No "Free Lunch" in Banking Regulation

The Bankers' New Clothes:
What's Wrong with Banking and What to Do about It

by Anat Admati & Martin Hellwig.

Publisher: Princeton University Press

MY REVIEW

The ability of financial intermediaries, normally banks, to create money via the device called fractional reserve banking ("FRB") is capable of being both a boon and a bane.

When it works well, savings are mobilised, economic activity is facilitated, incomes increase, wealth accumulates and occasional set-backs are accommodated. It is a magical device without which the modern world could not exist.

In this, it resembles fire. Fire is essential to civilisation but is also extremely destructive when control of it is lost, Similarly,when money creation goes "bad", the consequences can be cataclysmic.

Some say that this is basically unavoidable, and that humanity is condemned to endure such disasters from time to time, just as we must expect another Ice Age sometime, no matter how well we restrain our pollutive natures. That may or may not be so, but I agree with the authors of this book that lessons can be learned and things can be done.

Admati & Hellwig are enthusiasts for the idea that Society can be spared future pain by a more conservative approach to one of the key fractions in FRB, the leverage ratio (often also called the capital ratio). "Whatever else we do, imposing significant restrictions on banks’ borrowing is a simple and highly cost-effective way to reduce risks to the economy without imposing any significant cost on society" is the message of this book, which also gives much space to rebuttal of many contrary arguments. It is a good book, and overall, I think that it makes its case well.

I really wasn't aware, before the book came to my notice, that the issue was so controversial, and I am still a little bemused at the pretty unanimous enthusiasm with which the book has been greeted by some. You can read The Grumpy Economist (No, John Cochrane - and he claims that he is "not really grumpy") and Patrick Honohan - who does admit to some "chafing", mind you - to get the full enthusiastic flavour, or just look at the reviews (including one by Ken Rogoff) summarised by the publishers here. Based on what I have seen myself, the selection appears, unusually for a publisher, to be quite representative. The Amazon ones are here.

My reason for buying the book, though, was because I was astonished by the authors' vehemence (visible in interviews and the Internet) on a point that I (still) think to be incorrect.

I agree that lower bank leverage will bring probably all the benefits that the authors say that it will. Furthermore, I note that they have wisely avoided pinning their colours to the mast of a specific figure, though it's clear that they have roughly 30% in mind (the current average figure is 3%, they say; others put it at nearer 11%). I also tend to side with them in the rebuttals of objections.

My problem is with their insistence that their plan is cost-free for the economy as a whole. I find it odd that there has been so little discussion or challenge of the view that higher bank capital requirements will not actually reduce the flow of loan finance out of the banks. Their approach to this in the book, in interviews and their website is not only wrong, in my view, but perverse.

It is perverse because it requires us to accept that banks' funding structure will have NO effect on banks' activities, whereas Admati & Hellwig spend quite a lot of space describing how the need to attract equity will improve lending standards. Better lending ceteris paribus pretty inevitably means less lending. Admati and Hellwig at different points appear to accept and also to deny this.

While one of the points well made in the book is that (non-bank) users of capital have become too fond of credit and too equity-averse, the authors appear to believe that this preference will frictionlessly pivot on both sides of the balance sheet i.e. depositors will voluntarily become more inclined to take an equity position in the institution where they keep their liquid savings, and borrowers will become more willing to pay in the form of a profit-share to lenders. If anyone doubted that before the Cyprus "bail-in", their fears will not have been assuaged by that fiasco.

I share Arnold Kling's view,

The non-financial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets. The financial sector accommodates this by doing the reverse.

.

Finally, though, I am dismayed by this book, and nearly all of its reviewers, because I see no appreciation of the multiplier effects of capital, and other ratios, on the dynamism of FRB. (Indeed, the words "multiplier", "fractional" and the phrases "fractional reserve banking" and "money-creation" are entirely absent from the text.) Central Banks wishing to dramatically slow down over-heating economies or sectoral markets always could (but very rarely did) increase the minimum ratios.

Raising the capital ratio, which is another way of saying "reducing the leverage ratio" even from 11% to 25% will drastically cut the money supply, even if the appetite for bank equity increases a lot. Raising equity capital may not be as difficult as it once was, but it is still and will always be slower than borrowing from money markets. For Klingian reasons, I doubt that bank balance sheets will, following such a change, end up as big as they were. This will have effects in the real economy.

But, even if this is, improbably, insufficiently optimistic, consider what the position will be going forward with a ratio of 25 instead of 11. Where before the multiplier was 9, now it is 4. For every extra million in deposits, 4 million can be injected as new credit, instead of 9 million. That is a formidably less dynamic monetary environment.

Of course, there will be positive aspects to this: less inflationary pressure and less reckless lending, to name but two benefits well worth having. And as we have painfully re-discovered, excessive dynamism is undesirable. However, as the authors say in another context, "it is impossible to discuss coherently the need for anything without considering its cost". The flow of credit will be reduced, and money creation will be suppressed considerably if we do, as we probably should, adopt Admati & Hellwig's proposal either in whole or in part. Those are significant costs. We should not pretend that they do not arise, even if we think that they are exceeded by the benefits.

Update on Friday, July 12, 2013 at 11:15AM by Fergus O'Rourke

Whoops ! Nearly forgot to mention this by Arnold Kling on the book, in which he adopts, unsurprisingly, a Klingian perspective. My own review was drafted before I discovered this article.

Update on Friday, July 12, 2013 at 11:19AM by Fergus O'Rourke

It's not explicit above, so let me make it so: the authors' repeated claim that they will show, and then that they have shown, that there is no cost to be paid for what they propose is, I say, not sustained in the book, or in the subsequent responses to its critics.

Book review: "Engineering The Financial Crisis" by Friedman & Kraus

"Engineering The Financial Crisis" by Jeffrey Friedman & Wladimir Kraus, University of Pennsylvania Press. Available from Marston Book Services, 160 Milton Park, Abingdon, Oxon, OX14 4SD, England / direct.orders@marston.co.uk. Price £29.50

This is a superb book, which deserves to be read by anyone who is serious about trying to understand how the Banking Crisis happened.

It has insights to offer on more general topics as well. These relate inter alia to the (alleged) delusions of the economics profession, the futility of some common expectations of democratic policy-making, and even to the limitations of human capacity to manage the complex systems that now dominate our lives. We think we understand these systems because it is we (or people like us) who constructed them, but even the most sophisticated of us are sometimes caught out.

A long time ago, the American wit H.L.Mencken observed

for every complex problem there is an answer that is clear, simple, and wrong.

The response of commentators, wherever located, to the Banking Crisis illustrate this quite well. The standard narrative (hereinafter "TSN"), not just in Ireland, is that what happened in 2008 followed years of reckless behaviour accompanied - indeed encouraged - by inflated salaries and ridiculous "bonus" payments to bankers. When the inevitable "feco-ventilatory intersection event" occurred, these same bankers then turned around and expected to be rescued from the consequences of their folly.

As Friedman & Kraus point out

... [these views have] immediate and important consequences. The informed public's impressions of the crisis are based in part on journalists' and scholars' hasty pronouncements. These impressions have now hardened into convictions. Political movements of the right and the left are already acting upon dogmas about the crisis that have little or no basis in fact, and policy changes have been made on the basis of these dogmas.

They go on to pick apart systematically the most popular U.S. explanations for the Crisis - which overlap with the most popular in Ireland, too - test them against the facts, and, one by one, discard them as unsatisfactory. (The authors might put it more strongly than that).

For example, they show that, as indeed in Ireland, the banks that failed most disastrously were also the ones led by men whose personal shareholdings were highest. This is counter-intuitive, as well as inconsistent with TSN.

They also show, in what they appear to regard as their most controversial finding, that the banks consistently chose security over high returns. This, too, is inconsistent with TSN, which takes it as axiomatic that "moral hazard" wreaked havoc by encouraging executives to take excessive risks, since it was (supposedly) a "tails I win, heads you lose" situation.

"The Right Kind of Regulation" ?

The book authors go on to propound their own explanation, which could be briefly summarised as

it was the Basel rules wot done it.

That is their précis, not mine. (The wording is not theirs, though).

And, more fundamentally,

the crisis was caused by ignorance on all sides.

That ignorance was not necessarily attributable to incompetence or similar faults. Nor was it otherwise culpable: it was a consequence, possibly not completely avoidable, of the complexity of the systems which had to be understood, and managed. Friedman & Kraus describe it as "radical ignorance".

In doing so, they "take a pop" - one of several, mainly at him, but at the economics community generally - at Joe Stiglitz, the Nobel laureate:

Essentially, his solution to this problem is consistently to downplay the possibility of human error - that is, to deny that human beings (or at least uncorrupt human beings such as himself) are fallible. ...

Simply turning over all power to a Nobel laureate economist such as Stiglitz is no answer. There are many Nobel laureate economists, and they quite frequently disagree with one another. Which one of them should be the economist-king who will ensure that regulators do not make even worse mistakes next time ?

...If economists are our most important advisers, but their world-views have no place for genuine human error, we are in deep trouble

While the book is about only the U.S. dimension of the crisis - the authors say that all the data available there is not available for Europe or elsewhere - I believe that the basic analysis is accurate for Ireland as well.

What we have (or had) in common was an unquestioning belief that property values could never fall significantly. While I was previously aware of this fateful delusion, this book has brought home to me more than before the extent to which the Basel rules not only sanctified it, but incentivised banks to become more property-focussed.

In view of where we are now, the fact that the same conventions, in effect, also encouraged banks to over-lend to badly-run sovereign states is noteworthy as well.

Remembering that our own Nyberg report laid so much emphasis on the role of "group-think", the book’s observations on what it describes as "homogenisation" as a necessary effect of regulation are thought-provoking.

Another insight which merits attention, and helps to explain why "the bail-out keeps clocking up the billions", is the inappropriateness of the term "cushion" to describe minimum capital standards for banks. As the authors say, "hard-floor" would be a more accurate short-hand: as soon as a bank hits that level, those in control are in imminent peril of losing that control. They are naturally, and this is the intention, impelled to either raise fresh capital or to shrink loan-books.

That looks fine in theory, and may be considered to work well for a crisis confined to a single bank. As we have found, it does not work well in circumstances when there is a system-wide, and international, problem. In that situation, it is illusory to suggest that borrowers can repay quickly (or perhaps at all), and this will be so well-known that the normal suppliers of capital will not re-capitalise lenders.

In another finding which TSN ignores, Friedman & Kraus point out that

even the commercial banks that actually became insolvent had significantly higher regulatory capital levels than required by law

It is difficult to quarrel with their observation on that, viz.

This suggests that the chief cause of their insolvency was not (as a rule) deliberate risk taking but ... risk taking in which the bankers were ignorant of the true level of risk

I do not agree with every judgement of the authors. For example, contrary to their view, not every economist - and none of those who taught and still teach me - believes that any economist has precisely modelled reality. Also, while generally correct as to it having a major direct role in causation, their implicit view that remuneration models were of no relevance at all is one that I am not yet prepared to accept. As Steve Randy Waldman remarked recently on Twitter:

to the frustration of social scientists everywhere, a thing can be an important factor yet neither a necessary or sufficient cause...

Nevertheless I am grateful to them for their scholarship, and for their clear presentation of it, to which I cannot do adequate justice in a short review.

I heartily commend this book.

David Drumm's Interview with Niall O'Dowd

On the wonderful website The Irish Economy, I made a number of contributions in the Comments section following a post on the above subject. A commenter called Bklyn_rntr responded to me (and to others) on November 28th last and again early on the following day. As the comments to the post in question had already gone on for too long, I promised to respond here and I belatedly do so now.

I shall address his points in the order in which they were made.

...Anglo had only one reasonably effective system for managing risk and that was to insist that loans granted MUST be deposited with the bank. Indeed, a minimum deposit was required or the loan would become callable. In 2008, apparently, when Lenihan was presented with a series of choices surrounding the guarantee, he chose to guarantee everything AND to allow deposits to be withdrawn, including those subject to the minimum deposit requirement.

I don't believe that when considering, and deciding upon, the Guarantee, the then Minister or anyone involved would - even if they knew about them, which I also doubt - have had the position of such security deposits in mind. If the suggestion is that Anglo management later released such security without repayment of the loans, then I will await sight of the evidence that this happened before commenting.

...if you want to demonstrate your superior legal skills by offering a definition of treason, feel free. I don’t pretend to have training here. However a dictionary says it is acting to weaken or harm your state or sovereign or offering help or succor to your country’s enemies. Well, IMHO, foisting what were clearly private sector losses onto the sovereign in order to protect the banks of Germany and France, was an act that weakened Ireland.

Compliment acknowledged, but I don't think that it requires legal training to appreciate the fact that to speak of treason is out of place here. Indeed, working out what constitutes the offence in the modern world caused grave difficulty as far back as 1916, when Roger Casement ended up being "hanged by a comma".

If a country is at war with another, someone who aids the enemy might be reasonably described as a traitor. At a stretch, one might also so refer to someone who works to replace, by force, our democratic constitutional arrangements with rule by one man, or by a small group, accountable to no electorate.

In both cases, the intention of the traitor to actually bring about the bad results would have to be an essential ingredient of the offence. One is not validly called a murderer automatically just because one is the cause of someone's death. It can be an accident.

I might agree with the opinion that the actions of many people - from all walks of life, not merely politicians and bankers - have, with the benefit of hindsight, damaged our state. Unless it can be shown that they did so with that intention, it is not just inaccurate but ludicrous to speak of what they did as criminal in any sense, never mind treason. And we are not at war.

Of course, I realise that many serious people, not excluding better lawyers than I, will speak in those terms in informal social encounters, but they will not do so in a serious context such as the present one.

If anyone really believes that people like Seán FitzPatrick, David Drumm or Brian Cowen took the disastrous decisions that they did with the intention that they would damage Ireland and/or aid the country's enemies, then it is long past time for evidence of such intentions to be produced. I have seen nothing which has even tended to constitute such evidence, and those who keep muttering about it are, it seems to me, living in a fantasy.

...it is shocking to think that concealed management loans, back handers, irresponsible lending practices, nefarious share support schemes were, and I suppose are still, legal...

None of those things have ever been or are "legal". (It might be useful to know, though, whether we share the same understanding of the terms "irresponsible" and "back-handers"). I don't understand Sarah Carey to suggest that she disagrees. What I understand her to be saying is that, because so many of the crimes alleged happened with the apparent connivance of the authorities, the miscreants can't and won't be prosecuted.

The world still spins on its axis in the same way, and accordingly I disagree with Sarah, but she has a valid point. Just ask yourself if a jury would convict Willie McAteer if they believe - I am not sure that I do - that he was actively encouraged ("Fair play to you,Willie") by the Financial Regulator to "window-dress" Anglo's balance sheet. And would a jury convict Kevin Cardiff of conspiracy if he persuaded the jury members that he sincerely believed that the interests of the State required him to do what he did ?

And that those who ran the country into the ground (public and private sector) are ... given an opportunity to state their side of the story to an obviously sympathetic journalist is shocking to me.

Sigh.

How are we to judge whether these people are really responsible if we object to hearing their side of the story ? Even if some issues of their responsibility may be clear by now, there is still a lot that they can explain. I would like to hear them do so.

In this case, a provocative interview with one of the most spineless, grasping thieves, and I will say it again, a traitor to boot is really too much to bear

Contact me if you have the evidence for those accusations, and I will help you to bring a prosecution yourself, if it can be done. I will not be holding my breath while I wait.

And "what about" sentences won’t do to justify why NOBODY, including this traitor, has been called to account

There haven't been any "what about" arguments made against your position, as far as I can see.

(By the way, I also participated starting here in the discussion about the same interview on the rather good Namawinelake website).

Carswell in 60 seconds

Simon will probably be able to digest this in a minute "flat", but no-one else should be upset if it takes them longer than that ! The title originally referred to how long my first draft took to sketch, but to finish it consumed much longer than 60 seconds.

Here is my reaction - it's not really a review - to Simon Carswell's Anglo Republic.

• The crux: Anglo directors were agreed in 2004 that the exposure to development property needed to be reduced sharply, but because the bank lending staff were "deal junkies", they ...just...couldn't
• Another explanation: Chairman Gerry Murphy said in 1995 that the aim was 30% p.a. growth. New C.E.O. David Drumm repeated this target in 2004! Large property deals were the most, um, effective route to this goal...and took the bank over the precipice
• Something that might surprise you #1: Seán FitzPatrick did not like 100% (LTV ratio) loans
• Quotation from FitzPatrick: "We never employed people to tell us why we shouldn't lend" - a bit of an exaggeration, but only a bit
• More crimes were committed during the final slide over the precipice than have previously been revealed
• As the growth "snow-balled", anything, including prudential procedures, that slowed loan approvals was characterised as "inefficient" and was dismantled, wholly or partially. Not a thought seems to have been given to macro issues of sensible lending - all "turnover vanity", little "profit sanity", so to speak. In time, no-one was left who was likely to shout "stop !" or even to hesitate to lend more
• Something that might surprise you #2: Anglo's expense ratio was only one-third of the industry average
• It is tempting to see Seán Quinn as the "real villain", but Anglo was "going down" even without his astonishing shenanigans
• Anglo - other Irish banks too - was full of people with business degrees who had trained as accountants (as opposed to bankers or economists) and who saw banking as "just selling money"
• In early 1990s, 90% of Anglo lending staff were ex-AIB
• Something that might surprise you #3: there was really no "special relationship" with Brian Cowen, or even with Fianna Fáil in general
• At least after the departure in 2005 of Tiarnan O'Mahoney, the funding discipline, such as it had been, disappeared
• The biggest omission from the book: there is no detail on how the loans to Mr FitzPatrick were actually approved e.g. who did the due diligence (if any) ?
• I was surprised at the description of personal guarantees as an "Anglo trademark". During my banking days, which ended in the mid-1980s, they were more associated with my employer, Industrial Credit Company (as it then was named). There was constant pressure on us to abandon the requirement, not just in individual cases but in principle, and by 1985 seeking them was much less prevalent as a practice. How did Anglo get away with it so easily ?
• Something that might surprise you #4: The Financial Regulator was not completely useless: at several points, he obliged Anglo to modify its behaviour

The reasons for Anglo's specific route to disaster viz.

1. the lenders' addiction to deals
2. the ludicrous growth ambitions
3. the weakness of the funding function
4. and (my own gloss) the overall shallowness of the corporate culture

prompt the (for me) obvious question to those directing the other banks, and especially AIB Group

What's your excuse ?

MOPE: "Most Oppressed Profession Ever" ?

In Ireland, the grievances of Northern nationalists have occasionally been exaggerated, leading to the derisive label of MOPE ("most oppressed people ever") being applied by some of the more cynical among us.

I am often reminded of this when reading the complaints of some independent financial advisers ("IFAs") in the United Kingdom. A current example is this article by Alan Lakey of Highclere Financial in Hemel Hempstead. Mr Lakey has been a vociferous critic of financial regulation for quite a while (at least 5 years, if I recall correctly), and there is much to criticise. As with the Northern Irish nationalists, the "hype" about the precarious position of IFAs reflects real grievances, not imaginary or invented ones.

However, in the recent article, Mr Lakey parades two "hoary old chestnuts" beloved of the "IFA community".

Expanding the Complaint

A big bone of contention is that

Unlike a court, the FOS is able to depart from the specific allegation being levelled and pick through the advice process looking for some aspect it does not like. This inquisitorial process often results in the original allegation being rejected but another, often disassociated matter, being used to uphold the complaint...Some of these are clearly vexatious or devoid of logic yet the FOS invariably accepts jurisdiction causing the adviser hours of unnecessary work, interaction with his PI insurer and, potentially, payment of a £500 case fee.

(Emphasis added by me)

This is based on a misconception of how judges - at least the better ones - deal with cases. Particularly with litigants-in-person, a judge will seek to be sure that s/he understands the real source of what has given rise to the proceedings. If that means permitting the claim to be amended, that will be done.

I would doubt that Mr Lakey could sustain his charge that vexatious, illogical claims are invariably added to original complaints, but I accept that when it does happen, as it probably does, it is not a nice experience, for the reasons mentioned by him, and others.

Limitation Rules -A Human Right

Another area causing outrage is ...[that the] FOS totally ignores the 15-year long stop.The lack of a long stop is the most emotive as it singles out our industry for a removal of human rights. No rationale is used for this confiscation of rights apart from some mumbling about the long-term nature of financial advice.

This is where Mr Lakey really "loses it" and loses me, too.

The idea that benefitting from the English (or any other) statutory rules on limitation could be regarded as a "human right" is - I cannot think of a more polite word - ridiculous. All limitation rules are inherently arbitrary and work a lot of injustice in themselves. (Sadly, that does not mean that we can do without them, but that's a story for another day). For that reason. presumably, they are restricted to "legal proceedings", and complaints to the FOS are not legal proceedings.

To put it another way, it is said that the limitation rules do not extinguish the right but merely remove the remedy of being able to sue (in court) to enforce the right.To my mind, it is entirely reasonable that the FOS, not least because of the very long-term nature of some financial-services contracts, should leave open the possibility of examining complaints about events older than the 15-year long-stop.

Naturally, to do that raises difficulties of evidence on all sides, and one would expect that the FOS would not neglect this. Nor should it fail to have regard to the normal legal approaches to protests by defendants that there has been unconscionable delay in making or pursuing a claim, and similar protests.

On the evidence point - which is normally the main difficulty - it is relevant to wonder, nearly a quarter-century after the 1988 Financial Services Act, whether it should not be severely embarrassing for the industry to be be still worried that its paperwork might not vindicate its position.

The Cards We Were Dealt & How We Played Our Hand

Cormac Lucey, if I do not misunderstand this article of his, thinks that the EMU project is the ultimate culprit for our current economic mess. He is not alone in holding that view.

I do not agree: in my opinion, it is the lack of an appropriate Irish fiscal/regulatory policy response to the implications of our circumstances that is the proper culprit in that context. My recollection is that flaws in the Eurozone architecture were competently identified and policy prescriptions recommended by the "economist community".

Very unfortunately, those recommendations were not followed, and that is why "we are where we are". I don't claim to have been prescient about the extent of the financial "meltdown", but do claim that my opposition to the Lisbon Treaty was partially due to a revulsion from the failure - a failure of the EU elites, not just the Irish - to face the fact that the EU governance arrangements were neither one thing nor the other, and not fit for purpose, especially for a monetary union.

See these statements, for examples:

Having to play by the EMU rules is an acceptable long term price to pay for EMU’s economic benefits

I remain concerned by the robustness of the arrangements for the Euro. The Stability Pact is not the only one of its foundation pillars that is looking shaky

They are extracts from a 2008 post of mine.

La Trahison du...peuple?

I am prompted to write this by a recent post by Professor Eoin O'Dell, for whom I have considerable respect.

Notwithstanding that respect, we have many disagreements. For our latest, see the comment I made to the said recent post.

The issue is linked to the on-going discussion about how we in Ireland got ourselves into our current economic mess. Many commentators believe that a)there are identifiable culprits (many of whom are criminally liable), and b)all are members of the property developer, political, higher civil servant, financial regulator, banker or estate agent classes. (I propose to restrict myself in this post to the domestic targets - I may discuss the foreign scapegoats another time). I have even heard bankers, property developers and estate agents express the view that their own excesses should have been prevented by one or more of the other groups.

The link I see is this: both narratives posit that Irish adults cannot discover value or its absence without top-down guidance.

Supposedly, property buyers cannot divine, unassisted, that properties selling at 30 times annual rental value - the multiple reached much crazier levels in the supposedly more sophisticated areas - are over-priced and/or that there are times in every market when the market price is a signal not to buy. Similarly, clients of lawyers are allegedly incapable of understanding that a charge of €300 per hour to handle a straightforward probate matter is an offer which should be refused.

It is not that I don't see a real problem. There is a thorough-going failure of society here. Even property investors with millions at stake and bankers with billions at risk, to my personal knowledge, still resist the notion, ignorance of which has cost all of us so dear, that capital values of property relate to other variables such as market rent levels and trends.

And, though it is sometimes exaggerated, there is considerable reluctance among end-users of legal services - even ones who are otherwise sophisticated - to adopt a rational approach to selecting and paying their lawyers.

I suppose that another variety of the same thing is the commonplace reaction to reports that petrol station A is charging 10 cents per litre less than petrol station B: "B is a price-gouger", it will be said. The next day, or sooner, the same people will say of a report that stations C and D charge exactly the same price that it is clear evidence of illegal collusion.

Along the same lines, one constantly encounters people who bitterly complain that Tesco will not reduce their prices - all of them - to the same level as Lidl or Aldi, but who will not actually switch their custom from the former to the latter. (Yes, I know that for some, it is not an available option. And, one must exclude those who will not patronise Aldi or Lidl because they are "full of immigrants".)

How to characterise this ? "Irrational" seems too mild. Is "juvenile" too harsh ?

Whatever, it seems to me that the answer cannot be for government to attempt to put "crutches" in place so that adults are protected from their refusal/failure to use their brains when buying legal or financial services. Apart from anything else, recent experience has confirmed that the people who will be implementing such measures are no better at using their brains than the rest of us.

(None of that means that I oppose all regulation of the financial or legal services markets, and I do not.)

Unanswered Questions ?

The single-reason explanation for Ireland's banking catastrophe was a drastic deterioration in the quality of the lending done by the major lenders.

An aspect of this constantly mentioned in popular discussion is that this resulted from "bankers' greed" otherwise known as the so-called "bonus culture". Anecdotally, one hears that lenders at relatively senior level were receiving weekly cash bonuses in return for boosting the volume of loans advanced.

If true - and there does seem to be some truth at least in the anecdotes - this was indeed incompetent management of a high order.

Just as incompetent, but less commonly criticised (probably because so many, including journalists, are beneficiaries), was the banks' collective decision to extend home mortgage loans almost exclusively on a "tracker" basis. What this meant was that the customer paid interest at a rate above "the ECB rate". Unfortunately, the banks could never actually borrow the funds from the ECB at that rate, and now are left with half of their home-loan portfolios guaranteed to lose money even if the borrowers pay up in full.

Before writing this post, I turned to the three major reports (Honohan, Regling & Watson and Nyberg - N.B.all are PDFs) on the disaster to see what they had to say about these two major blunders. From my quick searches (I have still not read the reports in full), I found nothing substantial said about either.

They do appear to confirm that there were inappropriate incentives in the remuneration systems, and that the tracker lending was as badly priced as it seemed from media reports. Significantly,however, they offer no explanations for how these practices developed, whether they were appreciated as such by top management or board directors or whether there was any controversy about them whether internally, or externally (with regulator or auditor).

For me, this is less forgiveable, or even understandable, than the more general failure by these reports to assign blame to individuals for the overall situation. Moreover, while there is an effort to explain the latter by reference to atmospheric issues such as "group-think", excess optimism and the like, the pure incompetence of bad pricing (of the trackers) and bad remuneration practice attracts no attempt at explanation.

Worse than that, I have seen no sign that anyone has been asking the questions.

I hope that some reader can show me that I am mistaken.

It Was The Lending

What really caused the Irish banking crisis ?

Although some of them made a contribution

• It wasn't the PDs
• It wasn't Charlie McCreevy
• It wasn't Bertie Ahern
• It wasn't Brian Cowen
• It wasn't "the Government" or "the politicians"
• It wasn't the Central Bank
• It wasn't the Financial Regulator
• It wasn't the ECB
• It wasn't the builders or developers
• It wasn't Lehman Brothers
• It wasn't the bonuses, or high executive pay
• It wasn't the tax-breaks
• It wasn't the hidden directors' loans
• It wasn't the "Golden Circle"
• It wasn't interest rates
• It wasn't the "Partnership process"
• It wasn't benchmarking
• It wasn't the economists
• It wasn't the tribunals
• It wasn't the "wall of €100 billion euros"
• It wasn't the EU or the Euro
• It wasn't the Bondholders
• It wasn't the Media
• It wasn't fraud
• It wasn't the house-buyers or other borrowers
• It wasn't securitisation
• It wasn't exotic derivatives
• It wasn't over-charging customers
• It wasn't "pure greed"
• It wasn't NAMA
• It wasn't even property prices

No, it was the lending. The bad lending. The giving of mis-priced loans to unworthy borrowers, over-concentrated in one sector notorious for regular "bubbles", for uneconomically sound purposes backed by inadequate "collateral" incompetently assessed and often negligently secured, if at all.

Lending money carefully has always been regarded as the "key competence" of the banking industry. Even at single-digit interest rates, it can be profitable if done well. To lend well requires diligent application of standards throughout the process. The scope for error is minuscule. If "grip is lost" across the process, disaster is not merely courted but guaranteed.

That is what happened at Irish banks in the period up to 2007.

It was the lending.

Update on Saturday, January 1, 2011 at 01:54PM by Fergus O'Rourke

Edited to add links and a reference to executive pay

Update on Saturday, January 1, 2011 at 04:03PM by Fergus O'Rourke

More links added