Brian Lenihan. Brian Murphy

in finance and banking recommended that the State inject €10 billion of capital into the banks to repair them. They predicted a ‘good prospective return’ for the State on this investment.

      All of these projections proved optimistic. To be fair, the ultimate cost of a banking crisis is impossible to determine early on. In the end, the State would inject €64 billion into the banks, much of which will probably not be recouped.

      The higher-than-expected cost of saving the banks in part reflected the greater-than-expected severity of the recession. In Budget 2009, which was announced two weeks after the introduction of the bank guarantee, the Department of Finance projected a small decline of 1 per cent in economic activity (measured by GNP) for 2009, followed by a rebound to positive growth of 2.5 per cent in 2010 and 3.5 per cent in 2011. The Department anticipated that the unemployment rate would peak at 7.3 per cent in 2009.

      Other economic forecasters were also pencilling in a relatively soft landing for the economy. In the ESRI’s Quarterly Economic Commentary (QEC) for autumn 2008, released just before Budget 2009, the QEC team forecast a modest contraction of less than 1 per cent in GNP in 2009 and a small increase in consumer spending. The Central Bank of Ireland and the IMF published similar projections. In the event, GNP plummeted more than 9 per cent in 2009 and consumer spending slumped more than 5 per cent. By the end of 2013, the depth and length of the economic downturn was such that both these measures of economic activity were still far below their peak levels in 2008. Unemployment soared to roughly twice the rate that economists had forecast.

      If the economy had performed as anticipated in late 2008, banks’ losses would have been contained. But the exorbitant cost of shoring up the banks was also due to another factor. Reckless lending practices by the banks during the bubble years meant that the underlying quality of the banks’ loan books was much worse than could be gleaned by reading the banks’ financial statements. The detailed loan-by-loan due diligence examinations of the banks’ loans carried out in late 2009 and 2010 as part of the NAMA valuation process revealed a disturbing picture of poor loan documentation, of loans not properly legally secured and of marked deficiencies in the banks’ measurement and management of risk. The banks’ books were laden with landmines hidden beneath the financial accounts.

      The blanket bank guarantee covered some €440 billion of banks’ debt. Deposits and bonds that were scheduled to be repaid by the banks over the next two years were covered. If the banks were not in a financial position to meet these obligations, then the State promised to make good on the repayments. The scheme categorically ruled out imposing losses on senior bank bondholders – also known as burden sharing with or bailing in bondholders – for a period of two years. Contrary to claims from some quarters, the blanket scheme was not extended beyond September 2010. Two other bank guarantee schemes were still in operation at that time and were extended well beyond 2010, but neither covered bank bonds issued before 2010. The two-year duration of the scheme meant that there would be no opportunity to bail in bondholders until October 2010. By that time, however, most of the bonds had reached their maturity dates and had been repaid in full.

      Some people have argued that a narrower guarantee scheme which excluded existing senior bonds would have allowed burden sharing and reduced the cost to the State of rescuing the banks. At an abstract level, this might be true. In practice, however, this argument ignores the European Central Bank’s entrenched position regarding burden sharing with senior bank creditors. The ECB vehemently opposed bailing in bondholders. The ECB’s stance on this issue would later frustrate Lenihan’s plans to impose losses on senior bonds after the blanket scheme expired. Although promises to burn the bondholders featured in the general election campaign in 2011, to date no losses have been imposed on senior bonds of any bank in the euro area. At this remove, it is clear that the State would have had to make good on senior bank bonds, even if they had been excluded from the blanket guarantee.

      More generally, there are mixed views among observers today as to whether the blanket guarantee was a mistake. A well-researched book by Donal Donovan and Antoin Murphy concludes that the guarantee was the least-worst option and that critics have failed to supply evidence that other solutions would have worked. The former President of the European Central Bank, Jean Claude Trichet, recently described the decision by the Government as ‘justifiable given the situation it found itself.’ In contrast, European Commissioner for Economic and Monetary Affairs Olli Rehn recently said: ‘In retrospect I think it is quite easy to spot some mistakes like the blanket guarantee for banks.’ Rehn’s comment is puzzling since the European Commission approved the guarantee scheme for state-aid purposes. To conform to EU state-aid rules, government intervention in the banking system ‘has to be necessary, appropriate and proportionate.’ How can a policy that is deemed to be necessary, appropriate and proportionate be a mistake? Moreover, the Commission later sided with the ECB against Lenihan and the IMF staff in protecting senior bank bondholders. It is not clear how these apparent contradictions can be explained.

      One cannot help feel that for many people it is convenient to blame the country’s entire economic woes on the blanket guarantee. Many people are uncomfortable discussing what they said and did – and in some cases what they did not say and did not do – during the years of the bubble. If the public can be convinced that our problems began on the night of the guarantee, then nearly everyone is off the hook. The simplistic narrative that the bank guarantee cost the State €64 billion and that we ended up in an EU/IMF bailout programme because of the guarantee is too often used to distort the truth.

      BATTLE TO RESTORE MARKET CONFIDENCE

      The introduction of the guarantee bought time for the banking system, but by early 2009 the banks’ funding position was becoming strained again. For sure, the banks were supported by the State, but investors were becoming concerned about the sustainability of the State’s finances. During the first quarter of 2009, the economy lost nearly 8,000 full-time jobs per week. The bulk of these jobs were in construction and other property-related sectors. Economic activity plunged, led by a collapse in new homebuilding, and the public finances deteriorated at an alarming pace. The economy was falling off a cliff. Ireland’s costs of borrowing on international markets rose steeply.

      The deepening recession affected investor confidence in the banks. In turn, the weakening banking system further depressed the economy and damaged the public finances. The toxic inter-relationship between the State and the banking sector was threatening to bring both of them down. It would be another four years until European leaders would agree to begin to build a banking union in Europe to break the link between sovereigns and banks. In the future, we may see a common backstop for banks in the European Union. But during Lenihan’s tenure at Finance, each member state was responsible for stabilising its own banking system.

      Lenihan believed that the battle to restore market confidence and stabilise the financial system had to be fought on three fronts. First, the public finances had to be put on a sustainable footing. The transient taxes of the boom had evaporated, revealing a huge structural gap between government spending and revenues. To that end, Lenihan ‘executed’ (as he put it himself) €21 billion of budgetary adjustments, pushing the enormous boulder of fiscal correction more than two-thirds the way up that particular mountain.

      Second, the country had to regain international competitiveness to improve its potential for growth. As Lenihan put it: ‘Unless we regain our competitive edge, we will be unable to return to the tried and tested strategy of export-led growth that ushered in the boom in the early 1990s. We must be able to compete and win again in the international marketplace.’ To measure competitiveness, Lenihan put a great deal of stock in Ireland’s unit labour costs. He studied these data regularly and was encouraged by the marked drop in costs in Ireland relative to our main trading partners during 2009 and 2010.

      Despite the tight constraints imposed by the need to reduce the fiscal deficit, Lenihan’s Budgets contained initiatives to boost the competitiveness of various sectors of the Irish economy, including tourism, agriculture and agri-food, forestry and bio-energy, cons- truction and the retail trade. He also enhanced the incentives for R&D and intellectual property to help the country to attract new business and new jobs.

      Lenihan was an optimist. He was convinced that the Irish people could work their way through the crisis. Lenihan could