Fear Ireland’s shadow banks

The Emerald Isle is ripe for a volatile market correction

Artillery Row

Cast your mind back to the short-lived tenure of prime minister Liz Truss. Whilst memes about a cabbage outlasting her time at Downing Street eclipsed any serious analysis of how she managed to last less than 50 days in Downing Street, the economic tremors that led to her downfall warrant serious consideration when examining the increasingly opaque financial landscape. The impact of the “Truss-Kwartang” mini-budget showed that, despite the nebulosity of shady financial instruments that seek to circumvent economic regulations, the impact on wider society can be profound. What happened in the aftermath of the mini-budget was the collapse of British pension funds’ Liability Driven Investments (LDIs). Following the announcement of unfunded tax cuts, which were heavily criticised by the International Monetary Fund (IMF) amongst others, bond yields rose with a resultant fall in their price which the pension funds needed to make sure their assets, which included bonds, generated enough cash to meet liabilities — the monthly payouts guaranteed to pensioners. As the funds struggled to acquire cash — which acted as collateral — they sold gilts putting further downward pressure on the bond market.

Post-financial crash, Ireland became one of the largest sellers of distressed assets in Europe

To help alleviate the wider impact the Bank of England (BoE) engaged in an over £60 billion bond-buying scheme to stabilise gilts. LDIs were sold by major asset managers including Blackrock and reached a gargantuan £1.6 trillion by 2021. The impact on the real economy was immense. 10-year gilt yields rose from 3.5 per cent to 4.3 per cent before falling back to about 4.05 per cent which saw a surge in costs for homeowners with monthly mortgage payments rising by over £200. Indeed, food price inflation saw a major surge rising to over 10 per cent.

Whilst the Republic of Ireland may have looked gleefully at the economic and political instability across the pond, Dublin would be wise to examine its own underground financial structures that are ripe for a similar and equally volatile correction. 

Following the election of incoming US President Donald Trump much has been made of the potential impact his return to the oval office may have on the Irish economy. His incoming commerce secretary and head of the White House’s tariff team Howard Lutnik has publicly questioned why little Ireland has a trade surplus with big America. As Dean Céitinn pointed out in this publication last week, “President-elect Donald Trump has signalled his intent to onshore … multinationals’ with tariffs and a lowering of the US” corporate tax rate all on the agenda. Whilst there is certainly the possibility of a US tech and pharma exodus from the Emerald Isle as an increasingly protectionist America seeks to onshore these companies, ultimately years of goodwill and diplomatic harmony between Ireland and America means the latter will be reluctant to see the country’s economy implode overnight. However, a much more sinister threat looms in the ether that bears all the hallmarks of a repeat of a 2008-like scenario.

In a recent assessment of the so-called “shadow banking” industry, the Irish Central Bank Governor Gabriel Makhlouf said that there are “systemic risks” associated with the sector. But what is shadow banking, you may ask. According to the Financial Stability Board (FSB), Shadow Banking is an umbrella term used to describe “credit intermediation involving entities and activities outside the regular banking system” such as private equity vehicles, non — bank lenders etc.

In contrast to normal banks which, according to the FSB, “issue short-term deposits and invest the money in long-term assets such as loans, leases and mortgages, shadow banks fund themselves “wholesale through deposit-like instruments and securitisation of long-term assets” with “loans, leases, and mortgages securitised and thus tradable instruments.” Post-financial crash, in which Dublin suffered the brunt, Ireland became one of the largest sellers of distressed assets in Europe. This was facilitated via the Irish State’s bad bank The National Asset Management Agency (NAMA) which had a commercial mandate to dispose of the “toxic” loans off the domestic banks’ balance sheets whose liabilities primarily in residential property, now non-performing, due to years of loose mortgage lending exceeded performing loans. From 2014-16 NAMA sold over €50 billion worth of distressed loans to investment funds with Irish loans accounting for over one-third of all distressed loan sales in Europe in both 2013 and 2014. According to the United Nations, over 90 per cent of these loans were sold to US hedge funds and/or private equity. The aim was to recapitalise property following the crash and get the banks to start lending again. However, the law of unintended consequences has meant history is slowly repeating itself with storm clouds on the horizon. Due to the size and scale of these asset transfers conducted by the Irish State via NAMA following the financial crash, the shadow banking sector has ballooned. As such, Ireland is home to the fifth largest shadow banking industry holding some €3.5 trillion in assets — thirteen times the size of the real economy. Reminder: according to former US Secretary Treasury Timothy Geithner at the peak of the “Celtic Tiger” Irish banks “were eight times the size of their economy”. The sector has skyrocketed since the crash, rising by over 40 per cent accounting for almost half of the global financial sector, according to the UN. The worldwide industry is estimated to be worth over $200 trillion. The FSB has singled out the so-called “core” figure which is vulnerable to “bank-like financial stability risks” and “liquidity stress” worth over $60 trillion.

Directly regulating the sector is futile given the inability of regulators to access the byzantine structures

Whilst the shadow banking sector may, as its name hints, lurk in the shadows away from the “real economy” I.e. domestic lenders such as banks, the contagion impact, should these “stability risks” and “liquidity stresses” occur, is a huge risk to overall financial health. Beyond the mini-budget debacle other black swan events have shown that ordinary people and governments are often forced to pick up the bill for these speculative wheelers and dealers. 

In 1998 the collapse of the highly leveraged American hedge fund Long Term Capital Management required a $3 billion bailout due to the wider contagion effect. Ireland is particularly vulnerable to these shocks given the sheer scale of the shadow banking presence. 

To avoid potential economic uncertainty what is required is a reassessment of the overall shadow banking system including what these banks have invested in such as property. Whilst post-crash regulations have constrained the ability of banks to lend and homeowners to borrow, these measures are simply a case of fighting the last war. Right now, there are over 100,000 loans held by non-bank, unregulated entities in Ireland — 16 per cent of all households in the State — with many of these home loans securitised in wholesale money markets.

When a bank disposes of mortgages off their balance sheets they are usually sold to a US private equity and/or hedge fund who in turn set up what is known as a Special Purpose Vehicle (SPV) which is a holding company for the securitisation of debt but off the balance sheets of the parent company. As such, the SPV turns the portfolio of mortgages into a securitised loan which is warehoused in Ireland.

This scheme has made Ireland’s International Financial Services Centre (IFSC) the third-largest global shadow banking centre. Under Section 110 of the Irish Taxes Consolidation Act (TCA) 1997 an SPV is given charity status which allows the entity to claim tax neutrality and thus pay no tax on capital gains or VAT. More worryingly, according to the Irish Department of Finance, none of these entities are subject to prudential regulation by the Irish Central Bank (CBI) despite Ireland having the largest securitisation sector in the euro area by assets under management. Indeed, the department has also stated that non-Irish registered SPVs are not subject to data regulation. For context, according to IDSA Securitisation securitisation in Ireland is predominantly international, with 91 per cent of Irish SPVs set up on behalf of non-Irish sponsors with the US and UK accounting for 75 per cent of all Irish domiciled SPVs. Whilst some of these loopholes have since been closed the damage done through years of tax neutrality and little to no regulation means Ireland is vulnerable to a potential economic shock similar if not worse in magnitude to the UK’s mini-budget aftermath. 

Discussion on directly regulating the sector is futile given the inability of regulators to access these opaque and byzantine structures. However, by regulating some of the methods by which the sector has been allowed to flourish such as SPVs which are the core of the deeply unpopular “vulture fund” phenomenon that is often cited in discussions on Ireland’s housing crisis this could clip the wings of this unregulated and volatile sector.

Following the publication of the McDonald report, named after yours truly which I presented to the Irish Parliament, I made several recommendations to address the systemic issues associated with non-bank lenders. This included a ban on foreign ownership of property mainly by investment funds, and a remittance tax on foreign domiciled investment funds. 

Citing the report, Independent Irish parliamentarian Mattie McGrath put forward an amendment to the annual Irish Finance Bill that sought to address the systemic issues with SPVs. The bill aimed to “reclassify SPVs utilizing Credit Servicers — who service loans for investment funds — as “investment undertakings” which would enable “Credit Servicers to deduct tax at source and serve as local agents for SPVs in their interactions with Irish Revenue” and would aim to “prevent these entities from evading tax responsibilities.”

He also called out “the lack of transparency behind Central Bank closed doors raising significant concerns about potential undisclosed activities.” Whilst this specific amendment was defeated, at some point Dublin will have to address the elephant in the room before America starts calling on us to bail out their hedge funds in a similar way Jean Claude Trichet of the ECB called the Irish government to bail out European banks, many of whom had claims in Irish lenders, in 2008 to the tune of over €60 billion.

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