In the spotlight while bearing the stress of Ireland's banks on his shoulders

 

FRIDAY INTERVIEW: PATRICK HONOHANGovernor, Central Bank

IF THERE was ever a movie made of the Irish banking crisis, Central Bank governor Patrick Honohan quips that Woody Allen would be the best person to play him.

He is talking in the context of a new US film Too Big To Failabout the 2008 near- collapse of Wall Street, in which Paul Giamatti plays Honohan’s US counterpart, Federal Reserve chairman Ben Bernanke.

Allen once quipped: “If only God would give me some clear sign – like making a large deposit in my name at a Swiss bank.”

Honohan feels the European Central Bank’s statement following last month’s severe stress tests, that it would continue to lend more than €140 billion in discount loans, was a clear sign of its commitment to the six Irish banks.

There was surprise that the ECB did not unveil some medium-term lending facility for the banks to give them time to reduce in size. He doesn’t want to make excuses for others about why there wasn’t a structured lending facility for Ireland’s banks to put it on a more stable footing.

“My European colleagues will immediately point to the very substantial lending that is going on, particularly at a very low interest rate, now 1.25 per cent, on €140- something billion to the particular banks we are looking at,” he says, sitting in a room on the seventh floor of the Central Bank. “This is just a huge, almost unprecedented level of support to the financial system of a single country.”

The other boxes were ticked on the day of the stress test results.

The severe PCar capital stress test covered all expected and some highly unexpected losses and what additional cash (€24 billion) would be required to cover the banks.

The PLar liquidity test showed how many loans the banks would have to shed (€72 billion) to make them self-funding again. The Government then set out a plan to reshape the sector around the “two pillars” of Bank of Ireland and a merger of AIB and EBS.

The aim of the series of March 31st “big bang” announcements was to reassure international investors that Irish banks would be repaired again, but the absence of a new ECB facility was notable.

“What hasn’t been put in place is something that would put that on autopilot and would free the banks from any concern that it might not continue,” Honohan says.

“It is that sort of marginal change that would make a lot of difference to the banks to feel that they have squared off those liquidity needs for a longer period. But it is understandable that the ECB is reluctant to change from its standard procedures of taking every month as it comes and providing the necessary liquidity to the banking system on the basis of its standard policies.

“It is the legal innovation that I think the ECB probably would be reluctant to change its way of doing things in that regard.”

Honohan says the banks’ heavy reliance on emergency lending from the Central Bank, which soared to €70 billion in February, was not a new problem but “an entirely predictable consequence” of the overblown expansion of the Irish banking system from 2003 to 2007 not backed by good lending.

The emergency lending was “a mirror image” of this expansion and it was backed by “Government promises” if there were sufficient good loans in the banks as security.

The wider reluctance of the European authorities to consider EU-wide solutions to the euro zone’s debt crisis has not stopped Honohan floating some ideas.

Last week, he said GNP-linked bonds could allow Ireland to repay more on the €40 billion EU bailout loans when the economy was strong and less when the economy weakened as part of a plan to aid a recovery. European bailouts are recent developments, he says, and could be improved and adapted.

“The country has too much debt, public and private, and quite apart from the problem of servicing that debt and paying it back over the years, which is something that we have to get down to do, that overhang can have a dampening effect. Trying to remove that kind of overhang of debt so that it will be repaid and it doesn’t provide a burden evolution of the economy – I am really trying to consider options around that.”

Seeking concessions from one another on terms such as the lowering of an interest rate was a zero sum game, he says. “People may fall into the ‘I’ll give you something if you give me something back’ framework, but I think they have to stand back from it and look at the situation as a whole and the way in sorting out this challenge is resolved in the best interests of all. It’s not in the interests of the rest of Europe if Irish economic recovery is slower than it could be.”

The ECB’s decision to raise interest rates last week for the first time since July 2008 was also driven by the need to serve wider interests and to curb inflation. This is despite the fact that it will increase mortgage repayments for 400,000 borrowers for the first time in almost three years, putting further pressure on Irish citizens. He voted for the increase. He couldn’t fight Ireland’s corner on this as it was only a tiny part of the euro area.

“I would regard it as very important that I not wear an Irish hat going into a discussion on monetary policy.”

He has always been at pains to fully brief fellow central bankers on the ECB governing council about the condition of the Irish banking sector and the economy, but he stresses that he cannot act only in Irish interests on inflation, despite being Ireland’s voice at the Frankfurt-based bank.

“I would be doing a terrible disservice if I were to try to segment it,” he says. “It would actually be a disservice to Ireland because small countries benefit from the application of standard law. If it is a question of might is right, small countries lose out.”

This might be tough on Irish borrowers but it is also why politicians no longer set interest rates. Central bankers “take the longer view” and are “not subject to transitory pressures”.

Another contentious issue was the decision to categorically rule out any sharing with senior bondholders of the €70 billion upfront cost of repairing the banks. There are €16.4 billion of senior bonds, including €12.7 billion at the “live banks”, Bank of Ireland, AIB, EBS and Irish Life Permanent, which are not guaranteed by the Government and not secured by assets which could be seized in a default.

Last month Honohan and the Government ruled out any burden-sharing with these lenders to the banks. Instead taxpayers will have to dig deeper. These bondholders will be repaid in full. Ireland has a sophisticated economy governed by “a network of contracts”, he says, and it was “fully expected” that these contracts would be fulfilled.

“Sustaining that network of contracts and ensuring that we are taken seriously as a nation is something that is very important and can be achieved, and [it is] much more important than cutting off your nose to spite your face in the interest of settling old scores.”

It may not seem fair, he admits, but it was, again, for wider interests of the country.

“I am thinking of the benefit to the people – the poor people and the rich people. It is the poorest people and most vulnerable people who lose out most when the economy stumbles and falls into a recession. These things aren’t absolutes. It is about finding the package that does the best not for one section of society but for society as a whole.”

Another area that would benefit some people is debt forgiveness for mortgage holders in distress.

The idea was raised as a possibility on Tuesday by AIB executive chairman David Hodgkinson at the bank’s annual results outing.

Honohan expects banks to deal fairly and efficiently with borrowers, as they are required to do under the Central Bank’s code of conduct covering people who had missed mortgage repayments or are at risk of doing so.

Some have argued for new EU-wide tools to fix the euro debt crisis, such as 30-year bonds and euro bonds, to allow peripheral countries to borrow at sustainable rates. To avoid a higher bailout bill, Honohan last November proposed an ECB insurance scheme to cover potential higher bank losses instead of having to keep pumping cash into the banks unnecessarily. The idea was not entertained by the ECB.

There are no solutions that can be “taken off the shelf”, he says, and any proposals still had to be squared by politicians who are responsible to their electorates. “The more complicated the idea, the more downsides that the people can see to it. It is not very easy to immediately leap to a solution.”

Honohan says the recent stress tests did not really identify new loan losses at the banks – Bank of Ireland, AIB, Irish Life Permanent and EBS – but rather applied “a new degree of severity and the costs of deleveraging” to them. Much had been made of the fact that the tests were the fifth attempt in more than two years to draw a final line under the upfront cost of banking crisis, he says.

So does he feel €70 billion will be enough?

“I am not worrying about what might come up in next year’s annual capital requirements,” he says. “We have looked at those four banks now. We have put them through a very strict and extreme scenario.”

On the third bailout in March 2010, the Central Bank felt the substantial losses on the 10 biggest borrowers transferred first to the National Asset Management Agency would be a reasonable estimate of the final losses.

“In retrospect, it would have been great if we had said ‘let’s put another €10 billion on top just in case’ but there are consequences of doing that. Even in retrospect I don’t think it would have been a very wise way to proceed.”

If he could re-run the Nama process again, he would apply a different valuation process, but this was not possible as it was driven by the European Commission.

“We would have sampled the loans, established an average price and let the loans be transferred at an average price. Then it could have been done much more quickly and with less bureaucracy, and we could have had a decisive number right away.”

Honohan says he was being “sort of facetious” when he said last month that the higher capital bill from the stress tests caused him reputational damage. He believes investors knew the Central Bank was working “in a broad brush way” last year by arriving at an estimate of loan losses. Besides, stress testing was “not an exact science”, he says.

“If anybody had asked me, I would have said plus or minus quite a large number last year,” he says. “Nobody asks you that question. They only want to know ‘is this the last number?’

“We have to say that it is the best number we can come up with. But the plus or minus would have been a larger number last year than this year.”

The Irish banks will now shrink in size. Honohan says they became “over-dimensioned with property lending” and would be downsized by selling off “non-core and non-Irish assets”. “A much smaller Irish banking system still has loads of room in terms of capital, in terms of their access to liquidity to provide their funding that is needed for economic recovery,” he says.

He believes the proposed new “two pillar” banking system built around Bank of Ireland and a combined AIB/EBS will still be competitive, although having just two main banks was not perfect.

“The role of the foreign banks is potentially a lot stronger in the future,” he says. “They will see that if competition is weaker, there is potential for them to be more active.”

The fitness and probity checks on senior bankers will help address cultural problems.

“I know that a lot of bank directors who have continued right on for several months after these problems arose probably think of themselves as having stayed at the wheel when it would have been easy to walk away,” he says. “On the other hand, it is absolutely clear that there has to be a new approach to banking in Ireland. A lot of new people have come into the system. We need to see more of that.”

Today Honohan is in Washington DC for meetings with the International Monetary Fund, which is supporting Ireland with a loan facility of €22.5 billion.

Between stress testing the banks and meetings with Ireland’s new lenders, it has been a busy time for Honohan, who is almost two years in the job. Late last month he hosted the annual dinner of former Central Bank governors. Four attended – Ken Whitaker (who was governor from 1969 to 1976), Tomás Ó Cofaigh (1981-1987), Maurice O’Connell (1994-2002) and Honohan’s predecessor, John Hurley (2002-2009).

“The former governors are very supportive and are looking forward to bringing the Irish banking system and Irish central banking into the place where we would always like it to be. It is always good to have people whose tenure dates back in one instance 42 years.”

ON THE RECORD

Born: Dublin in 1949.

Family: married with one son.

Career: economic adviser to Fine Gael taoiseach Garret FitzGerald in 1980s after working at IMF from 1971-1973 and Central Bank (1976-1981 and 1984-1986). Has advised successive Irish governments and worked at World Bank for almost a decade. Became professor of international financial economics at Trinity College Dublin in 2007.

Education: UCD then PhD in economics from the London School of Economics.

Something you might expect: is the 10th governor of the Central Bank in 68 years.

Something that might surprise: he is the first governor not to be appointed from the Department of Finance.

READY, SET, TALK: HONOHAN ON . . .

On European Central Bank support for Irish banks

“I am not worrying about what might come up in next year’s annual capital requirements,” he says. “We have looked at those four banks now. We have put them through a very strict and extreme scenario.”

On the size of Ireland’s debts

“The country has too much debt, public and private, and quite apart from the problem of servicing that debt and paying it back over the years, which is something that we have to get down to do, that overhang can have a dampening effect,” he says. “Trying to remove that kind of overhang of debt so that it will be repaid and it doesn’t provide a burden evolution of the economy – I am really trying to consider options around that.”

On whether €70 billion is enough for the Irish banks

“This is just a huge, almost unprecedented level of support to the financial system of a single country."

On the upcoming tests of bank directors

On the other hand it is absolutely clear that there has to be a new approach to banking in Ireland. A lot of new people have come into the system. We need to see more of that.

On the future of the Irish banking sector

A much smaller Irish banking system still has loads of room in terms of capital, in terms of their access to liquidity to provide their funding that is needed for economic recovery.