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Opening Statement by Governor John Hurley to the Joint Oireachtas Committee on Finance and the Public Service

21 January 2009 Speech

Good morning Chairman and members of the Joint Committee. Thank you for the invitation to speak with you today. I am accompanied by Tony Grimes, the Director General of the Central Bank and Tom O’Connell, Assistant Director General, Economics.

The Central Bank and Financial Services Authority of Ireland consists of the Central Bank and the Financial Regulator, each with its own responsibilities. Among the Central Bank’s key responsibilities are the maintenance of price stability, the provision of liquidity and contributing to financial stability. The Financial Regulator’s key responsibilities are prudential regulation focused on the individual financial institutions and consumer protection.

In my own opening remarks, I would like to briefly recall the background to the current issues in our financial system and in the economy more generally, up to and including the nationalization of Anglo Irish Bank, and to outline the on-going role of the Central Bank in dealing with these issues. As you know, last week’s Government decision regarding Anglo Irish Bank was taken in consultation with the Central Bank and Financial Regulator. This necessary decision reflects the commitment of the authorities here to maintaining the stability of the financial system and demonstrates that whatever actions are necessary in that regard will be taken. With reference to financial stability issues more generally, I will comment on the actions taken by the authorities here to secure the stability of our domestic financial system, particularly since the Lehman’s bankruptcy last September.

The Domestic Economy

The Irish economy is currently going through a very difficult period and is facing into a second consecutive year of contraction. The contraction in output is set to result in significant job losses and a sharp rise in unemployment. Given the uncertainty as to the speed with which the global financial market crisis can be overcome, the assessment of the domestic economic outlook is especially difficult. What is certain is that we are in a significant downturn and two courses of action are essential. It is imperative that we move to correct the sizeable deficit in the public finances over a reasonable timeframe. It is also vital that we improve our competitiveness, which has weakened steadily in recent years. This is necessary to protect employment, to maintain and attract foreign investment and, over the longer term, to improve the potential for the economy to grow. In our present circumstances, pay developments need to take account of the changed outlook for inflation and the extremely difficult situation facing the Government’s finances. They also need to take account of the necessity to restore competitiveness in a difficult international trading environment so as to be in a position to avail of improved economic conditions worldwide when these eventually emerge.

Notwithstanding current difficulties, Ireland’s medium-term prospects are good. On the basis of still favorable demographic trends and some improvement in productivity growth, Ireland has the potential to grow strongly again in a few years. However, the achievement of this potential is not inevitable and is contingent on sound economic management. In the short term this will involve painful but necessary action to ensure long-run sustainability in the public finances and to restore our competitive position.

The Global Financial Crisis

When I last appeared before you in July, I pointed out that we were in a challenging environment. At that time, we were experiencing a greater-than-expected slowdown in domestic growth in conjunction with a generalized disruption in international money markets. In mid-September this situation deteriorated dramatically with the failure of Lehman’s bank in the United States. This event served both to accentuate and accelerate the adverse effects of the crisis across global financial markets.

Among developed countries, as confidence and trust waned, even the strongest banking systems were affected. To protect financial systems, which are so vital to every country’s economy, policymakers internationally moved from interventions in individual institutions to scaled-up assistance, including funding guarantees and recapitalizations, on a system-wide basis.

I have made it clear over the last number of years that the Irish economy was facing an increasing number of downside risks and that, if an international shock interacted with these domestic vulnerabilities, it would give rise to serious consequences for our economy. In the event, this is what occurred and a rebalancing in the domestic economy, which could have been painful but manageable, has turned into a much more difficult challenge.

The excess supply of liquidity and large global imbalances, which emerged in the early years of this decade, were major causes of the significant vulnerabilities that materialized within the global financial system. These vulnerabilities included excessive credit growth, increasing leverage in the financial sector, and a search for yield leading to an under-pricing of risk in financial markets generally.

These developments had a marked influence on the Irish financial system. Although the Irish banks avoided the toxic assets associated with the US subprime market, there were specific domestic vulnerabilities, such as the banking system’s strong credit growth, over-exposure to property-related assets and growing dependence on international wholesale funding.

These domestic and international vulnerabilities were identified clearly in our Financial Stability Reports in recent years. However, the severity, breadth and rapid onset of the financial crisis that has developed and the consequent impact on the global economy is unprecedented. This is reflected in the very large deterioration in financial stocks globally and exemplified in our own market. The upshot of all these developments is that all banking systems in advanced industrial countries have now required a number of rounds of support from their respective authorities. We have seen actions in this regard by some of those authorities again this week.

The Central Bank’s Response to the Current Crisis

The Central Bank has responded to the unfolding crisis in a number of ways.

Provision of Liquidity

The Irish central bank, on behalf of the Eurosystem, and along with central banks globally, has been providing significant volumes of liquidity to the banking sector, since major financial stress began to become evident in autumn 2007. The Eurosystem entered this crisis with a relatively broad collateral framework for supplying liquidity to banks, in comparison with other major central banks. It has since made its liquidity more easily accessible for banks by widening its list of eligible collateral, providing the funds on a full allotment basis and extending the maturity of its operations. Other central banks have since moved closer to the Eurosystem model.

Euro area Monetary Policy

In response to the turmoil, and the associated impact on the real economy, the Eurosystem along with other major central banks, has eased monetary policy, in some instances, to levels not previously seen. The Governing Council of the ECB has cut its policy interest rate by 225 basis points cumulatively since last summer. This substantial fall in rates over the last few months has been a response to reduced inflation risks at a time of deteriorating economic and financial developments in the euro area. Clearly, if events cause our expectations regarding inflation to be revised, then the Governing Council remains ready to act.

Membership of the euro area has given us significant advantages, for example, in relation to liquidity support to our banks and elimination of exchange rate risk within the euro area. The advantages can also be seen by the fact that debates are now taking place in countries outside of the euro area regarding the benefits membership could bring them. However, membership of a monetary union and the absence of an independent monetary and exchange rate policy means that member state’s domestic economic policies have to be appropriate. In particular, as I have mentioned earlier, in the absence of an independent monetary policy, it is essential in present circumstances that a strong focus is placed on policies to restore competitiveness

Contributing to Financial Stability

While monetary policy and liquidity provision have always been the key functions of central banks, in recent years there has been an increasing emphasis on their contribution to financial stability.

Through the publication of financial stability assessments, central banks in the major industrial countries draw attention to risks to the financial system. This information and analysis is provided to the wider public, financial market participants and directly to the banks so that they are informed about the economic and financial environment, thus allowing them to adjust their behavior consistent with those risks.

It is precisely this role that the Central Bank here has played over the past four to five years pointing out the domestic and international risks to the economy at a time when house prices and credit growth were increasing at very high rates. These risks, based on our ongoing analysis and research, were highlighted not only in our annual Financial Stability Reports, but also in our Quarterly Bulletins and in statements made by me regularly. In the context of an unprecedented period of expansion and wealth creation, this proved a difficult message to get across. It is evident there was not a sufficient or timely change in behavior in response to these warnings. Other central banks around the world faced similar headwinds in changing behavior consistent with the risks identified in their own financial stability assessments.

An international debate has now begun on how authorities might directly change the behavior of financial market participants to mitigate the risks identified in Financial Stability Reports. This debate, in part, is focusing on whether central banks need specific powers to intervene directly in this regard. For example, one proposal is that central banks might have an explicit role in setting capital ratios in response to emerging risks identified in their financial stability assessments.

A further area for discussion is how monetary policy might better respond to asset price developments. For example, should policy “lean against the wind” by tackling asset price inflation more directly.

Recent developments

 In late-September, following the Lehman’s bankruptcy and when the global interbank markets froze and funding was unavailable even at the shortest maturities, the Central Bank formed the view that the risks to financial stability were becoming unacceptably high with knock-on effects for the wider economy. The scale of liquidity outflows was such that some of our institutions had acute liquidity risks. The concentrated nature of the Irish banking system meant that there was a high risk of contagion in the event of an individual bank encountering difficulties. There was no impending pan-European initiative to address these international pressures at that time, although it was to emerge subsequently. Our own Government decision to guarantee key liabilities of the banking sector was taken at that time to protect the stability of the domestic financial system by ensuring renewed access to funding for Irish financial institutions. A success of this measure was evident by the immediate improvement in the liquidity situation, including a substantial net inflow of funds in the days after the guarantee was introduced, and the ability of a number of the covered institutions subsequently to raise longer-term finance on the international markets. In the subsequent weeks, most other European countries moved to introduce some form of guarantee arrangements.

It was recognized at the time that it would also be necessary to determine if additional capital was required, particularly in the context of demands for higher Tier 1 capital by international investors and pressure on property valuations in the context of a much more significant downturn. Accordingly, after consultation with the Central Bank and the Financial Regulator, the Government announced details last month of its capitalization scheme. The risk for banks that do not meet higher market standards is that they face a much more difficult environment for raising funds. It was not acceptable to the authorities that banks would attempt to achieve these higher ratios by curtailing credit to the real economy. A very important aspect of the capitalization scheme is the agreement of the participating banks to develop specific credit policies targeted at small and medium sized enterprises, first time buyers and consumers generally.

As part of the response of the authorities to ongoing events, the Government last week made its decision to bring Anglo Irish Bank into full public ownership in order to secure the bank’s continued viability. The action was in response to a weakened funding position and the reputational damage to the bank arising from unacceptable practices that took place within it at a time when overall market sentiment was already negative towards the institution. It meant that recapitalization was no longer the appropriate and effective way to secure its continued viability. So far as Allied Irish Banks and Bank of Ireland are concerned, the Government has reiterated that it sees these banks as central to the Irish financial system and essential to the proper functioning of the economy. It has also indicated its intention that both banks remain as independent banks in private ownership and has stated that it is proceeding with the planned re-capitalizations of both banks.

A well functioning financial system is central to the well-being of any economy. The Government has underlined the strong commitment of all the authorities to take whatever action is necessary to achieve this outcome.

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