1. Irish Economy Conference, Dublin, Jan 31st 2014 A Banking System for Economic Recovery Colm McCarthy

2. Signs of Recovery  Employment data is improving  External environment, especially outside the Eurozone, is better  But there is still no hard evidence of a broad-based recovery.

3. The L-Shaped ‘Recovery’

4. Macro Prospects……..  Sharp decline in activity seems to be over  Fiscal stance remains deflationary, credit availability weak  Through 2014 and 2015, nominal GDP unlikely to grow more than 4% per annum (CB Forecast)  While a recovery from 2014 is plausible, there is a clear debt sustainability problem

5. Domestic Demand Prospects  Since Ireland must run a BOP surplus for many years to come, domestic demand must be restrained.  This means consumption and fixed capital formation cannot grow too quickly.  Growth needs to be mainly export-driven.

6. What Infrastructure Deficit?

7. The Banking System  Domestic banks have closed, foreign banks have withdrawn  Balance sheet contraction continues  But the three ‘guaranteed’ banks still had consolidated assets > 200% of GNP in mid-2013

8. Housing Finance  At bubble peak in 2006, mortgage lending for house purchase reached €28 billion.  In 2013 below €3 billion.  25 - 30K houses needs €8 billion, or more  At the end of a bust, credit requirements for asset transfers are additional.

9. The Contingent Liability  There will be no centralised Eurozone backstop for bank resolution, so the liability remains national.  No centralised deposit insurance means national liability for deposits in foreign- owned banks too?  Does sovereign sustainability require further bank balance sheet contraction?

10. Other Credit Demands  Finance also needed for inventory re-build, trade credit, working capital, dairy herd expansion.  Multinationals, large Irish companies, semi-states, have external credit access  Households and SMEs are captive.

11. Bank of Ireland  Assets 98% of GNP  Leverage 17  If further 5% of loans lost, leverage = 42  Price-to-Book 105%  Mortgages + property = 73% of all loans, 52% of all assets  Loan to deposits = 121%

12. AIB  Assets 88% of GNP  Leverage 11  If further 5% of loans lost, leverage = 16  Price-to-Book 684%!!!!!!  Mortgages + Property = 73% of all loans, 42% of all assets  Loan to deposits 106%

13. PTSB  Assets 28% of GNP  Leverage 15  If further 5% of loans lost, leverage = 37  Price-to-Book 127%  Mortgages + Property = 99% of all loans, 78% of all assets  Loan to deposits 157%

14. Not a New Problem….  ‘The banking system is heavily exposed: the big Irish banks, such as Bank of Ireland and Allied Irish, are in effect mortgage banks, observes Colm McCarthy of DKM Economic Consultants. A property crash would badly hit their balance sheets.’  The Economist, October 2004

15. Clearing or Mortgage Banks?  Until the mid-1980s, the Irish clearing banks did not carry large mortgage books. The asset duration mismatch was seen as unsuitable for deposit-funded institutions.  Mortgages were extended by specialist and tax-privileged building societies.  There are no more building societies, and credit unions are not a replacement

16. How to Fund Housing?  Bank balance sheets need less, not more, long-duration mismatches.  Covered bonds are not the answer, since they leave the liability with the bank, whatever the accounting treatment.  If a major increase in mortgage lending is needed, mortgage-backed securities in an originate-and-distribute model is better.

17. Banks and SMEs  Deposit-funded banks are a suitable vehicle for SME finance (not for equity!).  And paradoxically for builders/developers.  Bigger firms, and some medium-sized firms, will increasingly be accommodated via securities markets, and foreign banks.