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JFRC
18,3 What caused the Irish banking
crisis?
K.P.V. O’Sullivan
224 Department of Government, London School of Economics, London, UK, and
Tom Kennedy
Department of Accounting and Finance, Kemmy Business School,
University of Limerick, Limerick, Ireland

Abstract
Purpose – The purpose of this paper is to explore the Irish banking crisis and explain how various
factors contribute to a collapse in asset prices, an economic recession and the near failure of the
banking system. The paper seeks to document the dangers of pro-cyclical monetary and government
policies, particularly in an environment of benign financial regulation and pent-up demand for credit.
Design/methodology/approach – The paper maps the Irish banking crisis against its general
background. It describes the roots of the crisis, with particular attention given to government and
monetary policies, the practices of the financial regulator and banks during the property bubble,
together with the difficulties associated with the international sub-prime crisis.
Findings – While the global financial crisis exacerbated matters, the banking crisis in Ireland was
largely a home-grown phenomenon. The crisis stemmed from the collapse of the domestic property
sector and subsequent contraction in national output. Its root cause can be found in the inadequate risk
management practices of the Irish banks and the failure of the financial regulator to supervise these
practices effectively.
Originality/value – The paper documents the “Celtic Tiger” phenomenon of the last decade: the
Irish economic and property miracle, its sharp decline, and the sub-prime crisis. It delineates one of
the most severe banking and economic crisis in a developed country since the great depression with
a number of key policy lessons for rapidly expanding economies.
Keywords Ireland, Regulation, Banking industry, Recession, Financial economy
Paper type Research paper

Journal of Financial Regulation and
Compliance
Vol. 18 No. 3, 2010
pp. 224-242
q Emerald Group Publishing Limited
1358-1988
DOI 10.1108/13581981011060808
1. Introduction
The banking system provides the fulcrum around which the economy turns. It underpins
the efficient allocation of capital stock, provides essential transaction and intermediation
services and funds the development of new businesses and technologies in the wider
economy (Harper and Chan, 2003). As seen with recent events in 2008, banking crises can
depress economic growth, increase unemployment and destabilise the wider economy.
Roghoff and Reinhart (2009) suggest that following a severe financial crisis, gross
domestic product (GDP) per person falls by an average of 9 per cent in two years, the
unemployment rate increases by 7 per cent and house prices fall by approximately
one-third in real terms and take about five years reach its nadir. Concomitantly, real
government debt grows by an average of 86 per cent in countries afflicted by financial
crises, reflecting a collapse in tax receipts due to a reduction in economic activity
(Roghoff and Reinhart, 2009). Therefore, downturns following a banking crisis are
typically long and deep (Gup, 1999). Consequently, it is necessary to understand how
these crises develop, in order to limit the probability of such events reoccurring.
 In 2008, Ireland experienced its worst financial crisis to date. While this phenomenon The Irish
was not unique to Ireland at that time, the speed and severity of the Irish experience banking crisis
makes it an interesting case study. This paper attempts to show how macroeconomic
conditions contributed to a systematic failure of the banking system and how a rapid
growth in the Irish economy stimulated a property boom. This together with an
increasing population, historically low interest rates and expansive fiscal regime,
contributed to the property boom becoming a bubble. In effect, a liberalised regulatory 225
banking system enabled credit to fuel an already overheated property market which
ultimately gave rise to a crash rather than the anticipated soft landing. The resultant
sharp decline in house prices led to an increase in credit defaults in the bank’s
property-exposed loan books and, allied to the freezing of international money markets,
gave rise to major funding difficulties for banks in Ireland. Consequently, the Irish
Government in September 2008, had to take the unprecedented and somewhat
controversial decision to rescue its financial system by issuing a blanket guarantee of all
its debt obligations. This was followed by the nationalisation of Ireland’s third largest
bank, a e7 billion recapitalisation of its two main financial institutions and the creation
of a type of “bad bank” (National Asset Management Agency (NAMA)) to manage the
billions of non-performing or toxic loans in the banking system.
This paper is structured as follows. Section 2 provides the theoretical framework by
examining the determinants of international banking failures with special reference to
the Swedish financial crisis in the early 1990s. Section 3 investigates the expansionary
phase of the Irish economy between 1997 and 2007. In particular, it describes how the
property boom became an asset price bubble as prices and the production of house units
escalated. The next section presents the monetary and public policy framework which
facilitated the Irish property bubble. Section 5 describes the Irish regulatory
environment and delineates its liberalisation and adoption of principle-based regulation
(PBR). Section 6 describes the changing nature of banking practices during the property
bubble. Section 7 documents the current state of the Irish economy and the challenges
facing the banking system. Finally, the paper concludes with a discussion of the key
conclusions and recommendations.

2. Determinants of international banking failures

Recent experience suggests that financial systems are prone to periods of instability and
market failure. Since the 1990s (and particularly in 2008), the scale and frequency of
banking failures have been common, large and expensive. Eichengreen and Bordo (2008)
have identified 139 financial crises between 1973 and 1997 compared with a total of only
38 between 1945 and 1971. The majority of banking failures in the recent past have been
associated with adverse macroeconomic conditions, such as: cyclical downturns in
output, difficult trading conditions and fluctuations in property prices (Caprio and
Klingebiel, 1996; Lindgren et al., 1996; Kaminsky and Reinhart, 1996; Demirguc-Kent
and Detragiache, 1998; Gorton, 1988). The latter is the main triggering agent causing
banking fragility and ultimately systemic crisis (Woods, 2007; Berg, 1998; Gup, 1999).
For example, a FDIC (1997) study concluded that price changes in commercial property
markets was the main cause of losses at financial institutions during the US banking
crises in the 1980s and early 1990s. Nevertheless, the practices of banks, regulators and
the government ex ante can be seen as the root cause of the majority of financial crises.
Drage et al. (1998), Llewellyn (2000) and Altman (2009) suggest that many banking
JFRC failures in the last 20 years have been, in part, a product of a lack of government
18,3 intervention. Similarly, others (Benston and Kaufman, 1994; Dowd, 1996) have
attributed the Asian and Nordic financial crises of the 1990s to the indirectly malign
effects of regulatory frameworks and inappropriate banking practices.
The Swedish banking crisis is a good example of a property-induced banking crisis and
provides an interesting perspective given its similarities with Ireland’s experiences in
226 2008. Historically, credit markets in Sweden were heavily regulated. The Riksbanken
(Swedish Central Bank) set the rate of interest and the size of capital flows within the
economy (Jonung, 2008). Lending ceilings, placement requirements and interest
regulations created an environment of excess demand for credit (Drees and Pazarbasioglu,
1998; Berg, 1998). A lack of competition within the banking sector (Woods, 2007)
contributed to the tight credit conditions as banks were highly cautious when assessing
risk. Furthermore, financial institutions in Sweden were intensely scrutinised by the
Riksbanken to ensure prudent behaviour was maintained (Englund, 1999).
In the early 1980s, the Swedish financial system underwent a period of significant
deregulation. First, liquidity ratios were abolished in 1983, followed by the removal of
interest and lending ceilings two years later. These factors stimulated an increase in
competition amongst banks. Overall, lending increased by 73 per cent in real terms
(Englund, 1999) as risk management criteria were loosened by banks to maintain market
share. In the five years following the liberalisation of Sweden’s financial market, mortgage
lenders increased the maximum loan-to-value ratio from 75 to 90 per cent. The expansion
of credit in the economy was supported by low or even negative real interest rates
(Englund and Vihriälä, 2007) and a tax system that favoured borrowing (Bäckström,
1997). Banks also started to enter new and more risky markets to take advantage of
positive conditions. Loans were increasingly used to fund highly leveraged commercial
property investments. However, mortgage lending saw the greatest increase, growing by
129 per cent over a five year period, following liberalisation (Englund, 1999). This allowed
banks and mortgage institutions to expand rapidly and post significant profits.
In Sweden, increased household borrowing was followed by a surge in domestic
demand, as the government instigated an expansionary fiscal regime (Agell and Berg,
1996). There was also a boom in the stock market, and financial assets grew from 82 per
cent in 1995 to 102 per cent of GDP in 1988 (Englund, 1999). The economy was
characterised by full employment, rising consumption and falling savings rates (Jonung,
2008). The national budget deficit turned into a surplus, due to: the growth in the property
sector, the expansion in consumption and the large increases in nominal wages. The
occurrence of robust economic growth, financial deregulation and heightened credit
demand led to an asset and credit boom in Sweden (Woods, 2007). In fact, Bäckström (1997)
outlines that during the second half of the 1980s, real aggregate asset prices increased by
over 125 per cent. However, economic irrationality began to present itself in the property
market and yields on asset values reduced from 7 per cent in 1985 to only 4 per cent in 1990.
However, the process could not continue indefinitely and the bubble burst in the late
1980s, as a perfect storm of monetary tightening, tax reforms, loss of competitiveness
and adverse macroeconomic conditions hit the economy (Bäckström, 1997). Amid
growing concerns over the health of the country’s banking system, international capital
began to leave the country ( Jonung, 2008). Lower income growth, rising unemployment
and a 50 per cent decline in property prices over an 18-month period (Andersson and
Viotti, 1999), resulted in considerable credit losses for the Swedish banking sector.
According to Drees and Pazarbasioglu, 1998, the real estate sector accounted for the The Irish
majority of these losses, representing 75 per cent of the bank’s total loan write-down’s in banking crisis
1991 and about 50 per cent in 1993. In light of these losses and to rescue its ailing banking
system, the government spent over 4 per cent of GDP, or 65 billion kronor, on its bank
rescue plan. It issued a blanket guarantee of bank deposits and liabilities and formed two
new agencies, one to supervise institutions that needed recapitalisation, and another, to
deal with all the non-performing assets on the bank’s balance sheets. While these policies 227
proved successful and the economy recovered by the mid-1990s, the crisis left a
considerable scar on the Swedish banking system and is estimated to have cost the
exchequer approximately 2 per cent of GDP. The main thrusts of the solutions applied in
Sweden are now being used to address the current difficulties experienced in Ireland.
This is not surprising given the inherent similarities in the roots of both crises.

3. Expansionary phase of the Irish economy

Ireland experienced unprecedented levels of growth during the economic boom period
(1997-2007). During that time, it transformed itself into one of the most vibrant
economies in Europe (D’Agostino et al., 2008) and was aptly described as the
“Celtic Tiger” economy. GDP increased by an average of 7 per cent per year and was the
highest among European Union (EU)-15 OECD, 2009). In terms of GDP per person,
Ireland went from the 22nd richest countries in 1997 to the 5th richest by 2007 (IMF,
2009). Additionally, foreign direct investment (FDI) stocks increased by over 23.5 per cent
(OECD, 2009), supporting the exporting sector. As a result, outflows of goods and
services increased by over 300 per cent. Growth within the Irish economy was also
supported by significant demographic trends. During that ten-year period, the Irish
population grew by 12.76 per cent due to high net migration, particularly from the new
accession EU member states together with the repatriation of migrates from the USA
and Britain (Central Statistics Office (CSO), 2007). As the population increased, the
unemployment rate decreased, from 9.9 per cent in 1997 to only 4.6 per cent in 2007. The
growth in the population also triggered an expansion in domestic demand which led to a
huge surge in imports, increasing from e10.5 billion in 1997 to over e54.3 billion in 2007
(OECD, 2009). This resulted in Ireland going from a balance of payments surplus of
e226 million in 1999, to a deficit of e10.3 billion in 2007 (CSO, 2009a, b). D’Agostino et al.
(2008) reflect the general consensus by suggesting that the Irish economy more than
doubled in size in this ten-year period.
However, the economic boom in Ireland gave rise to, and ultimately became over
dependant on, the property sector. The initial investment in property was based on solid
demand and supply fundamentals, such as rising population, strong income growth and
low unemployment, as presented above. However, after the successful recovery of the
Irish economy in 2002, following the dotcom bubble crash, a degree of speculation crept
into the housing market. Individuals underestimated the risk involved in entering the
property market, saw the opportunity to benefit from significant capital appreciation
and satisfy their innate propensity to own their own home. As a result, the demand for
housing soared and loan approvals rose from e4.4 billion in 1997 to over e31.4 billion in
2006. Supply rushed into meet this demand with the total stock of house completions
increasing by over 430,000 units in six years (2001-2007). The growth peaked in 2006,
where approximately 93,000 house units were completed, compared with only
38,000 units at the start of the boom in 1997 (Figure 1).
JFRC 1,00,000
18,3 90,000
80,000
70,000
House units 60,000
50,000
228
40,000
30,000
20,000
10,000
Figure 1. 0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
House completions,
1970-2008
Source: Statistics from the department of the environment, Heritage and Local Government (2009)

However, the supply of houses was not large enough to keep prices constant (Figure 2)
and the opportunity for capital appreciation and property speculation was created.
According to the Department of the Environment, Heritage and Local Government
(2009), the average price of a house in Ireland in 1997 was e102,491. This reached
e350,242 by the first quarter in 2007. Apartment prices grew in a similar manner,
increasing by over 246 per cent in the same period (Department of the Environment,
Heritage and Local Government, 2009). The link between asset prices and their
fundamental value became disconnected as people began purchasing houses as an
investment strategy. Over this period, the cumulative growth in rental values on all
commercial property was just 7.4 per cent, compared with 46.2 per cent for capital values
(Woods, 2007). Furthermore, apart from a brief interlude in 2001 and 2002, nominal
income yields on all types of Irish property have followed a general downward trend
since the mid-1990s (Woods, 2007). Between 1980 and 1997, the rent to price ratio for
private property fluctuated within a narrow range of around 9 per cent. Yields then
began to drop significantly as rents failed to keep pace with house prices. Although rents
staged a recovery in 2005 and 2006, they continued to be outpaced by prices. By 2007,

4,00,000
3,50,000
3,00,000
2,50,000
Euros

2,00,000
1,50,000
1,00,000
50,000
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008

Figure 2.
House prices, 1970-2008
Source: Statistics from the department of the environment, Heritage and Local Government (2009)
the yield on rental property had slumped to around 3 per cent (Irish Central Bank, 2008; The Irish
Daft, 2008). A similar story was evident in the commercial sector. In 2006, rents had risen banking crisis
by 5.7 per cent, compared with a rate of capital appreciation of 23.1 per cent (Irish Central
Bank, 2008). This divergence resulted in considerable yield compression across all types
of Irish commercial property during the boom.
From 2004, the property market displayed the signs of an asset price bubble. Many
international commentators highlighted the dangers of Ireland’s over reliance on the 229
construction and property sectors. The IMF (2006) observed that growth in Ireland had
become increasingly unbalanced since 2002, with a “heavy reliance on building
investment, sharp increases in house prices, and rapid credit growth, especially to
property-related sectors”. (The) Economist (2004) survey of Ireland indicated that the Irish
banking system was heavily exposed to the property sector and a crash would “badly hit
the balance sheets of the two big Irish banks, Allied Irish Bank (AIB) and Bank of Ireland”.
However, these warning went unheeded by policy makers, the regulator and banking
institutions and Ireland’s monetary and public policy initiatives reflected this ignorance.

4. Monetary and public policy framework

Ireland’s monetary and public policy has to be viewed in the context of its membership
of the European Monetary Union (EMU) and the argument that the single currency
could generate forces for greater economic integration (Rose, 2000). From 1999 to 2006,
the European Central Bank (ECB) engaged in a policy of low interest rates (Figure 3)
designed to stimulate demand, credit growth and housing markets in the German and
French economies. The ECB was willing to pursue this strategy due to the low risk of
inflationary pressures it presented (ECB, 2004). This meant that the Irish economy,
which was experiencing atypically high growth and inflation rates compared with its
European partners (Lane, 2006), was subjected to low or even negative real interest
rates from 2000 (Figure 3). Perhaps, the concerns raised about the benefits of business
14.00
Nominal interest rate
Inflation
12.00
Real interest rate

10.00

8.00
Percentage

6.00

4.00

2.00

0.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

–2.00
Figure 3.
Real interest rates,
Source: Statistics from the CSO (2009) and department of environment, Heritage and Local Government 1990-2007
(2009)
JFRC cycle synchronisation (McCarthy, 2005; Giannone and Reichlin, 2005) and convergence
18,3 in inflation differentials (Lane, 2006; Angeloni et al., 2006) should have been given more
consideration. According to Honohan and Leddin (2006), the increase in mortgage
credit in Ireland was influenced by its membership of the EMU and the subsequent
removal of interest rate controls. They argued that the interest rates in Ireland,
between 1999 and 2004, had a “dramatic” effect on property prices and were “much too
230 low” by the Taylor criterion (Woodford, 2001).
Consistent with the USA, this low ECB driven interest rate environment contributed
significantly to a construction-led boom and resulted in the Irish economy suffering a
severe loss in labour competitiveness (Honohan and Leddin, 2006). It also led to an
over-dependence on the property sector for employment and the once-off, largely
transactional-based, taxation revenues that it generated. This is evidenced by a
doubling of the number of people employed in the construction sector between 1997 and
2007 to about 13 per cent of the total workforce. In relation to property taxes, capital
gains taxes together with stamp duty accounted to over 15 per cent of all tax revenues in
2006, compared with 4 per cent in 1996 (Addison-Smyth et al., 2008.).
The property market was further inflated by the government’s pro-cyclical economic
policy during that period. In order to maintain growth in the construction sector (and thus
maintain public funds), the Irish Government shifted its underlying strategy in the late
1990s through structural adjustments and an expansionary fiscal regime (Kirby, 2005).
In this context, Ireland pursued a neo-liberal and market-orientated agenda. As the Irish
Deputy Prime Minister in 2000 pointed out, Ireland’s economic policy was “spiritually a
lot closer to Boston than Berlin” (Department of Trade, Enterprise and Employment,
2000). It promoted the privatisation of semi-state companies, the deregulation of
economic institutions and the propagation of “pro-business” policies (Coulter et al., 2002).
The government pursued a policy of low corporate and commercial tax rates in order to
encourage investment and growth in the business sector (particularly FDI). It reduced
capital gains tax from 40 to 20 per cent and introduced mortgage interest relief to
stimulate the property market. These policies resulted in a significantly reduced
underlying tax intake (Eurostat, 2009). It also introduced a series of “give-away
budgets”, which offered tax breaks primary focused on high earners (Coulter et al., 2002).
This meant that, despite posting huge budget surpluses (Eurostat, 2009), the Irish
Government was unable to divert sufficient funds towards improving infrastructure and
public services, because of the capacity constraint caused by the construction industries
bias towards housing. Therefore, Ireland in the period 1997-2007, had the lowest level of
government expenditure (34.4 per cent), as a portion of GDP, relative to any other EU
country and significantly lower than the EU-15 average of 47.7 per cent (Eurostat, 2009).
In general, therefore, the policy of the Irish Government in this period was to
stimulate economic growth and encourage borrowing and lending. This led to a public
reprimand from the European Commission ((EC) 2001), stating in February, that its
budgetary plans for 2001 were “expansionary and pro-cyclical” and inconsistent with
the Community’s support for “budgetary constraint”. It indicated that the budget risked
further “overheating the economy” and increasing the inflation rate. More recently, it has
reiterated this stance, by outlining that Irish policy makers failed to maintain “a prudent
fiscal course” during the boom, particularly in relation to its spending targets
(Irish Times, 2009).
 Following these policies and other initiatives, Ireland transformed itself from being a The Irish
highly regulated and taxed economy in the 1980s to become an open and pro-business banking crisis
one, especially in terms of taxation, barriers to entry, entrepreneurship, market openness
and labour markets (OECD, 2003). The reorganisation of its supervisory entities and the
introduction of more market-orientated regulatory frameworks was a key part of
Ireland’s economic success, particularly in relation to the financial services sector.
However, it meant that its risk profile had changed dramatically as a result of its public 231
policy initiatives and it became much more vulnerable to market cycles, both nationally
and internationally, as evidenced by its current deep economic recession.

5. Irish banking regulatory environment and practice

The Irish banking regulatory system has been the subject of much debate and change in
recent years (O’Sullivan, 2010). According to DKM (1984), the Irish banking system was
one of the most “intensely regulated” in all developed countries. At that time, an interest
rate cartel existed as a key factor affecting competition. Additionally, the Irish Central
Bank controlled new entrants in the Irish banking system meaning that entry was
practically unattainable except by way of a takeover (O’Sullivan and Kennedy, 2007).
Ironically, many of the regulatory restrictions, that were designed to protect the stability
of the banking system, were removed as well as artificial distinctions between different
levels of financial institutions in the 1990s. For example, the Credit Union Act 1997
increased the range and scope of services that Credit Unions could provide. Recent
initiatives led to the enactment of the Central Bank and Financial Services Authority of
Ireland (CBFSAI) Act 2003, which mapped the institutional arrangement of supervision
in Irish banking (Westrup, 2005). This act created a single financial regulator, called the
Irish Financial Services Regulatory Authority (IFSRA). IFSRA operates within the
newly formed CBFSAI while still maintaining its independence. IFSRA was given a dual
mandate to protect consumer interests and to build a regulatory framework that protects
the stability of the banking sector (IFSRA, 2008). It sees the “fostering of an international
competitive banking industry in Ireland” as its third main responsibility (IFSRA, 2008).
This newly created institutional arrangement, through a process of both horizontal and
vertical integration, fused together all conduct of business and prudential supervisory
practices in financial services (O’Sullivan, 2010). Its main objective is to achieve a
balanced regulatory framework with strong enforcement provisions. Previously,
supervisory institutions were separated on the basis of activity and type. This gave rise
to a complex and multifaceted matrix of regulatory processes and entities that are seen
as cumbersome and effectively an outcome of institutional compromise (O’Sullivan and
Kennedy, 2008).
The liberalisation of the Irish banking system together with a relaxation of entry
requirements to the Irish Payment Clearing System (O’Sullivan and Kennedy, 2007),
facilitated the entry of a number of international banks to the domestic market. These
included the Royal Bank of Scotland (RBS), Halifax Bank of Scotland, Rabobank and
Danske Bank. This increased level of competition was beneficial for customers as banks
competed aggressively for market share. For example, with the entry of Bank of
Scotland in 1999, margins in the mortgage market of up to 3 per cent were forced down to
1.5 per cent. This initiative, based on a targeted, low cost technologically driven model,
was cited as a critical development in terms of increasing competition in a highly
concentrated home loan market Office of Director of Consumer Affairs (ODCA, 2003).
JFRC In the retail savings and investment market, there has also been an increase in
18,3 competition from outside the traditional market sector (Department of Finance, 2003).
Although the international nature of competition in the corporate banking sector
protects the interests of customers, the development of the International Financial
Services Centre in Ireland has further increased the number of overseas institutions
engaging in corporate banking services. Since the mid-1990s, Ireland has been able to
232 attract financial institutions such as Depfa Bank, RBS, Citi Bank, Union Bank of
Switzerland and Merrill Lynch (Finance Dublin, 2008). It has grown to become the tenth
most attractive financial services centre in the world (City of London, 2009). However,
this competition had an effect of further inflating property lending, as presented by the
Governor of the Irish Central Bank: “without large-scale foreign borrowing by the banks,
the [Irish] property boom could not have grown as it did” (Honohan, 2010). Much of the
increase in competition can be explained by the “light touch” and “flexible” regulatory
regime that was designed to encourage international investment (Westrup, 2005).
Since its inception, IFSRA has followed a principles-based regulatory framework in
order to maintain a pro-business environment in Ireland and in accordance with
government policy (Department of the Taoiseach, 2004). PBR is concerned about setting
desirable regulatory outcomes in principle and using outcome-focused rules (O’Sullivan,
2010). It aims is to work with banks in deciding how best to align their corporate objectives
with pre-defined regulatory outcomes. PBR sets out basic principles in relation to, for
example, solvency, governance, consumer protection and disclosure. It allows banks to
determine the compliance provisions on each regulatory principle. Its virtues have been
long debated amongst policy makers, particular in accounting and tax circles and more
recently in relation to financial regulation itself (Black, 2008). Pioneered by the British
financial regulator (Black et al., 2007), the PBR framework has been extended to many
other countries, with the USA investigating its value, subsequent to its crisis in 2007
(Office of the Mayor New York, 2007; United States Department of Treasury, 2008). This
type of regulatory system creates a certain degree of flexibility and innovation by allowing
banks “to develop their own compliance ethos within the context of their own market,
legislative backgrounds and cultures” (IFSRA, 2004). PBR is likely to encourage new
entrants and increase competition (IFSRA, 2004) which in turn improves levels of service
provision in the market (IFSRA, 2008). However, its application requires a high degree of
mutual trust between participants in the supervisory framework (Black, 2008) and does
not work with people “who have no principles”, as the Chief Executive of FSA stated in
2009 (Sants, 2009). Its system of governance relies on self-observing and responsible
organisations within its framework (Black, 2008; Parker, 2002). The global financial crisis
of 2008 and its spillover effects have clearly demonstrated that this benign approach
to supervision is not appropriate in the current business and cultural environment
(IFSRA, 2009a).

6. Banking practices in Ireland

As anticipated, the shift towards PBR was broadly welcomed by most banks (AIB,
2003) and industrial bodies (Irish Banking Federation (IBF), 2007; Consumer Credit
Association of the Republic of Ireland, 2004). This gave financial institutions scope to
expand their operations and they took full advantage of the ECB’s low interest rate
regime by ramping up their credit outflows, particularly in relation to property backed
lending (Figure 4). In effect, the financial sector adopted a host of strategies that
 35,000 The Irish
30,000 banking crisis
25,000
Euro millions

20,000

15,000 233
10,000

5,000

0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Figure 4.
Source: Statistics from the CSO (2009) and the department of the environment, Heritage and Loan approvals, 1970-2008
Local Government (2009)

resulted in a sharp increase in the size of their lending books (Standard & Poor’s, 2008).
They offered 100 per cent mortgages to first time buyers without occupational
restrictions, interest only mortgages and fewer restrictions on credit products (Table I).
These practices led to the personal-sector credit to GDP ratio rising to 95 per cent by
September 2007, the highest in the euro area, vs the EU average of 50 per cent (Irish
Central Bank, 2007a).
Consistent with the private sector, the indebtedness of the non-financial corporate
(NFC) sector increased from 103 per cent of GDP in 2005 to 139 per cent in 2007 (Irish
Central Bank, 2008). This was particularly due to the financing of highly leveraged
commercial property deals supported by soaring equity prices and atypically low
interest rates (Standard & Poor’s, 2008; O’Sullivan and Kennedy, 2008). The commercial
property-related sector had the fastest growth rates between 1999 and 2007. It accounted
for approximately 85 per cent of all new lending to the NFC sector in 2007 (Irish Central
Bank, 2008). Overall, credit growth to this sector increased by 245 per cent in the period
2004-2007 (Table II) following a period of relatively low growth in the early 2000s.
The Irish corporate sector was highly indebted by European standards (Irish Central
Bank, 2008) posing a significant threat in the event of an economic shock. Year-on-year
growth peaked in 2006, with a 40 per cent increase in lending. By 2007, the three largest
Irish banks had between 34 and 84 per cent of their loan book exposed to the commercial
sector. By 2007, property-related lending had reached 62.5 per cent of private sector
lending vs 38 per cent in 2001 (Woods, 2007) and was over 50 per cent of the total stock of
bank lending (OECD, 2009).

Percentage of total loan stock 2004 2007

100 per cent mortgages 5 15

Range of loans, .31 years 10 33
Interest only loans 3 12
Size of loans, .300k 7 23 Table I.
Changing nature
Source: Department of the Environment, Heritage and Local Government (2009) of banking practices
JFRC
Stock (e million) Change Change
18,3 2004 2007 (e million) %

Agriculture and forestry 3,271 4,702 1,431 44

Fishing 364 406 42 12
Mining and quarrying 221 447 226 102
234 Manufacturing 5,673 8,095 2,422 43
Electricity, gas and water supply 551 1,127 576 105
Construction 7,572 24,351 16,779 222
Wholesale/retail trade and repairs 7,107 12,103 4,996 70
Hotels and restaurants 6,486 10,537 4,051 62
Transport, storage and communication 1,986 2,939 953 48
Real estate 20,812 71,834 51,022 245
Personal credit 78,022 139,903 61,881 79
Table II. NFC total 132,065 276,444 144,379 109
Sectoral breakdown of
NFC loans, 2004 and 2007 Sources: Irish Central Bank (2004, 2007c)

These practices resulted in unprecedented profit growth for domestic and foreign
financial institutions in Ireland (O’Sullivan and Kennedy, 2007). Banks and most Irish
commentators believed that such strategies were justified as nominal householder
wealth had increased by 21 per cent from 2002 to 2007 (Department of the Environment,
Heritage and Local Government, 2009) and that most of the macroeconomic variables of
the Irish economy were fundamentally sound. However, even the Irish Central Bank’s
(2007b) warning that this increase in indebtedness “mainly for asset purchase” left the
sector vulnerable to the risk of default in the event of a negative shock to the economy
went unheeded. The negative shock in the form of collapse of Lehman Brothers in
2008 was to fundamentally change everything. During that time the Irish financial
regulator was silent publicly and totally ineffective privately.

7. Challenges that need to be addressed

The Financial Regulator and its regulated entities are now operating in a very difficult
economic landscape and respond to the criticism that they were not prudent enough
during the property boom (O’Sullivan and Kennedy, 2008). After more than a decade of
strong economic growth, Ireland is now experiencing a deep recession. The downturn
was caused by a sharp correction in the housing market (O’Sullivan and Kennedy, 2008;
Economic and Social Research Institute (ESRI), 2008a,b; Irish Central Bank, 2009a), the
2008 sub-prime financial crisis and the recession in Ireland’s main trading partners,
Britain and the USA (EC, 2009). The Irish economy, the first in the euro zone to enter a
recession, contracted by between 1-2.5 per cent in 2008 (Irish Central Bank, 2009a; ESRI,
2008b). Its GDP is likely to decline by a further 9-10 per cent in 2009 (ESRI, 2009; Irish
Central Bank, 2009b), the sharpest fall in an industrialised country since the Great
Depression. The unemployment rate has risen to 9.2 per cent (CSO, 2009c), its highest
rate since the mid 1990s and is set to hit 17 per cent by the end of 2009 (ESRI, 2009).
Additionally, domestic demand fell sharply in 2008 (Irish Central Bank, 2008), reflecting
the lowest level of consumer confidence in the Irish economy since the mid 1980s (IIB
Bank/ESRI, 2008). Tax revenues have also fallen rapidly, with the 2008 intake almost
13 per cent lower in 2008 relative to 2007 (ESRI, 2008b). These developments have led
to a very sharp deterioration in Ireland’s public finances, with the government balance The Irish
moving from a small surplus in 2007 to an estimated deficit of 6 per cent of GDP in 2008 banking crisis
and 12 per cent in 2009 (ESRI, 2008a, 2009).
The correction in the housing market commenced in early 2007, as interest rates
started to increase and the economy became affected by the shock of the sub-prime crisis.
In 2008, property prices declined nationally by 9.1 per cent, compared with a fall of
7.3 per cent, the previous year (Permanent TSB/ESRI, 2009). According to Friends First 235
(2008), house prices have dropped by 25 per cent since the height of the housing boom in
2006 and are set to drop within a range of between 20 and 30 per cent over the course
of the next three years. Recent indications are that the reductions are closer to
40-50 per cent. Construction output has contracted each month since June 2007, resulting
in 40 per cent reduction in house unit completions in 2008 (Department of the
Environment, Heritage and Local Government, 2009). The impact of the adjustment in
the housing market has spread to other sectors of the economy including non-housing
investment and consumption. The commercial building sector further contracted in 2010
with substantial declines in both output and capital values also expected (Irish Central
Bank, 2009a, b).
Following the falloff in property prices, customers are now facing the possibility of
negative equity and banks are left with loan books which are heavily exposed to the
declining property market. The failure of IFSRA to limit these consequences is a product of
its laissez-faire approach to supervision. The Irish Central Bank (2008) had clearly
identified strong credit growth and rising indebtedness as major systemic vulnerabilities.
This is especially true in relation to the latter stages of the property cycle where the loan
books of Irish banks increased from e166 billion in 2004 to e275 billion by 2007.
The majority of the expansion in credit was funded through “disproportionately high”
borrowing from the ECB (Morgan, 2008; Goodbody, 2008), as “banks leveraged their
deposits with sizeable borrowings from abroad” (Honohan, 2010).
The rapid deterioration in the Irish economy is reflected in the financial results of the
main Irish banks. In May 2009, recently nationalised Anglo Irish Bank, posted a loss of
over e4.1 billion, the largest in Irish corporate history, and expects loss to be e7.5 million
by the end of the year. In 2008, AIB reported pre-tax profits of e1 billion, a 60 per cent
reduction from the previous year. It announced a e4.3 billion bad debt charge in 2009,
due to an increase this year in its loans in difficulty by e9 billion to e24.3 billion. The
Bank of Ireland, in the year ended 31 March 2009, recorded a loss before tax of e7 million
vs a e1.93 billion profit in 2008. It has raised its expected bad debt charge for the three
years to March 2011 to e6 billion. In relation to foreign players, Bank of Scotland
(Ireland) has reported a “significant increase in impairments” because of falling asset
values in 2008 and described the severe deterioration in the property market as
“unprecedented”. As of February 2010, in light of difficult market conditions, the bank
closed its retail arm, Halifax, with the loss of over 750 jobs. Therefore, it is clear that the
Irish banking sector will have to deal with the consequences of the imprudent and high
risk lending practices that fuelled the property bubble and resulted in short-term super
profits. Its capital base has been destroyed and years of steady progress and integrity
have been eroded in a few short months.
As regards regulation, the “invisible hand” of the regulator and his failure to act is not
a new phenomenon in Ireland. In the aftermath of the Taylor scandal in 1996, which saw
an insurance broker abscond with client’s funds, the Irish Central Bank (which was the
JFRC regulator at the time) admitted that there was a “gap in the regulatory system” with
18,3 regards to the interest of customers (Westrup, 2005). In 1999, a government committee
highlighted that the Irish Central Bank did little to prevent the widespread evasion of
deposit interest retention tax over a 12-year period. It outlined that the relationship
between the regulator and banks was “particularly close and inappropriate” and
suggested that the authority was perhaps “too mindful of the concerns of the banks, and
236 too attentive to their pleas and lobbying” (Committee of Public Accounts, 1999). Again in
2002, a government inquiry into widespread use of off-shore bank accounts, found that
the Irish Central Bank was at fault for not supervising these accounts effectively
(Westrup, 2005). In the light of these scandals and others, the Irish Government
reorganised the regulatory structure of the banking system in 2003, creating the IFSRA
within the Central Bank’s structure. Its aim was to restore, what the Competition
Authority noted as, the “shattered” public confidence of the banking system at the time
(Westrup, 2005). History will show that this objective was not met and that a more
challenging task now needs to be addressed.

8. Conclusions
This paper has presented a chronological description of the conditions which led to the
Irish banking crisis in 2008. The current malaise was mainly caused by the inadequate
risk management practices of the Irish financial institutions and the failure of
the regulator to supervise these practices effectively. The situation was stoked by the
pro-cyclical monetary and public policy initiatives enacted by the Irish Government at
that time and amplified by the international financial sub-prime crisis in 2008. The
decline in the Irish property market has been the prime reason why the capital
structures of the Irish banks have been significantly eroded with the prevailing global
credit crisis compounding liquidity concerns. The Irish banking sector has effectively
lost the confidence of international markets and the public in general.
The government now needs to act to restore its credibility. It has shown itself to be
innovative in introducing a guarantee scheme to safeguard all deposits, covered bonds,
senior debt and dated subordinated debt for six of the largest Irish-owned financial
institutions in September 2008. It has deliberated for sometime before deciding to
establish a NAMA in order to cleanse Irish banks of its troubled assets and release
badly needed credit for the productive sector of the economy. It is anticipated that this
“bad bank”, similar to the model used during the Swedish crisis of 1990-1992, will take
ownership of loans with a nominal value of e77 billion, one-fifth of all loans in the Irish
banking system, with a view to extracting the best possible value over a number of
years. This transfer of debt to NAMA will result in an acceleration of the credit losses;
the government forecasts that it will pay a 30 per cent discount for the transferred
loans. However, the discount could rise and there is a strong possibility that the
government will be forced to take Ireland’s two largest financial institutions, AIB and
Bank of Ireland, into temporary national ownership to facilitate the critical process of
rebuilding their capital reserves to international norms.
Finally, the Irish Government needs to address the benign regulatory regime that
failed to live up to its obligations. This regime has presided over a culture of collusion
that resulted in director’s loans being concealed from auditors over an eight year period.
In reviewing this warehousing practice, IFSRA (2009b) found that there was a
“breakdown in internal communications and processes” in the regulator’s office and that
this resulted in a failure to take “appropriate and timely actions” to what was “a serious The Irish
matter”. The Minister of Finance (2009) with responsibility for this area, has clearly banking crisis
demonstrated the challenge by stating that “the Irish regulatory system badly needs
reform and that “a root and branch review is required”. IFSRA, itself, has accepted that
its overall strategic approach to regulation during this time was inappropriate,
suggesting that it was constructed in a “benign environment” where many of the current
issues where not foreseen (IFSRA, 2009b). In April 2009, the Minister of Finance 237
announced that the Irish Central Bank, and not the Financial Regulator, will be at the
centre of financial supervision and financial stability oversight in the future. The Irish
Central Bank will provide for the full integration and co-ordination of prudential
supervision and the stability of individual financial institutions and the financial system
as a whole. The international financial community will be watching these developments
closely in order to ensure that the implementation process matches the desired
objectives. This is the ultimate test in rebuilding the reputation of the Irish financial
services industry and the Irish economy.

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About the authors

K.P.V. O’Sullivan is a graduate student of the MSc Regulation (Research) programme at the
London School of Economics. He has previously worked in economic and research positions for
Industrial Development Agency Ireland, Forfás, Bank of Scotland, GDSI Limited, University of
Limerick and the National University of Ireland, Galway. He has published a number of articles
and a book chapter focusing on financial regulation in Ireland. K.P.V. O’Sullivan is the
corresponding author can be contacted at: kpvosullivan@gmail.com
Tom Kennedy is a Professor of Accounting and Director of the Centre for Taxation Studies at the
University of Limerick. He has published widely in the areas of intellectual capital and contemporary
cost management systems. He has previously worked in senior management and financial positions
with Abbott Laboratories, ACS Teoranta, Digital, Irish Shell, Kerry Group and Dunnes Stores.
Tom Kennedy is the corresponding author and can be contacted at: tom.kennedy@ul.ie

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