As share prices fell last week, before the govern­ment guarantee scheme was unveiled, Irish banks must have wondered what they had done to deserve this fate. The short answer is they have mismanaged their risks in recent years, while pursuing short-term profits. The traditional rules governing exposure to the building and construction sector have been ignored, as have the criteria for loans.

In past building cycles house buyers were typically advanced 65% to 75% of the purchase price and builders would only be advanced construction finance as houses were sold. Activity was automatically reduced when the markets turned and the banks were well-covered with the underlying security. This time lending standards were dropped and the various risk controls failed to operate.

It is in nobody's interest to precipitate a deeper crisis. Just as the failure of banks recently in the UK and US has had a damaging effect on confidence, so too would the failure of a major developer here. Bankers are working closely with developers, some of whom are acting as bankers in offering finance to potential buyers. Interest is rolled up where necess­ary and loans restructured where appropriate.

There is one central thing all banks should consider. How much of the rapid growth of their property loan book was caused by their rewards system? If you set heavy lending tar­gets for managers and link these to bonuses, it should not be surpris­ing if big loans to property developers result. It is much simpler to advance €50m in a single loan than to advance 50 loans of €1m each. Exces­sive pressure for short-term profits is dangerous and has resulted in a decline in standards in the past, when Dirt-free deposits were taken with bogus overseas addresses.

There has been much talk of late of "moral hazard" or the possibility of antisocial behav­iour as a result of ill-considered systems. When a loan is securitised or passed to another party there is the danger it will not be prudently made, partic­ular­ly if the originator gets a handsome commission.

If a rating agency is paid by the company whose securities it is evaluating there is a danger objectivity will be lost. If the admin­istrat­or of the loan is just paid a small fee for collect­ing repayments, there is a danger arrears will not be fully pursued. All these issues have contributed to the problems of the sub-prime market in the US. But the greatest moral hazard exists if banks are rewarded for mismanagement.

Last week's news that the government will guarantee the liabilities of Irish-owned banks for two years on commercial terms should do much to reassure depos­itors and stock markets. But the guarantee in effect nationalises the liabilities of the banks and creates the ultimate moral hazard. It was the US government's guarantee to depositors of the thrifts or savings and loan institutions, the equiv­alent of our building societ­ies, that caused a crisis. In 1989 the initial cost of clearing up bad lending was $50bn, but after six years it amounted to $300bn.

In the US the rejected Paulson plan of injecting $700bn to rescue the banks met with a mixed reception, but it tried to limit the remuneration bankers take. Since government support has been given in Ireland, it seems sensible to publicise the terms. The last rescue here was the bail out of AIB, following the disastrous purchase of the Insurance Corporation of Ireland. The other banks were railroaded into a bank levy to pay for it. After that there were no resignations in AIB. In fact shortly afterwards the bank announced an unchanged dividend. Eaten bread is soon forgotten. There is now space not only to strengthen the banks, but also the system which regulates them.

Tim McCormick worked for 17 years
at the investment banking subsidiary
of Northern Bank, subsequently
National Irish Bank