Re-Designing Banks to Succeed or Fail

I have no qualifications whatsoever in banking, other than my own life experiences. Naively I assumed ‘banking’ looked after itself, or rather that there was proper and sufficient oversight of banking at a national and European level. In my mind somewhere there was even such a thing as a ‘World Bank,’ about which I knew very little—I considered it a positive thing in that it brought wealthy economies together to help developing countries. Modern major banks (the big names, national and international) were pillars of respectability, responsibility and hard-learned conservatism—at least in respect to their capital base and financial security. I had never set myself the specific objective of becoming wealthy. For example, I chose my career direction in keeping with my interests and what I perceived as my strengths, rather than to maximize my earnings or become a millionaire or billionaire. The distinction between the two never seemed very important to me, although in recent times in Ireland, especially before 2007, euro-millionaires (on paper) were common and included a lot of ordinary hard-working people who had not come from privileged backgrounds. These ‘millionaires’ included many who owned or had substantially paid-off their mortgages on, for example, three-bedroom houses in or around Dublin.

I was not insensitive to, or un-attracted by, the enticement of ‘earning’ more money and, by nature and experience, was inclined to live within my means, preferring to save for something or do without it rather than seeking comfort or gratification on the basis of borrowing. I was happy to leave ‘banking’ to the experts! I was sensible in managing my affairs and knew I was fortunate in having married someone with a similar outlook.

Things have changed, to bring me to writing this blog about re-designing banks! It feels as though the time has come for banking ignoramuses like me to speak out. We might as well, for if we do not we can only have ourselves to blame when experts, specialists and leaders make a mess of things.

Banks that Fail

What is a bank? It is a business that manages money and money transactions on behalf of its clients, who may be individuals, companies, other banks or even countries. What is money? Money is an ingenious, iconic representation of ‘that which is of value or worth to individuals and other entities (e.g. companies, countries, organizations).’ Money is one of the greatest inventions: it is right up there with, for example, the wheel, sanitation, the lever, electric power, citizenship, mathematics and the digital computer.

Regulation, transparency and accurate reporting of financial accounts are central to the functioning of banks. The financial position of banks must be clear to other banks—otherwise they will not be able to lend to one another, as has been seen in recent times. Simplistically, it seems to me that the setting and enforcement of the rules for commercial banks is the role of central banks. That is what I had assumed naively was already the case.

Banks have always crashed or failed. What’s new? Human progress (it is progress, so far, because we still exist and the manner in which we exist has developed through experience and passed-on knowledge) is characterized, among other things, by a series of mistakes. I, for one, am not in the slightest embarrassed by mistakes, unless they are the same mistakes, made in the same way, when lessons could have been learned from the earlier mistakes. In those cases I am embarrassed and, being human, I have to admit that I make those types of mistakes sometimes. Life goes on, we might as well enjoy it, but let’s try not to keep making the same mistakes! It would be great to move on to some new, challenging and ultimately more rewarding mistakes to confront and redress.

State Guarantee to Irish Banks

On the 30th September 2008, approximately, a small nucleus at the head of the Irish Government, possibly under pressure from the financial authorities of the European Union, made what I (an economics ignoramus) consider to have been one of the greatest economic mistakes made by politicians or governments ever. That decision was that the Irish state would guarantee Irish commercial banks using the entire wealth of the state as collateral. Emergency legislation implementing the decision was subsequently approved in the Dáil. An ordinary, common or garden political and legal ignoramus finds this very hard to comprehend. It is amazing that such a snap decision was possible under the Irish Constitution. Think of the political debate and public discussion that occurs in relation to such matters as what VAT rate is appropriate, or what the marginal rate of income tax should be, or the level of social welfare payments. Sometimes, in fact much of the time, huge amounts of political energy are expended and widespread national discussion takes place in relation to such matters as charges for water, or how roads and motorways are funded. Much contemplation has been expended, for instance, on the impracticality of paying children’s allowance only to parents who would need it. Reorganization of state services and anything involving cuts for individuals usually engender lively political and public reaction. Consider how long it takes, on average, for governments to introduce and pass any legislation that would bring about significant change to the status quo. The greatest economic decision ever made in Ireland was made almost instantly by very few persons, based on information that was clearly insufficient and, in retrospect, some of which was false. Some members of the cabinet at that time now claim that they were not party to the original decision. There was only very limited discussion in the Dáil of the emergency legislation to implement the guarantee.

Why have we not held a referendum to make sure that such a thing can never happen again? As a citizen I would like the security of knowing that no politician or group of politicians, even if they are the government, can make a bet where the stakes are the entire wealth of the Irish nation. I look forward to that referendum (better too late than never), whenever someone thinks of it.

State Ownership of Irish Banks

One of the great tragedies of the state guarantee to the Irish banks, of the subsequent bailout of the banks and of the greed, commercial dishonesty and poor economic governance that preceded these has been the severe-to-extreme hardship unfairly distributed over the citizens of Ireland. Highly talented young persons, without jobs in Ireland and forced to emigrate, are not to blame for the lack of jobs. Distressed mortgage holders, who find themselves in totally different economic circumstances to what they could reasonably have expected, are not to blame for their inability to meet their ‘commitments.’ The banks that have been bailed-out are not deserving of having being bailed-out—they are only commercial entities after all. Their original shareholders, who have suffered disastrously, were in many cases ordinary persons with savings or pensions who did not deserve what befell them. It is galling to think of all the good that could have been achieved over decades with the tens of billions of euros that have been blown away. The economic damage being suffered by the people of Ireland is ‘post-major-war-like,’ without there having been the deaths, the blood or the ruins and rubble of war. Some aspects of the emotional anguish and trauma are similar too: the emigration of loved ones, the indignity of unemployment, the distress of the most vulnerable in society and the precipitous collapse of what we had. Ireland appears to have lost its economic sovereignty. I do not wish to stretch the ‘war-torn’ analogy too far because, in fact, war and its aftermath are far worse and, objectively, Ireland is very fortunate. I am very proud indeed that Ireland has a democracy that is functioning. We are a small, great and talented nation. Now, more than ever, we need to make our democracy work for us.

I find it worrying that, having been landed with a majority shareholding in certain Irish banks, the Irish government appears unsure how to manage that situation. It is important that a clear and unambiguous plan should be put in place and implemented. It is perfectly reasonable, while it is a majority shareholder, for the government to insist that a bank passes-on a decrease in the ECB rate to its borrowers. If the Irish government expresses such a wish, it would be logical to enforce it by replacing any of its nominee directors who do not comply with its instructions. Apart from that, the government and the EU must work to ensure that commercial banks exist in an environment where it is possible both for them to interact with one another, where it is for their mutual benefit, and compete for business, thereby ensuring a healthy and efficient banking system. If some banks are charging excessive interest rates, legislation must ensure that the affected borrowers are facilitated in having the possibility to transfer to more competitive lenders. The second-last thing the Irish state needs is to be a majority shareholder in banks. The last thing it needs is ever again to be a guarantor without limit for any commercial bank.

On 24th November 2011 it was announced by the Irish government that it intended setting up a special loan facility for businesses that were unable to borrow money from the banks. This seems inappropriate, especially when the government is a major shareholder in some of the banks that are not able or willing to extend credit to these businesses. The underlying issue is that, currently, it is commercially unattractive for any banks, worldwide, to extend credit to Irish businesses at rates that would be commercially viable for the businesses. What I would like to see happen is that the European Central Bank would make funds available at about the EU base rate to the banks—the banks would then be able to do their job, as commercial lenders, in a competitive environment. The businesses could then borrow from the most efficient banks (those that would charge the smallest interest rates). I am sure I am being a total simpleton, but these are my non-expert views.

Banking Re-Design

As an ordinary Joe Soap citizen I consider that Ireland has been very badly let-down by its own Central Bank and by the European Union and the European Central Bank. I am one of the minority that voted for the Lisbon Treaty twice. I will be very cautious about voting in favour of any further EU treaty amendments. In my humble opinion, the banking system of the EU is not well conceived and needs to be re-designed. This applies equally to the common currency, the euro. Banks are entitled to succeed in commercial terms and the shareholders of banks are entitled to their due rewards. It is a known fact that banks may very occasionally fail, but, up to now, they do not seem to have been designed with that in mind. No commercial bank should ever be considered to be too big to be allowed to fail. Rather, the precise processes and procedures by which banks of any size fail must be pre-ordained, ‘designed’ in an economics-engineering sense.

On the face of it this should be straightforward: a bank has assets, liabilities and shareholders. If the total liabilities become greater than the assets, the shareholders will have to wind-up the bank and will be left with nothing. In the case of a bank, borrowers comprise a large part of its assets. If many of its borrowers become distressed or impaired, the asset value may be reduced to a fraction of what it had been. Nonetheless, where a bank fails, the loan book should be disposed of commercially at its market value and, of course, there must be legislative protection for the rights of borrowers and for the terms under which they borrowed from the original lender. The creditors of a bank, its lenders and its depositors, may lose very heavily when a bank fails, but the fact of that possibility must be part of the terms of business. The ranking of depositors and lenders must be clearly stated.

A great concern that I have as an Irish citizen is that a disastrous mistake was made in not allowing the natural occurrence of bank failure to take place. The Irish Government waged the entire wealth of the state as a bet that it could sustain confidence in commercial banks that had made mistakes, or where dishonest practices had gone unchecked. It lost the bet. So far, very little has been done to re-design the Irish banking system and to ensure that this can never happen again. Ireland as a state must have the courage to declare and make known that banks, like all commercial companies, may fail and will not be supported by the state. Likewise at a European level this must be done.

Ireland within the EU

One of the reasons that I voted for the Lisbon Treaty was that I believed the promise that was made to the Irish people that the European interest rate would be managed and would be likely to remain low into the future because of the economic strength of the European Union. I now feel that I was seriously misled. I am speaking as an ignoramus of economics, politics and banking. In fact the European Central Bank has held its interest rate at the type of level and with the type of stability that I would have expected. That has been done in a manner to support the major European economies. For instance, interest rate increases were announced to avoid inflation in France and Germany, at times when Ireland badly needed an interest reduction. The rate has recently been reduced, because France and Germany are no longer fearful of inflation.

Yet, as it appears to me, the maintenance of low interest rates by the ECB has been delusional. In my naiveness I would have assumed that banks throughout the EU would have had access to borrowing at close to the ECB base rate and that regulation would have operated to ensure that. I do not fully understand what the ECB rate is (I use the term loosely because there are several rates), but clearly it is not what I believed it should be. Quite apart from the dishonesty that occurred in Irish banks and the greed that propelled the escalation of property prices in Ireland and the lack of adequate financial regulation and governance at national and European level, when Ireland needed to borrow in support of the survival of the Irish economy, the European Union did not provide support at an interest rate close to the ECB base rate. Ireland has been forced to pay much higher rates. Moreover, these latterly somewhat reduced, but still damagingly high rates are being used by our strongest EU partners to ‘motivate’ Ireland to comply with their requirements.

The strength of the European Union is, in my view, something that is jointly possessed by the citizens of the member countries of the union. The EU is a huge single market that is inherently large enough and diverse enough to operate independently if ever there is a need to do so and thereby to fully and adequately support its own shared economy. Unfortunately, it has not operated in this way. There has been a clear and very serious lack of leadership and democracy within the EU in recent times. From a citizen’s point of view, when things have become difficult economically, the wealthiest countries in the European Union have stood up for themselves and for their own interests, first and foremost. In its recent difficulties, Ireland has not been supported in the way that it should have been. In fact, the EU as a whole has allowed the ‘markets’ to swallow-up a major part of its own shared wealth. The EU has failed to see the obvious and react to it, to the point that now only Germany appears to be capable of being left standing by the time the markets finish their work. However, I drafted the previous sentence before Wednesday 23rd November 2011. On that day, the financial standing of Germany itself was challenged by the markets, as investors ‘stayed away’ from purchasing German ten-year bonds.

I am not suggesting that the European Union should ignore bad economic management and governance that has occurred within it. Indeed the community as a whole must accept responsibility for poor economic and banking governance at a community level. However, the political structure of the EU has so far proved inadequate to deal with the crisis. The various steps that have and are being taken seem to continue to be too little, too late. On 16th December 2011 Christine Lagarde, the head of the International Monetary Fund, was reported as having said that ‘the European financial crisis is “escalating” and is so serious that it is unlikely to be solved by eurozone countries alone.’ I agree absolutely. Back in September 2011, Barack Obama stated that the financial crisis that Europe was going through was ‘scaring the world.’ The draft new, December 2011, EU fiscal compact entitled ‘International Agreement on a Reinforced Economic Union’ is the most elaborate proposal from the European Union, or a potential subset thereof, to address the issues of the European financial crisis. It does not directly address the matter of how banks could be designed to be capable of failing and of how individual states could be protected from having to ‘underpin’ commercial banks using their entire national wealth, or from having to pay interest rates well in excess of the ECB base rate on their sovereign debt.

I would no longer take it for granted that Ireland will always continue to be a member of the European Union. The world is a small place for communication, transport and trade. Any alliances that Ireland forms need not necessarily be based on adjacency to its economic partners. The citizens of Ireland are facing enormous challenges at the present time and I believe that we are up to meeting them. I am a legal ignoramus, but the draft EU fiscal compact reads to me like something that will require a referendum and my gut feeling is that Ireland’s experience of ‘fairness’ within the EU to this point in time would not justify a ‘yes’ vote. However, the pressure on the Irish electorate is likely to prove overwhelming. It is hard to see how the existing loss of economic sovereignty will not translate into, simply, the loss of our sovereignty. Ireland must be alert to the difficult decisions ahead.

Re-designing banks for success or (very occasional) failure must be part of addressing the eurozone and the worldzone crisis. I strongly believe in market driven incentives for people to work hard and for innovative and dynamic companies to set-up and grow. However, I also believe that there have to be agreed ‘rules of the game.’ Part of the rules must be that banks may occasionally fail, in a relatively orderly way that causes the minimum of unfairness in society. Another part of the rules must be that commercial banks operate within safe parameters and are monitored for compliance. For instance, I always assumed that banks were not permitted to ‘borrow short’ while ‘lending long.’ In purely mathematical terms, to allow banks to engage in speculative activity with the assets of their depositors is a recipe for disaster. It seems this bad recipe was followed by the banking regulators at European and Irish national level and in other parts of the world. The European Union must now use its huge weight and its huge shared wealth and potential to re-design the entire European banking system. Simultaneously the EU must engage with other economic blocks, on a world-wide basis, to secure the world economy from the damage that can be caused if regulation and governance are inadequate to ensure ‘fair play.’

Assertions of a Citizen

There are some matters in relation to which I do not consider myself an ignoramus. I assert the following with confidence. It makes no sense whatsoever to have a large pool of talented persons in Ireland who are willing and able to work, but have no jobs. It makes no sense that there are dynamic companies and prospective companies in Ireland that cannot operate normally, develop or expand because of a dysfunctional banking system. It is grossly unjust that so many talented and highly educated young people of Ireland are being forced to emigrate, in many cases to destinations outside the EU; it makes no sense either, because this is Ireland’s or Europe’s loss. While ‘markets’ that operate freely are probably essential for the economic well-being of the world and for efficient resource management, if the nations of the world do not coordinate themselves, through their leaders, to set appropriate ground rules for the ‘markets’ a type of economic chaos could ensue in which there would be few winners and many losers and whereby there would be an increase rather than a decrease in the prevalence of unfairness distributed over the nations and citizens of the world.

Ultimate and Intermediate Dreams

The European Central Bank, on behalf of all member states of the EU will have to take firm control of European banking. Failure to do so will result in the unregulated world markets taking full control, to the detriment of all the citizens of Europe. My ultimate dream is of a truly democratic ‘World Government’ or ‘World Council’ (perhaps the United Nations) and an associated world bank that will draw-up the rules of play for free world markets and the commercial banks of the world. My intermediate dream is of a democratic European Union and a European Central Bank that act in the interests of all the citizens of the EU, without being subservient mainly to the richest EU countries. In a well managed eurozone there should be no particular need for Irish commercial banks. Most banks would be trans-European.

It is fortunate that I am an economics and political ignoramus, because if I were not, Europe and the whole world could be heading for an ignoramus’s recession, for no good reason.