Open Dissent

by Mike Soden

  The US’s battle to save its banking system, which was on the verge of collapse, was achieved by political negotiation, intelligent corporate solutions and strong, capable people who were competent decision makers. Had the US not come out of this potential meltdown, the global systemic effect would have been catastrophic. Two books, Too Big to Fail: Inside the Battle to Save Wall St by Andrew Ross Sorkin9 and On the Brink: Inside the Race to Stop the Collapse of the Global Financial System by Hank Paulson,10 provide valuable insight into this turbulent period. When the crisis struck in 2008, Hank Paulson was the US Treasury Secretary, unquestionably the most powerful financial position in the world. On the occasion of President Obama’s inauguration in Washington in January 2009, Paulson was replaced by Timothy Geitner.

  Paulson has had time to reflect on what lessons were learned that could help the US avoid a recurrence of such a disaster in the future. His reflections on his experiences in 2007−2008 led him to lay out the following principles,11 which are equally applicable to the Irish market:

  The structural economic imbalances among the major economies of the world that led to massive cross-border capital flows are an important source of the justly criticised excesses in their financial system. These imbalances lay at the root of the crisis. Simply put, in the United States we save much less than we consume. This forces us to borrow large amounts of money from oilexporting countries or from Asian nations, like China and Japan, with high saving rates and low shares of domestic consumption. The crisis has abated, but these imbalances persist and must be addressed.

  Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age. It is rife with duplication, gaping holes and counterproductive competition among regulators. The system hasn’t kept pace with financial innovation and needs to be fixed so that we have the capacity and the authority to respond to constantly evolving global capital markets.

  The financial system contained far too much leverage, as evidenced by inadequate cushions of both capital and liquidity. Much of the leverage was imbedded in largely opaque, complex financial products. Today it is generally understood that banks and investment banks in the US, Europe, and the rest of the world did not have enough capital. Less well understood is the important role that liquidity needs to play in bolstering the safety and stability of banks. The credit crisis exposed widespread reliance on poorer liquidity practices, notably a dependence on unstable short-term funding. Financial institutions that rely heavily on short-term borrowings need to have plenty of cash on hand for bad times. And many didn’t. Inadequate liquidity cushions, I believe, were a bigger problem than inadequate capital levels.

  The largest financial institutions are so big and complex that they pose a dangerously large risk. Today the top 10 financial institutions in the US hold close to 60 per cent of the national financial assets, up from 10 per cent in 1990. This dramatic concentration, coupled with much greater interconnectedness, means that the failure of any of a few very large institutions can take down a big part of the system and, in domino fashion, topple the rest. The concept of ‘too big to fail’12 has moved from the academic literature to reality and must be addressed.

  When President Obama took office in January 2009, he was able to look back at a financial landscape strewn with eight major institutions,13 now no longer in existence, that had once formed the bedrock of US financial services, and the five major investment banks that had either been taken over, had gone bankrupt or had become bank holding companies. The measures taken by the previous administration were decisive, which may have been the salvation of the global financial markets. President Obama sought the assistance of Paul Volcker, who introduced what is described as the Volcker Rule, a proposal to limit the size of financial firms and to stop the risky activities of banks.

  On 25 June 2010, the Dodd–Frank Bill, which implements most of the proposals put forward by Volcker, was agreed by Congress and was subsequently passed in July 2010. Most people in the marketplace refer to the Dodd–Frank Wall Street Reform and Consumer Protection Act as a reintroduction of the Glass–Steagall Act or a facsimile thereof, because ultimately it separates and limits the activities of banks. The Act makes broad changes to the existing regulatory structure, streamlining it and creating new regulatory agencies. The object of the Act is to address and eliminate the loopholes that led to the economic crisis and to protect the economy, investors, businesses and the taxpayer. The Act ends the bailout of financial institutions by the taxpayer.

  Among other restrictions, the Act prevents banks that have a direct or indirect relationship with a hedge fund or private equity fund from entering a transaction with the fund without disclosing the full extent of the relationship to the regulating entity. It also puts limits on the activities and transactions that may be conducted by non-bank financial companies. The Act explicitly limits the largest financial companies in terms of growth by acquisition. No financial company will be permitted to merge with another company if the total consolidated liabilities of the combined company would exceed 10 per cent of the total liabilities of the financial system. This changes the emphasis from deposits to total liabilities, which acknowledges other sources of funding used by the market.

  The Act’s restrictions on some types of proprietary trading by banking firms may lead banks to reconsider their status. Under the bailout of the US financial system on 22 September 2008, investment banks Goldman Sachs and Morgan Stanley became bank holding companies. The benefits associated with proprietary trading has greater relevance to Goldman Sachs than Morgan Stanley with regard to their respective operating performances. Today, Morgan Stanley has moved away from proprietary trading as a main activity in its business model. The Act may be the catalyst for Goldman Sachs to consider going back to its roots as a private partnership.

  The aftershock of the liquidity crisis of 2008−2009 continues to be felt today. It is comforting for some to believe that the liquidity crisis that had its roots in the US financial system and that spread across the world with speed was at the heart of the Irish banking meltdown. There is no doubt that when confidence is lost in banking, liquidity dries up immediately. Ask any businessperson today how difficult it is to get liquidity for his or her small or medium enterprise (SME). However, as mentioned, we cannot blame the global crisis for what happened and is still happening in Ireland. The effects of the liquidity crisis in Ireland may well be a continued downward spiral in property prices and a prolonged period of deflation. Our international reputation, earned and built over a sixteen-year period and that saw us reach the highest levels of credit ratings in the world, has been swiftly reversed.

  Very powerful people all over the world sang the praises of the Celtic Tiger. We had achieved the status of ‘most enviable nation’ for the speed at which we moved from stagnancy to prosperity. The economic miracle that was created and that flourished for sixteen years earned respect and admiration throughout the financial world. Many cynics would have us believe that we were blessed with massive investments from Europe, without which we would not have succeeded. True or false, we invested and managed these funds to the betterment of our society. The reputation that we earned was that of an educated, hard-working, energetic, innovative workforce. Circumstances have tarnished this image but it is in our own hands to use these qualities to drive our recovery. Through various government bodies, the Industrial Development Agency (IDA), Enterprise Ireland and others, we managed to catch wave after wave in the changing economic world through intelligent planning and execution of such plans. We can do it again, but we need the leaders in all areas of our society working together to achieve a common goal − recovery.

  Paying the piper in the financial markets has been almost instant, but our decision-making abilities often lag behind. As the Government continues to drip feed bad news about future tax cuts sprinkled with hopeful messages about a jobless recovery, one must really wonder what our leaders are about, and if we have any alternatives. The Americans were
able to make their decisions quickly, which saved their country and, in turn, the global financial markets. Whether these actions will lead to a deferred double dip in the economy, only time will tell. Forecasting is better left to meteorologists.

  It was old-fashioned teamwork that enabled the recession-damaged Swedish economy to recover in the 1990s as all parties put the good of the country ahead of political parties or personal agendas (see Chapter 7). The concept of working together is not ingrained in the culture of politics and public service in this country. The key parties to our crisis are bankers, developers, regulators, politicians and civil servants. If they believe they can create a long-term solution to our country’s economic problems without talking to one another, they are sadly mistaken. Too often the political agenda is put forward as a reason for the various parties not consulting one another. The somewhat dictatorial attitude of the Department of Finance and its colleagues in NAMA needs to be questioned and reined in. They do not have the experience or wit to create solutions that will re-instill confidence and trust in Ireland’s commercial market. The need for a collaborative approach between key parties – bankers, developers and NAMA − is essential to see us out of this crisis.

  CHAPTER 2

  A View from Dame Street –

  The Crisis in Ireland

  On 10 December 2007 I visited the Governor of the Central Bank of Ireland in the presence of the two executive directors who were responsible for the issuance of the Financial Stability Report that had been published a few weeks earlier. I had come to discuss this report. All EU nations provide a status report annually for the European Central Bank (ECB), which in turn is consolidated into an EU report. As each country focuses on the strengths and challenges in their domestic financial market, any weaknesses can be subsequently addressed with or without input from Europe. In their Financial Stability Report of November 2007, the Central Bank of Ireland recognised liquidity and the credit crunch as market concerns that required observation. The outcome of the meeting on 10 December was simple and reassuring – we were in for a ‘soft landing’. I dissented and I expressed myself accordingly.

  On 30 January 2008 the Central Bank of Ireland presented its Financial Stability Report to the Oireachtas. During this presentation the twin challenges of liquidity and the credit crunch were addressed. However, in conclusion, the report and the Governor made the judgment that the country was in for a soft landing and that we did not have to worry. On 29 September 2008, some eight months later, all the debts of the Irish banking system were guaranteed by the Government to prevent the genuine threat of a meltdown of the Irish banking system.

  One week earlier, and following on from the meeting of December 2007, I wrote the following letter to Governor Hurley. The letter indicates the level of my anxiety and concern in 2007−2008 over the deterioration of the financial markets. In fairness to the Governor, the pressurised environment at that time left him little opportunity to respond to my concerns.

  22 September 2008

  Central Bank and Financial Services

  Authority of Ireland

  Dame Street

  Dublin 2

  Re: Market Stability

  Dear Governor,

  Since we met in December 2007 I have given considerable and continual thought to the stability of the financial markets and the many causes behind our present situation. My worst fears were realised this morning with the news of the two remaining US investment banks (Goldman Sachs and Morgan Stanley) being authorised to become bank holding companies. This, I believe, is truly the worst thing to happen to the financial markets.

  Investment banks traditionally deal with investors and have done so since the early 1900s under the adage caveat emptor. This implies very clearly that the informed investor is aware of the risks their money is being used for. The [retail] banks, on the other hand, have for a long time dealt with depositors’ money with due consideration of their fiduciary responsibilities to this constituency. I don’t have to tell you or anyone within the bank that the primary reason for the regulatory framework in relation to banking is to ensure that depositors’ money is protected and the payment system safeguarded.

  Investment banks, in my belief, have not had a culture of concern for their investors (as reflected in the recent turmoil) other than an attitude that could be reflected in the following – ‘When we bring you a deal there are risks attached and both of us share in these on an equity basis.’

  Letting the investment banks into the preserve of bank holding companies with the right to attract depositors’ money is akin to letting the fox into the hen house to arrange its next meal! This recent proposal from Mr Hank Paulson to ensure the liquidity of the investment banks is perceived not to be impaired, in fact puts the fate of the depositors at risk. Somehow, to achieve stability in the market, there is a perception being created that, with having the ex-investment banks now regulated as bank holding companies, our worst fears of a meltdown will be avoided. I believe these actions simply give us a deferment of a problem rather than a solution.

  If regulation is required to control the activities of the banking community then the unpalatable but possibly more attractive solution would be the reintroduction of the Glass–Steagall Act. The dilution of this Act during the 1980s and 1990s, which led to the repeal of the Act in 1999, in my judgment, has been at the heart of the current turmoil in the marketplace.

  As you may recall in our conversation last December, I mentioned that the liquidity crisis and the credit crunch were symptoms and not the principal illness that we were experiencing. I have contended for some time that the real problem has been the intrusion of the investment banks into the traditional banking marketplace. They achieve this through the creation of sophisticated, highly engineered products, which were very highly leveraged while being made to look attractive to mortgagees on the one hand, and to investors and depositors on the other. The lack of confidence that has grown out of these products has led to the consequent liquidity and credit problems. The current situation appears to have a lot in common with 1929−33. Unfortunately I think we are only, in relative terms, in 1931 ... a couple of years to go!

  For the sake of brevity I attach my own conclusions on a single sheet to this letter as to the principal causes of the current state of instability in the marketplace. I would be more than pleased to discuss at length or briefly my suggestions as to the solutions that should be adopted to prevent a recurrence of this situation with your colleagues or anyone else who you may feel appropriate.

  Yours sincerely,

  ____________________________

  Michael D. Soden

  The contents of the attached sheet were:

  ‘Potential Meltdown in the Marketplace’

  Who caused the current situation?

  The investment banks, hedge funds, rating agencies and brokers in various linked ways managed to create the current situation. There are more participants to this dilemma but the principal protagonists are those mentioned.

  Why did it happen?

  A combination of astute financial engineering and creative accounting, together with a culture of excessive greed, were the principal ingredients.

  What caused this to happen?

  Excessive leverage and unfettered abuse of this age-old corporate finance technique are at fault. It could also be put down to the delayed consequences of the repeal of the Glass–Steagall Act.

  How did this occur?

  Through lack of regulation and control of investment banks whose creativity, energy and ingenuity went awry. It must be highlighted that the investment banks were aided in their frenzied development of the securities market by the extremely poor judgment of the rating agencies. The excessive use of the technique of shorting the market has contributed substantially to the acceleration of the current market instability.

  Solution:

  A reintroduction of the Glass–Steagall Act or facsimile thereof, which controls and monitors the liquidity and capital str
uctures of the investment banks, would be the first step in a two-part strategy. The second step would be a constraint placed on the banking sector with regard to providing any monies through the interbank market to the investment banks, together with a restriction on the banks investing in any leveraged securities.

  I stand by my recommendations in the above document.

  The crisis that started in the US financial system in August 2007 was going to have far greater impact on the rest of the world than most would have imagined and forecasted. It would appear that, while we listen to forecasts and commentaries on all areas of the international markets, the tendency is to only hear that which suits our own domestic outlook. We had decided that we were in for a soft landing, because anything else would be politically unpalatable and unpatriotic.

  It is true that the Central Bank would have given warnings to the Irish banks as regards the overheating of the commercial and residential property sectors. It seems that the six Irish banks – Bank of Ireland, Anglo Irish Bank, AIB, Irish Life and Permanent, EBS Building Society and Irish Nationwide – did not fully listen to the advice of the Central Bank. It is likely that they only heard what they wanted to hear, that we were in for a soft landing. The lack of action taken by the banks was not out of disrespect for the Central Bank but more likely because of the demands for increased profits from their shareholders.