Open Dissent (5 page)

Paulson has had time to reflect on what lessons were learned that could help the US avoid a recurrence of such a disaster in the future. His reflections on his experiences in 2007−2008 led him to lay out the following principles,
¹¹
which are equally applicable to the Irish market:

The structural economic imbalances among the major economies of the world that led to massive cross-border capital flows are an important source of the justly criticised excesses in their financial system
. These imbalances lay at the root of the crisis. Simply put, in the United States we save much less than we consume. This forces us to borrow large amounts of money from oilexporting countries or from Asian nations, like China and Japan, with high saving rates and low shares of domestic consumption. The crisis has abated, but these imbalances persist and must be addressed.

Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age
. It is rife with duplication, gaping holes and counterproductive competition among regulators. The system hasn't kept pace with financial innovation and needs to be fixed so that we have the capacity and the authority to respond to constantly evolving global capital markets.

The financial system contained far too much leverage, as evidenced by inadequate cushions of both capital and liquidity. Much of the leverage was imbedded in largely opaque, complex financial products
. Today it is generally understood that banks and investment banks in the US, Europe, and the rest of the world did not have enough capital. Less well understood is the important role that liquidity needs to play in bolstering the safety and stability of banks. The credit crisis exposed widespread reliance on poorer liquidity practices, notably a dependence on unstable short-term funding. Financial institutions that rely heavily on short-term borrowings need to have plenty of cash on hand for bad times. And many didn't. Inadequate liquidity cushions, I believe, were a bigger problem than inadequate capital levels.

The largest financial institutions are so big and complex that they pose a dangerously large risk
. Today the top 10 financial institutions in the US hold close to 60 per cent of the national financial assets, up from 10 per cent in 1990. This dramatic concentration, coupled with much greater interconnectedness, means that the failure of any of a few very large institutions can take down a big part of the system and, in domino fashion, topple the rest. The concept of ‘too big to fail'
¹²
has moved from the academic literature to reality and must be addressed.

When President Obama took office in January 2009, he was able to look back at a financial landscape strewn with eight
major institutions,
¹³
now no longer in existence, that had once formed the bedrock of US financial services, and the five major investment banks that had either been taken over, had gone bankrupt or had become bank holding companies. The measures taken by the previous administration were decisive, which may have been the salvation of the global financial markets. President Obama sought the assistance of Paul Volcker, who introduced what is described as the Volcker Rule, a proposal to limit the size of financial firms and to stop the risky activities of banks.

On 25 June 2010, the Dodd–Frank Bill, which implements most of the proposals put forward by Volcker, was agreed by Congress and was subsequently passed in July 2010. Most people in the marketplace refer to the Dodd–Frank Wall Street Reform and Consumer Protection Act as a reintroduction of the Glass–Steagall Act or a facsimile thereof, because ultimately it separates and limits the activities of banks. The Act makes broad changes to the existing regulatory structure, streamlining it and creating new regulatory agencies. The object of the Act is to address and eliminate the loopholes that led to the economic crisis and to protect the economy, investors, businesses and the taxpayer. The Act ends the bailout of financial institutions by the taxpayer.

Among other restrictions, the Act prevents banks that have a direct or indirect relationship with a hedge fund or private equity fund from entering a transaction with the fund without disclosing the full extent of the relationship to the regulating entity. It also puts limits on the activities and transactions that may be conducted by non-bank
financial companies. The Act explicitly limits the largest financial companies in terms of growth by acquisition. No financial company will be permitted to merge with another company if the total consolidated liabilities of the combined company would exceed 10 per cent of the total liabilities of the financial system. This changes the emphasis from deposits to total liabilities, which acknowledges other sources of funding used by the market.

The Act's restrictions on some types of proprietary trading by banking firms may lead banks to reconsider their status. Under the bailout of the US financial system on 22 September 2008, investment banks Goldman Sachs and Morgan Stanley became bank holding companies. The benefits associated with proprietary trading has greater relevance to Goldman Sachs than Morgan Stanley with regard to their respective operating performances. Today, Morgan Stanley has moved away from proprietary trading as a main activity in its business model. The Act may be the catalyst for Goldman Sachs to consider going back to its roots as a private partnership.

The aftershock of the liquidity crisis of 2008−2009 continues to be felt today. It is comforting for some to believe that the liquidity crisis that had its roots in the US financial system and that spread across the world with speed was at the heart of the Irish banking meltdown. There is no doubt that when confidence is lost in banking, liquidity dries up immediately. Ask any businessperson today how difficult it is to get liquidity for his or her small or medium enterprise
(SME). However, as mentioned, we cannot blame the global crisis for what happened and is still happening in Ireland. The effects of the liquidity crisis in Ireland may well be a continued downward spiral in property prices and a prolonged period of deflation. Our international reputation, earned and built over a sixteen-year period and that saw us reach the highest levels of credit ratings in the world, has been swiftly reversed.

Very powerful people all over the world sang the praises of the Celtic Tiger. We had achieved the status of ‘most enviable nation' for the speed at which we moved from stagnancy to prosperity. The economic miracle that was created and that flourished for sixteen years earned respect and admiration throughout the financial world. Many cynics would have us believe that we were blessed with massive investments from Europe, without which we would not have succeeded. True or false, we invested and managed these funds to the betterment of our society. The reputation that we earned was that of an educated, hard-working, energetic, innovative workforce. Circumstances have tarnished this image but it is in our own hands to use these qualities to drive our recovery. Through various government bodies, the Industrial Development Agency (IDA), Enterprise Ireland and others, we managed to catch wave after wave in the changing economic world through intelligent planning and execution of such plans. We can do it again, but we need the leaders in all areas of our society working together to achieve a common goal − recovery.

Paying the piper in the financial markets has been almost instant, but our decision-making abilities often lag behind. As the Government continues to drip feed bad news about future tax cuts sprinkled with hopeful messages about a jobless recovery, one must really wonder what our leaders are about, and if we have any alternatives. The Americans were able to make their decisions quickly, which saved their country and, in turn, the global financial markets. Whether these actions will lead to a deferred double dip in the economy, only time will tell. Forecasting is better left to meteorologists.

It was old-fashioned teamwork that enabled the recession-damaged Swedish economy to recover in the 1990s as all parties put the good of the country ahead of political parties or personal agendas (see
Chapter 7
). The concept of working together is not ingrained in the culture of politics and public service in this country. The key parties to our crisis are bankers, developers, regulators, politicians and civil servants. If they believe they can create a long-term solution to our country's economic problems without talking to one another, they are sadly mistaken. Too often the political agenda is put forward as a reason for the various parties not consulting one another. The somewhat dictatorial attitude of the Department of Finance and its colleagues in NAMA needs to be questioned and reined in. They do not have the experience or wit to create solutions that will re-instill confidence and trust in Ireland's commercial market. The need for a collaborative approach between key parties – bankers, developers and NAMA − is essential to see us out of this crisis.

On 10 December 2007 I visited the Governor of the Central Bank of Ireland in the presence of the two executive directors who were responsible for the issuance of the Financial Stability Report that had been published a few weeks earlier. I had come to discuss this report. All EU nations provide a status report annually for the European Central Bank (ECB), which in turn is consolidated into an EU report. As each country focuses on the strengths and challenges in their domestic financial market, any weaknesses can be subsequently addressed with or without input from Europe. In their Financial Stability Report of November 2007, the Central Bank of Ireland recognised liquidity and the credit crunch as market concerns that required observation. The outcome of the meeting on 10 December was simple and reassuring – we were in for a ‘soft landing'. I dissented and I expressed myself accordingly.

On 30 January 2008 the Central Bank of Ireland presented its Financial Stability Report to the Oireachtas.
During this presentation the twin challenges of liquidity and the credit crunch were addressed. However, in conclusion, the report and the Governor made the judgment that the country was in for a soft landing and that we did not have to worry. On 29 September 2008, some eight months later, all the debts of the Irish banking system were guaranteed by the Government to prevent the genuine threat of a meltdown of the Irish banking system.

One week earlier, and following on from the meeting of December 2007, I wrote the following letter to Governor Hurley. The letter indicates the level of my anxiety and concern in 2007−2008 over the deterioration of the financial markets. In fairness to the Governor, the pressurised environment at that time left him little opportunity to respond to my concerns.

22 September 2008

Central Bank and Financial Services
    Authority of Ireland
Dame Street
Dublin 2

Re: Market Stability

Dear Governor,

Since we met in December 2007 I have given considerable and continual thought to the stability of the financial markets and the many causes behind our present situation. My worst fears were realised this morning with the news of the two remaining US investment banks (Goldman Sachs and Morgan Stanley) being authorised to become bank holding companies. This, I believe, is truly the worst thing to happen to the financial markets.

Investment banks traditionally deal with investors and have done so since the early 1900s under the adage
caveat emptor
. This implies very clearly that the informed investor is aware of the risks their money is being used for. The [retail] banks, on the other hand, have for a long time dealt with depositors' money with due consideration of their fiduciary responsibilities to this constituency. I don't have to tell you or anyone within the bank that the primary reason for the regulatory framework in relation to banking is to ensure that depositors' money is protected and the payment system safeguarded.

Investment banks, in my belief, have not had a culture of concern for their investors (as reflected in the recent turmoil) other than an attitude that could be reflected in the following – ‘When we bring you a deal there are risks attached and both of us share in these on an equity basis.'

Letting the investment banks into the preserve of bank holding companies with the right to attract depositors' money is akin to letting the fox into the hen house to arrange its next meal! This recent proposal from Mr Hank Paulson to ensure the liquidity of the investment banks is perceived not to be impaired, in fact puts the fate of the depositors at risk. Somehow, to achieve stability in the market, there is a perception being created that, with having the ex-investment banks now regulated as bank holding companies, our worst fears of a meltdown will be avoided. I believe these actions simply give us a deferment of a problem rather than a solution.

If regulation is required to control the activities of the banking community then the unpalatable but possibly more attractive solution would be the reintroduction of the Glass–Steagall Act. The dilution of this Act during the 1980s and 1990s, which led to the repeal of the Act in 1999, in my judgment, has been at the heart of the current turmoil in the marketplace.

As you may recall in our conversation last December, I mentioned that the liquidity crisis and the credit crunch were symptoms and not the principal illness that we were experiencing. I have contended for some time that the real problem has been the intrusion of the investment banks into the traditional
banking marketplace. They achieve this through the creation of sophisticated, highly engineered products, which were very highly leveraged while being made to look attractive to mortgagees on the one hand, and to investors and depositors on the other. The lack of confidence that has grown out of these products has led to the consequent liquidity and credit problems. The current situation appears to have a lot in common with 1929−33. Unfortunately I think we are only, in relative terms, in 1931 ... a couple of years to go!