocqueville's definition." He added: "Since the euro came into being 15.7 million new jobs have been created, over one million more than on the other side of the Atlantic."

The Irish Central Bank publicly declared its impotence before launch of the euro and futilely pleaded for restraint from the banking sector as fiscal policy fuelled the boom. In contrast, Spain's biggest banks survived a huge housing boom because the Spanish central bank insisted onadditional provisioning during the good years and other risk controls.

The euro has survived its severest test since its creation in 1999 and European Central Bank president, Jean-Claude Trichet, has warned of "a very bumpy road ahead," but the time of greatest peril has passed.

The contrasting fortunes of the biggest banks in Ireland and Spain, are a clear refutation of the argument that the euro is the primary cause of Ireland's banking woes.

Central bank governor Maurice O'Connell, told the Oireachtas Committee on Finance and the Public Service in early 1997: "There seems to be a perception that the Central Bank can exercise some legal authority in restricting credit. It has no such authority. Any restriction would be inconsistent with European Union practice. Besides, it would be unworkable as demand would probably be met by overseas lenders."

He said the Bank had warned financial institutions repeatedly of the dangers inherent in high rates of credit growth and any relaxation of lending standards.

In the following years, as Finance Minister Charlie McCreevy stoked the property boom with income and capital tax cuts coupled with a massive expansion of property tax incentives, the annual reports of the Central Bank chronicled the letters that were sent by the governor to the financial institutions, pleading for prudence.

In April 1999, the governor had issued a letter stating that an analysis of practices had shown that some lenders had no evidence as to how borrowers came by the balance of their money. The governor criticised what he called, the particularly disturbing practice of allowing large amounts of the borrowers after tax income to go towards paying off a mortgage.

The 1999 annual report notes: "Institutions were...advised that it remains vitally important for them to take a medium term perspective and to reckon with the potential consequences of rising interest rates and a return to lower rates of growth in the economy. All institutions gave assurances that there would be no slackening in prudential lending standards."

In April 2000, the US magazine BusinessWeek, quoted the governor: ''There's no monetary policy prescription for the problems of the Irish economy.''

Five years after the enactment of the Constitution, which in Article 45 states: "That in what pertains to the control of credit the constant and predominant aim shall be the welfare of the people as a whole," the Central Bank Act of 1942 gave no powers to the planned new bank, to restrict credit. It was not until 1965, that the Bank first formally advised banks to restrict an increase in credit.  More than three decades later, the Irish Central Bank governor had a counterpart on the ECB's governing council, from Spain's central bank, Banco de España, who had a different view on EU rules.

A World Bank paper says Banco de España and its banking supervisor, put a system for special loan-loss provisions, in place in July 2000, to cope with a sharp increase in credit risk on Spanish banks’ balance sheets following a period of significant credit growth. Moral suasion had proved to be inadequate in inducing banks to become more conservative. Moreover, intense competition among banks had resulted in inadequate loan pricing - - that is, risk premiums were too low. The new system in effect obliged the banks to build up a fund for the rainy day.

The World Bank paper says Spanish banks had accumulated a significant buffer to cover incurred losses, a buffer that they have now started to draw down as individual loan losses have begun to mount in parallel with the deterioration in the economy. The buffer was never intended to be permanent. Instead, it is meant to be used in periods such as the current one, when problem loans and specific provisions are surging. By being drawn down, dynamic provisions fulfill their anti-cyclical purpose.

Besides central bank intervention, an intense board-level focus on risk is another reason why Spain’s large banks have so far weathered the credit crunch in better shape than many of their European rivals.

The risk committees of the two biggest banks, Banco Santander and Banco Bilbao Vizcaya Argentaria (BBVA), include several external non-executive directors and they meet usually more than one each week.

In August, BBVA made a deal with the US government to acquire the failed Texas-based Guaranty bank. In the UK last September after the collapse of lender Bradford and Bingley (B&B), Banco Santander, which controls Abbey and Alliance & Leicester, agreed to buy B&B's retail branches. In 1986 Emilio Botín, then aged 52, took over from his father as head of Banco de Santander. Botín's great-grandfather founded the bank in 1857. So the bank is not just run by hired hands.

Within the Eurozone, prudent banking could not offset unbridled fiscal policy and the economic slump in Spain has put some lenders at risk

A government report in June showed that Spain had 614,000 new homes unsold at the end of 2008. Almost half of those are by the over-developed coast, according to the housing ministry study, which surveyed or visited 6,810 property companies. The survey also noted that Spain had 627,000 homes in the process of construction at the end of 2008 - - 70 per cent of them almost finished and 39 per cent already sold.

In 2007, Spain with a population of 40 million, built 690,000 new homes - - as many as France, the UK and Germany combined. In Ireland 78,027housing units were builtdown from 93,419 in 2006 and 1.5 million units were built in the US, with a population of 305 million, down from 2 million in 2006.

In Ireland, in 2005, Davy Stockbroker economist Rossa White, used what economists call the Taylor Rule, to estimate the appropriate interest rate for Ireland as 6 per cent, compared with the then ECB policy rate of 2 per cent. The contemporary rate in Iceland was 8.25 per cent.

Membership of the euro system is incompatible with casino economics. The option of devaluation and a quick route to restoring competitiveness isn't available in a downturn. In Iceland, with its own currency, the high interest rate attracted foreign money to fund reckless adventurers, who put their economy on the road to ruin.  Today, its central bank’s policy interest rate is 12 per cent to underpin the value of its currency and it is facing a 30 per cent cut in public spending in coming years. The IMF and Nordic neighbours have provided a bailout.    

In Ireland, it's a fanciful notion that outside the Eurozone, a boomtime Irish fiscal policy would have been matched by a prudent monetary policy.

Apart from the example of Iceland with its independent central bank, even allowing for a foolish trust in the independence of an Irish central bank, the argument that as Irish trade was primarily with the US and the UK, also does not support the anti-euro argument. The Euro is the world's second reserve currency and US companies generally do not repatriate profits unless they have no funding requirements overseas.   

It's instructive to note that no senior manager in the civil service or the central bank, had the courage to publicly oppose irresponsible economic policies including the special benchmarking payment that was based on a false premise. Self-interest always trumped principle and simply, nobody stood up to the reckless politicians.

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