14/1/2012: Irish banking crisis - on a road to nowhere

This is an unedited version of my Sunday Times article from January 8, 2012.

In the theoretical world of Irish banking reforms, 2012 is supposed to be the halfway marker for delivering on structural change. Almost a year into the process, banks are yet to meet close to 70% of their total deleveraging targets, SMEs are yet to see any improvements in credit supply, households are yet to be offered any supports to reduce their unsustainable debt burdens, longer-term strategic plans reflective of the banks new business models, now approved by the EU not once, but twice are yet to be operationalized, and funding models are yet to be transitioned off the ECB dependency.

In the period since publication of the banking sector reforms proposals, total banks core and non-core assets disposals are running at some €14 billion of the €70 billion to be achieved by the end of 2013. Even this lacklustre performance was heavily concentrated in the first nine months of 2011, when few of Irish banks competitors were engaging in similar assets sales.

Since then, things have changed. Plans by the euro area banking institutions, already announced in Q4, suggest that some €775 billion worth of euro area banks’ assets will come up for sale in 2012. That is more than 8.5 times the volumes of assets disposals achieved in 2011. And 2012 is just the tip of the proverbial iceberg. According to the Morgan Stanley research, 2012-2013 can see some €1.5-2.5 trillion worth of banks assets hitting the markets. With 2012 starting with clear ‘risk-off’ signals from the sovereign bond markets and banks equities valuations, the near term future for Irish banks deleveraging plans can be described as bleak at best.

Further ahead, the process of rebuilding capital buffers, in both quantity and quality, can take core euro zone banks a good part of current decade to achieve. In this context, Irish banks deleveraging targets are grossly off the mark when it comes to timing and recovery rates expectations.

Progress achieved to-date leaves at least €35-40 billion in new assets disposals to be completed in 2012 – two-and-a-half times the rate of 2011. The two Pillars of Irish banking alongside the IL&P are now facing an impossible dilemma: either the banks meet their regulatory targets by the end of 2013, which will require deeper haircuts on assets and thus higher crystallized losses, or the 2013 deleveraging deadline is bust. In other words, Irish banks have a choice to make between having to potentially go to the Government for more capital or suffer a reputational cost of delaying, if not derailing altogether, the reforms timetable.

This is already reflected in the negative outlook and lower ratings given by S&P to AIB last month. The rating agency stressed their expectation of the slowdown in assets deleveraging in 2012 as one key rationale for the latest downgrades. Post-recapitalization in July, AIB core Tier 1 regulatory capital ratios stood at a massive 22%, the fact much lauded by the Irish authorities. However, per S&P “AIB’s capital ratio… will be between 5.5% ad 6.5% by 2013” due to materially “higher risk weights [on] capital, estimated deleveraging costs, as well as further capital erosion from the core business”.

Bank of Ireland finds itself in a better position, but, unlike AIB, it has much smaller capital reserves to call upon in the case of shortfall on July 2011 recapitalization funds.

Another area of concern for Irish banking sector relates to funding. Central Bank stress tests (PCAR) carried out in March 2011 assumed that by the end of 2013 Irish banking institutions will be funded on commercial terms. This too is subject to significant uncertainty as euro area banks enter a period of rapid bonds roll-overs in 2012-2014. Overall, the sector will face ca €700 billion of bonds maturing in 2012 and total senior debt maturing in 2012-2014 amounts to close to €2.2 trillion once ECB’s latest 3-year long term refinancing facility is factored in. For comparison, in 11 months through November 2011, euro area banks have managed to raise less than €350 billion in capital instruments, and various senior bonds. Again, international environment does not provide any grounds for optimism about Irish banks ability to decouple themselves from the ECB supply of funds.

In the short run, Irish Pillar Banks dependency on central banks’ funding is a net subsidy to their bottom line, as central banks credit lines come at a fraction of the expected cost of raising funds in the marketplace. This makes it possible for the banks to sustain their extend-and-pretend approach toward retail borrowers.

However, in the longer term, reliance on this funding represents major risks of maturity mismatch and sudden liquidity stops. The latest data clearly shows that the major risk of Irish banking sector becoming fully dependent on ECB as the core source of funding is now a reality. Reductions in the emergency liquidity assistance loans extended by the Central Bank of Ireland are now matched by increases in ECB lending to these banks. A recent research paper from the New York Federal Reserve shows that Irish banks continue to account for the largest proportion of all loans extended by the ECB to the banking systems of the euro area ‘periphery’.

Lacking functional banking sector, in turn, puts a boot into Government’s plans to use reforms as the vehicle for reversing credit supply contraction that has been running uninterrupted since 2008.

Another major risk inherent in the Irish banks’ funding and capital dependencies on Central Banks and the Government is the risk that having delayed for years the necessary processes of restructuring household debts, the banks can find themselves in the dire need of calling in the negative equity loans. This can happen if the Irish banking sector were to be left lingering in its quasi-transformed shape when ECB decides to pull the plug on extraordinary liquidity supply measures it deployed. While such a prospect might be 2-3 years away, it is only a matter of time before this threat becomes a reality and the very possibility of such eventuality should breath fear into the ranks of Ireland’s politicians.

As the current reforms stand, the sector will not be able to provide significant protection against the ECB policies reversal, even if the Central Bank-planned reforms are completed on time. The reason for this is simple. Our twin Pillar banks will be facing – over 2013-2018 – a rising tide of mortgages defaults and voluntary property surrenders, as well as continued mounting corporate loans losses as the economy undergoes a lengthy and painful debt overhang correction, consistent with the historical evidence of similar balance sheet recession.

While the capital for writing these assets down might have been at least in part supplied under PCAR 2011, the banks have no means of managing any added risks that might emerge alongside the mortgages defaults, such as, for example, the risk of their cost of funding rising from the current 1 percent under the ECB mandate to, say, 6 or 7 percent that private markets might charge.

For all the plans for banking reforms proclaimed for 2012 by the Central Bank and the Government, in all likelihood, this year is going to see more mounting corporate and household loans writedowns, amidst the continuation of the extend-and-pretend policies by the banks. The longer this process of delaying losses realization continues, the less viable the remaining banks assets become. And with them, the lower will be the credit supplied into the real economy already starved of investment and funding.

Box-out:

Irish banking sector structure envisioned under the Government reforms plans will not be conducive to an orderly deleveraging of the real economy and simultaneous repairing of the banks balance sheets. Sectoral concentration, in part driven directly by the Government dictate, in part by the massive subsidies provided to insolvent domestic banks, will see a colluding AIB & BOFI duopoly running circles around the regulators, supervisors and politicians.

How serious is this threat of the duopoly-induced markets distortions in post-reform Irish banking? Serious enough for the latest EU Commission statement on Bank of Ireland restructuring plans to devote significant space to outlining high-level set of subsidies that the Irish authorities are planning jointly with ECB.

No one as of yet noticed the irony of these latest amendments to the Government plans for the banking sector reforms: to undo the damaging effects of state subsidies to the incumbents, the EU and the Government will offer more subsidies to the potential newcomers. Such approach to policy would be comical, were it not designed explicitly to evade the real solution to the banking sector collapse in this country – a wholesale restructuring of the sector, that would have used insolvent banks’ performing assets as the basis for endowing new banking institutions to serve this economy.

Economics 27/02/2010: How to reform our broken risk pricing system

This is an unedited version of my article in March 2010 edition of Business & Finance magazine:


There are several deeply rooted problems with the current analysis of the ongoing financial crisis. These relate to the sources of the crisis itself and to the solutions proposed for ensuring that a new financial bubble will not emerge out of the ashes of systemic risk under pricing that characterized the period of 2003-2007 around the globe.

So far, the public aspects of the regulatory responses to the crisis have been focused on ‘political’ topics, such as executive compensation. Fine: the incentive for banks executives to structure their own compensation to reflect short term gains is well established.

Political issues are non trivial as well. We all are aware of the fact that politicians – from Bill Clinton to Gordon Brown to Bertie Ahearn and on – have strong incentives to placate voters through fattened Exchequer revenue, expanded public spending and broadened access to credit irrespective of risks. Active encouragement of loose lending standards (especially in the case of the US SGEs: Fannie Mae, Freddie Mac and Ginnie Mae) were enshrined in regulatory and legislative mandates. And look no further than Greece, Portugal, Spain and Ireland as to the troubles this can cause – politicised spending breeding scores of vested interest groups that cannot be disentangled from the feeding trough.

All of these forces, underlying the crisis emergence, are well known. What is less frequently discussed in the media is that wrong incentives alone are not a sufficient condition for markets malfunctioning, since in efficient markets, a contrarian view should be able to price out those players aligned with wrong incentives.

It is a much deeper question as to whether this has happened in the case of the current financial crisis. Anecdotal evidence suggests that this was indeed so. Early in 2007-2008, a number of short positions, including those taken well in advance of the crisis, were generating the payouts consistent exactly with the rapid pricing-out of the malfunctioning lending strategies. Ironically, banning short sales has resulted in the restoration of the mis-aligned incentives in the market. An act by the regulators aimed at restoring order in the financial markets turning out to be nothing more than reinforcing the very causes of the crisis.

This means that we must look back beyond the immediate crisis to find any evidence to either support or dispute the proposition that mispricing of risks by the financial system was systemic (in the sense that existent models of risk pricing could not have allowed for contrarian pricing strategies).

It remains a puzzle that the main villains of the game, sub-prime mortgage packages (the famed ‘Collateralised Debt Obligations’), seem to have been so badly mispriced. This apparent mispricing lay not so much in the slicing of the mortgages but in the failure to price into the packages as a whole the apparent systematic risk due to the general response of property prices to the business cycle.

Suppose that the current view that greed blinded markets participants to the fact that CDOs packages were not properly pricing risks is correct. This explanation requires that not a single market participant was willing to take a contrarian strategy betting against the consensus view. Alas, this is patently untrue.

So ‘collective madness’ explanation does not hold and the crisis roots lie somewhere else – more likely, in the balance of incentives. My suggestion is that on the margin, regulatory and market incentives led to favouring of underpricing risks inherent in CDOs and MBSs. Thus, on the margin, excess returns to unpriced risk for going long on mortgage-backed products were made greater than the expected returns to shorting mortgage-backed products once the price of insuring / shorting these products was taken into account.

In other words, it was a combination of:

• Artificially low perceived cost of long positions;
• Artificially high cost of shorting; and
• Recklessly elevated correlations between product risk (mortgages risk) and insurer risk (AIG)

that drove the bubble formation. The reason why this understanding is important is the following:

If contrarian strategy could have been formulated based on existent risk pricing systems, then short sellers were ‘fundamentally’ justified in their positions and their gains were not ‘speculative’. Furthermore, this would imply that the current crisis is not systemic from the financial point of view, but is driven by incentives and regulatory failures.

If, however, existent risk pricing systems were not sufficient to support the contrarian investment strategy and those short sellers who were betting against the consensus obtained speculative profits, then the markets are not efficient and the crisis is systemic in nature.

So, if we take information about the markets available pre-August 2007, could the crisis been pre-priced? Put differently, were Irish or for that matter UK or US property and credit bubbles predictable on the back of fundamentals or were they random events?

The systemic crisis argument supporters show that since Irish property prices have indeed collapsed on the back of weaker-than-expected ‘fundamentals’ market price risk discounting has failed.

Those opposing the argument point out that the fundamental in the housing market is ultimately driven by income dynamics, which in turn are driven by productivity. In the case of Ireland, productivity growth (income growth) should follow a random walk because innovation is largely unforecastable and in the case of a small open economy it is also subject to global trends. In other words, Irish productivity growth should be following a random walk that is even ‘more random’ than the productivity growth processes in the rest of the world.

Both are wrong. It turns out that close to the crisis – at least from 2003 on – Irish property prices appeared to become a non-stationary process having been largely stationary in the previous decade. Ditto for the US and UK, and even Spanish, Russian and Dutch property prices.

This means that the conditional forecast of the property prices in Ireland was best modelled by a reference to the current prices. More importantly, from the point of view of risk pricing, expected conditional volatility of house prices was a scale factor of the observed current volatility. In other words, the degree of risk 6 quarters from, say February 2003 was simply 6 times greater than very low volatility observed back in February 2003.

The scaling relationship, alas, failed to hold in the real world. As the property boom became, using Bertie Ahern’s terminology, ‘boomier’ through 2003-2006, property prices stopped following non-stationary process and their volatility became largely trend driven. The trend presence means that at least in part, future risk could have been priced into lending decisions by the banks and regulators. Alas, it was not. All evidence on lending suggests that the banks lending margins were heading down during 2003-2008 period, not up. In other words, Irish mortgage lenders, with tacit consent of the regulators, were pricing in decreasing risks into the future during the bubble inflation time. Ditto for all other countries that have experienced the collapse of property markets.

So whilst the financial markets were correct in pricing risks, subject to significant regulatory incentives constraints that skewed their willingness (and later ability) to actually adjust their risk pricing positions, mortgage lenders and regulators were grossly mispricing risks. This realisation leads to two major conclusions.

It shows that globally, financial crisis of 2007-2010 has been driven by the risk mis-pricing that originates in the very institutions whose business is preventing this from happening – the banks and the regulatory bodies.

And it shows where the future reforms attempting to address the issue of financial bubbles formation must lie. And it certainly has nothing to do with bankers compensation packages. The main solution to the problem suggested today is heavy re-regulation of bank risk; moving Basel I and II up to Basel III to include a pro-cyclical risk capital provision.

While a useful idea, greater buffer reserves of risk capital built over the years of credit expansion cycle, are not a panacea to the problem outlined above. The reserves are only sufficient in so far as they reflect actual risk expectations. Missing risk forecast will, in the end, still imply sub-optimally low levels of capital.

Instead, the answer to the problem of how can we prevent future bubble formation similar to the one that has been deflating since August 2007 lies in a more holistic approach to risk pricing reforms. This approach must involve several policy changes along the following directions.

Firstly, a more transparent early warning system must be deployed across the financial markets that would make short trading positions a part of open market pricing mechanisms. Put more simply, short trading must be allowed to operate on unrestricted basis, but all short trading positions must be disclosed and reported in the market in the same way in which we current disclose long positions.

Secondly, property must be treated as investment instrument, with full price and hedonic information disclosure rules mirroring those required for liquid financial instruments under MiFID.

Thirdly, there must be a clear set of strict ‘no pain, no bail out’ rules that will impose severe penalties on the management, bondholders and shareholders in financial institutions seeking public assistance. If countries can change governments within weeks after elections, banks can be weeded of their failed management as a matter of months. Instead of restricting their pay, in the future, we must make bankers accountable for their failures.

Third, regulatory authorities must be beefed up with independent, fully protected risk analysis boards drawn across the broader economy. These boards must be politically unconstrained, free of interest groups influence and must be operated behind a strict Chinese Wall relative to the entire regulatory process. A formal requirement must be imposed that at least 1/3 of the board members should be drawn from outside financial services sector, with the same proportion of members being required to hold a publicly verifiable policy positions that are contrarian to the consensus.

What the current crisis has taught us is that in the environment where politicians and industry drive risk pricing-related policies, failures of the market to cope with distorted incentives and incomplete regulatory oversight will be spectacular. Crises are a natural way for the markets to reassert proper order on inept regulatory and institutional systems.