Banks in Ireland are beginning to realise there's a downside risk to their top regulator moving on.
The last Central Bank governor, Patrick Honohan, made sure before announcing his plan to step down in 2015 to get his mortgage-lending rules over the line to help borrowers and banks from themselves by restricting how much debt households can take on, relative to their incomes and a property's value.
Lenders would complain privately that the rules, while worthy, are hampering their ability to rebuild their loan books after a decade of contraction – and many would-be homeowners argue that they are affecting their ability to get on the property ladder. But the limits have done the job that Honohan envisaged from the outset, which is to prevent “the credit-chasing-prices-chasing-credit” bubble of the past.
Honohan's successor, Philip Lane, who was also plucked from academia to lead the Central Bank, came out this week with a departing gift of his own as he prepares to move to Frankfurt to take up Ireland's first seat on the executive board of the European Central Bank (ECB) at the start of June.
With one eye on his legacy, Lane told an audience at the University College Dublin school of economics on Tuesday evening that he recently wrote to the Minister for Finance, Paschal Donohoe, looking for the powers to force banks to hold additional capital to safeguard against hidden risks to the Republic's economy.
Capital demands
It’s just the latest in a series of capital demands that have been imposed on lenders in recent years.
The Central Bank moved in 2015 to order the country’s banks to start setting aside capital between 2019 and 2021 to reduce the probability of an important bank – or what regulatory wonks call an O-SII, or other systemically important institution – collapsing and unleashing chaos on the economy.
Last year, the regulator told banks to hold an additional layer of capital – or what’s known as a countercyclical capital buffer, or CCyB – from this July to help shield themselves from downturns in normal economic cycles.
However, neither addresses what Lane calls “tail systemic risks” facing the country. That’s where a so-called systemic risk buffer – or SyRB – that Lane is looking to have the power to impose comes in.
The biggest systemic risk facing Ireland, aside from Brexit, is its high dependence on multinational firms, according to Lane.
The Irish economy is particularly exposed to the twin forces globalisation and technological innovation
“If there were a persistent shock to this sector, the cumulative decline in economic activity would dwarf a normal cyclical recession, with its attendant implications for the financial system,” he said. “In addition to much-discussed factors such as revisions to international tax regimes and the world trade system, idiosyncratic shocks to individual industries and firms could also be systemically important for Ireland, in view of the concentrated nature of the multinational sector.”
Exposed
The Irish economy is particularly exposed to the twin forces globalisation and technological innovation, given how it has become a base for some of the biggest tech groups in the world, according to Lane. These include the likes of Facebook, Google, Apple and Amazon.
But other types of systemic, or “structural”, risks include climate change. “Through an increase in the frequency and scale of severe weather events, climate change may increase the intrinsic volatility of the economy,” Lane said, adding that a transition to a low-carbon economy also poses financial stability risks if it is mismanaged.
While Lane said that it is often hard to tell cyclical economic wobbles apart from structural shifts, this doesn’t mean that regulators shouldn’t act. “Rather, given the potential impact of adverse tail risks on the economy and financial system, prudence dictates that the policymakers look to ensure that the macro-financial system is resilient to such shocks,” he said.
Lane gave no indication as to when banks may have to start setting aside money for a SyRB. There is also no minimum or maximum limit to the size of such a buffer. But it can be offset against O-SII capital that banks need to set aside.
However, as Permanent TSB does not have to set aside an O-SII capital reserve, it would be hit with the full systemic risk buffer whenever one comes into force.
Upward pressure
All told, the introduction of a systemic buffer will keep upward pressure on banks' total reserves of expensive capital and result in Irish loan rates remaining "structurally more elevated than other European countries," Davy analyst Diarmaid Sheridan concluded in a note to clients this week.
As things stand, the average Irish new standard variable mortgage carries an interest rate of about 3 per cent, compared to less than 1.8 per cent for the wider euro zone. That’s largely because the legacy of the Irish arrears crisis has meant that lenders here must hold about €50 of capital in reserve against every €1,000 they lend, compared to €16 per €1,000 for European banks.
The last thing he needs is for his old charges to blow up when he's in Frankfurt
With Lane widely expected to be named as ECB president Mario Draghi’s next chief economist, he’s taking his last opportunity to make the Irish financial system more resilient. The last thing he needs is for his old charges to blow up when he’s in Frankfurt.
But there’s a cost. And, as usual, it will ultimately be borne by borrowers.
