The Irish banking system is not working – and that rarely ends well

The Central Bank is supposed to run monetary policy, but have you heard it commenting on the collapse of credit in the economy?

Where does money come from? Who creates it? Can it run out? These are the sorts of questions a child might ask and are the sort of questions that every economist must be able to answer.

Money is created by commercial banks making loans. That’s it. If commercial banks do not lend more money out than they are taking in through deposits, then the economy will seize up, small business will not have enough capital to operate, small housebuilders will stop building and the economy will lose the essential lubricant of capitalism: credit.

This is precisely what has been happening in Ireland over the past 15 years. The Irish banking system is not working. The role of banks in the economy is to take in deposits and lend out money. This is how money circulates from depositors to lenders.

There will always be people who want to save and those who want to invest. The bank matches these savers and investors, paying the savers a rate of interest to save and charging investors a higher rate to invest. The difference is called the “spread” or the margin. In effect, this is the profit of the bank.

In theory, and in an ideal world, if the economy is humming along then the ratio of deposits to loans would be around 90 per cent, meaning most of the money saved is lent out. The bank might keep 10 per cent of the loans in liquid form to make sure there is sufficient money for the small amount of depositors who might want to take out their money immediately.

In any modern economy like the Irish economy, the commercial banks are like franchisees operating under licence from a central bank. They create the money. Double-entry bookkeeping is key to understanding how banks create money: every asset has a corresponding liability.

Imagine you want to buy a house and you go to the bank requesting a mortgage. Without asking the central bank’s permission to create that money, the bank generates new money after its own credit committee decides that you are good for the loan. This loan to you will pay the seller of the house.

On the bank’s balance sheet, there is a liability, the newly created deposit that you transfer to the seller of the house. There is also a newly created asset, which is the loan to you, collateralised by the deeds of the house, on which you pay interest.

After this bit of financial alchemy, there is still only one house, which you now own, but the seller of the house now owns a deposit created by the loan the bank has made to you. The magic of bank leverage is you get the house, the seller gets the cash and the bank has a new asset (the loan to you) and a new liability (the deposit now owned by the seller of the house).

The bank can do this over and again. Indeed, as the profitability of the bank is based on income from its assets, there is an incentive for the profit-maximising bank to keep lending. Additionally, if the bonus of the boss is linked to the bank’s share price then there will always be a management incentive to lend as much as possible, even if this becomes reckless, which is why some might conclude the easiest way to rob a bank is to run one. (Banks go bad from the inside out.)

But what happens if the bank stops lending?

This process goes into reverse and the economy seizes up for want of credit. This is where we are in Ireland. At the top of the Celtic Tiger credit splurge, the ratio of deposits to loans peaked at 160 per cent, meaning that for every €100 on deposit in the Irish banks, they were lending €160.

They plugged the difference between what was on deposit and what they were lending with borrowings from abroad. The more they lent, the more they borrowed, recklessly. Once the foreigners called in their loans, the banks went bust in the great Irish bank run of 2008.

Now the opposite is happening. Today, the ratio of bank deposits to loans has collapsed to 40 per cent, the lowest in the western world. For every €100 on deposit, the banks are only lending €40. The economic potential of the Irish domestic economy is trapped because the banks are not lending enough.

Rather than being an instrument for the circulation of credit throughout the economy, the banks have become glorified safe deposit boxes where the savings are stuck. Banks are now making their money by placing your deposits at the European Central Bank where they accrue interest at 2 per cent while they pay out less interest than that to the Irish saver, pocketing the difference.

In addition, relentless internal cost-cutting is pushing down their operating costs. When you hold on the phone for ages for some automated help-centre in India, while an artificial intelligence -generated voice message reassures you that your business is important to the bank, that’s cost-cutting.

But if all this private money is not flowing around the domestic economy then why is the aggregate economy not contracting?

Here is where international money comes in. The reason that the economy is humming along is that international money has replaced local money.

Take, for example, the property market. Much of the wealth creation associated with the property boom is going into the pockets of private equity companies that are buying apartment developments to rent them out.

But the main source of international money in our economy is the continuing tax bonanza generated by corporation tax and income tax from the multinationals. Foreign-owned multinationals now employ more than 400,000 workers and contribute about two-thirds of all corporate and income tax.

More than 80 per cent of Ireland’s €24 billion corporation tax take comes from multinationals. In 2023 Ireland received more than €24 billion in net foreign direct investment (FDI) inflows, making it one of the highest per-capita recipients of FDI in the world.

Corporation tax earnings have allowed the Government to expand public spending dramatically, which has doubled since the pandemic. Public spending has taken over from private credit as the main singular source of demand in the economy.

American corporate money is leading to the socialisation of the Irish economy, squeezing out local small businesses, which are starved of cash, pitting the State against the citizen in the first time buyer’s market for new homes – and all the while the banks retreat from the economy.

What is the Central Bank of Ireland doing about this? The Central Bank is supposed to run monetary policy in the economy – and monetary policy means the amount of money circulating in the economy through the banking system.

Have you heard the Central Bank commenting at all on the collapse of credit in the economy? Have there been any moves by the Central Bank to encourage lending? Ireland desperately needs competition in the banking sector, which is why news of the arrival of British bank Monzo into Ireland later this year can only be good news.

In the meantime, Ireland remains a two-tier economy where the local private sector is starved of credit and the public sector is flush, so flush indeed that accountability and cost-control have gone out the window.

When the answer to the child’s question, “Where does the money come from?” is that it comes from the Government then you should be concerned. That story rarely ends well.