On September 30, 2008, the Irish government announced that it had put a guarantee on the entire liability side - except for the equity - of the balance sheets of the six largest majority-Irish-owned banks.  This includes all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II). The guarantee will cover all existing and new facilities  issued from midnight on 29 September 2008, and will expire at midnight on 28 September 2010. 

Unlawful

Clearly, the Irish central bank, the regulator and the government did not do their homework.  The guarantee violates EU rules on state aid in a number of ways.

• First, the aid is selective in a way that violates EU rules.  It discriminates between banks incorporated in the Republic of Ireland, based on the ownership of the banks.  The Irish authorities have recognised this, and are admitting majority-foreign-owned banks incorporated in Ireland one bank at a time.  Before long, all subsidiaries of foreign banks will be covered and this will cease to be an issue.
• Second, the guarantee is scheduled to last for 2 years. Under EU rules, state aid cannot be granted for more than six months.
• Third, the guarantee obviously has an effect on competition and trade.  Irish banks, safe in the knowledge that their depositors will not run (for the next couple of years at any rate) and that other creditors will be happy to renew any maturity debt and extend new credit (at least with a maturity of up to two years) have received a huge funding cost subsidy from the Irish taxpayer.  There is supposed to be a payment for the guarantee, but this will not eliminate the international competitive advantage gained by the Irish banks.  That this is no idle speculation is evident from the following e-mail sent out by the Irish Nationwide Building Society on Wednesday October 1:
  • Irish Nationwide Building Society – Government Guaranteed UK Savings Accounts
    • As you may be aware on Tuesday 30^th September the Irish Government put in place a guarantee arrangement to safeguard all deposits (retail, commercial, institutional and Interbank), covered bonds, senior debt and subordinated debt (lower tier II) with Irish Banks.
    • As Irish Nationwide qualifies under this scheme we now represent the safest place to deposit money in Europe with a AAA guarantee from a country with the lowest national debt to GDP ratio of any AAA country.
    • Irish Nationwide are offering the following GBP£ products for savers:
    • Six month 6.75% fixed rate bond (Irish Government Guarantee for any amount)
    • One year 7.10% fixed rate bond (Irish Government Guarantee for any amount) 
    • Money in these accounts are guaranteed regardless of the size of deposit and represent the best value in the UK market.

My first response on reading this was to go out and short this building society despite the guarantee.  There are no safe investments yielding a sterling rate of return of more than seven percent.  Then I realised (a) shorting was illegal and (b) this was a mutual society and not a public limited company.  Still, it is easy to see, based on this and similar idiocies, why the Irish banks and building societies were among the most vulnerable in Europe before the government guaranteed their liabilities.

Obviously the British government will be all over Dublin and the European Commission to end this grotesque distortion of the competitive playing field.  The most likely solution is a limit on the amount of sterling deposits the Irish banks can issue. 

Beggar-thy-neighbour

Financial crises may not be the best time to make friends and influence people, but the Irish guarantee is the most ‘in-your-face’ beggar-thy-neighbour provocation since medieval armies catapulted bubonic-plague-ridden corpses into the cities they were besieging.  Between the attempt to favour Irish shareholders at the expense of foreign shareholders and the poaching of UK sterling deposits (and indeed euro deposits anywhere else in the euro area) through subsidy-fuelled interest rate offers, Ireland should not be surprised to encounter limited support and solidarity in the EU the next time the country is up against it, for whatever issue.

Shortsighted

A 100 percent guarantee of all deposits is over the top.  It’s way more than what is required to discourage unsightly queues outside the banks and building societies.  An insured limit (with a guaranteed speedy pay-out) of € 100,000.00 would be enough to stop deposit runs. 

Guaranteeing the debt of the banks as well is plain silly, unless the guarantee had been accompanied by a haircut (charge) on the debt holders.  Bank debt holders, along with equity holders, permitted the banks to engage in the reckless property- and construction-related lending that has blown such huge holes in their balance sheets.  The debt holders earned risk premia while the going was good and should now be made to pay to discourage future similar reckless behaviour. 

Only if punishing the debt holders were to endanger systemic stability would there be a reason for making the holders of the debt whole.  Clearly, the debt does not create any problems until it matures.  Since the Irish banks have to shrink their balance sheets quite significantly, problems with rolling over maturing debt should be manageable; at worst, it might require government guarantees on new debt issued to replace maturing debt (if debt matures at as rate faster than the desired rate of contraction of the Irish banks’ balance sheet).

Instead of having to fund a limited expansion of deposit insurance for its banks, which would have been enough to prevent bank runs, the Irish tax payer has socialised all the funding risk of the banks, except for the equity.  There is no upside for the tax payer in this arrangement.  The state gets no equity or warrants out of this scheme.  It is a straight transfer from the Irish tax payer and the competitors of the Irish banking system, to the shareholders and other creditors of the Irish banks.  They have now been rewarded for incompetence and recklessness.  The example of the Irish Nationwide Building Society shows us how this inept bail-out will affect the Irish banks’ incentives for future reckless lending.  I hope the Irish tax payers have deep pockets. 

October 2, 2008 2:28pm in Economics, Ethics, European Union, Financial Markets, Monetary Policy, Politics | Comment