WHAT IS A SENSIBLE STRESS TEST OF A BANK?
WHAT SHOULD IRELAND AND EUROPE DO NOW?
People in Ireland are awaiting with acute interest the results of stress tests on their banks to be made public on Thursday. Stress tests are estimates, estimates of what assets might be worth at some time in the future .
Estimates can be made on either very pessimistic, or very optimistic, assumptions about economic developments in the future.
The hope in some quarters is that the EU exercise of stress testing banks will generate confidence in banks based on certainty, but we should be careful here. Certainty about the future is a logical and philosophical impossibility. All banking, everywhere and always, is a matter of confidence, not of certainty. If one makes exceptionally pessimistic assumptions these can become avoidably self fulfilling. One must avoid accentuating the economic cycle in the downturn phase, just as much as one should lean against the wind in the up phase!
In Ireland’s case, the credit of the state itself has unfortunately become entangled with that of the banks. It would be no solution to anything to enhance the credit of the banks, by diminishing the credit of the state. This is the issue with which the newly elected Irish Government is working with its EU partners.
I am sure EU decision makers are by now fully aware that the Irish banking problem has been influenced by the requirement of free movement of capital within Europe since 1990, and the deep interdependence that that has created, with all its good and bad aspects.
In a sense, the Irish banking problem is a manifestation of a wider European banking problem that grew in the context of monetary union. We have had, as President Barroso has said, a monetary union without an adequate economic union.
But I would add that we have also had monetary union without adequate monitoring of risks to European financial stability through lax banking practice across borders within the EU . Systemic interdependence between banks was allowed to develop, indeed encouraged, but without systemic supervision of the cross border risks that that created .
I will show that, back in 1992, the framers of the Maastricht Treaty foresaw these risks, and created the necessary powers to monitor them, but that EU institutions failed to follow up on key provisions. of that Treaty. If these provisions had been fully followed up, it would have helped us avoid what happened to European banking in 2008.
As a result of the failure to follow up on some of the Maastricht provisions, there was not adequate Europe wide monitoring of the risks arising from flows of money across borders from countries, with surplus saving, to other countries where banking bubbles developed. Ireland is a country in the latter category, unfortunately.
To make that point is not to argue that Irish institutions should avoid their financial responsibilities, to bondholders or others. A bond is a promise, and promises should not be broken, especially if ones economy is based, as Ireland’s is, on the provision of international services, in which trust is vital. Let me reiterate, of course, that the main responsibility for Ireland’s plight rests with Irish institutions.
In Ireland, private sector institutions were first and foremost responsible for the bubble, especially the property development industry for it’s reckless borrowing, and estate agency community .
The boards and managements of banks for the reckless lending share responsibility, as do the media, with their reliance on property advertising ,for encouraging people to climb the so called property ladder, as if one place on this ladder was a measure of one’s place in society.
The Irish economics profession has a responsibility for, generally speaking, not calling attention to the obvious unsustainability of the borrowing , and of the level of construction activity, which could not possibly have been maintained. The methods of the accounting and auditing professions have also to be called into question.
It is obvious that the Irish Central Bank, the Financial regulator, and Government made major errors.
But , if we are to overcome the crisis and avoid a new one, everybody must be self critical, including the ECB and other European institutions. A single currency for 16 or more separate nations was always a challenging project, intellectually, politically and economically. If there were design flaws in the project, these must be remedied but , even more so, if powers to act existed, and these were not used, that must be acknowledged.
Risks inherently flowed from the decision to allow free movement of capital within the EU. Exchange controls at national level were no longer available as a means of preventing bubbles developing. That gap had to be filled at a higher, EU wide, level.
The ECB has, under its statute, which was appended to the Maastricht Treaty in 1992, a responsibility to oversee supervision of banks. Some in the ECB may feel that that responsibility rests solely with national central banks but a close reading of the statue of the European System of Central Banks shows that that is not so.
A single currency for 16 or more separate nations was always a challenging project, intellectually, politically and economically. If there were design flaws in the project, these must be remedied. If powers to act existed, but were not used, that too must be acknowledged.
To assess what the ECB could ,or should , have done, about the credit bubble in Ireland one should look at the statues under which it was established, which were appended to the Maastricht Treaty in 1992.
Article 3.3 of the statute of the ESCB says that the ECB
“shall contribute to the smooth conduct of policies pursued by the competent authorities relating to prudential supervision of credit institutions , and the stability of the financial system”.
Note two phrases here… “the prudential supervision of credit institutions” and the “stability of the financial system” .
The ECB would claim that this does not give them a frontline or direct responsibility for prudentially supervising individual banks. But it does give them a contributory responsibility, a role that I would construe as including drawing attention to banking practices that threaten the overall stability of the financial system in the euro zone. Forinstance if in one country, credit was growing at 30% a year and lending had reached 300% of GDP, that was something that the ECB would have been aware of, and which would certainly have come within its mandate under Article 3.3.
Furthermore, Article 25.2 of the ESCB statute says that the ECB
“may perform specific tasks relating to prudential supervision of credit institutions”
and Article 34.1 goes on to say that the ECB may make regulations to implement Article 25.2 that is concerning prudential supervision.
Under Article 14, the ECB had power to issue instructions to national central banks.
A normal reading of this would suggest that it was the intention of the framers of the Maastricht Treaty that prudential supervision would be a responsibility of the ECB, in conjunction of course with the central banks of the member states.
Unfortunately these provisions were never activated. This is because the Council of Ministers never adopted the necessary enabling regulations. One really ought to know why.
The Treaty provided that the Council of Ministers, acting by means of regulations in accordance with a special legislative procedure, may unanimously , and after consulting the European Parliament and the ECB, confer specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions. A proposal from the Commission would have been required. This was never done. We now have a European Systemic Risk Board, but that is 18 years late
It would appear that the ECB found itself with a clear responsibility ,under one article of its statute, to contribute to supervising credit institutions like those in Ireland which have come to pose a systemic risk, but was never given the powers under another article to exercise those powers, as the framers of the Maastricht Treaty expected it would.
An explanation ought to be forthcoming from the European Commission, from each of the member states, and from the ECB itself, as to why these provisions were never activated.
A failure to activate specific Treaty powers, that could have been used to prevent EU wide systemic risks in the banking system, is no minor omission. The omission suggests that responsibility for failing to prevent a banking crisis in a number of EU member states is shared in part by EU institutions.
Clearly, as we now know all too well, the expansion of credit in some countries like Ireland and Spain has affected the “stability of the financial system”, in the words of Article 3.3 of the ESCB statute.
I repeat that this does not mean that the ECB was ever to have, or ever had, the primary responsibility for failures of supervision of individual institutions ,like Anglo Irish Bank. But it does mean that the ECB, the Commission and Council could, could have seen the risk that overall imbalances in banking would upset the stability of the overall financial system, and could have activated the ECB’s Treaty powers to enable it to deal with that. They could have activated the ECBs powers to issue binding instructions to national central banks.
Even if the ECB could not use these powers I have mentioned above, it also had power under Article 4(b) of the statute to submit opinions to national central banks where it saw bubbles developing. It appears that the ECB took a rather narrow interpretation of this power and did not use it ,unless it was specifically consulted by a member state. This is a pity.
The ECB may have been inhibited here by the principle of subsidiarity, but I think it was mistaken in this judgement. We now know these banking risks were in fact not confined within one country, but spread across borders. With the benefit of hindsight, one can thus see that the principle of subsidiarity did not apply.
If the ECB felt it was not getting enough information from national central banks to form a judgement, it also could have used Article 5.3 to obtain better information. But unfortunately the Council regulations to give effect to this power excluded ,until 2009, information about prudential supervision of credit institutions. The Council and the Commission share responsibility for that critical omission.
EU institutions, including the ECB, are now helping to resolve the situation in Ireland and Greece, but this help is in the form of loans which will have to be repaid..
Of course, it would not have been politically easy for the ECB to have used its powers to warn the Irish authorities in 2003 or 2004 to rein in credit. There would have been an outcry from many in Ireland decrying “interference from Frankfurt”, and all that sort of atavistic nonsense. But the ECB can ignore that sort of thing, because it is politically independent under its statute, more politically independent even than the European Commission.
I repeat that I do not make these points to out of any wish to shift blame away from where it belongs. The main blame must be borne in Ireland. But if the EU is to learn from the crisis, it has to look at the whole picture. Part of that picture is the role of the ECB and other EU institutions.
Having said all that, it is important that Ireland approach its European partners in a realistic frame of mind.
Other European countries have problems too.
For example, almost all of them have budget deficits of their own. Many of them have more severe immediate problems with the fiscal cost of the ageing of their societies and workforces than Ireland has. They are also aware that the original justification for the cohesion and regional funds of the EU, to which many were net contributors and we were net recipients, was precisely to prepare countries like Ireland to be able to face the rigours of a single currency. If Ireland now discovers it was ill prepared, the first responsibility is its own.
Other EU countries have domestic political constraints too.
For example, Germans have a justified horror of inflation after their unique experience in the 1920s when inflation peaked at level higher than were seen in Zimbabwe recently, and destroyed the saving of all thrifty families.
Reactionary and nihilistic anti EU sentiment, of the kind we seen in Ireland during the first Nice and Lisbon referenda, is rising in many other countries, and transferring money to countries that can be presented as not having managed their affairs well, feeds those sentiments. This is especially so if the country lending the money has a lower income per head than the recipient.
Irish people must understand these political realities, just as others must be realistic about what Ireland can do on its own about what is part of a systemic European banking problem.
It would make no sense for other EU countries, in their own interests, to make counterproductive demands of Ireland. Demanding that it change our corporation tax system is counterproductive. Corporation tax is one of the ways whereby Ireland will be able to repay the loans it has received. The 12 and a half percent corporation tax raises an amount equivalent to almost 3% of Irelands GDP, more than France collects in corporation tax, and a lot more than Germany collects, which comes to just over 1% of German GDP.
More importantly, low corporation tax rates to attract foreign investment, mainly from outside the EU, has been the core of Ireland economic model since 1956, before the EU had even come into being, and before many of the leaders sitting at the European Council were born! This foreign investment contributes hugely to Irish tax revenues, not only through corporation tax ,but even more so through all the other taxes paid by those working for and supplying these foreign firms. It also has made Ireland, a peripheral island by any standard, one of the most internationalised economies in the world, and that gives it a unique capacity to trade its way out of its current difficulties.
Lending Ireland money, but simultaneously asking it to dismantle the economic model that enables it to repay the money, would not be good banking practice, to put it mildly!