October 30, 2005

Banks are drowning us in debt

Posted in Celtic Tiger ·
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This Tuesday, the Central Bank will publish what is probably its most important report this year. The bank will unveil its financial stability report on Irish banks. It will assess whether the banks have been prudent in their lending over the course of the past year and whether there is any evidence of risk to the system.

In a former life, I used to write economic reports for the Central Bank, so am reasonably well placed to give you an idea of what it will say. To get an idea of what the read will be like, imagine you are listening to a theatrical prosecuting barrister outlining a long list of offences he alleges were committed by the defendant, �Mr Banks’.

�M’lud, in front of me is this snivelling piece of financial delinquency, who has been engaged in practices so heinous, so depraved, so despicable that he threatens the integrity of the entire system. His profligacy knows no bounds; his self-serving greed is so transparent as to suggest that he is beyond redemption.�

The prosecution’s charges are detailed, meticulously aided by charts, spreadsheets and stress ratios. In the end, the list is so exhaustive, the accusations so plausible that most of the jury are already convinced that the banks are guilty of breaching all the lending guidelines and breaking all the laws.

Then, just when we expect the prosecuting barrister to deliver the denouement, he crosses the floor and begins the defence of Mr Banks explaining that, although the litany of charges is explicit and serious, no real crime has been committed and that in general, Banks’ activities are kosher.

He concludes by ignoring all the evidence he has produced and announcing that all is well – an Irish insider’s solution to an Irish insider’s problem. I believe that the expression in English is a whitewash.

The jury is likely to be confused, but that is the Central Bank’s way. It will pull its punches because, as seen in the Dirt inquiry a few years back, the Central Bank is much more concerned about the integrity of the banking system and is on the side of the banks’ management.

In the words of a former Central Bank governor, it does not want to �frighten the horses’�. This is the financial equivalent of the familiar Irish phrase, taken by Seamus Heaney for the tile of his poem �Whatever you say, say nothing’�.

But by pulling punches, the Central Bank will not serve any of us. Goodbody stockbrokers pointed out last week that we are getting into debt faster than any other country in the world. By 2008, we will have, on average, debts of 200 per cent of disposable income – an alarming trend highlighted by the Central Bank’s chief economist Tom O’Connell last week in its quarterly bulletin.

As this figure is an average, it implies that certain groups, notably those between 25 and 40, are in much deeper debt. This means that the banks are breaching lending guidelines, and in so doing, undermining the stability of the banking system.

In fact, there is a self-reinforcing logic as to why the banks, the so-called bastions of prudence, are actually the main agents of profligacy.

To shed light on the system and how it works, consider the following little story.

Some time ago, the following letter arrived at my retired parents’ house: �Dear Mr McWilliams, it has come to our attention that you bought your house in 1957 for �1,000. Today,we have had it valued at �700,000.

�We believe that this offers you a once-in-a-lifetime opportunity to liberate equity.

�Yours sincerely, Mr Bank Manager.�

My dad called me: �Son, I’ve heard of liberating Kuwait and liberating Iraq, but what in God’s name does liberating equity mean?�

It means that one of our supposedly prudent banks was urging my father, a 75-year-old pensioner, to borrow and spend against the value of his house.

Now I realise that bank managers are under pressure to increase margins, but this is taking the biscuit, don’t you think?

However, this is happening every day.

Irish banks are lending hand over fist.

There are three forces at work here.

The first is the law of insecure middle management. Let’s not forget that, behind all the slogans like �working together’ or �your partner’, banks are simply moneylenders and the more money they lend, the more money they make. So yellow pack bankers, whose status within the bank and outside has been dramatically eroded by ATMs, are at pains to exceed lending targets set by senior bosses.

The middle manager does not see my father as a person in this transaction, but sees his suburban house as collateral. My dad is simply the conduit to the asset. If the banker can get his hands on a bankable piece of collateral, such as the house, he can make an easy sale and hit or exceed his target. After all, if he does not hit the target, there are plenty more suits coming behind him who will. The second force at work is the law of shareholder value.

Bank bosses’ salaries are linked to the share price of their outfits, so it is in their interest to push the share price up above the average. The problem, however, is that the people who ultimately own the banks – large pension funds – expect too large a return every year.

How can a business like a bank, which is involved in a typically low-growth, mature industry like money-lending, make returns on equity of 20 per cent-plus as expected by the pension funds and banking stock indices?

The only way they can do this is by working their workers to the bone, capping costs and wages and lending recklessly. Therefore, and ironically, our own pension funds are driving our banks to lend to us with abandon. So the prospects of your pension fund when you retire are indirectly linked to getting you into debt when you are working.

The third � and most important – factor at work in the lending frenzy is the impact of land on the balance sheet of the bank. If the price of land is rising in tandem with the amount of money gushing into property, the banks will be able to lend more against it. The balance sheet starts to play tricks with them.

Counter-intuitively, the more money they lend, the safer it looks in terms of the ratios they use to assess secure lending. So it becomes a self-reinforcing dynamic where, the more money they lend, the more they feel they should lend.

So credit becomes the crack cocaine of the financial industry. The initial hit leads to euphoria, but it wears off quickly, leaving the junkie needing more. And, like the addict, all the economy’s senses have been blurred by credit, so it doesn’t know when to stop.

We have all become hopelessly addicted to the soothing balm of credit, and the banking system is desperately dependent for its living on the price of land, houses and property. The banks can be regarded as the dealers – the middlemen – who cut up the deals, take a fee and keep the addict hooked. But because of the impact of the lending on them, their balance sheets, their bonuses and share price, they are as addicted as their clients.

So we have junkies acting as dealers, feeding the habits of other junkies. The agency in charge, the Central Bank, is afraid to upset the dealer/junkies, so the corroded system thrives.

This is similar to what might be a prison drugs policy. In order to prevent large numbers of prisoners going cold turkey, the guards turn a blind eye to heroin getting into the jail. It is better to have the junkies placid and off their heads than agitated and strung out.

Our credit junkies act in the same way and the entire system is in denial. When will we wake up? When debts are 300 per cent of disposable income? When the average house price is �400,000 or when interest rates rise?

Whatever happens, don’t expect the Central Bank to tell it as it is. After all, when was the last time you heard of cold turkeys voting for Christmas?


  1. Helen Carty

    Dear David

    Well done again. I long for you to do an article on fiscal
    reserve banking and explain it for the Ponzi / pyramid
    scheme it is – how it only creates debt and does not create
    money – how the debt can only be repaid by passing it on to
    the next poor sucker.

    Helen Carty

  2. j

    Things will get more expensive everywhere. Prices of raw
    materials are going up if inflation rises quickly. Inflation
    is a strange beast. It hides for years as interest rates
    decline. As long as the rates decline inflation is invisible
    because Mr. Anyone can afford to buy just about anything.
    Sales Volumes rise in companies all over the globe and
    prices remain constrained. For example DELL and Ryanair have
    customers swinging from trees and can keep prices down and
    sell sell sell.

    However, Mr. Anyone may have been living in cloud cuckoo
    land buying everything when everyone is borrowing money and
    interest rates are falling if they make that decision on
    current rates/repayments and current earnings, earnings that
    fall as prices rise.

    Now we all think that this is Great. Germany is doing poorly
    so interest rates will never go up here as we’re tied to the
    euro. This is arse. We couldn’t be tied to a worse animal.
    It has showed constraint even though we have been drinking
    excess cash from the well for ages. However, this animal
    doesn’t care that Ireland gathering debt because we can’t
    drink the well dry. It’s thinks big picture. We’re too
    small. However, when the larger beasts start to drink Global
    capital at alarming rates they can drink it dry. American
    debt is rising rapidly and Americans are now experiencing
    the property boom we had first. You can bet your life
    interest rates will spike here if they spike there and they
    may. Americans will be the first to suck funds out of
    Europe, as its rates will be the first to rise steeply. This
    will happen because America is in an earlier cycle of what’s
    happened here in Ireland. Basically, if rates were low in
    the euro and high in America why would anyone save money
    here in this global economy?

  3. eoin

    That’s right Helen. I am amazed in general conversation how few Irish people
    think that the ECB will ever raise it’s rates again, even in thirty years.Some
    may agree that it may go to 2.5% (I assume they think that is a radical once in
    a lifetime max and then it will just have to fall again).

    Shock them by telling them that the US federal reserve went from 6.5% to
    1.5% and now up to 4% ( and rising) since we joined the Euro. Thats standard
    enough central bank movement. If Germany gets going – and it will – then it
    may inherit the property bug as fast as us, and the ECB will control it by
    raising interest rates: and the central bank said that we should plan for 6%
    sometime.

    Germany is in the position we were in in 1992. Jobless growth. Productivity is
    increasing rapidly: a bout of confidence in the German consumer and they are
    away. We on the other hand have per capita declining productivity and even
    declining exports, with large job gains in the non-tradable sector. We are at
    the tail end of a boom with huge job growth: growth which produces nothing
    except for ourselves.

    If this non-export led growth is so real it is a wonder that we were poor in De
    Valera’s time. It seems all we have to do is produce for ourselves.

    The real reason is credit growth. The cost of money remains in negative
    territory in real terms, with the inflation rate being higher. Again. When te
    bust comes, however, interest rates will rise ( in fact this will cause the bust)
    but in general prices will probably fall. The lidls and Aldis will see to that.

    In a deflationary enviroment with growing interest rates we are likely to see
    the real swing in interest rates be much higher than the nominal swing.

  4. adrian

    Its my understanding that the banking sector has become
    more of a middle man facilitating our mortgage borrowing of
    money from the broader european money/investment markets.
    European fund managers are channeling money to us through
    our banks, -the profits are good and their end of year
    bonus is tantalising! The long term view isnt in their risk
    calculation.
    The vested interests have been defying all the odds for god
    knows how long now in keeping the bubble up. The deceipt of
    the govt via the central bank will probably be seen as
    criminal in the fullness of time. The Northern bank robbers
    are smalltime compared to the vested interests aboard this
    gravy train. The young irish housebuyers have been
    financially annialated – no compensation available for this
    particular group of irish victims!
    As U.K and republics prices have been coming off the boil
    over the past 18 months it is interesting to note the boom
    in Northern Ireland house prices. No celtic tiger here, no
    return of Irish ex-pats, Polish people are thin on the
    ground.. The Irish banks dominating the Northern market are
    lending ever more casually. As with other activities
    casual, it feels good at the time but often it ends in
    tears. I wouldn’t wish that they catch something nasty!

  5. Dave

    Do bankers know how to stress their loan books? – we have
    gone through an unprecedented period when banks have
    incurred little or no bad debts. General provisions
    against bad debt have been written back to income (they
    arent allowed for tax relief) and specific provisions arent
    required – Do banks have any idea how to predict which
    loans and customers will turn bad with a tweak (or more) in
    interest rates? How can any regulator say with certainlty
    that the system is sound…?

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