Irish Banking Crisis and Herd Behaviour

By Devasish Mathur

INTRODUCTION

Before we dwell into the causes – psychological or non-psychological, it’s imperative to have a brief understanding of the background and the events of the crisis. The following paragraphs explain the Irish Banking Crisis and the concept of Demonstration Effect (Herd Behavior).

Irish Banking Crisis

Soon after the onset of the Great Recession in 2008, as the domino effect reached Europe, Ireland was amongst the first country in the Eurozone to slide into recession. As noted by Regling and Watson in their book, Ireland’s economic crisis bears a clear imprint of global influences, yet it was in crucial ways “home-made”. The crisis caught the ‘Celtic Tiger’ off guard and crumbled Ireland’s fortune, which was seen as the top of the European class in its economic achievements. In the period of two decades from 1987 to 2007, the Irish economy almost doubled its employment steadily increasing it from 1.1 million to 2.1 million, which then combined with other improvements in productivity delivering a period of extraordinary economic growth averaging 6.3% per year. Houses were in a great demand due to this ever-increasing population and the income of the people of Ireland. The proximate cause of this exceptional boom in Ireland could be easily traced to the construction and housing sector but driving this construction boom was a less recognised boom, in bank lending. The growing economy generated enough money that even after adopting policy decisions like lowering tax rates and increasing public expenditure, the Government could still run the budget in surplus. However, by 2007, most of the factors that had generated exceptional growth had played themselves out.

Soon enough, the Irish financial institutions started lending mortgage finance at a historically low rate, which dropped from 10% to below 5% resulting in house prices to increase four times over the decade from 1996 to 2007. The Irish economy experienced a rise in bank lending, with loans increasing to about 200% of the GDP by 2008. Irish banks were lending forty percent more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and seventy-five percent more as mortgages. In order to meet such demand, Ireland’s banks borrowed from international wholesale markets to fund increases in lending and the speed and scale of this expansion, driven by increased domestic competition, access to cheap international finance and apparent initial success, could only be achieved by a weakening of lending standards and large-scale wholesale borrowing. The subsequent investigations revealed that the Financial Regulator could not observe the risk in such weakened lending standards and failed to regulate the standards with prudence. Similarly, even the Apex Bank of Ireland failed to notice the potential threats concerning the financial stability. By the time this bubble reached its peak, the average house cost about 10 times of the average earnings, where the cost of the houses and the mortgage amount mutually pushed one another resulting in increase in house prices and larger mortgages with the amount of mortgage loan reaching 106 billion Euros in the third quarter of 2008, which was about 60% of Ireland’s GDP.

As the risk of financial danger remained unnoticed or was underestimated by the key financial players as well as other actors in the economy, the inevitable self-destructive nature of this bubble finally burst and collapsed the Irish economy. When the amounts became too large to afford, the mechanism of mutually increasing the cost of houses and mortgage started to work in reverse and a huge number of houses started to remain unsold. The property slowdown so caused became a dreadful situation for the financial institutions that had lent a huge amount of money to the constructors and developers to finance their projects. The Irish economy faced a number of challenges where their banks saw a tremendous fall in share value, property prices dropping to about half, huge loss in income tax revenues, collapse of the construction sector, fall in GDP by 10% between 2008-2009, unemployment and a sudden fiscal deficit of about 20% of the GDP. Eventually, the Government intervened and guaranteed all deposits and senior debt in the six Irish banks in September 2008; was forced to nationalise Anglo Irish in January 2009; invested €3.5 Bn in preference shares in the two large retail banks AIB and Bank of Ireland in February 2009; and established a National Asset Management Agency (NAMA) to buy non-performing development loans from banks in November 2009. As an aftermath of this bubble, the Irish banks suffered enormous losses on loans for properties with increasing international liabilities.

Demonstration Effect as a Crisis Behavioral Attribute

There exist countless situations in our daily lives when we make decisions based on what other people are doing around us. This tendency to imitate the decisions taken by others or conforming to the majority views is known by a number of terms- “Herd Behavior”, “Demonstration Effect”, Bandwagon Effects”, “Group thinking’ etc. with fine differences between them. One of the theory or rationale behind this all-pervasive human instinct proposes that we observe the choices made by others and then use them as valuable information on which to base our own decision thinking that we might have the information they have. Although it might be a good idea to use this approach when an individual is uncertain while making a choice, such acts of deciphering information contained in the decisions made by others also make each person’s decision less responsive to her own information and hence less informative to others. The other rationale behind herding trace this behavior to improve our own decisions, to maintain our reputation, to influence the decisions of others, to maintain group dynamics, to avoid majority sanctions, and more. In an economic context, “Herding” refers to the willingness of investors and banks to simultaneously invest in, lend to and own the same type of assets, accompanied by insufficient information gathering and processing. In the contemporary financial setting, herding by the actors in the market is often a concern for the policymakers regarding the stability of the market. Moreover, adding to it, various studies show that there is empirical evidence proving the presence of herding behavior in financial markets.

CRISIS BEHAVIORAL ATTRIBUTES INFLUENCING THE CRISIS

As the six main Irish Banks were caught in the collapse – Bank of Ireland; Allied Irish Banks; Anglo Irish Bank; Irish Life & Permanent; Irish Nationwide Building Society and Educational Building Society, it was the Anglo Irish bank that led the way. Anglo Irish Bank, specializing in property development, expanded its loan book at over 20 percent per year, with its assets growing from €26 billion in 2003 to €97 billion in 2007. Prior to 2003, these banks had operated in a very traditional manner, with loans being roughly equal to deposits but after 2003, the rapid expansion of property lending was largely financed with bonds issued to international investors. This started a practice that later came to be known as “chasing Anglo” whereby the other banks were tempted to accelerate loan book growth and consequent lowering of lending standards may have partly reflected incentive structures, especially remuneration schemes that rewarded market share at the expense of long-term risk. In order to compete with Anglo Irish Bank, the other banks started following Anglo’s footsteps, aiming for the same set of consumers and adopting similar techniques to attract them. The surge in the housing market blindfolded the risks involved to both the banks as well as the consumers, who could not see anything beyond their increasing wealth, affordable mortgages in a never-ending boom, the bubble. Instead of figuring out their own way to the most profitable path, the management of the other banks chose to imitate Anglo’s techniques resulting in the herding of the banks fear the loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect. As Peter Lunn notes, “Anglo-Irish Bank was an apparent success story that executives in other banks sought to emulate”. Reports suggest that the banks had the impression that in case they adopt a “contrarian” approach, they might face a resistance from the stakeholders.

The contribution to the Irish Banking Crisis was not limited to the crisis behavioral attribute of herding of banks only; it was well complemented by the herding behavior of the consumers as well. In order to understand this part, one has to view the pre-crisis situation from the point of view of a regular bank customer. The steady and rapid growth rate of the earnings and property prices for a considerable long duration convinced the consumers that the taking out mortgage would be considered safe and effective. Moreover, it must be noted that unlike other countries, Ireland had not experienced a crash in house prices for more than a generation, so there were unlikely to be influential norms of borrowing behavior borne of painful experience. Given the scenario, any prudent customer having a limited sense of economics and how financial institutions work would consider it beneficial to “get on the property ladder” before the prices further increased as per the prevailing trends. When the market optimism met lack of past experiences, even the media campaigned and promoted investing in property with TV shows preoccupied with the same. Although international evidence in relation to the influence of the media in stoking house prices is sparse, there is good evidence that the media can have a “social amplification” effect in relation to perceptions and expectations of prices generally. Due to the factors mentioned above, the majority of the consumers made an unsound economic choice in the pre-crisis period. There were a limited few who were waiting for a drop in prices to get their hands on the property and waiting while the herd is in moving ahead with rising prices. The bank employees, journalists, policymakers, customers or any other player in the financial market showed no will to depart from the strong public opinion and consequently walking down the same lane herding.

CONCLUSION

Honohan correctly summarizes the crises in his article as “an interesting boom and bust story, which combines hubris formed during the years of solid growth (before about 2000), the unprecedented experience on inward migration and the demonstration effect of financial excess in neighbouring countries”. The Irish banks had forgotten the basics of banking while lending out money considering it a sale and undermining the risk acquired as a result achieving virtually common goals. The complementing factor of the customers acting in herd behavior and reaching out for mortgage loans without having the required amount of information about the transaction and its consequences pushed the Irish economy into utter chaos. Ignoring the non-psychological factors responsible for the Irish Banking Crisis, the “home-made” disaster was majorly brought by the crisis behavior attributes of the key players in the financial market i.e., herding behavior by banks, customers, media, and policymakers. The timing of this event was such catastrophically placed following the Great Recession and preceding the European Debt Crisis to make the condition worse when half of the globe was itself struggling financially. In order to pull the banks out of this crisis and save people’s money, the Government had to give bailouts to the banks eventually itself running into a debt crisis.

Clearly, these crisis behavior attributes of the actors cannot be predicted or theorized up to a level where prevention could be feasible. At best, the governments and the financial regulators may be cautious of such events and their symptoms, spread awareness amongst all the key players of the financial market and learn from the mistakes made by the other economies. These findings are not limited to Ireland and should concern every individual.


SOURCES

  1. Regling, Klaus, and Maxwell Watson. A Preliminary Report on the Sources of Irelands Banking Crisis. Dublin, 2010.
  2. Whelan, Karl. “Ireland’s Economic Crisis: The Good, the Bad and the Ugly.” Journal of Macroeconomics39 (2014): 424-40. doi:10.1016/j.jmacro.2013.08.008.
  3. Whelan, “Ireland’s Economic Crisis: The Good, the Bad and the Ugly.
  4. Bank lending for UK from Bank of England, for Eurozone economies from the ECB: Aggregated balance sheet of euro area monetary financial institutions, excluding the Eurosystem http://www.ecb.int/stats/money/aggregates/bsheets/html/outstanding_amounts_index.en.htm
  5. Kelly, Morgan. “The Irish Credit Bubble.” UCD Centre For Economic Research, University College Dublin, December 21, 2009. https://www.ucd.ie/t4cms/wp09.32.pdf.
  6. Lunn, Peter. “The Role of Decision-Making Biases in Ireland’s Banking Crisis.” May 2011
  7. Bikhchandani, Sushil, David Hirshleifer, and Ivo Welch. “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades.” Journal of Political Economy100, no. 5 (1992): 992-1026. doi:10.1086/261849.
  8. Banerjee, Abhijit. “A Simple Model of Herd Behavior.” The Quarterly Journal of Economics107, no. 3 (August 1992): 797-817.
  9. Misjudging Risk: Causes of the Systemic Banking Crisis in Ireland. Dublin: Stationery Office, 2011.
  10. Honohan, Patrick. “What Went Wrong in Ireland?” Trinity College Dublin, May 2009. http://www.tcd.ie/Economics/staff/phonohan/What went wrong.pdf.

Devashish Mathur is a student of Jindal Global Law School in JGU, Sonipat

Featured image source- LATimesBlog

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