Professor Gregory Connor:

I thank the committee for inviting me. I have your thoughtful list of suggested topics on bank funding and the Irish banking crisis. Let me start with a key point. An enormous uncontrolled flow of foreign debt capital into the Irish domestic banking system is the key cause of the Irish financial crisis. Obviously, there are other secondary causes, but the basic and most fundamental cause of the Irish economic crisis was a poorly controlled very large inflow of foreign debt capital into the commercial banks of Ireland.

This foreign debt capital flow had two effects. One, it created unstable debt levels throughout the economy but, two, it acted as a Keynesian stimulus to the economy - it raised incomes, production costs, wages and tax revenues. That increase in tax revenues then led to an increase in Government spending. When we think about the fiscal calamity that hit Ireland after the banking bust, it was directly and indirectly caused by this foreign debt capital inflow. It was directly caused through the big costs of the bank bailout but also indirectly, because one had a sudden stop to the Keynesian stimulus from foreign debt funding and this fed disastrously into private and Government spending, so there was a sudden stop - basically a Keynesian effect.

From a global perspective, people often say this Irish banking crisis is unprecedented but it is not really unprecedented. Economists talk about what they call "a capital bonanza", which is a large flow of capital, equity or debt, into a national economy. Often if there is a regulatory policy or business failure or some combination, capital bonanzas lead to financial bubbles, followed by busts. This is what happened in Ireland. There were policy, business and regulatory failures and there was an enormous capital bonanza, financial bubble and bust, so it is not really unprecedented.

Where did the capital come from? In the early years of this century, there was a global tidal wave of liquidity across developed markets. We were aware of this at the time and people used that phrase "global tidal wave of liquidity". It was a period called the great moderation, which lasted about 20 years. If one looks across countries in the developed world and through time, there was fairly stable economic growth and people said this is a new paradigm, the business cycle is solved, we have new institutions, we have new technologies and there is going to be stable growth. It was just a tidal wave of liquidity across markets.

All developed markets were hit by the great recession which followed the US credit liquidity crisis of 2008 but only a handful, including the USA, Greece, Iceland and Ireland, had identifiably distinct credit bubbles and busts. If one looks at Iceland, its credit bubble and bust has a lot of parallels to Ireland. It too had excessive foreign debt capital into its banking system as the main cause of its credit bubble and bust. Another parallel, which I think has been underappreciated, was the very poor prudential oversight of the Icelandic Central Bank during their credit bubble.

If we turn briefly to Greece, their credit bubble and bust was very different. There, the same global tidal wave of liquidity did not go into the banking system but it went directly into Government borrowing, which was hidden in various ways, including with some complicity by the banking system and the international investment banks, in particular. It was a different source of capital, but again a credit bubble and bust in Greece.

A key objective of Economic and Monetary Union was to allow free capital flows across member states. That was considered one of the great advantages of EMU - that we were going to have funds flowing quickly into high funding cost states, like Ireland, from low funding cost states, like France and Germany. This worked, in fact, one could say one of the big causes of the Irish crisis was that this EMU mechanism worked too well. That was a deep clear flaw in the EMU system, and the economics profession shares some blame for that. We underappreciated the instability which would be caused by allowing very free capital flows across member states. That was an error in the design of EMU by the economics profession. Partly because of the political enthusiasm, which many of us share for EMU, we overlooked the problems - both in the economics and the policy world.

JK Galbraith said that one of the advantages of being an economist is that the more one messes up, the more they need one. There has certainly been a great deal of work to try to correct that EMU flaw but I do not think it has been fully corrected.

Let me turn to funding and capital risk at the Irish banks as the committee requested. The source of the funding is straightforward. During this period, German and French banks had more deposits than they could profitably use at home so they moved funds to a growing economy with high rated banks and no exchange rate risk, Ireland in particular, as well as others. Three main vehicles were used for the funding, namely, the interbank borrowing market, bond issuance by Irish banks and direct deposits by foreign financial institutions and corporations into Irish banks. In terms of the size of the funding, I said it was massive. The net foreign liability of the Irish domestic banking sector in early 2003 was €29 billion. This grew over the next five and a half years by 449% to €158 billion in 2008. The net foreign borrowing ratio to GDP was 88% in the third quarter of 2008, which was massive. That was a very large and very risky overhang of foreign debt. In fact, if one thinks about some of the early macroeconomist discussion and talk about the Irish debt ratio, or Government debt, one has to think about the 88% that the banks owed to foreigners. It was very unstable, hidden borrowing. The risk from this was amplified for property development lending which grew from €21 billion in early 2003 by 524% to €133 billion in late 2008. It was an enormous growth in what is one of the riskiest classes of bank borrowing. It is much riskier than mortgages and much less diversified than SME lending. This is a very narrow concentrated lending growing by 524% over five and a quarter years.

The Irish Central Bank and the Financial Regulator should have blocked the enormous debt capital inflow and should have blocked the too fast growth in property development lending. If they had done either of those things, the Irish banking crisis would not have happened. They should have done both. There was a massive failure by the Irish Central Bank and Financial Regulator in not blocking both of these. I do not blame the crisis entirely on them, however. Economists were mistaken also. Globally, there was an overly complacent attitude toward the risk of a banking crisis in developed markets. We had not had one in 50 years in many countries and were too complacent. There were also big errors in bank risk and liquidity regulation, in particular the level of bank equity capital was much too low. The definition relied too much on tier 2 equity, which is only available when a bank is no longer a going concern. It does not provide a buffer to a going concern bank. It provides a buffer to a bank which is being restructured. Relying on that was a big error. That interacted with a misunderstanding of the big risk of systemic liquidity problems in the banking sector. That was also missed. As such, the economists share some blame.

A solvent commercial bank has a backstop in the case of a serious liquidity problem. It can use its long-term assets as collateral. Central banks stand ready as lenders of last resort to provide funding to banks. In the case of the eurozone, this failed because the ECB had very strict rules. It could only lend for good collateral to solvent banks. This dichotomy between the lender of last resort function and the problem with insolvent bank restructuring was very problematic. The ECB's attitude was that it was in its charter that it would only lend to solvent banks for good collateral and that what happened where a bank was distressed was someone else's problem, namely, a national problem. That was a big issue and a major difficulty. Another problem of course was that, along with many other European countries, Ireland did not have an effective, quick bank resolution mechanism at that point.

The committee has asked me to address how interbank competition increased risk taking. Here I want to differentiate between blame and causes. In terms of risk taking by Irish bank managers, they are to blame for what they knew in many cases was overly risky lending. Many people in the industry knew that what they were doing was too risky. However, in terms of causes, there was a rivalrous environment from the maverick banks, particularly Anglo and Irish Nationwide, which increased risk levels and then pulled in the other banks. Irish shareholders were also leading this. They were forcing the banks to adopt more aggressive strategies. As such, the shareholders also contributed to this pulling of the strategies to be too risky. That is in terms of causation. In terms of blame, the bank managers who knew they were taking too much risk are to blame. In terms of causation, that was deeper. Without the control from the Financial Regulator and the Central Bank, it was very difficult in this environment to avoid the banks being pulled into this ethically wrong strategy.

I turn now to the capital outflows from Irish banks and the liability guarantee. The problems with refunding in the banks really started in August 2007 with the early stages of the crisis. Over the whole next year, the ability of various banks to access the three main vehicles became increasingly difficult. A global credit liquidity freeze hit after the bankruptcy of Lehman Brothers in mid-September 2008. There also had developed institutional bank runs, particularly in the USA, but spreading to some of the maverick banks in Ireland during October 2008. There were liquidity problems in the system at this point. They played a central role in the 2008 US crisis in that month. The US crisis is correctly termed a credit liquidity crisis. Ireland did not have a liquidity crisis, it had a bank credit crisis. It received €136 billion in liquidity support at peak from the ECB and Irish Central Bank. That was more than enough liquidity support. Ireland did not suffer a liquidity crisis, it suffered a bank insolvency crisis. The ECB began providing liquidity funding to the Irish banks in early 2008 and the funding amount rose sharply. The ECB began to question under its charter whether it was providing liquidity support or risky capital infusion, which it felt it could not do. In my judgment, in fact, some of the liquidity support provided under ELA was risky capital. It did not really meet the ECB claim that it was liquidity support only.

With hindsight, the domestic banking system's aggregate balance sheet was actually insolvent in September 2008. There was a claim at that point of €43 billion tier 1 and tier 2 equity but bank accounting statements even relative to other corporate sectors greatly lagged the reality. They presented a very lagged picture of reality as Professor Honohan noted earlier. The Government in fact injected €64 billion into these banks, after which the banks only had tier 1 equity of €13 billion. That is a minus of €51 billion somewhere. The banking system aggregate balance sheet was insolvent in September 2008. In September 2008, the Irish Government provided a blanket liability guarantee to an insolvent banking sector. It was a very costly error. There are three caveats to muddy the picture. First, the lender of last resort function of the ECB was not working properly. The liability guarantee was partly intended to allow access to this very flawed funding function from the ECB. Second, the guidance provided to the Government by the Irish Central Bank and Financial Regulator was poor. Third, the information provided by some of the banks may have been embellished deliberately to disguise their real capital positions. Those are my comments. I thank the committee for listening.