Abstract
This Selected Issues paper examines the competitiveness of the Irish manufacturing sector. The paper highlights that in 2001, production cuts and accelerating wage growth arrested the trend improvement in external competitiveness, but the level remains high. The paper presents some medium-term fiscal scenarios. It discusses indicators of financial system soundness based on official data and publications, as well as discussions with the authorities. The paper also examines indicators on the vulnerability and solvency of the financial system and presents a brief description of supervision arrangements.
IV. Ireland’s Financial System—Structure and Performance1-2
1. This paper discusses indicators of financial system soundness based on official data and publications, as well as discussions with the authorities. Following a description of the structure of the banking system in Ireland, the paper examines indicators on the vulnerability and solvency of the financial system and concludes with a brief description of supervision arrangements.
A. Structure of the Financial System
2. Ireland’s banking system comprises banks and building societies, the latter whose role has been gradually declining. The broader financial system includes, in addition, a variety of nonbank financial institutions, including: Collective Investment Schemes (mutual funds); investment intermediaries such as securities trading companies and portfolio management companies; exchanges and their member firms; and insurance and leasing companies. As described in the Central Bank of Ireland’s Annual Report 2000, a deposit protection scheme provides coverage of 90 percent (including on nonresidents’ deposits) up to a maximum of €20,000. The fund is paid for by banks and administered by the Central Bank. No compensation has been paid to date under this scheme. A similarly organized investor compensation scheme was established in 1998. In the event an investment firm (e.g., stockbrokers, investment and insurance intermediaries) is unable to meet its obligations, the fund will pay out 90 percent of the amount invested by a client up to a maximum of €20,000. The scheme is funded by contributions from investment firms and is overseen by the Investor Compensation Company Ltd., a separate legal body independent of, but supervised by, the Central Bank.
3. Following rapid growth in the number of banking institutions in the mid-1990s, the system has stabilized in recent years (Table 4.1). There is a large presence from foreign banks, operating primarily in the International Financial Services Center (IFSC).3 However, their role in the domestic market has so far been limited as they have been mainly involved in dealings with nonresidents.
Ireland: Structure of the Banking System
Building societies.
Ireland: Structure of the Banking System
| 1998 | 1999 | 2000 | 2001 | ||
|---|---|---|---|---|---|
| Number of banks: | 57 | 56 | 54 | 55 | |
| Majority state-owned (as a percent of total assets) | 4 | 3 | 2 | 0.7 | |
| Majority foreign-owned (as a percent of total assets) | 42 | 37 | 39 | 42 | |
| Foreign branches (as a percent of total assets) | 16 | 14 | 13 | 12 | |
| Number of banks accounting for: | |||||
| 25 percent of total assets | 3 | 3 | 3 | 3 | |
| 75 percent of total assets | 23 | 23 | 23 | 21 | |
| Nonbank deposit-taking institutions 1/ | 3 | 3 | 3 | 3 | |
| Percent of total assets | 4.3 | 3.4 | 2.9 | 3.0 | |
| Percent of GDP | 12.5 | 13.6 | 12.0 | 12.8 | |
Building societies.
Ireland: Structure of the Banking System
| 1998 | 1999 | 2000 | 2001 | ||
|---|---|---|---|---|---|
| Number of banks: | 57 | 56 | 54 | 55 | |
| Majority state-owned (as a percent of total assets) | 4 | 3 | 2 | 0.7 | |
| Majority foreign-owned (as a percent of total assets) | 42 | 37 | 39 | 42 | |
| Foreign branches (as a percent of total assets) | 16 | 14 | 13 | 12 | |
| Number of banks accounting for: | |||||
| 25 percent of total assets | 3 | 3 | 3 | 3 | |
| 75 percent of total assets | 23 | 23 | 23 | 21 | |
| Nonbank deposit-taking institutions 1/ | 3 | 3 | 3 | 3 | |
| Percent of total assets | 4.3 | 3.4 | 2.9 | 3.0 | |
| Percent of GDP | 12.5 | 13.6 | 12.0 | 12.8 | |
Building societies.
4. The banking system is highly concentrated. As indicated by Table 4.1, 25 percent of total assets is concentrated in only three banks.
B. Indicators of Vulnerability
5. The assets of the banking system have grown rapidly in the last few years (Table 4.2). Total banking system assets increased by about 100 percentage points of GDP in the four years up to end-2001, mainly because of the growth of IFSC business with non-residents. Private sector credit has also grown rapidly, albeit at a much slower pace. During 1998–2001, the ratio of credit to the nongovernment sector to GDP increased by slightly more than 20 percentage points, although the growth rate has been on a declining trend.
Ireland: Assets and Liabilities of the Banking System
Includes lending for construction, hotels and restaurants, real estate activities.
Ireland: Assets and Liabilities of the Banking System
| 1998 | 1999 | 2000 | 2001 | ||||
|---|---|---|---|---|---|---|---|
| Total assets as a percent of GDP | 266.9 | 340.1 | 343.4 | 365.7 | |||
| Foreign currency-denominated | |||||||
| Assets (as a percent of total assets) | n.a. | 41.0 | 41.5 | 44.6 | |||
| Liabilities (balance sheet/ as a percent of total assets) | n.a. | 42.8 | 44.4 | 47.4 | |||
| Total loans to non-government sector (as a percent of GDP) | 89.6 | 103.6 | 107.5 | 112.2 | |||
| Housing mortgage finance (share of total domestic bank loans) | 40.7 | 39.7 | 39.0 | 38.8 | |||
| Other housing finance (share of total domestic bank loans) | 1.0 | 0.9 | 1.0 | 0.9 | |||
| Other personal lending (share of total domestic bank loans) | 12.4 | 13.0 | 12.2 | 12.5 | |||
| Commercial property lending (share of total domestic | |||||||
| (domestic bank loans, excluding financial intermediation) 1/ | 15.7 | 18.2 | 20.5 | 21.6 | |||
| Contingent and off-balance sheet accounts | 413.5 | 400.5 | 465.0 | 591.8 | |||
| (percent of total assets) | |||||||
| Total deposits, excluding interbank (as a percent of GDP) | 118.4 | 110.9 | 111.2 | 113.5 | |||
| Central Bank credit to banks (as a percent of GDP) | 2.9 | 5.7 | 8.1 | 11.4 | |||
Includes lending for construction, hotels and restaurants, real estate activities.
Ireland: Assets and Liabilities of the Banking System
| 1998 | 1999 | 2000 | 2001 | ||||
|---|---|---|---|---|---|---|---|
| Total assets as a percent of GDP | 266.9 | 340.1 | 343.4 | 365.7 | |||
| Foreign currency-denominated | |||||||
| Assets (as a percent of total assets) | n.a. | 41.0 | 41.5 | 44.6 | |||
| Liabilities (balance sheet/ as a percent of total assets) | n.a. | 42.8 | 44.4 | 47.4 | |||
| Total loans to non-government sector (as a percent of GDP) | 89.6 | 103.6 | 107.5 | 112.2 | |||
| Housing mortgage finance (share of total domestic bank loans) | 40.7 | 39.7 | 39.0 | 38.8 | |||
| Other housing finance (share of total domestic bank loans) | 1.0 | 0.9 | 1.0 | 0.9 | |||
| Other personal lending (share of total domestic bank loans) | 12.4 | 13.0 | 12.2 | 12.5 | |||
| Commercial property lending (share of total domestic | |||||||
| (domestic bank loans, excluding financial intermediation) 1/ | 15.7 | 18.2 | 20.5 | 21.6 | |||
| Contingent and off-balance sheet accounts | 413.5 | 400.5 | 465.0 | 591.8 | |||
| (percent of total assets) | |||||||
| Total deposits, excluding interbank (as a percent of GDP) | 118.4 | 110.9 | 111.2 | 113.5 | |||
| Central Bank credit to banks (as a percent of GDP) | 2.9 | 5.7 | 8.1 | 11.4 | |||
Includes lending for construction, hotels and restaurants, real estate activities.
6. Growth in lending was backed in part by relatively strong expansion in deposits, although they increased far less sharply than assets and remained broadly stable as a share of GDP since 1999. Much more important has been an explosive growth in money market liabilities, largely to nonresidents, which were virtually nonexistent in 1999 and totaled over 90 percent of GDP in 2001. Central Bank lending to credit institutions rose markedly in 2000–01 to about 11½ percent of GDP for structural reasons related to the move to a single European monetary policy. These credits were to foreign-owned IFSC institutions, whose parent companies were monetary policy counterparties of other central banks, prior to the introduction of the euro, and who now operate within the integrated euro area.
7. The foreign (non-euro) currency-denominated asset and liability positions remained closely matched.4 Despite the adoption of the euro, the share of foreign currency-denominated assets and liabilities has increased slightly in recent years.
8. Personal sector credit has contributed an average of 35 percent of total private sector credit growth in 2000–01. It grew by 16.2 percent in 2001, just slightly lower than the 17.8 percent growth experienced in 2000. Personal sector credit increased from 71 percent to 73 percent of disposable income in these two years. This measure is dominated by housing finance but remains relatively low, in comparison to some other OECD countries.5 Nevertheless, domestic banking system exposure to the property sector remains high, at about 60 percent of total loans. While credit institutions have somewhat reduced their exposure to household mortgages, their exposure to commercial property has risen. The continued high growth in credit to the private sector and, in particular, to the personal sector has prompted the Central Bank to express concerns on a number of occasions.
9. There appears to be substantial activity related to derivatives, with total contingent and off-balance sheet accounts amounting to almost 600 percent of total assets in 2001.6 The bulk of the derivatives seems to comprise foreign exchange and interest swaps and the amount of complex transactions is apparently not large. The central bank requires institutions to have proper procedures and measurement systems in place for derivative activities and imposes capital requirements on such activities in line with best international practices.
C. Indicators of Profitability and Solvency
10. Despite recent decreases, profitability remains relatively high by international standards. However, the average pre-tax returns declined from 1.5 percent in 1998 to 0.9 percent in 2001, in part reflecting increased competition, and in 2001 an economic slowdown and some one-off events (including restructuring costs and contributions to Tier I capital, Table 4.3).
Ireland: Indicators of Profitability
Ireland: Indicators of Profitability
| 1998 | 1999 | 2000 | 2001 | |
|---|---|---|---|---|
| Average pretax return on total assets (in percent) | 1.5 | 1.3 | 1.2 | 0.9 |
| Average pretax return on equity (in percent) | 26.0 | 23.0 | 23.0 | 16.0 |
| Risk-weighted capital/asset ratio: all banks | 37.9 | 23.5 | 21.3 | 24.2 |
| Risk-weighted capital/asset ratio: domestic banks | 11.0 | 10.4 | 9.7 | 11.2 |
| Overall stock market price index | 4,956 | 5,018 | 5,723 | 5,707 |
| Bank stock price index | 10,378 | 6,371 | 7,864 | 8,035 |
Ireland: Indicators of Profitability
| 1998 | 1999 | 2000 | 2001 | |
|---|---|---|---|---|
| Average pretax return on total assets (in percent) | 1.5 | 1.3 | 1.2 | 0.9 |
| Average pretax return on equity (in percent) | 26.0 | 23.0 | 23.0 | 16.0 |
| Risk-weighted capital/asset ratio: all banks | 37.9 | 23.5 | 21.3 | 24.2 |
| Risk-weighted capital/asset ratio: domestic banks | 11.0 | 10.4 | 9.7 | 11.2 |
| Overall stock market price index | 4,956 | 5,018 | 5,723 | 5,707 |
| Bank stock price index | 10,378 | 6,371 | 7,864 | 8,035 |
11. Notwithstanding rapid growth in lending, domestic credit institutions remain, on average, adequately capitalized. The average domestic risk-weighted capital-asset ratio was 10–11 percent during 1998–2001, with much higher average capital-asset ratios when foreign banks are included.7
12. Credit institutions are expected to review their asset quality at least on an annual basis (Table 4.4). For assets with deteriorating quality, this review should take place quarterly. No standard asset quality criteria are applied, but the Central Bank expects each institution to assess the quality of its loan book on a conservative basis—rating and scoring systems are encouraged. Asset quality and the systems used to assess them are subject to review by supervisors during on-site inspections. Aggregate data on nonperforming loans show a reduction in the ratio of nonperforming loans to total lending. This indicator, however, tends to lag the economic cycle and, hence, would not necessarily capture the quality of the portfolio in the event of an adverse shock, or an economic downturn.
Ireland: Provisioning Against Bad Loans
Ireland: Provisioning Against Bad Loans
| 1998 | 1999 | 2000 | 2001 | |||
|---|---|---|---|---|---|---|
| Nonperforming loans, substandard or lower quality | ||||||
| (percent total loans) | 2.5 | 1.8 | 1.9 | 1.9 | ||
| Total provisions for loan losses | ||||||
| (percent of nonperforming loans): | 90.3 | 110.4 | 106.1 | 110.8 | ||
| Specific provisions | 35.1 | 41.5 | 39.9 | 42.0 | ||
| General provisions | 44.5 | 59.0 | 57.4 | 57.6 | ||
| Interest suspense accounts | 10.7 | 9.9 | 8.8 | 11.2 | ||
| Total provisions for loan losses | ||||||
| (percent of total loans): | 2.2 | 2.0 | 2.0 | 2.3 | ||
| Specific provisions | 0.9 | 0.7 | 0.7 | 0.8 | ||
| General provisions | 1.1 | 1.1 | 1.1 | 1.1 | ||
| Interest suspense accounts | 0.2 | 0.2 | 0.2 | 0.4 | ||
Ireland: Provisioning Against Bad Loans
| 1998 | 1999 | 2000 | 2001 | |||
|---|---|---|---|---|---|---|
| Nonperforming loans, substandard or lower quality | ||||||
| (percent total loans) | 2.5 | 1.8 | 1.9 | 1.9 | ||
| Total provisions for loan losses | ||||||
| (percent of nonperforming loans): | 90.3 | 110.4 | 106.1 | 110.8 | ||
| Specific provisions | 35.1 | 41.5 | 39.9 | 42.0 | ||
| General provisions | 44.5 | 59.0 | 57.4 | 57.6 | ||
| Interest suspense accounts | 10.7 | 9.9 | 8.8 | 11.2 | ||
| Total provisions for loan losses | ||||||
| (percent of total loans): | 2.2 | 2.0 | 2.0 | 2.3 | ||
| Specific provisions | 0.9 | 0.7 | 0.7 | 0.8 | ||
| General provisions | 1.1 | 1.1 | 1.1 | 1.1 | ||
| Interest suspense accounts | 0.2 | 0.2 | 0.2 | 0.4 | ||
13. Total provisions against bad loans comprise specific and general provisions, and interest suspense accounts. Specific provision is made against a loan or other receivable, when the estimated repayment is likely to fall short of the balance. General provision is made in relation to latent losses which, although not specifically identified, are known to be present in any portfolio. Interest suspense accounts arise when an institution, having identified non-performing assets, considers it imprudent to continue crediting its income statement with doubtful receivables, but wishes for internal purposes to monitor such flows. The Central Bank can request institutions to increase the level of provisions if it is deemed inadequate. Since 1998, total provisions, and their components have increased as a share of nonperforming loans, but remained stable as a share of total loans.
D. Supervision
14. The Central Bank has full responsibility for the supervision and regulation of the banking system and most non-bank financial institutions and exchanges, including those operating within the IFSC, and also, from April 1, 2001, insurance and assurance intermediaries (totaling 6,010 institutions, of which 2,870 are authorized collective investment schemes, including sub-funds, 2,485 are retail insurance intermediaries and authorized advisors, and 87 are banks). The Minister of Finance has a statutory role in specified circumstances (e.g., with regard to the refusal to grant a banking license or to the revocation of a banking license or acquisition of banks with significant assets in Ireland). Insurance and assurance companies, including those based in the IFSC, remain subject to statutory regulation by the Minister of Enterprise, Trade and Employment. A bill to introduce a unified financial services supervisory authority was introduced to parliament in April 2002.
15. The legislative basis for the Central Bank’s supervision comprises 14 domestic statutes and 15 EU directives (codified under a single directive in 2000) that together provide a modern supervisory framework. The 2000 Financial Sector Assessment Program found that Ireland complies, or largely satisfies the necessary criteria for compliance, with international codes and standards for financial sector supervision. All relevant EU directives on banking regulation and supervision have been implemented8 In certain circumstances, supervisory decisions may be subject to appeals procedures or judicial review by the High Court.
16. The objectives of supervision, as stated by the Central Bank, are to protect the stability of the banking and financial system and to provide a degree of protection to the consumer of financial services. The prevention of commercial failures is not an objective of regulation, rather the aim is to set down parameters governing risks that banks take and the provisions and capital charges made against such risks. The bank carries out its supervisory responsibilities through the authorization of new entities, and ongoing supervision of existing entities.
17. The licensing/authorization process is fundamental to supervision as the process seeks to prevent the establishment of unsuitable financial institutions in Ireland. Where necessary, detailed supervisory requirements are imposed at the time of authorization. The Central Bank has the exclusive authority to license banks, although when a license application is refused or an existing license is revoked, the consent of the Minister of Finance is required. Written licensing guidelines are provided in the Licensing and Supervision Requirements and Standards for Credit Institutions issued by the Central Bank.9
18. The approach to ongoing supervision is tailored to reflect the risks associated with each type of institution and activity. A range of supervisory techniques, both quantitative and qualitative, is used.10 These include: quantitative techniques (including meeting various required financial ratios); regular mandatory reporting; regular review meetings with senior managers of supervised entities; required internal control systems and procedures (although with discretion regarding how these are structured and implemented); and periodic on-site inspections. Finally, the Bank has discretion regarding the action to be taken when prudential standards are breached, although in certain cases, the law obliges specific actions.
19. Supervisors also rely on banks’ external auditors, who have specific obligations under the law. While external audits of prudential returns are not specifically required, external auditors have a statutory duty to report to the Central Bank if, during the course of their audit, they believe that there are material inaccuracies or omissions in returns to the Bank. External audits are required on banks’ annual financial statements, and any material inaccuracies in or omissions from banks’ financial statements relevant to the ability to issue a “clean” opinion have to be brought to the attention of the Bank.
20. In pursuing its mandate to contribute to the stability of the financial system, the Central Bank of Ireland has published Financial Stability Reports as part of its last two Annual Reports. In addition to an assessment of the international economic and financial setting, which has an important bearing on the strength of the financial system in an economy as open to international trade and financial flows as Ireland, the reports focus on internal sources of potential misalignment and “home-grown” risks. In particular, the Bank has been concerned regarding the rapid, albeit slowing, growth of private sector domestic credit and the sharp escalation in property prices. In this regard, the Bank has directed and evaluated a series of stress testing exercises by credit institutions (the latest in November 2000) simulating a variety of hypothetical economic situations, including a significant slowing of domestic economic growth, an appreciation of the exchange rate, and a drop in housing prices. In general, it was concluded that the financial system was well placed to respond to the various shocks, with solvency and liquidity ratios maintained. The financial system appeared to be more vulnerable to increases in general unemployment than to a fall in housing prices; thus, the appreciation of the euro would appear to be a particular risk. The Central Bank is further examining the results of the stress tests on an individual institutional basis, with a view to identifying and spreading best practices regarding methodologies employed before undertaking further testing. In addition, in response to the recent slowdown in the global economy, the weakness of the technology, media and telecommunications industries and the events of September 11, the Central Bank undertook detailed assessments of credit institutions’ exposure to the telecommunications sector, and to industries vulnerable to the after-effects of terrorism (including airlines, insurance and tourism). It was determined that while bank exposure to the relevant sectors was in some cases not insignificant, it was not of systemic importance.
21. The Bank has also initiated an assessment of macro-prudential risks in order to better inform financial supervisors regarding potential systemic tensions arising from both external and domestic developments. While the analysis of Irish-specific risks is at an initial stage, recent empirical work by the Bank suggests that the probability of a financial crisis in Ireland in recent years based on macro-prudential indicators was minimal.11 Nevertheless, as the authors suggest, it would be useful for supervisory purposes to further improve the methodology to make it more forward looking rather than contemporaneous, and to adapt it more closely to reflect the Irish financial system. In addition, work has begun to integrate macro- and micro-prudential indicators in an effort to assess financial sector risks.
Prepared by Mark Lutz.
This note updates “Structure and Performance of the Financial Sector,” Chapter V of Ireland: Selected Issues and Statistical Appendix, IMF Staff Country Report No. 99/108, October 1, 1999.
The IFSC, established in 1987, has developed into a significant center for a wide range of internationally traded financial services. The distinguishing feature from the rest of the financial system is qualification for tax advantages including a reduced (10 percent) rate of corporate taxes, relief from local municipal taxes, and tax relief for capital expenditure and rents on property. However, this distinction will disappear beginning in 2003 with the harmonization of all corporate tax rates at 12½ percent (with a grandfathering until 2005 of the 10 percent rate for projects begun before 1998). No distinction is made between domestic and offshore operations from a regulatory point of view. There are currently about 490 stand-alone projects in operation at the IFSC, employing in excess of 11,000 people.
Although no limits are imposed on open position in foreign currencies, capital adequacy requirements are imposed on open foreign exchange positions. Off-balance sheet items are included in the calculation of the open position.
According to the OECD Economic Outlook No. 70 (Dec. 2001), mortgage credit outstanding as a percentage of annual disposable income in Ireland was 55.5 percent at end-2001, compared to 55 percent in France, 71 percent in Germany, and 108 percent in the United Kingdom.
The reporting of off-balance sheet items is in accordance with the provisions of the EU solvency ratio and capital adequacy Directives, which set out requirements in relation to calculating the credit equivalent amount and application of applicable risk weightings to capture credit and market risks. In the case of interest-rate and foreign exchange related items these are marked-to-market in determining the appropriate credit equivalent. The credit equivalent amounts of these accounts has averaged 8–9 percent of total assets during 1998–2001.
In early 2002, AIB reported a loss of $691 million due to fraudulent trading at its subsidiary U.S. Allfirst Bank. Upon discovery of these events, the parent bank immediately estimated the losses and informed the regulatory authorities in both countries and the markets about the situation. In the event, the financial stability of the AIB group is not in question, with only a temporary dip in the risk-weighted capital adequacy ratio. In addition, the U.S. subsidiary and parent bank have worked closely with the U.S. Federal Reserve in investigating the events and resolving outstanding legal and regulatory issues.
In addition, Revised Guidance Notes for credit institutions relating to money laundering were issued in November 2001. Following the events of September 11, a set of eight special recommendations on terrorist financing were agreed by the international Financial Action Task Force (FATF). The Central Bank subsequently advised financial institutions in Ireland of these recommendations, and the government is preparing enacting legislation.
This, as well as other relevant legislation and regulations, are available on the Central Bank of Ireland’s supervisory webpage, http://www.centralbank.ie/supervision.asp.
The Central Bank had at end-2001 185 staff involved in financial system supervision, of which 35 were involved in banking supervision, and some 64 staff supervising IFSC funds.
See Frank Browne and others (2002), “A Framework for Macro-Prudential Indicators,” Central Bank of Ireland.