The Irish Financial Crisis – Governance Lessons Learned
© ICMCI and David Duffy, FCA, CMC + Dr. William Byrne; 2015
Governance in a corporate sense could be defined as “the system by which organisations are directed and controlled” (The Cadbury Report, 1992). When governance functions well or as it should, it is unremarkable, often taking place seamlessly behind the scenes.
However, when governance is absent or goes awry its true value becomes patently obvious. Nowhere were the ramifications of poor governance more painfully exemplified than in Ireland. This feature piece discusses universal issues surrounding governance through the lens of Ireland’s banking crisis – a catastrophic consequence of poor governance and regulation or the lack thereof. The impact of poor governance at a political, regulatory and social level is explored and the governance reforms are outlined.
Finally, the lessons learned from an Irish context, are shared with global applicability.
Reflective descriptions of Irish banking governance in the run up to the banking crisis have been far from complimentary; Klaus Regling and Max Watson in their 2009 report noted that "internal governance and risk management procedures were overridden, sometimes systematically" and firmly ascribed weak governance in Irish banks as one of the key “home-made factors” that contributed to the banking crisis. Central Bank governor Patrick Honohan in his 2010 report identified a "regulatory approach which was… excessively deferential and accommodating; insufficiently challenging and not persistent enough..."
Another consideration was the “light touch” regulation by the Central Bank – The Regulator, which failed to fulfil its oversight mandate and in particular did not identify or ignored the imbalance of the banks’ loan portfolios towards property; and also the fact that enormous amounts of money were lent to relatively few developers with minimal due diligence.
But why did governance fail?
1. Warning signs were not observed
A number of red flags should have caught the attention of those involved in governance both internally within the individual banks and externally within the regulators office (The Central Bank of Ireland) and at the IMF and European Commission. These included credit growth, asset concentration, high loan to value ratios, and funding exposure;
Credit growth: During the period 2003-2006 compound annual average loan growth for the six main banks grew by between 28% and 47% (Annual Reports from Banks). At the same time private sector credit grew by nearly 10% (Central Bank of Ireland). All this growth derived from property lending and was facilitated by heavy non-deposit funding and “light-touch” regulation.
Asset concentration: There was a threefold concentration. In the broad sense, assets were concentrated in the property sector with a heavy preponderance for commercial property loans to a select group of key developers. While this concentration was initially confined to Anglo Irish Bank and Irish Nationwide Building society it was not long before the other banks embraced the property bubble. The asset vulnerability issue thus became a systemic problem.
Loan-to-value ratios: For the period 2003 to 2006 LTVs continued to increase across the banking sector. This was even more pronounced for new loans to first time buyers where a culture of LTVs of 100% emerged. Such high LTVs did not allow for risks for future economic growth and property price developments.
Funding risks: Loan to deposit ratios of above 200% for the banking system as a whole were higher than other comparable euro area economies. This left a large hole to be filled with debt securities and interbank borrowing.
2. The prevailing global culture
While it in no way absolves those involved in Irish banking governance of their shortcomings, the objective observer should be cognisant of the lax governance culture that permeated the global supervisory community. Light-touch regulation and reliance on banks’ own risk assessments were the order of the day. Against this backdrop a heavier approach to governance might have seemed out of kilter – this made action even less likely.
3. Skin in the game
A misguided system of incentivisation pervaded all levels of the Irish banking sector from senior managers all the way down to loan officers. In essence this system fostered a culture of reckless lending. This greatly hampered any form of in-house governance within the banks.
4. Unacceptable Corporate Governance Practices
The Irish government referred to “unacceptable corporate governance practices” at the Anglo Irish bank in particular. More specifically, issues included a failure to disclose some loans to directors, falsifying balance sheets and the use of in-house loans to prop up the banks own share price. The important role of external auditors in this context would also have to be questioned, with leaders of this sector to be held to account.
5. Market Forces
The Irish economy had done well in the period to 2000 – 2006. Consequently all of the lending institutions were keen to benefit from this economic boom. Developers were treated like royalty by the banks and politicians alike and it would appear could do no wrong. Banks competed to lend money to this cadre without really considering that what goes so rapidly up must come down. Morgan Kelly, an economist from UCD warned of the impending issue in 2006 that house prices could crash by over 50%. He was right, they did.
It is possible that regulators and other agencies placed too much emphasis on the apparently strong capital adequacy ratios. For example, the 2007 IMF report on Ireland summarised the position of the banking sector as follows; “Banks Have Large Exposures to Property, But Big Cushions Too.” By early 2008, the warning signs were there that the economy was in trouble. By late 2008 it was!
7. A failure of implementation
Perhaps the most significant reason for governance failure within the Irish banking sector lies here; supervisory and governance structures were in place but they were simply not implemented. For example on-site inspections were a rarity and there existed a cultural belief within the banks that regulators were reluctant to impose penalties – indeed when major questions around governance were asked no penalties at all were imposed on banks.
The impact of poor governance
The banking crisis and the bank guarantee
During 2008, as evidence built up of the scale of the Irish construction collapse, international investors became concerned about the exposure to property investment loans of the Irish banks. These banks found it increasingly difficult to raise funds on bond markets and on September 29, 2008, two weeks after the collapse of Lehman Brothers, the senior management of the largest Irish banks turned up at government buildings looking for help. Anglo Irish Bank was losing deposits and running out of eligible collateral to be used to borrow from the ECB. Anglo was possibly days away from defaulting on its liabilities and the other banks were extremely concerned about the impact on their operations if such a default was to occur.
What exactly happened during the meetings that took place between the bankers, the politicians and staff from the Department of Finance and Central Bank, is still unclear. Indeed, there are ongoing calls in Ireland for an official investigation into the details of these meetings.
What we do know is that on the morning of September 30, 2008, the Irish public awoke to find out that the government had provided a guarantee for almost all of the existing and future liabilities of the domestic Irish banks. The guarantee was to run for two years, meaning any default on bank liabilities that occurred during that period would be covered for by the Irish government. Many felt that this guarantee was too generous and that perhaps the bondholders should have been burnt in the process. Pressure from Europe may have prevented this.
A fiscal crisis and massive budgetary consolidation
Property related taxes had been a major contributor to the Exchequer, but after the crash this income vanished as the property market went into near stagnation for nearly 5 years. This meant severe budgetary deficits that will take until 2016 to balance.
The scale of these budgetary deficits meant that, despite the low starting level of debt, the Irish government realised quickly there was no room for discretionary fiscal stimulus to ease the effects of the severe downturn.
Instead, from late 2008 onwards, there has been a series of contractionary budgets. Public sector pay has been cut by significant amounts, income taxes and VAT rates have been raised, non-welfare current spending has been cut back and capital spending has been slashed. Taken together, these budgets have implemented a total amount of discretionary tax increases and spending cuts of €28.8 billion. These adjustments are the equivalent of 18 percent of 2012’s level of GDP or €6,270 per person and represent one of the largest budgetary adjustments seen anywhere in the advanced economic world in modern times.
The IMF’s October 2010 World Economic Outlook examined historical episodes of fiscal consolidation in fifteen advanced economies over 1980-2009. As a percentage of GDP, Ireland’s 2009 consolidation was the biggest the IMF researchers could find. The subsequent adjustments for 2010 and 2011 were of similar size.
A residential mortgage crisis
Ireland also has a burgeoning mortgage crisis with levels of arrears that far outstrip every other country in Europe. By the end of 2012, almost one in five mortgages on primary residences was in arrears, with most of these over 90 days in arrears and a growing number falling ever further behind. There is also a substantial stock of buy-to-let mortgages that were performing even worse than those backed by primary residences. Most of these mortgages in arrears are also in negative equity, many significantly so. While the Financial Measure Programme Report from 2011 published by the Central Bank provided detailed estimates of the losses likely to be incurred on mortgage books, this report assumed that unsustainable mortgages would quickly be dealt with via a wave of repossessions.
In practice, Ireland’s Dickensian legal framework relating to personal debt prevented any quick resolution of the mortgage crisis. As of mid-2013, there are signs that the banks are finally making some progress to restructure unsustainable mortgages but, until this process is further advanced, it will be difficult to estimate the full scale of mortgage-related losses.
Banking governance post crash
On the 23rd December 2013 the Central Bank of Ireland published a revised Corporate Governance Code for Credit Institutions and Insurance Undertakings. The revised Code came into effect on 1st January 2015. The Code sets out minimum statutory requirements on how credit institutions and insurance undertakings should organise the governance of their institutions. The key objective of the Code is to facilitate good corporate governance in those institutions which fall within its remit.
The publication of the revised Code follows engagement with key stakeholders and incorporates feedback from the Central Bank’s public consultation.
The main changes to the Code are:
- Institutions will be required to appoint a Chief Risk Officer (CRO) and a new section has been introduced which outlines the role and responsibilities of the CRO. The risk committee will be made up of a majority of non-executive or independent non-executive directors, one of whom must be the Chairman of the committee;
- The risk and audit committees will be required to have a minimum of three members;
- Institutions will be required to ensure that there is at least one shared member between the risk and audit committees. In addition, High Impact institutions will be required to have at least one shared member between the risk and remuneration committees;
- Institutions will be required to introduce a diversity policy for board membership;
- The minimum number of board meetings required for High Impact institutions has been reduced from eleven to six per annum;
- The Chairman can now hold the role of Chairman in other credit institutions and / or (re)insurance undertakings within the group, subject to prior approval by the Central Bank; and
- The Chief Executive Officer (CEO) of a Medium-Low or Low Impact institution can now hold up to two additional CEO positions provided they are in Medium-Low or Low Impact institutions, subject to prior approval by the Central Bank.
While these measures were welcomed by the business world, the insurance sector felt hard done by as it did not cause the crisis, so why should it be penalised as a consequence. Despite the new regulations for banking ………..and insurance, there have been two very significant insurance failures in the last two years, which were not apparently picked up by the regulator.
While learned the hard way by the Irish people, the lessons emanating from failures in Irish banking regulation and individual institution governance could foreshadow future governance policy at a global level and serve some useful purpose in preventing similar catastrophes.
To this end such lessons pertaining to governance are outlined below:
- At an organisation level, it is not sufficient simply to have governance structures in place – they must function. Many organisations have governance structures in place, including independent directors on their boards, rules for rotation of directors, risk and other committees, authorisation levels for payments, loan approval levels for lending. Too often these structures do not function as they should. Boards that are too big, authorisation levels are ignored, certain decisions are made without board approval, board committees do not meet or have no formal terms of reference in place. As Lord King QC once said, you can’t legislate good behaviour. Values and ethics at board level set the tone for good governance, without this, good governance is put at risk.
- At an individual level a board appointment must be re-evaluated by many and viewed as the onerous job it surely is. Where previously a board appointment might have been seen as a reward for service to an organisation, community or a political party, this mentality is no longer valid. Directors need relevant skills and independence to be effective and be drawn from a range of backgrounds. Where previously management might have determined what information was provided to the board it is now incumbent upon directors to seek out the information they need to be effective governors. Ignorance is no longer a defence. Directors need to be objective, independent and questioning.
The Irish people have suffered enormously as a result of poor regulation of financial institutions. Many have lost their homes, their livelihoods and indeed their lives. No one could have imagined that this could happen, but it did.
Poor governance was the root cause of this. Let the world take note!
Authors: David W Duffy FCA, is the founder of Prospectus Management Consultants and the author of “A Practical Guide to Corporate Governance” published in 2014 by Chartered Accountants Ireland. Dr. William Byrne is a Senior Consultant with Prospectus.