Central Bank of the Year: Central Bank of Ireland

In 2009, the Irish economy lay in tatters. Its property market had imploded and its financial system collapsed under the weight of loans to that sector. The Irish state had turned to the International Monetary Fund for financial relief after taking on around €64 billion ($69.3 billion) of bank liabilities, amounting to about 40% of GDP.

The root causes were multiple. However, it is generally accepted that poor governance and weak controls at the Central Bank of Ireland, particularly at its autonomous 'financial regulator' unit, contributed to a failure to address the problems in time. The resulting collapse of the Irish financial system, which included the closure of two of the country's six domestic banks, the state takeover of a smaller bank and the establishment of a bad-asset agency, hit the real economy hard. At its peak, unemployment in Ireland soared to more than 15% in 2010 and 2011 from a rate of around 5% at the start of 2008.

In early 2009, the Financial Services Consultative Consumer Panel, a national body tasked with monitoring the performance of the Central Bank of Ireland, said most consumers had lost "significant amounts of money" due to the inadequacies of the financial regulatory structure. The panel also criticised the "deficient" response of the central bank to threats to consumers, including the Irish property bubble. The 'financial regulator' was an operating unit under the Central Bank of Ireland at that time, but one that did not report to the governor.

The reputation of the central bank – and that of the Irish authorities more generally – was also damaged in international circles. In particular, the unheralded decision by the Irish government in September 2008 effectively to guarantee all deposits and debt (including subordinated debt) related to major Irish financial institutions, in a bid to restore confidence in the sector, caused a domino effect around the world. It forced authorities as far away as Australia to introduce similar measures or risk facing a flood of outflows from their own financial institutions at a time of heightened risk in the global financial system.

Former governor, Patrick Honohan

Fast-forward to 2015 and the Irish economy, its financial sector and its wider economic system are back on a more stable and sustainable footing – a remarkable turnaround. The central bank cannot and would not claim all the credit. The determination of the Irish people to get out of the crisis as soon as possible, as well as important actions by the European Central Bank, international policy makers and the Irish government have all helped. But the impact of efforts by the central bank's staff – in particular under governor Patrick Honohan between September 2009 and November 2015 and subsequently by Philip Lane – to put in place important new processes and procedures has ensured a better functioning financial system. Moreover, the painful adjustments have been made without the ability to devalue the nation's currency, as Ireland remains a core eurozone economy. This constraint puts a premium on skilful use of macro-prudential tools.

Much of the reform effort in Ireland stems from insights gained from Honohan's Irish banking crisis, regulatory and financial stability policy 2003–2008 report to the minister of finance. In his 2010 report, the former professor of international financial economics and development at Trinity College Dublin, who had spent a decade at the World Bank as a senior adviser on financial sector policy, said financial stability reports produced up to 2008 reflected a "triumph of hope over reality". They also highlighted the unusual organisational structure in which the financial regulator looked after both prudential considerations and consumer protection for insurance firms, securities brokers, mutual funds, credit unions and banks; yet it "was neither within the central bank nor outside it".

Philip Lane, Central Bank of Ireland's current governor

The Central Bank Reform Act 2010 ratified the reintegration of the regulatory and supervisory apparatus fully within the central bank, and established the Central Bank Commission to ensure its responsibilities are properly discharged. The Central Bank of Ireland introduced a new systematic framework of assertive risk-based supervision called 'Prism', backed by significantly enhanced enforcement. This approach to supervision is based on well-targeted challenge and intrusiveness, increased resources, and requirements that are proportionate to risk and potential impact. The calibre and success of the Prism effort is reflected in the ECB's decision to adopt the system as the basis of its framework for Single Supervisory Mechanism (SSM) supervision, launched at the end of 2014, according to some officials.

The Central Bank of Ireland has also significantly strengthened its policy and supervisory approaches in the context of investment funds. Using changes to EU fund law as a platform, the Irish regulatory regime for funds was restructured significantly. Ireland was the first to require loan-originating investment funds to comply with robust rules on credit management, leverage and liquidity.

Most regulatory powers at the Central Bank of Ireland are now delegated to the deputy governor for financial regulation. Since October 2013, that role has been occupied by Cyril Roux, who has long experience working in and regulating the French insurance and broader financial sector. He was previously first deputy secretary general of the French resolution and supervisory authority (ACPR), which was set up in March 2010, and has been instrumental in ensuring Irish insurance companies are ready to meet incoming European Union Solvency II risk-based regulatory rules.

In 2015, the project plan included: the completion of a dedicated, bespoke supervisory handbook to assist supervisors in the execution of their new responsibilities; the delivery of 11 bespoke Solvency II supervisory training courses, the development of a new risk-based supervisory framework, specifically tailored for Solvency II; the roll-out of a Solvency II preparatory reporting system; the introduction of software for the central bank's internal model application process; and the reorganisation of the directorate. The Central Bank of Ireland also embarked on a major communications offensive to create greater awareness of Solvency II across the Irish insurance industry.

Stefan Gerlach, deputy governor, Central Bank of Ireland

Roux's appointment was part of an ongoing effort by the Central Bank of Ireland to recruit talent from a wider pool that reached beyond Ireland's borders. During most of 2015, both deputy governor positions were held by foreigners. Former head of Secretariat to the Committee on the Global Financial System at the Bank for International Settlements (BIS) and managing director of the Institute for Monetary and Financial Stability at the University of Frankfurt, Stefan Gerlach, took on the role as deputy governor for central banking in September 2011. "There are new staff coming in from outside at all levels, and a breath of fresh air comes through any institution when this happens," Honohan told Central Banking in 2009.

Gerlach describes Honohan "as likely the most reforming leader that the Central Bank of Ireland has had over its 72-year history". Other notable achievements include the decision to move the central bank to purpose-built headquarters, as well as the aim of developing an engaged and motivated staff through improvements in internal communications, performance management, leadership development and the establishment of clear principles and behaviours.

Gerlach characterises Honohan as possessing "independence, innovative thinking and a strong public service ethic": "The vision he has set for the Central Bank of Ireland – that of being trusted by the public, respected by its peers, and a fulfilling place to work for its people – can also be applied to his own personal approach as governor." It is a legacy that looks set to continue under Lane, the former Whately professor of political economy at Trinity College Dublin, who succeeded Honohan late last year.

In short, 2015 witnessed the culmination of much of the staff's good work in addressing balance sheet concerns and supervisory failings at the central bank.

Balance sheet resolution

For example, at the height of the crisis, the Central Bank of Ireland had extended unprecedented liquidity support to the domestic banking system both in the form of standard Eurosystem operations and emergency liquidity assistance (ELA). Liquidity support reached a peak of more than €153 billion in February 2011, €21 billion short of total Irish GDP that year. This fell back to just under €15 billion at the end of July 2015. One of the main challenges the Central Bank of Ireland faced was dealing with the large amount of ELA in the system and in particular the collateral linked to lending from the Irish Bank Resolution Corporation (IBRC). As part of a liquidation plan for IBRC, carefully constructed over many months, the central bank negotiated an exchange of that collateral for marketable government bonds. This facilitated an end to ELA with acceptable assets on the bank's books.

The central bank is still disposing of these bonds, with sales of €2.9 billion in 2015. This has helped, alongside reduced monetary policy lending (also a sign of a return to normalisation), to further reduce the Central Bank of Ireland's balance sheet by €30 billion. The lasting impact of these developments is seen not only in improved financial stability conditions more generally, but also – when combined with the returns from its investment assets – in significant profits being recorded by the Central Bank of Ireland. It earned €1.5 billion and €2.1 billion in 2013 and 2014 respectively, and is expected to post broadly similar profits in 2015.

Another key challenge for the central bank in dealing with the fallout from the financial crisis has been protecting the interests of borrowers who have struggled to keep up repayments and fallen into arrears. The Central Bank of Ireland has worked hard to ensure borrowers have access to support via a statutory mortgage arrears code, and is viewed as influencing and shaping wider policy debate in this area. "This work has also been a big influence on developments at a European level to protect borrowers, which has resulted in the European Banking Authority publishing in 2015 Guidelines on arrears and foreclosure," says Gerlach.

The central bank continues to take action regarding non-performing loans (NPLs) – in particular, mortgage arrears – as part of its overall approach to resolving distressed debt (including commercial NPLs). The bank's supervisory engagement has contributed to a significant shift from relying on short-term forbearance, to longer-term sustainable solutions, with the Central Bank of Ireland estimating that sustainable solutions have been proposed to the majority of those in arrears, and concluded in 62% of these cases. The bank's approach to addressing NPLs has been highlighted by the ECB, with SSM chair Daniele Nouy noting in an October interview that the ECB's SSM approach on NPLs was "using the experience of Ireland, a country which has already made considerable progress on this issue".

The SSM also turned to Ireland for help with its IT system to support supervisors located at the ECB as well as at participating national supervisors. "In view of the very tight time constraints during the SSM's implementation phase, it was decided not to develop a new system, but to rely on an existing solution and customise it to fulfil the SSM's needs for the short term," says Korbinian Ibel, director general for micro-prudential supervision IV at the ECB. "The Central Bank of Ireland solution was ideally suited to this approach as it was a modern, up-to-date tool developed in English that already covered most of the processes relevant for SSM supervision. This allowed us to focus system developments on areas of particular importance and rolling it out to more than 3,000 users in 19 countries. As a result, the system was operational from Day 1 of SSM supervision and now underpins day-to-day supervisory work."

Back in Ireland, much progress has also been made in raising bank's capital ratios and the banks are now seen as well-capitalised by international standards (OECD Economic Survey for Ireland, September 2015, page 24).

Learning from its mistakes

In February 2015, learning from the experience of the financial crisis, the Central Bank of Ireland introduced macro-prudential measures for the Irish housing market. These took the form of limits on new lending at high loan-to-value (LTV) and loan-to-income (LTI) ratios. The primary objective of the measures was to increase the resilience of Irish households and banks to financial and housing market shocks. This objective was viewed as important from both a cyclical and a structural standpoint. Structural features, such as high household indebtedness, high mortgage arrears and levels of negative equity arising from the legacy of the last crisis and the high exposure of both households and banks to property, meant that banks and households in Ireland are very vulnerable to shocks in the property market. In addition, a further objective was to reduce the pro-cyclicality of property lending and to reduce the risk of a bank credit-property price cycle developing in the future.

Efforts by the central bank were criticised by a range of political, banking and property interests. Recent data appears to show clear evidence of a levelling-off in house prices in Dublin and elsewhere in Ireland since the final quarter of 2014, coinciding with the introduction of the macro-prudential measures. The annual rate of increase in house prices moderated from 25% in Dublin and around 15% nationwide, to around 3.3% in Dublin and 6.5% nationwide in November 2015, according to the Central Statistics Office. The evidence suggests that the mortgage measures have had an effect in moderating price pressures by reining in demand and tempering price expectations. A quarterly Central Bank of Ireland/Society of Chartered Surveyors Ireland ‘survey of property professionals' shows market participants expect prices to rise steadily over the coming one to three years, but at a more modest rate than was expected prior to the announcement of the measures. Moreover, the main reason given for the change in expectations appears to the introduction of the macro-prudential measures.

Moreover, the macro-prudential tools were designed to ensure prudent lending standards across the property cycle and to become a standard feature of the mortgage market in Ireland. This means that once expectations are ingrained, the tools may have longer-term deterrent benefits and may need to be deployed less frequently. And it is the central bank's confidence to ignore the protests of vested business and political interests in addressing the potential property bubble that demonstrates its new-found resolve to tackle sensitive issues in an independent manner.

In short, the Central Bank of Ireland has regained its reputation among its peers as both a forward-thinking and strong institution.

The Central Banking awards were written by Christopher Jeffery, Tristan Carlyle, Daniel Hinge, Arvid Ahlund, Dan Hardie and Rachael King.