Karl Whelan: banking
Despite the best of intentions, the Government’s banking policy in the last two years yields a disappointing scorecard - A for effort, D- for execution, writes Karl Whelan.
It is now almost two years since it became clear that the Irish banking system was in crisis, so it’s a good time to assess the steps the Government has taken to resolve the situation. In doing so, it’s worth starting by pointing out that, shocking as recent developments in Ireland have been, banking crises are not that unusual and they usually proceed in a similar fashion.
The story usually begins with a period of loose credit that leads to banks making ill-judged loans that go bad. Those who supply funds to the banks, particularly bond investors, get nervous about the ability of these banks to pay them back and so they take their funds elsewhere.
The banks then claim they are fundamentally sound, that they merely have a temporary “liquidity” problem and just need some short-term help from governments in the form of guarantees for their funding. Over time, however, it becomes clear that the banks are sitting on big losses and have severe solvency problems.
History shows that best practice is to recognise these losses in a realistic fashion and get the banks recapitalised as soon as possible. This needs to be forced by governments and regulators because bankers are reluctant to seek external equity investment that would dilute existing ownership.
Worst practice is to allow the bankers to drag the process out and delay recapitalisation. When this is allowed to happen, banks usually tighten up on credit. This credit crunch is very damaging to the economy but the bankers don’t mind because their smaller balance sheets reduce the amount of money they need to raise to keep their capital ratios within legal limits.
The Irish banking crisis has followed all the classic steps and, by and large, the Government has made all the classic mistakes. The banks convinced the Government in September 2008 that they were suffering from a liquidity problem but were fundamentally sound. So the Government spent months saying there was no solvency problem, then conceding that there was a little problem, then a serious problem until finally we had the admissions from Brian Lenihan this year that bank lending practices had been reckless and that “at every hand’s turn, our worst fears have been surpassed”.
One consequence of this mistaken diagnosis of a fundamentally healthy banking system was that the Irish Government issued a blanket liability guarantee that was far more generous than that given by any other country during the crisis. It was this guarantee that landed the State with the responsibility of paying back all of Anglo Irish Bank’s liabilities, thus presenting the taxpayer with a bill that currently stands at €24bn.
In terms of the resolution of banking problems, the aftermath of the recent international crisis has seen some examples of good practice with many countries recapitalising their banks quickly and restoring them to something approximating good health by last year. The Irish Government, however, has veered more towards the ‘slow boat to China’ approach to fixing the banks.
Rather than quickly recapitalise, we have allowed the loss-recognition process to drag on and on. The government decided to use Nama’s tortuous loan-by-loan evaluation to assess the capital needs of the banks, a process that took almost a year from initial proposal to first tranche transfer. It then allowed the banks until the end of 2010 to get recapitalised.
Minister Lenihan may believe that the scale of losses on development loans could only have been revealed by Nama’s slow and methodical process. However, the extent of losses revealed has not been at all surprising to anyone following commercial property prices or developments at the High Court. Indeed by early 2009, the combined market value of our two biggest banks had fallen to well below €1bn as market participants anticipated development loan losses wiping out almost all their equity capital.
This long delay in officially acknowledging the obvious has allowed the Irish banks to continue restricting credit in the meantime. Recent figures from the Central Bank show a steady pattern of reductions in the loans available to Irish firms and households since late 2008. This has undoubtedly added to the severity of the Irish recession.
That the Nama process would not fix the banks was predictable from the outset. In an Irish Times article in February of last year, I noted that the EU may limit how much the Government could pay the banks for their loans and argued that it was “easy to imagine a scenario in which the Irish banks struggled on with weak capital bases even after a bad-bank scheme has been put in place.”
I’m not at all happy to see that this outcome has come to pass. The market still does not trust the solvency of the major Irish banks, a fact demonstrated by their continued reliance on, and calls for extensions of, State liability guarantees.
Market participants appear to be telling the Government that they have little faith in the recapitalisation targets that it has set the banks, with further losses on the non-Nama loan book looming ever larger as a serious concern.
The Government’s reluctance to adequately recapitalise the banks last year stemmed largely from the absence of interest from private investors and thus the knowledge that adequate recapitalisation would lead to full State ownership of at least one of the two major banks. This was an outcome that both the Government and the bankers were very keen to avoid.
However, with AIB struggling to meet the target capital levels set for it by the Financial Regulator, the process may still end with this outcome.
All told, despite the best of intentions, the Government’s banking scorecard isn’t pretty. A for effort, D- for execution.
