Crash crushed competition in banking

Before the economic crisis there was extensive competition to provide banking services across Europe. Many banks had expanded their activities across borders. In Ireland, for historic reasons, the Irish-owned banks had extensive operations in the UK. AIB had also expanded into the US, not very successfully, and more successfully into Poland.

In Ireland the number of foreign banks providing retail services had also grown with the entry of the likes of Bank of Scotland.

This picture was mirrored across many EU countries. In some, such as Estonia, the only banks providing retail services were foreign-owned. In others, such as Poland, foreign banks were major players alongside domestic ones.

As individual banks grew through expanding into a wider EU market, the scale of potential problems if they were to fail also grew. However, these banks’ regional diversification also meant that some of them were less exposed to difficulties in any individual economy.

Spain’s Banco Santander offers an example of this spreading of risk through geographical diversification, limiting its exposure to the Spanish economy. Another reason it came through the Spanish banking crisis reasonably well was that it was better run than many of its fellow Iberian banks.

After the creation of the Single EU Market in 1993, increased transnational banking competition moved capital from those countries where savings were accumulating faster than demand for credit, to countries where there were more investors looking for funding. In doing so the increased competition between lenders reduced the cost of capital for borrowers, promoting growth.

As is now well recognised, the run-up to the financial crisis in Ireland and Spain was marked by failures of banking regulation. In the Irish case the response of the banks to the increased competition in the lending market was to undertake ever more unwise lending. The regulator did not step in to bring them to their senses.

With the advent of the crisis, the Single Market in banking services effectively broke up. Individual national banking regulators applied their own rules to protect depositors in their own countries. In the aftermath of Northern Rock and of the bank collapse in Iceland, that rush to protect national depositors was understandable.

An immediate outcome, however, was a reversion from evolving cross-national banking in a single European financial market to a series of national banking markets. This has meant that, for similar risks, borrowing carries a different price depending on the country where the borrower is located.

For example, after the crisis where an Italian bank had major businesses in Austria and Italy, it had to charge a much higher interest rate in Italy for projects that it could finance at much lower cost in Austria. Other EU countries experienced a similar divergence in the cost of funds according to the national location of the borrower.

In a paper in 2013 with colleagues from the National Institute of Social and Economic Research in London, we looked at the impact of this fragmentation of the European banking market on European growth. We found that renationalisation of banking reduced euro zone growth for a number of years by 0.1 to 0.2 per cent a year, with larger effects in Greece, Spain and Ireland.

The margin between the short-term interest rate that banks can borrow at and what they charge on mortgages in Ireland has shifted over time. In 1999 this margin was around two percentage points. However, with the boom-time competition the margin fell to under one percentage point. This margin did not reflect the risks the banks were running and, when the crisis hit, the banks faced massive problems with non-performing loans, as well as serious losses in financing existing mortgages.

However, the margin has not only recovered but it is now at exceptional levels – more than 2.5 percentage points. This reflects the extremely limited competition in the Irish banking market in recent years.

Given the problems in the wider EU banking market, and the losses experienced here by previous foreign entrants, there has been no enthusiasm for a new wave of foreign lenders to enter Ireland.

There has been a substantial cost to countries such as Ireland from the reversion in the EU to a series of 28 national banking markets: SMEs and many mortgage holders are paying the price in a higher cost of funds than would otherwise prevail. For this reason the development of banking union in the EU is very important.

In the long-term banking union holds out the prospect of recreating an integrated EU banking market, where competition should ensure that projects carrying similar risk will pay similar interest rates whether they are in Ireland, Slovenia, Germany or France.

A key element of banking union is an EU-wide regulation of major banks. This should provide additional safeguards against the kind of regulatory failure we saw in Ireland.

However, the effects of the financial crisis will linger for some time to come. Few banks in the EU are in a position to expand into new markets, to provide additional competition.

In Ireland we still have two domestic banks which are fully State-owned. There are competing considerations as these banks are gradually sold off.

On the one hand, if they continue to operate in a domestic market that is effectively sheltered from outside competition they may attract a higher price for these State-owned assets.

On the other hand, the long-term interest of the Irish economy would be better served by opening up our banking market to enhanced competition.