Professor Patrick Honohan:

It is just six months since I last had an opportunity to engage with the joint committee. On that occasion, my introductory remarks focused on three main areas, namely, the macro-prudential measures on which the Central Bank of Ireland had just published a consultation paper; the transfer of ultimate responsibility for the micro-prudential supervision of the main banks to the single supervisory mechanism of the European Central Bank, which had just taken effect; and the level of mortgage interest rates, which was already attracting increasing attention from the Central Bank given its consumer protection mission.

In the intervening period, as members will be aware, the Central Bank concluded its macro-prudential consultation and introduced the calibrated loan-to-value and loan-to-income restrictions for mortgage lending. We will continue to monitor the impact and effectiveness of these and we are not dissatisfied with subsequent developments in that market.

The European Central Bank's new micro-prudential regime for banks is settling in well. The transition has been smooth, as has been exemplified by the results of the ECB's comprehensive assessment of the banks at entry, which confirmed the merits of the asset quality review previously conducted by the Central Bank of Ireland. The modest additional capital requirement for Permanent TSB, which was triggered by the higher capital standard set in the European Central Bank's comprehensive assessment, has since been raised in the private market.

The concerns I expressed around the standard variable mortgage rate in November last foreshadowed a wider public focus on this issue, reflecting the widening spread between Irish mortgage rates and those in many other parts of the euro area. The Central Bank has conducted a good deal of research on the topic, some of which it had previously published, and a summary of it was included in the document which was prepared at the request of the Minister for Finance and published last week.

Since the crisis, banks' standard variable rates have moved higher than previously, relative to their cost of funds and, arguably, higher than a fair-minded customer might have reasonably expected. While this development was manifest in a number of eurozone countries, the divergence has become particularly large in Ireland. Is this compliant with the contract that the customers signed? Is it consistent with good business practice on the part of the banks for the long-term relationship? Is it good for the overall recovery of the economy on which the banks depend for their long-term success?

Admittedly, it is essential for the survival of banks that they achieve a sufficient return on the investment of funds, including equity, much of which, in our case, is owned by the Government. If not, they will not be able to achieve and maintain the growing requirement for capital adequacy in the years ahead. The profitability goal has to take account of long-term considerations, including the risks involved in lending, especially the actual and prospective losses on non-performing mortgage loans. Nonetheless, I would welcome a reduction in bank standard variable rates in current circumstances as a benefit to the economy at large. If it were not for the firm conviction that the introduction of administrative control on interest rates would be bad for the country as a whole in the medium term, there could be a case for some Government intervention. Why would intervention be bad for the country as a whole in the medium term? The two notable reasons are that it would have a stultifying effect on bank efficiency and a chilling effect on the entry of other banks.

Let me say something about the standard variable rate type of contract, which was the mainstay of Irish mortgage lending for decades. This type of contract had the advantage of being adjustable in response to changing conditions and, as such, insulated the lender from sharp rises in the cost of funding. For example, it avoided the devastating squeeze on profitability that occurred in the United States, resulting in the insolvency of a large part of that country's savings and loans industry in the 1980s. However, the wording of most standard variable rate contracts means that borrowers are vulnerable not only to changing funding costs, as they will recognise when they take out the mortgage, but to many other types of influence which the lender judges to warrant a change in rates.

The standard variable rate was increasingly replaced for new lending by the tracker mortgage, especially in the boom. This much more tightly defined interest rate contract protected the borrower against any interest rate changes other than those occurring to the European Central Bank policy rate. This is a rate at which the ECB lends a small amount of the funds required by euro area banks and which is adjusted to help ensure the ECB meets its monetary policy objectives, principally with regard to inflation in the euro area. Whereas in the pre-crisis period the Irish banks were easily able to secure deposit and bond funding at close to the ECB policy rate, their ability to do so since the crisis has been constrained, to say the least, although it has been improving recently.

Arising from this constraint and inability to fund at close to the ECB policy rate and because the spreads they set above the ECB rate were too low to cover the loan losses that were to come, the tracker contract has been extremely costly for the State and the other shareholders of the banks. For this reason, the banks stopped offering tracker mortgages. Looking to the future, a different or new contractual arrangement that linked the floating rate on new mortgages to actual funding costs of the banks could be designed in such a way as to achieve the original aims of the tracker without retaining the vulnerability of the ECB policy-rate linked tracker. Of course, the spread would have to cover the costs and risks of lending, which includes prospective losses, but such contracts are not currently offered.

Given the wording of the standard variable rate, SVR, contract, I assume that borrowers agreed to those terms largely because they trusted the banks to behave in a fair manner with regard to interest rate adjustments. For decades, it seems that this trust was, by and large, not misplaced. Is this still the case? There is clearly justification for some of the increase that has occurred in the spread, which was too low in the past. Relevant factors include the persistent drag on their viability from the combination of a large tracker book and the fact that funding costs are much higher than the ECB policy rate; the dramatic increase in non-performing mortgage loans and the need there has been to make large provisions against loan losses; and the sharply increased capital requirements on banks. All of these have threatened the viability of mortgage lending for the banks. In a general way, defenders of the banks can point to these factors as providing some justification for higher spreads on standard variable rates. Still, such arguments are rather open-ended and, in the absence of a transparent, clear and quantified policy on the part of the banks, can be seen as excuses for charging whatever the market will bear rather than being a fair application of the contract consistent with a borrower’s reasonable expectation. Under these circumstances, the standard variable rate borrower’s main protection is competition: the fact that, by setting its standard variable rate too high, any bank stands to lose business, whether new business or switchers, to competitors. Whereas this protection was effective before the crisis, the level of competition currently is too low. Ensuring that official policy does not inadvertently deter competition and entry of banks to the market is thus vital for the long-term health not only of banks, but of the economy.

The Central Bank wrote to each of the banks in February to ask for a clear statement of each bank’s pricing behaviour around standard variable rates. In their responses, none of the banks has so far provided what I would regard as a clear and quantified statement of their policy with respect to adjustments of the standard variable interest rate. In my opinion, good business practice of the banks would demand that they make upward adjustments to standard variable rates only following clear and objective changes in prevailing business conditions and not only funding costs. Good practice would also call on them to lower standard variable rates when the same conditions move in the opposite direction. That is the implicit element of the contract. To regain the trust of their customers, the banks should move to publishing a clear and quantified statement of their standard variable interest rate policy. Since they do not seem to have such a policy, they will need to develop one. If necessary, drawing on its legislative powers for consumer protection, the Central Bank will codify such a requirement formally but this should not be necessary. I have spent some time on that contractual issue as it is a dimension that has not been sufficiently discussed.

Insisting on transparency may seem to be an insufficient official response to the manner in which the spread of standard variable rates has drifted up but I would insist on my words of caution against the enacting of legislation that would provide for officially administered lending rates. Nothing could be more likely to curtail and discourage entry of new competitors into Irish banking, and without the possibility of such entry, I cannot see that banking can recover the operational efficiency and competitive pricing that is essential for Ireland in the long run. For the sake of modestly lower SVRs for a few quarters, a much larger and quasi-permanent, albeit somewhat invisible loss, would be incurred by the customers of the banking system in Ireland. Well-capitalised banks operating more competitively will, in the end, offer lower rates and better service. Besides this, close administrative control of interest rates would not be easily compatible with the principle of an open market economy with free competition, which has underpinned the considerable increase in national prosperity over the past half century in Ireland, and which, of course, is enshrined in the European Union treaty. This is not a matter to be taken lightly or opportunistically for what would clearly be at best a transitory advantage.

The health and ability of the banks to contribute to the needed services to the economy certainly requires them to operate on a profitable basis, and only then can they build and hold sufficient capital to be compliant with international regulations, to be fully financially autonomous and not dependent on an implicit backstop of the State, to have the resilience to deal with future shocks and to serve customers properly. Their recent return to profitability is modest and significantly dependent on provision write-backs rather than normal business profitability. I do not want to overstate that, and that should be seen and compared with the provisions that were there before.

The crisis continues to have serious legacy issues that cannot be resolved easily or painlessly. To mention just one example, ensuring that borrowers whose loans have been sold to unregulated firms continue to obtain the consumer protections that they previously had is a concern which the Central Bank has been to the fore in advocating action. I am very glad to see this being reflected in legislation, on which the bank has actively advised, currently being enacted by the Oireachtas. Without detracting from the importance of what I have mostly been addressing today, the appropriate pricing on the SVR loans, I should not conclude without emphasising that delays and uncertainties surrounding the resolution of non-performing loans remain a much more acute problem. The latter problem is one which we have discussed in this committee repeatedly and on which progress remains damagingly slow.