Exactly the theory was sound. But the banks at the time probably didn’t borrow from the ECB, they probably borrowed from somewhere else, at lower rates. That somewhere else was the money markets which were a wash with free and easy money. So they collected a margin difference between what they were charging, ie the ECB rate, and what costs they were facing, ie the money markets. The money markets didn’t want anything to do with bad credits, and stopped financing the Irish banks.
And then the tracker banks got squeezed. ECB rates went down, QE…, so the contracted rate in the trackers had to go down. The Irish banks were forced to borrow the expensive money at ECB and CBI rates, and the margin that they were making, was supposed to cover the defaults. But obviously that won’t happen now.
But the theory was right, just they got greedy. They normally borrow from Euribor money markets, so they should have linked against this. I am more familiar with USD Libor markets. But the concept is the same.
The strategy was this.
1: Make loans, regardless of how the risk was hedged
2: Get funding from the money markets to generate short term gains, even if it wasn’t hedged exactly
3: Get sales commission, bonuses, for giving everyone what they wanted.
And everyone got what they wanted. There was lots of business activity, profits looked good, commission and bonuses flowed on the back of good stock market reaction, pension funds bought up shares, stock markets looked for banks where there was an expansion of activity, and everyone bought into the hype.
The problem as I see it, is that those who managed the risk in the banks still get to keep their bonuses, their pensions and probably their jobs.
The reaction to what has happened is that those in banks should have their bonuses, commissions tied to the long term profit of the banks, instead of quarterly/annual profits. That would ensure those tied to managing the risk of the banks, do their job, and don’t get forced into taking cheap short term money, and using it to take long term risk. You can’t do real business, without taking risk, but you have to manage that risk, and price it accordingly.