The idea that yesterday’s collapse in Irish banking shares comes as a shock to the markets is nonsense. Anyone with a basic knowledge of how economies work should understand that banks get hammered when housing markets go into reverse.

The banks, by lending recklessly in the boom, will now bear the brunt of the slump. Whether their shares fall further might depend on international sentiment. However, it is clear that the financial market thinks the aggregate balance sheet of the Irish banking sector is in tatters.

During the boom, anyone who questioned the logic of betting the nation’s cash on the housing market was dismissed as a crank.

Now it is becoming apparent that the banks in Ireland ceased being banks some year ago and transformed themselves into leveraged gamblers on property.

The Irish banks morphed into hedge funds that bet one way on property. Today, when their darling asset is no longer rising but falling, we realise that the top managers of our banks were nothing more than bull market traders.

So, rather than being the guardians of prudence, the Irish banks became the agents of profligacy.

As long as house prices were going up, the balance sheet of the bank played tricks on the bankers.

Because banks use a ‘loan-to- value approach to assessing whether a loan is risky, the banks got caught in a situation where their balance sheets were deceiving them.

The central problem with the loan-to-value approach is that the loan actually drives the value, not vice versa, as the theory would suggest.

Let’s think about a bank lending €300,000 to a punter to buy a house that is “worth” €350,000. As long as the value on the bank’s books of the asset is greater than amount lent, the loan looked prudent. But if everyone is lending, the price of all houses will go up and the value side of the ‘loan-to-value’ will rise too. So that ultimately the loans are causing the value to go up.

This means that the collateral that the banks are basing their lending on is progressively becoming debased.

This process ultimately turns into a Ponzi scheme, where the entire system is based on getting more and more people to borrow money so that the valuations can be sustained.

Now that this has been exposed, the banks are in serious trouble. They are calling in loans all over the place and have dramatically changed their lending practices.

As many banks have stopped lending to each other, they have to go to the market to borrow. So in the UK, Bradford and Bingley — one of the champions of the buy to let Ponzi scheme — has had to issue shares, hoping to raise money to make sure that its balance sheet is credible. However, the news from the UK in the past 24 hours was that the bank could not raise the cash easily as investors were worried.

Many market watchers believe that the Irish banks — that have been playing the same games as Bradford and Bingley — are probably in a similar position.

So their shares have been sold off. If things are as bad as the market thinks, what is the likely upshot?

Here is where the EU, the Lisbon Treaty and, more particularly EMU, come in. Traditionally in a credit crunch of this type, the national central bank bails out the commercial banks by making loans to them.

The central bank takes IOUs from the commercial banks, prints money in exchange for the IOUs and the banks begin to rebuild their balance sheets.

In addition, in order to entice people to lend, the central bank also cuts interest rates. Gradually, people begin to borrow a bit more, banks begin to lend a bit more and the objective is to prevent making “a drama out of a crisis”.

We in Ireland are now in the unfortunate position of not being able to do this. Because of EMU, we can’t change our interest rates and nor can our central bank give preferential treatment to our banks. We are in effect an economy with no economic tools at our disposal.

This dilemma is made worse by newspaper headlines that the IMF is advising the ECB not to cut interest rates but to raise them in the face of higher European and global inflation pressure.

So instead of getting lower interest rates — which is exactly what our banks need — we might actually get higher rates.

If this occurs, the downturn in Ireland will get considerably worse, not because the actual effect such an interest rates hike would have, but because of the psychological effect it would have on people.

Only then would people realise the extent of the financial cul de sac we have waltzed ourselves up.

Given that this appears to be the type of scenario that the financial markets are betting on, what is the likely endgame for the Irish banks and the Irish credit market in general?

It is clear that with the evaporation of credit, house prices will fall further — there is simply nothing there to keep them up.

This will make things worse as the banks’ balance sheets will be even weaker. At this stage, the banks will need someone to lend them money and lots of it.

However, why would someone lend a bank some money when you can buy the whole thing?

But who would buy an Irish bank? The only people who have money now are the Arabs and the Russians.

The sovereign wealth funds of the Arab oil producers and the Russian Republic are constantly looking around the world for distressed assets.

With all this talk about the EU Treaty, someone has forgotten to tell us that because of exploding oil revenues, the real monetary power has shifted from Brussels to Bahrain and from Paris to St Petersburg.

Forget the rhetoric of the ‘Yes’ and the ‘No’ campaigns, the next big financial and economic development in Ireland is likely to come from much further afield.

Don’t be surprised if one of the upshots of our so-called economic miracle is an oil sheik or a gas oligarch running our banking system.

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