AIB Mending the Cracks

“AIB is facing a period of majority state ownership. The trick is to change its dominant culture and craft a new bank that acts in the best interests of all its stakeholders” writes Bill Hobbs

How AIB’s newly appointed senior managers unwind its aggressive business model and build a safer bank is key to its future as an independent bank. It is facing a period of majority state ownership and could be forced to divest itself of its international business in return for billions in state aid.

By making credit available to people and business, who make effective use of it, banks are central to what makes modern consumer economies and wider society thrive. It’s why banks are special and why they are regulated as public interest bodies. Without careful and prudent bank managers keeping a weather eye out for risks, a boom to bust credit fuelled economic cycle happens, as it has here.
Good bank managers should act responsibly in the best interests of all stakeholders and not solely in the narrow shareholder interest. Banking goes badly wrong when its managers use their power and influence to manipulate banking assets for short term gain and reward. It goes spectacularly wrong if they trade off their banks’ “too big to fail” status and take excessive risks, gambling that Government will always step into bail them out.

Moral hazard is the term used to explain this phenomenon. Governments and regulators are supposed to police and protect society from moral hazard risk. Bank managers should be constrained by public policy and regulations that inhibit their ability to destroy money and consequently undermine economic and social well being.
Banks are not inanimate objects that exist in parallel with the real world. They are business organisations of groups of people who act and behave according to norms they establish to get work done. They are led by small groups of powerful influential executives whose personal interests are aligned with shareholder interests. Bad banking happens when senior executives act irrationally and myopically to maximise short term gain at the expense of long term viability.
There are or course many fine people working in Irish banking who truly believe in prudent management. But if the dominant senior managers behaviours and values encourage excessive risk taking and insist on blind loyalty then bad things happen. Bad banking happens when good people remain silent and are manipulated and at times intimidated into acting out the designs of senior executives and their overseer boards.
Much has been written of the need to change banking culture or “the way things are done around here”. But changing culture isn’t easy. It takes authentic leadership and effective management to turn large organisations of thousands of people around. Unwinding from excessive risk taking embedded in “the way things are done around here” cannot be accomplished overnight.
This is the task of AIB’s leadership, both of its board and senior management team. But the jury is out on whether this aggressive, profit maximising, banking leopard can truly change its spots. AIB has a rich history where its private interests have collided with the public interest, stemming from a time when its senior executives learned how to leverage off it’s “too big to fail” status. Twenty years ago AIB management’s foray into insurance almost ruined the Irish banking system. Government stepped in and bailed it out by taking over the Insurance Corporation of Ireland and in the process burned up the states foreign currency reserves to support the Irish banking system.
Today AIB’s insistence on its absolute right to trade without due regard for public interest is seen within its arrogant rejection of a dire need for state aid and in subsequent behaviour during the process of appointing an insider as its most senior employee. While Bank of Ireland experienced flak for its own internal appointment, it has not engaged in protracted altercation with Government. Perhaps we are seeing the contrast between Bank of Ireland’s long experience of carefully aligning its interests with the State and AIB’s mercantile banking culture with its ambition to become an international bank headquartered in Ireland.
All organisations have a positive core – something they do well that forms the basis for their success. When things go badly wrong as they have for AIB, learning how to move on is as important as acting it out. The danger is that that internal change becomes a negative force intimidating people to fit the designs of those who continue to be wedded to the way things were done in the past.
Should its managers use the same forceful aggressive style that gave rise to the way things were done, then AIB may not change its ways. The trick for AIB is to change its dominant culture and craft a new bank that acts in the best interests of all its stakeholders – and gets good credit flowing again. Unfortunately bank managers are not known for their leadership ability – they may be good managers but can be extremely poor leaders.

Consumer protection agency must go hand on hand with bank regulation

“For too long policy has concentrated on regulating banks but consumers need protection too, writes Bill Hobbs”

Throughout the boom years both banking regulation and consumer protection failed to prevent financial intermediaries’ excessive expansion of credit. Like balloons, banks expanded their balance sheets to a point where they had to burst. What is now needed is a reformed, systemic bank regulator to protect banks from themselves and a consumer financial protection agency to protect ordinary people from banks and other financial firms.

In the US a new body, the Consumer Financial Protection Agency is being created in response to what is seen as a spectacular failure to protect citizens from banks excessive, value destroying financial intermediation. The response here has been muted, with no public enquiry yet into what went so badly wrong in Ireland.

“Safe as houses” was coined during the Great Depression to convince people it was safe to borrow long term to buy their own homes. Today such action, now termed behavioral economics, sees Governments and others look to influence ordinary people’s consumption, savings and borrowing behaviors.

As in the US, economic policy here influenced people’s behavior as consumers. Both the property bubble and consumer spending boom were wholly reliant on excessive credit provided by financial intermediaries who engaged in misselling on a gigantic scale. Borrowing vast sums from abroad to make excessive loans here, our banks became the most economically destructive force in the history of the state.

IFSRA, the Financial Regulator, is a carbon copy of Britain’s “Financial Services Authority” which evolved from a number of self-regulatory agencies. Dominated by career central bankers, it interpreted its role through the lens of a prudential banking culture with its roots in “principles” based regulation from a time when financial firms self-regulated through cozy cartels. Principles for bank safety and soundness are established and banks get on with the business of maximising shareholder value as long as they satisfy the regulator that they have applied the principles to their business operations.

Regulators such as IFRSA have twin conflicting mandates. These are to ensure bank safety and soundness and to protect consumers. Safety and soundness means profitability. And as unfair, abusive and deceptive practices can be highly profitable, consumer protection is trumped by prudential regulation save for the most egregious of practices more often than not exposed here by whistleblowers in the media.

Bank regulators look on consumer protection as a tool to regulate financial firms, which makes life easier for the regulator. Protecting consumers is dominated by the notion that improving financial literacy creates wise, educated, experienced citizens who as consumers are capable of self-regulation. This notion holds that “a person’s vulnerability to misselling is a matter of their imprudence which is most effectively controlled by them acquiring the basic knowledge and confidence to ask the right questions and to seek out the products that best suit them”.

Protection also requires financial firms to disclose basic price information, print health warnings and allow for cooling off periods. The objective is to provide information so that consumers can make an informed decision. Financial advice or selling must be done in a certain way for certain types of products. But critically there is no review of new or existing financial products for safety. Nor is there a requirement to modify dangerous products before they are marketed to the public. Generic high level product regulation does not stipulate minimum safety standards and only applies to regulated firms.

Banks create value by making more credit available to people who would safely use it. But it is possible for people to have access to too much credit as happened here. Products and services were designed to allow consumers borrow more than they ought to have or could prudently afford to repay. Marketing tricks encouraged people to behave as if they could afford to buy cheap abundant credit without fear.

Government policy considers consumer protection subordinate to ensuring the profitability, safety and soundness of financial firms. It does not extend to protecting consumers from themselves or from firms more dangerous products. It believes in a form of citizen that doesn’t exist - the rational, financially literate, well informed, self-regulating consumer. So consumer protection is crafted to make regulating financial firms easier and reduce public expectation of the Financial Regulator’s responsibility for the state of the market.

Regulating financial products is always met by a powerful industry lobby on one side that is not be balanced by an equally effective consumer lobby on the other.

What’s needed is a US style consumer financial protection agency that protects consumers from excessive and destructive innovation by financial firms; polices unfair, deceptive and abusive practices; whilst also ensuring they can continue to innovate.

Credit Union Members need to toughen up on their act

With some credit unions in the red, members should attend AGM’s to get some answers, writes Bill Hobbs

With a worsening economic climate, many credit unions face serious challenges in funding day to day operations, paying dividends and maintaining prudent levels of reserves.

Significant regulatory interventions to control risk taking and maintain capital reserves have been put in place. More recently the Minister for Finance has ordered the Financial Regulator to review the sector. Heightened public concern may also result in large attendances and challenging sessions at credit union annual general meetings this year.

Ranging in size from less than €0.5M to over €370m, credit unions are accountable for the safety of €11.5bn in household savings. 100 medium and large sized credit unions ,having full time management and staff, control close onto 80% of all savings.

It appears that 50- as yet unidentified credit unions - will be unable to pay a dividend this year. If these are medium or larger credit unions then upwards of €4.5bn- the savings of tens of thousands of ordinary people- may earn a zero return this year. Due to a lack of public information, people can’t judge the financial performance and relative safety of their local credit union until it publishes its annual accounts. From now too early in the New Year, credit unions will publish annual accounts and hold their annual general meetings.
Credit unions are owned and governed by their shareholding members, who are also their customers. Electing directors from their membership, members empower a board to govern and manage the business. In turn directors are held accountable, principally through producing annual accounts and holding an annual assembly of members.

A study on the financial accountability of Irish credit union boards to their members, published in Financial Accounting & Management in 2004, found “accountability is not discharged in the most appropriate manner by credit unions in Ireland”. It also found that “users of credit union financial statements (in particular members) are not provided with appropriate financial information to make judgments and decisions. Given that the powers of direct interrogation by members of credit unions are limited, such weaknesses can disadvantage members.”

The study highlighted the absence of standards for financial accountability and also noted “ If low quality financial accounts are prepared and audited (without qualification), and members rely on these as a ‘health check’ of the financial performance and position of the credit union, then the potential for members being misled is high.”

Provided with only basic financial accounting information and limited commentary on performance what might credit union members look out for this year? There are four “health check” issues people should be concerned with. These are losses in investments (funds not lent out in loans), bad debts and loan losses, liquidity (sufficient cash to fund operations) and reserves (sufficient capital to cover expected and unexpected losses). All four are unlikely to be dealt with in credit unions annual accounts through detailed notes showing policy in each area, data comparing one year to the next and commentary on performance.

Concerned members might prepare questions and look for “plain English” explanations during the AGM. Questions might be asked on investment portfolios such as the type of investment’s made, with whom, the risks being incurred and expected or anticipated losses. They might ask for an explanation of the investment policy and whether or not the credit union is in compliance with regulatory investment accounting requirements and guidelines. If not, then the board should be asked of its plans to achieve compliance.

Recent media reports indicate at least 10% of credit union loans are in trouble but less than 1% may be written off. Yet banks are reporting far higher levels of loan losses on their troubled consumer loans. Members might ask of the number and amount of loans in default, considered at risk of default and what the expected losses are. As a credit union is legally restricted in its lending activities, the board might be asked if it is in compliance with these restrictions and if not, how compliance will be achieved. Last year 90 credit unions were found to have been in breach of legal lending limits by the Financial Regulator.

Credit unions are generally expected to maintain liquidity (cash) in instruments that can be encashed without delay or loss. Typically these include bank current accounts, short term bank deposits and government bonds. They should have at least 20% of assets held in this way. The board should be asked if it is satisfied liquidity is sufficient as some credit unions are borrowing from others to meet their cash needs. Some have had their lending restricted by the Financial Regulator. The board should be asked if the credit union has been or is being restricted in its lending and what actions it’s taking to resolve the issue. With loan default risk rising in a recessionary economy, questions might be asked of lending policy, in particular if the credit union is using repayment capacity lending assessment. If it is not a member of the Irish Credit Bureau, then an explanation should be given for this.

Credit unions are expected to maintain safe levels of reserves (capital) as a safety buffer against expected and unexpected losses. From September this year the Financial Regulator requires them to maintain minimum reserves of 10% of total assets. International best practice indicates a ratio of 15% as being prudent. This new requirement was introduced in part to prevent reserves being used to fund dividends to savers. Credit unions are only permitted to use reserves previously set aside specifically to pay future dividends. The majority did not create these reserves. Members might question their board to explain its reserve policy and what plans it has to achieve and maintain the regulatory reserve ratio.

Typically less than 2% of members attend the Annual General Meeting and few robustly question their board on credit union performance. This may be about to change as many people are deeply concerned that credit unions should continue to provide a safe place to save and make affordable loans.

Without a personal debt resolution system we face a bleak future

“Negative equity is only the tip of the iceberg on personal debt, writes Bill Hobbs”

Countless thousands of ordinary people, through no fault of their own, are caught in a spiral of indebtedness that may prevent them becoming productive members of society again for years to come. That unwelcome scenario faces many citizens unless an alternative debt resolution or modern personal insolvency system is put in place – and quickly.

In 1995 the ratio of household debt to disposable income was 46%. By 2009 this had risen to a world beating 176%. In the space of five short years, between 2003 and 2008, consumer mortgage debt rose by over €70bn and other personal debt rose by over €11bn (excluding lenders such as car leasing companies and credit unions). Much of the money was borrowed by people under 40, many of whom have personal debt they cannot ever hope to repay and are now or will shortly be living in a state of long term insolvency.

It seems that one in three mortgaged households will end up owing more than their homes are worth – in negative equity. This recent estimate is based on a 50% decline in house prices from their peak 2007 values. In drawing parallels with other countries experience of property busts, it’s said that 10% of borrowers could default. But as Ireland’s property bust is of unprecedented scale and impact, defaults will probably be far worse. By year end it appears upwards of 36,000 unemployed homeowners will be on mortgage interest relief income supplement. This does not include people earning an income who are struggling with mortgage and other debt repayments.

Negative equity is only the tip of a large ice-berg that threatens not only to freeze economic activity at recessionary levels for years to come but is also currently causing a social disaster. Consumer’s unaffordable indebtedness is not fully captured by headline negative equity statistics. Add the billions borrowed to finance cars along with lifestyle debt and the real landscape of personal indebtedness becomes clearer. Not only are those with mortgages caught in a debt spiral but tens of thousands of others are unable to make their loan repayments as they fall due.

Clearly it is manifestly unfair to commit people to unending indebtedness with little hope of becoming once again productive members of society. Modern advanced societies realise that honest people who can’t pay must be given a chance to get out from underneath unaffordable debt. In the US, debt resolution laws allow people to declare personal insolvency and exit with a clean slate in less than six months. European debt resolution systems which stress responsible borrowing, allow for full debt relief over a 3-5 year time frame.

What’s more advanced societies realise that unsophisticated consumers are hopeless at understanding risks when borrowing money. And realise that pursuing people who cannot pay through the courts to try to recover debt in full is an outdated system belonging to a time when borrowers knew more than bankers. At one time the power in the banker/borrower relationship rested with the borrower and banking was far riskier. Banks did not make loans to ordinary people because banks could not manage the risks involved.

Today, banks deploy sophisticated credit and behavioral scoring models in lending to ordinary people. They are better able to judge risks than borrowers. Explicit within this is the notion that the responsible lender and not just the responsible borrower must bear losses when consumer banking fails, as it has here in Ireland. The power in the banker/borrower relationship rests with banks that have the capacity to understand risk and act accordingly. Borrowers must pay what they can and banks must write off the balance.

The outcome of the banking crisis here has seen far too many people being marginalised, as banks are lending only to their better credit risk customers. And bankers will also undoubtedly escalate aggressive court based debt recovery, unless tempered by a fair and just alternative non-court debt resolution system.

So far talk has been about doing something for home mortgage holders. From earlier this year, banks have had to comply with a code of conduct in dealing with mortgage arrears – but this merely piles more sand on the land mine of unaffordable mortgage debt. It is abundantly clear solutions will have to be implemented to stave off what will otherwise become a home repossession nightmare no one wants.

Recently published, the Law Reform Commission’s consultation document on personal insolvency, proposes an alternative debt resolution scheme similar to ones used in advanced societies for decades. The Commission distinguishes between people who “can’t pay” their loans and those who “won’t pay”. Under its scheme those who “can’t pay” would earn a debt discharge over time. It would; have open access for honest and long-term insolvent people; be a legally binding debt settlement agreement between a borrower and their lenders; preserve a reasonable standard of living for people; and would result in a debt discharge after a reasonable length of time. As such schemes typically exclude mortgage debt; the Commission did not propose solutions for homeowner mortgages.

It seems that Government is to contemplate an alternative to the current Dickensian debt recovery system which jails people who cannot afford to repay their loans. But is it to be left to Law Reform Commission’s slow pace of inquiry and consultation to ensure a just equitable solution to personal indebtedness?

Creating an alternative debt resolution system is not the stuff of rocket science nor does it require a uniquely “Made in Ireland” solution. Proven systems and mechanisms exist elsewhere. All it takes is resolute government action to implement a system. Bringing all stakeholders together within a fast track process aimed at enacting the requisite legislation and executing on a new system is something that should be done immediately.

It should not be conveniently long fingered by political rhetoric and lame excuses that home repossessions are low.