March 9, 2015
AIB emerged from the “Munster & Leinster Bank” and for years it was dominated by men from Cork. There can hardly be a better place to write about AIB than from a small café in the pretty area of Cork known as Sunday’s Well. The unique Victorian and Georgian architecture echoes the mercantile past of the city, dominated as it was by the famous “Merchant Prince” families. Below me, the fast flowing river Lee is swollen by a few days of rain. Let’s hope the city’s river defences have improved since a few years ago, when the Lee broke its banks and flooded the Mardyke.
AIB recorded profits of over €1 billion in the past 12 months. This is a big number. To put it in context, it is just over half the profit that the bank was making at the top of the boom. Back then, AIB’s management was busy blowing the entire balance sheet by lending to everyone and anyone.
For a time, until these loans go bad, they are profitable and drive up the share price of the bank. To be making such high profits so early in the economic recovery suggests something else is going on. Understanding that “something else” is critical to appreciating what is happening in the broader economy.
What does the balance sheet of the bank with the biggest branch network in the country tell us about the state of the general economy?
More than anything, the AIB results reveal what a rising property market can do to the national balance sheet. This is both good and bad. AIB is a microcosm of the Irish economy.
In the period 2006-2011, like AIB, Ireland suffered massive destruction of its over-leveraged balance sheet – eviscerating much of the wealth of the middle classes.
On the “assets” side of the Irish balance sheet was property, houses and apartments, which collapsed in value. In contrast, on the “liability” side of the balance sheet, the debt that people incurred to buy these assets remained. Not only did this debt not fall as the value of assets fell, but the burden of this debt rose because interest rates were positive.
The impact of both these developments – falling assets and rising liabilities – caused the national balance sheet to implode.
Worse still, those people with savings were petrified and they began to save more. And people with debts were equally petrified, and tried to pay back the debts as quickly as they could. These twin processes sucked money out of circulation and demand collapsed, causing unemployment to rise dramatically and incomes to fall further.
This type of recession is termed a “balance sheet recession” and it is different to other recessions because it can only be cured by fixing the national balance sheet.
The only way to fix a balance sheet is either (1) to reduce liabilities – the outstanding level of debts – by introducing some debt forgiveness or doing debt deals, or (2) to increase assets – and that means making property prices go up again.
Ireland has chosen the second option. Although this is never stated, the objective of Irish macro-economic policy is once again to push up house prices. This will repair the finances of the property-owning middle classes, making them feel richer and therefore coaxing them to spend more either by spending savings or taking on more debt.
It is working. Consumer spending and consumer confidence are unambiguously related to house prices.
As house prices have risen, so too has spending, which drives income and job opportunities. We see this in tax revenue, retail sales, car sales and, of course, rents. Rising house prices have reduced negative equity and, as we see in AIB’s numbers, hugely reduced the amount of money the banks have to set aside for bad loans. In short, all over the country, to use a “Bertieism”, bad loans are getting gooder!
Therefore, what is happening to AIB’s balance sheet is a reflection of what is happening to the country’s balance sheet: it is being gradually repaired.
Where do things go from here?
This is where Europe comes in.
On the same day that AIB announced its results, the ECB gave details of its latest money printing venture – quantitative easing. For the next two years, the ECB will make €1,000,000,000,000 (yes, 12 zeros) available to the banks to lend out. That’s a lot of money.
But what will it do to the economy?
This money will drive up asset prices as it has done in the US. European stocks and property prices will rise because of the simple mechanics of too much money looking for a home. In political terms this could be described as hyper-trickle down economics because who wins when asset prices rise? Rich people of course! They own the assets.
In Ireland, all this new money will cascade into the banks and they will do what banks do, which is to lend the cash out. We already see AIB’s new lending in the last year is up 30 per cent.
Now here’s where we might learn the lessons from the past. Hyper trickle-down economics needs a hyper-vigilant regulator to police the banks. As well as regulating what the banks lend, we need to regulate what they borrow so that we never again get into the situation where “hot-money” (short-term foreign loans) finances bank lending. In the boom, the banks borrowed from foreigners to lend to us. This must never happen again.
This is where the regulator must step in. We all say it could never happen again, but it does because we have short memories and we convince ourselves that this time it will be different. But it never is.
As I look out over river dams shepherding the fast-flowing river at the Mardyke in Cork (named in the 18th century after the Meer Dyke in Amsterdam that protected the low-lying Dutch capital from the sea), I wonder how many times this river has flooded.
After every flood, the people say it can never happen again. The city council reacts and talks about new dams and sluices and yet every decade it happens again.
Could the same thing happen with the deluge of cheap cash flooding into our banks from Europe?
What do you think?