In the past few weeks, the financial markets have suffered a heart attack.

The arteries and capillaries that supply credit to the economy have become clogged with bad loans and the supply of liquidity has been choked off.

The financial markets are so much more important for other industries because they act as the heart of the industrial system, pumping cash into every nook and cranny of the economy.

The scale of the coronary problem became apparent a few weeks ago, but was confirmed when the surgeon general announced that the patient’s blood was in danger of coagulating and possibly clotting in the most sensitive of areas – the investment banking world.

He prescribed that the best policy was to continue the financial Warfarin of easy credit.

Like many doctors who diagnose after the symptoms are obvious, last week the boss of the European Central Bank realised the extent of the systemic problem.

Jean-Claude Trichet announced, as if it were news to anyone, that it was ‘‘appropriate to gather additional information and examine new data before drawing further conclusions regarding monetary policy’’. So he abandoned his stated policy of raising interest rates and kept everything on hold.

Headlines on Friday suggested that this was a relief for Irish mortgage owners – and maybe it was; but the question is whether the problem for the financial markets will be solved by the ECB – or whether the ECB is now a bystander, observing rather than dictating.

There is much evidence to suggest the latter. Under its nose, the ECB allowed large investment banks to involve themselves in one of the greatest rackets the money markets have seen in years.

When the racket was revealed, the banks reversed their free-lending policy and this has resulted in the end of the easy-credit regime which dominated our economy for the past few years. In recent weeks, banks have dramatically tightened up on lending.

This is the problem with the banking system. When things are good, it is a feast; when things turn down, it is a famine. Now the same banks that last year would have financed everything, look you up and down as if you were mad to suggest a preplanning permission investment in Arklow is a good idea.

Mass greed has been replaced by mass fear in the place it matters most, the boardrooms of Ireland’s banking world.

To understand how the banking world’s taps can be turned on and off overnight and why the central banks are playing catch up – we have to examine how the banking system works and how it reacts to different stages of the credit cycle.

During the upswing the banks – the so-called bastions of prudence – are actually the main agents of profligacy for the following three reasons.

First, we have the law of insecure middle management. Let’s not forget that, behind all the slogans like ‘‘working together’ or ‘‘your partner’, banks are simply moneylenders – and the more money they lend, the more money they make. So yellow-pack bankers, whose status within the bank and outside has been dramatically eroded by ATMs, are at pains to exceed lending targets set by senior bosses.

The banker sees the borrower as yet one more target to be hit in the obsession to lend. If the banker can get his hands on a bankable piece of collateral, such as the house, he can make an easy sale and hit or exceed his target, so he will lend whatever he wants as long as there is bankable security. After all, if he does not hit the target, there are plenty more suits coming behind him who will. The second force at work is the law of shareholder value. Bank bosses’ salaries are linked to the share price of their outfits, so it is in their interest to push the share price up above the average. The problem is that the people who ultimately own the banks – large pension funds – expect too large a return every year.

How can a business like a bank, which is involved in a typically low-growth, mature industry like money-lending, make returns on equity of 20 per cent-plus, as expected by the pension funds and banking stock indices?

The only way they can do this is by working their staff to the bone, capping costs and wages and lending recklessly.

Therefore, and ironically, our own pension funds were driving our banks to lend to us with abandon. So the prospects of your pension fund when you retire are indirectly linked to getting you into debt when you are working.

The third, and most important, factor at work in the lending frenzy is the impact of land on the balance sheet of Irish banks. If the price of land is rising in tandem with the amount of money gushing into property, the banks will be able to lend more against it. The balance sheet starts to play tricks with them.

Counter-intuitively, the more money they lend, the safer it looks in terms of the ratios they use to assess secure lending. So it becomes a self-reinforcing dynamic where, the more money they lend, the more they feel they should lend.

Now think about the situation when the price of land is falling. The bank draws in its horns automatically. The credit bonanza is followed, almost overnight, by a credit crunch.

This is why the financial markets are still falling, despite the ECB’s best efforts. The markets understand that we are now in the downswing of a credit cycle. Warren Buffet once said that ‘‘it is only when the tide goes out, do you see who is swimming in the nude’’.

In Ireland, irrespective of last week’s decision to keep interest rates on hold, the credit tide is ebbing and all is about to be exposed.

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