Banks are drowning us in debt

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?