Credit Bubbles and Regulators: The Irish Case Study

The Irish Times ran an interesting article on credit bubbles and the role of regulators.  The article focused on Ireland.

Credit bubbles occur frequently around the world and the conditions which might give rise to bubbles are common. But not all incipient bubbles turn into real ones, and hardly any into the super-bubble Ireland experienced. The essential pre-condition for a credit bubble is a period of decent economic growth and a general improvement in business and consumer confidence. 

Just about every economy in the world, apart from North Korea, experiences conditions like these from time to time. But the enhanced willingness to borrow usually runs into an unwillingness to lend, and the baby bubble gets snuffed out. The unwillingness to lend can come from the banks themselves or, failing that, from the regulators.

Or the unwillingness to lend can come from the capital markets.  Since a sizable percentage of the loans originated by banks are distributed, either through covered bonds or structured finance securities, investors also have an ability to restrain lending.  Faced with a growing bubble, they could elect not to invest.  As a result, the banks would not have access to the funds to lend out and this would snuff out lending.

If the banks are able and willing to lend into the bubble, and the regulators are complacent, the incipient bubble turns into a real one.

And investors are willing to invest.

It is unusual for an incipient bubble to be halted through the exercise of self-discipline by borrowers, of which there tends to be a plentiful supply in any buoyant economy. 

The first line of defence against excessive credit growth is thus the commercial banking system itself. Banks are not providers of risk capital, which is the business of equity markets. They concentrate instead on well-secured lending designed to deliver low incidence of non-recovery. 

The dull, boring, sceptical bank manager is a socially necessary institution. Should the banks depart from this under-appreciated stereotype, the second line of defence is the regulatory and supervisory system, which has plentiful instruments at its disposal to deflate the bubble. 

As readers of this blog know, your humble blogger believes that with disclosure of all the useful, relevant information in an appropriate, timely manner, market participants, like investors, are the real second line of defense.

Market participants can exert discipline directly on the firms that are originating or heavily invested in lending into the bubble.  With all the useful, relevant data, market participants can analyze the risk and adjust the amount and pricing of any exposure to both the firms that originate and invest in the lending into the bubble as well as the loans themselves.

If both of these lines of defence fail, there will be trouble in the form of failing banks and the final resort is to the taxpayers and their representatives in government. 

The role of finance ministries in banking crises is a fire-brigade function. In Ireland, the first line of defence, the banks, crumbled across the line. Virtually every bank lost its entire capital, with the worst ones losing large multiples of their capital. Several appear to have lost one-half of all the loans they had made, equivalent to eight or 10 times their capital. 

The second line of defence, the Central Bank and Financial Regulator, failed to respond adequately.

The fire brigade arrived late, and has expended prodigious sums without fixing the problem.

100% of the time, if the regulators fail, the taxpayer have to pay the cost of their failure.  Therefore, the taxpayers' goal is to take every reasonable, prudent action to reduce the chances or eliminate the possibility of the regulators failing.

The current problem with the regulators having a monopoly on all the useful, relevant information on financial institutions is that it sets up the situation where it is much more likely they will fail and the taxpayers will have to bail them out.

This occurs because the information monopoly means that the market cannot intervene first and save the regulators from failure by exerting market discipline.

Getting the regulators to give up their informational monopoly will be a difficult task.

As has happened after every crisis, the regulators promise to do the job of keeping the banks solvent better.  The example from the current crisis of the regulators doing this job better is stress tests.  Regulators cannot wait to tell the financial markets about these tests and how it shows that the regulators are on top of what is happening at the financial institutions.  The only individuals who believe a once per year test where the results are known in advance, see previous discussion that JP Morgan would be allowed to resume paying dividends, proves the regulators are doing their job better are the regulators.

Stress tests are emblematic of how much effort regulators will put into preserving their informational monopoly.  Regulators are in pursuit of a mythical middle ground between full disclosure of the current asset and liability-level data and the current status of no disclosure.  With the stress tests, the regulators are claiming they have reached the mythical middle ground and are providing the market with the information it needs to exert market discipline.

As has been previously discussed on this blog, all stress tests do is reinforce the financial market's perception that the regulators are still practicing "see no evil" supervision of their banking "clients" and taxpayers are going to continue to pay the cost of their most recent failure.

This is the only possible conclusion because the regulators refuse to disclose the data necessary so that financial market participants could run the tests for themselves and prove or disprove the regulators' conclusions.  Absent this current asset and liability-level disclosure, all regulators are doing is maximizing the chances of failure in the financial system.