By Patrick Honohan
Perhaps it was inevitable that this month’s announcement of the Irish government’s bank recapitalisation package was a bit of a damp squib.
What the government, and the public, look for comes down to two things: a resumed flow of credit, and the banks financially restored to the point where they can stand on their own two feet and are not going to be a continuing burden on, or threat to, public finances.
These are not unrelated: the flow of credit is unlikely to move reliably until the banks are healthy, although the connection is far from immediate or strong.
Allied Irish Banks and Bank of Ireland (to which the government provided €3.5bn each) are certain to incur severe loan losses over the next few years. These losses will absorb much of the capital reported in their accounts. It has been clear for some time that they would need an injection of replacement funds by investors prepared to take risks that losses would be higher than expected. Given present uncertainties, there are no private investors willing to take this elevated risk.
Indeed, the market price of bank shares, a mere 3 to 4 per cent of where they were a couple of years ago, indicates that the market expects loan-losses to be far higher than the banks have themselves projected.
No wonder the injection of funds fail to boost bank shares.
Under these circumstances, it seems impossible for banks to sell equity to the private sector and others are unwilling to lend to them without government guarantee. The banks are wholly dependent on the government guarantee for their continued operation.
So what would it take to return the banks to financial independence and self-reliance? Templates can be found in the parallel efforts of governments in other countries to restructure their own banks and restore them to health. So far, no single model prevails. There are essentially three techniques, which have been used in different combinations .
The first restructuring technique is to inject enough government equity to ensure that any conceivable losses can be absorbed without threat to other lenders. (This is what the British government has been doing with Royal Bank of Scotland).
Second, provide the bank with some form of government insurance against extreme losses in the bank’s loan portfolio. (This was done for Citigroup and UBS).
Third, transfer the deposits, the performing assets, the branch network and most of the staff into a new bank (or they could be sold to a foreign bank, for example), and transform what’s left (the bad assets on which bank bondholders and shareholders have claims), into an AMC to be worked-out over years. (This is the nuclear option; it was used for Washington Mutual and Bradford and Bingley).
These techniques have a different impact on the allocation of losses. The public does not want to absorb costs that they believe should fall on bank shareholders and others.
The task of getting a reasonable allocation of losses is made more difficult by the wide discrepancy between the market’s pessimism over future loan-losses and the statements by both the banks and the regulator.
The latter, insiders as they are, have better sources of information than the market, but their conclusions may be coloured by over-optimism and cognitive dissonance.
Injecting government equity dilutes the claim of existing shareholders, though how much dilution depends on the price at which the shares are provided.
Providing insurance benefits the shareholders, because it frees them from the risk of extremely bad outcomes. But again, this depends on the pricing and other terms of the insurance. Both these techniques are great for the other lenders to the bank, the holders of unguaranteed bank bonds.
The third option – removing the good bits, and leaving the rest for an eventual liquidation – may seem theoretically to be the cleanest and it can be the fairest; it also moves the incentives for bank management in the right direction. It imposes losses in the first instance on the shareholders and then on other unguaranteed creditors.
But applying this third option to either of the two biggest banks in Ireland would be a shock to the economic system. Managing such a transaction without it resulting in alarm and disruption would require exceptional financial and political skills. It would also require considerable preparation.
The government has yet to employ any of these three options. It has been reluctant to take a controlling equity stake (fearing, as do other governments, heightened political pressure to provide relief to borrowers from a nationalised bank).
It has not wanted to take action that would amount to a hand-out to bank shareholders (though other bondholders do benefit from the injection). And it has certainly set its face against any step that could be disruptive to financial markets and to the credit of the state. These constraints are understandable. But their combined effect has been to limit policy action to what can only be described as a half-measure.
Although it is risky to allow undercapitalized banks to operate, because they will be tempted to gamble for resurrection, the government guarantee has in practice reduced the urgency of recapitalisation.
They can access funds to lend, even though not always in the most convenient form or at appropriate maturities. This month’s injection of funds is insufficient in itself to restore the banks to financial independence. Fortunately, it does not preclude more decisive action in the future.
Patrick Honohan is professor of international financial economics and development, Trinity College Dublin. A version of this piece originally appeared in the Dublin Sunday Business Post
