Professor Patrick Honohan:

Thank you very much, a Chathaoirligh. In my letter of 12 February, I sought to clarify parts of my evidence to the inquiry on 15 January. I have prepared these short introductory remarks on the presumption that the inquiry has invited me back on this occasion to amplify my views on the alternative courses of action that might have been taken by the Government at the end of September 2008. Perhaps I should recall explicitly that I myself had no involvement in the guarantee decision, so my views are based on what I learnt from preparing my May 2010 Report on Regulatory and Financial Stability Policy, as well as on many conversations with other experts and on my general knowledge of banking crises in other countries.

I will start with a critique of the decisions of end-September 2008. There are several features of the decisions at end-September that can be criticised even allowing for the limited information then available to the decision makers. The first was the guaranteeing of some of the subordinated debt. Providing an explicit guarantee to subordinated debt holders is not only potentially costly to the State, but undermines the rationale for allowing banks to meet part of their regulatory capital with subordinated debt. This was a definite design flaw in my opinion. True, thanks to steps subsequently taken, the payout to subordinated debt holders of Anglo in the end was a small proportion of the total fiscal cost; however, that payout was not negligible.

The second was guaranteeing existing outstanding debt, namely, senior bonds and term deposits, was not necessary to underpin the banks' continuing access to funds. Nor did the government guarantees introduced by other countries in 2008 offer any significant backward-looking protection in this way. It is true that imposing losses on such bondholders would have had a damaging reputational effect on Ireland as a whole, as well as impacting local holders of such bonds; but that is a different question. The decision to impose such losses could not have been lightly taken; but offering a pre-emptive guarantee on already outstanding or what I call "old" debt ahead of a full assessment of what it might cost was essentially gratuitous. Furthermore, because much of this debt entitled the holders to immediate accelerated repayment in what is called "an event of default", the Government was effectively precluded from liquidating or extensively restructuring the guaranteed institutions because it would have to repay the guaranteed debt forthwith, which it would have been unable to do because of the sums being so large. This effectively postponed the drastic restructuring action that was needed until the end of the initial guarantee period, by which time the Government's entry into the EU-IMF programme was actually imminent.

The third was failure to consult. The Irish decision to provide a blanket guarantee without prior consultation triggered immense pressure for guarantees all over Europe. Other governments resented the Irish action and this has made it difficult for the Government to make its case for burden sharing with Europe.

The fourth was the failure to seize immediate control over the management of Anglo Irish Bank. It should be assumed that the existing management of a bank whose business model has lost the confidence of the market and which has run out of cash has neither the expertise nor the incentive to recover the situation safely. The public authorities should have intervened immediately to take control of the bank, for which nationalisation was the available tool in Ireland. Fortunately, nationalisation did follow in January 2009 without evident value destruction having taken place in the intervening period.

How much does this matter? Having made these criticisms, it is important to keep the scale in perspective. The decisions on the night of the guarantee had consequences for Ireland but there has been a tendency to overstate the extent of the impact of that night's decisions on the subsequent welfare of the nation. It would be hard to deny that most of the overall hardship that followed the bursting of the bubble was already inescapably embedded in the situation. I will be put a number on this because quantification is important. While it is not a precise figure, I would hazard that at least between 80% and 90% of the overall hardship was already inescapably embedded in the situation, albeit unbeknownst to the decision makers that night.

The damage had been made unavoidable by the unrestrained credit and property boom. The fiscal austerity measures that had to be taken were not just due to the €40 billion or so in additional net debt that can be linked to the guarantee, which I mentioned the last time I came before the committee, but also reflect the far larger impact of the ending of the construction boom on the Government's tax revenue and spending needs. The fiscal costs are only one aspect of the total damage to Ireland.

In my letter to the inquiry of 12 February, I distinguished between a hypothetical hindsight scenario in which the Government would have been convincingly advised of the actual likely magnitude of the cost of a guarantee and the actual scenario with only the information available at the time. In the actual case, the Government had no information at hand indicating that any of the banks were about to experience losses far in excess of their capital reserves. What I have suggested as the best course of action, given the lack of such information in scenario 2, namely, buying time for negotiation with partners, seizing control over the two failing banks and limiting the scope of the guarantee, could hardly, unless the negotiations had proved remarkably successful, have reduced the direct fiscal bill by more than a few billion euro. While this is not an insignificant sum, it is a fraction of the actual damage.

The alternative under the hindsight scenario of bailing in some of the bondholders and depositors of Anglo Irish Bank and INBS would have imposed additional disruption to economic activity and capital formation, which would have offset much of the savings to the State from not paying the creditors. This point is made in the report of May 2010. I conclude that the need for austerity measures - the scale of tax increases and expenditure reductions that have proved necessary since - could have been reduced somewhat but not all that much by anything done at the end of September 2008.

It is important to maintain perspective and I would like to bring to your attention and call to mind some points of balance and perspective. First, as I remarked recently in an article in a newspaper, the boom and bust both damaged our economy. The boom and the decisions taken during it meant Ireland had to adjust down from living standards that could never have been sustained, with sizeable and capricious shifts in the distribution of wealth.

Second, the style of banking in Ireland, its regulation and broader economic policy were strongly influenced by comparable styles adopted at that time in countries often used as exemplars for Irish decision makers, in particular the United States and United Kingdom. This was not a solo run but the scale of the excesses in Ireland put its banking crisis in a different league, although they were not as bad as in Iceland.

The third point of balance is that the extent and nature of the guarantee decision frustrated subsequent efforts to minimise the costs and speed the recovery. However, the bulk of these costs could not have been avoided by a different course of action on the night of the guarantee.