Financial Economics Lecture 15: Governance & Financial Fragility in Ireland

FINANCIAL FRAGILITY IN IRELAND

Dr Stephen Kinsellastephen.kinsella@ul.iestephenkinsella.net

Changes in real GDP for Ireland, 1971–2008. Source: Central Statistics Office, Economic and Social Research Institute, and author's calculations. Note: 2007 and 2008 are estimates.

LAST TIME.Iceland vs. Ireland: History Matters

We’re not like Iceland really: our history is different, so our future will be different

NOW.Corporate Governance & Financial Fragility in Ireland

We should have made the rules tighter years ago.

WHAT I WANT YOU TO LEARN

1.Definition of Governance

2.History of Crises

3.Answer to Question: “Who does and who should regulate banks and financial intermediaries?”

4.History of Governance Structures in Ireland

5.Able to form an opinion about what went wrong wrt regulation.

RECALL:Minsky theory of the credit cycle

cf. Minsky, Stabilising an Unstable Economy, (1986)

MINSKY MOMENTS1.Idea: Credit markets will breed their own reversal

2.How?

1.Cheap interest rates lead to increased lending.

2.This leads to increases in leverage (L/D ratio).

3.Perverse incentives breed dodgy lending via financial innovations (Junk bonds/CDOS) ensues.

4.Something changes, dodgy loans default, banks fail, unless they get bailed out by Big Bank/Big Govt.

CORPORATE GOVERNANCE

WHAT IS GOVERNANCE?

Defini-tion

Governance concerns the exercise of power through policies enacted by self- interested agents working within institutions

ALL THIS HAS HAPPENED BEFORE, AND WILL HAPPEN

AGAIN

Latin American debt crisis of the 1980’s, US stock market crash of 1987,Japanese real estate and stock market crisis (and ensuing

liquidity trap) in the 1990’s, UK housing crash in 1991 and 1992, Mexican Peso crisis of 1994, Long-running Russian crisis of the mid-90s, East-Asian crisis of 1997/8, Bursting of the `dot com’ bubble in the US in 2000, Worldwide recession following the terrorist attacks of 9/11

in 2001, Argentinean currency crisis in 2002, Sub-prime crisis which began in the US in August 2007

Partial list of Crises 1980 - 2008

CAUTIONBanking is risky, must be regulated

BY WHOM?

• Since 2003, Financial Intermediaries licenced licensed in Ireland by the Financial Services Regulatory Authority (FSAI)

“Remit of the FSAI since its inception in May 2003 has been to license, liase with, and monitor the activities of licensed agents in the financial services sector, to ensure they act in the public interest according to legal strictures.”

WHO SHOULD LEND, AND WHY?

Lending by banks, for the most part, should be for productive, profit making activities

It is not clear that the practice of lending for investment in property, based on an expectation of ever-higher price increases in the value of that property, could be considered a productive activity.

It was, instead, a redistributive activity, where the future incomes of borrowers were transferred to the present to finance loans for mortgages on residential and commercial properties.

GOVERNANCE & REMUNERATION

• A Clear Principal-Agent Problem

GOVERNANCE & REMUNERATION

• “...the wave of corporate scandals that began in late 2001 shook confidence in the performance of public company boards and drew attention to potential flaws in their executive compensation packages. There is now recognition that many boards have employed compensation arrangements that do not service shareholders’ interests. But there is still substantial disagreement about the scope of such problems and, not surprisingly, how to address them. “

Bebchuk, L. and Fried, J. Pay without Performance: The Unfulfilled Promise of Executive Compensation, (Harvard University Press, Boston, 2004), p. ix.

US SUBPRIME LOANS

• Issued by FDIC

MINSKY CYCLE

Five stages in Minsky’s model of the credit cycle:

1.displacement,

2.boom,

3.euphoria,

4.profit taking, and

5.panic.

RECOMMENDATIONS FOR REFORM

• Speed up structural change

• Sponsor focused job creation programmes.

• Nationalise wayward Irish banks.

• Foster less procyclical leveraging

• Transparency.

NEXT TIME

• The European Central Bank & Investor Behaviour. Reading: Buiter, W: Why the United Kingdom Should Join the Eurozone