The Irish Banking Crisis

Table Of Content

1 Rise of the Celtic Tiger

2 Ireland's Economic Reorientation

3 Collapse of the Irish Banking Industry

4 Crisis Management
4.1 A Governmental Blanket Guarantee and Capital Injections
4.2 The European Union and International Monetary Fund-Programme
4.3 Rearrangement of the Irish Banking System
4.4 Restructuring of Credit

5 Conditions that Facilitated the Crisis
5.1 Liberalization of the Banking System
5.2 The Availability of Cheap Money
5.3 Relying on Market Powers and Good Corporate Governance
5.4 Financial Regulation and its Weaknesses
5.5 Moral Hazard

6 Conclusion

7 References

1 Rise of the Celtic Tiger

Ireland was stricken by crop failures, famine and emigration in the 19th and 20th century. The Catholic Church defined political decision-making, education and social life and had a very strong position in the country. Abortions were prohibited, condoms could be sold only to married people, divorce was not possible and homosexuality was criminalized. In this strictly conservative society, which was still plagued with its demographic constraints, only a low return economy could develop (Feldenkirchen, 2010, p. 164 ff.). Until the beginning of 1990 Ireland was economically a relatively poor country in Europe. However, in the modern change the Catholic Church lost its influence on Irish society. The onset of globalization detected Ireland as the rest of Europe and after a long period of illiberal economic orientation, Ireland turned towards neoliberalism (ibid.). After decades of conservative Catholicism, the Irish decided to meet their material needs and headed for capitalism. Their society should finally be amongst the winners.

At the end of 1980, Ireland lowered its corporate tax rate to 10%, one of the lowest rates in the EU (An Roinn Airgeadais Department of Finance, 2013). This caused a tremendous inflow of foreign direct investment (FDI). Companies from different branches built their European headquarters in Ireland, e.g. companies from the service industry, the transport business and from the IT-sector as well. A need for skilled and unskilled labour arose and people, especially from Eastern Europe, immigrated to Ireland and found a new home.

Due to its deregulated financial system, the Irish economy found its focus in the corresponding industry. International banks settled in Dublin and developed the city to one of the most important financial centres in Europe. The economic rise of Ireland around the year 2000 resembled those of the so called Four Asian Tigers Singapore, Hong Kong, Taiwan and South Korea. This is why Ireland was termed The Celtic Tiger.

2 Ireland's Economic Reorientation

Dublin became the hub city for foreign investment, especially for companies from the US. Those firms had multiple strategies to enter the Irish market as a part of their expanding process in Europe such as exporting, licensing, franchising and joint ventures. For the fact that the Irish corporate tax rate was one of the lowest in the world, the most-loved investment strategy of Google, Apple, Pfizer, Dow Chemicals and many others was FDI. These companies realized what Ireland had to offer: Well educated English native speakers and labour, willing to work for a minimum wage (Kaiser, 2010). For the case that companies opened their European headquarters in Ireland, they were able to claim the low corporate tax rate too. At the beginning of the year 2006 the rate was raised to 12,5%, but it still promised investors high returns and therefore a competitive advantage. Furthermore the Irish government provided various tax benefits such as refunds, corporate tax exemptions for young companies and double tax agreements with over 60 countries worldwide (Gilvarry & O'Leary, 2012, p. 3).

To boost activity and employment in the Irish economy, the government set up Dublin's International Financial Services Centre (IFSC) in 1987 (IFSCOnline, 2015). It still provides necessary infrastructure for banking, asset financing, fund management, treasury management, investment business and insurance operations. Half of the world's top 50 banks have a presence in the IFSC, half of the top 20 insurance companies and it is one of the leading hedge fund service centres in Europe. In the IFSC these companies find a sophisticated support network, shared service centres, software development companies, as well as legal and accountancy companies. The IFSC gives host to over 500 firms, employs more than 35,000 people and contributes more than 7% of Irish GDP (ibid.).

Ireland managed its economic reorientation through incoming foreign investments. Multinational firms were attracted by tax incentives and modern infrastructure, especially around Dublin. A major stimulus for the banking industry to settle in Ireland was financial deregulation. However, economic growth slackened from the year 2000 onwards and ended in 2008, when major Irish banks were about to collapse.

3 Collapse of the Irish Banking Industry

Mortgage defaults in the U.S. became more frequent and the country's crisis loomed ahead in mid-2007. The crisis exacerbated and found its climax in the bankruptcy of the financial services firm Lehman Brothers in September of 2008. The bankruptcy resulted from the firm's massive involvement in the doomed US-subprime housing market.

It is important to stress out that Ireland was not affected by the US-crisis directly, because Irish banks "did not have any significant exposure to US-based mortgages or other US-based securitized assets in their investment portfolios" (Connor, Flavin, & O'Kelly, 2010, p. 6). It is rather the case that the global liquidity crisis in the aftermath of the Lehman Brothers collapse had negative effects on Irish banks, relying heavily on short-term borrowing for funding (Connor, Flavin, & O'Kelly, 2010, p. 4). As international lending is pro-cyclical and the Irish financial market was already shaken, liquidity dried up quickly. The banks were unable to roll over their foreign borrowings on the liability side. On the asset side they were overexposed to the domestic property and construction sector. Falling housing prices and a diminishing demand for commercial estate led to write-downs and losses on loans (ibid.).

When the banks' share prices faltered in the face of their impending collapse in late September 2008, the Irish government guaranteed towards the banks' depositors and bond-holders extensively. At that time the Minister of Finance, Brian Lenihan, proclaimed that this would be "the cheapest bank rescue in history" (Clarke & Hardiman, 2012, p. 2). Hereafter the Anglo Irish Bank (Anglo) was unable to refinance its short-term liabilities and claimed governmental support. The government feared a domino effect, if one bank were forced into insolvency.

The blanket guarantee for the six major Irish banks^[1] created a liability for country of roughly 200% of GDP (Connor, Flavin, & O'Kelly, 2010, p. 5). Additionally Irish creditworthiness on international markets was devastated and refinancing was technically impossible. Interest charges for Ireland were horrendous. As the enormous scale of the banks' losses became apparent over the next years, the incoming governor of the Central Bank, Patrick Honohan, had to confess bewilderedly in May 2010, that this was "one of the costliest banking crises in history" (Clarke & Hardiman, 2012, p. 3).

The Irish banking Crisis resulted from a credit boom and bust. Excessive short-term borrowing of capital from the European interbank market served as a method of refinancing as well as Euro-denominated bonds. These funds had been channelled for the most part into the domestic property market so that Irish banks' loan books were poorly diversified. The property market was already overheated. A sharply decreased demand led to a deterioration of prices and to enormous losses for Irish banks. Foreign capital had been the driving force for the flourishing Irish economy, but suddenly it was not available anymore. European banks and foreign investors refused lending to Irish banks which ran out of liquidity. The Irish government had to take drastic and costly crisis management in order to prevent multiple bank insolvencies.

4 Crisis Management

Crisis management covered two steps: Stabilising the banking system and restructuring of credit as intermediate objectives, whereby the ultimate objective of the Irish government and Central Bank was sustainable economic growth (Schoenmaker, 2015, p. 9). Conformably O'Sullivan (2010) explains that a well-functioning banking system is essential for the whole economy (p. 2). With recourse to Levine (2004) the author refers to the banks' functions: Efficiently allocating resources, increasing capital formation, stimulating productivity growth and acting as a repository of national savings (ibid.).

4.1 A Governmental Blanket Guarantee and Capital Injections

The bankruptcy of Lehman Brothers in September 2008 put pressure on wholesale funding of Irish banks. A quick stabilising reaction to this was the already mentioned blanket guarantee of the Irish government by which all liabilities of major domestic banks were covered. At that time the government believed that banks were struggling with liquidity problems, rather than serious solvency issues. Unfortunately this assumption proved to be wrong. Underlying solvency problems unfolded over a period of roughly three years, from late 2008 to 2011 (Schoenmaker, 2015, p. 10). All six Irish banks needed a recapitalisation. In four consecutive rounds and over a period from early 2009 to March 2011, the government carried out capital injections amounting to € 80 bn. For the most part this new capital was funded by Irish tax payers (€ 64 bn), € 15.5 bn were contributed from the banks' subordinate bondholders and the remaining small proportion was provided from some private equity^[2] (Schoenmaker, 2015, p. 11). In this context it is remarkable that senior bondholders were exempted!

4.2 The European Union and International Monetary Fund-Programme

In November 2010, the Irish government received financial support from the European Union (EU) and the International Monetary Fund (IMF). A necessity for this arose from the fact that yields on Irish bonds went through the roof, curtailing Ireland's ability to borrow. Furthermore the programme addressed weaknesses in the financial system, stabilised public finances and created jobs, while the poor and most vulnerable were protected. The overall value of the EU and IMF-Programme had a total value of € 85 bn, whereby € 17.5 bn were acquired from Ireland's own sources (National Pension Reserve Fund and cash reserves)^[3].

4.3 Rearrangement of the Irish Banking System

Besides monetary actions, the stabilising process required a rearrangement of the Irish banking system. Hence the government decided on several closures and mergers. According to Schoenmaker (2015), who relates to the report of the Commission of Investigation (2011), Anglo Irish Bank (Anglo) and Irish Nationwide Building Society (INBS) were the most aggressive in striving for growth and in risk-taking (Schoenmaker, 2015, p. 12). Additionally the two banks had serious flaws in corporate governance. For these reasons both banks underwent a process of mergers. After their deposits had been extracted and transferred to other banks, the two institutes were put in liquidation (ibid.).

After the process of consolidation, the Irish banking system turned into a system with two broad banks, Bank of Ireland and AIB, and one small bank, Permanent TSB^[4] (PTSB). These institutes needed to rebuild profitability through cutting costs and widening of interest margins. Foreign-owned resident banks have reduced their business in Ireland (ibid.).

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^[1] At that time: Bank of Ireland, Allied Irish Bank (AIB), Anglo Irish Bank ('Anglo'), Irish Nationwide Building Society (INBS), Irish Life and Permanent (ILP) and Educational Building Society (EBS)

^[2] Private equity capital is off-market traded equity capital, provided by institutional investors. Insofar, investments are made directly into a company.

^[3] http://www.finance.gov.ie/what-we-do/eu-international/irelands-programme-eu-imf-programme (accessed: 25th March 2015)

^[4] Formerly Irish Life and Permanent