On last night’s Prime Time, Brendan Keenan argued that it didn’t matter much how the government dealt with the problem of bad loans at the Irish banks, as long as they got on with doing it, though he noted he would be very reluctant to nationalise. Similarly, David McWilliams said that the key thing was to do something to deal with the bad assets and that it doesn’t matter whether we nationalise or not, i.e. that we needed to produce cleaned-up banks and it didn’t matter who owned them.
Let me explain why I think it does matter how we go about this and who owns the cleaned banks. Start with a few figures. The combined capital of AIB and BOI is currently estimated at about €20 billion, but they are only beginning the process of writing down their bad loans. The fact that their combined market capitalisations are below €1 billion suggests that the market believes these losses will amount to at least €20 billion. Let’s say, just for illustrative purposes, that €30 billion is the figure for losses.
Consider now two scenarios for creating cleaned-up versions of these banks, both of which involve the removal of the bad loans from their balance sheet. I’m going to assume, for illustration, that after the bad loans are replaced with other funds, the banks will need €15 billion in capital to carry on as healthy operations (I’m thinking here that they should pay off some debts and operate with a lower loan-to-deposit ratio and a smaller balance sheet, thus requiring less capital.)
Scenario 1: The Irish government announces that it is not going to renew the liability guarantee beyond September 2010 or provide further supports. Without taxpayer support, the banks will not be viable and will thus need to be nationalised. The loans are taken over by a government asset management company and replaced on the bank balance sheets with government bonds worth €5 billion less than their book value. The government now owns two types of entities: An asset management company whose job is to sell off the bad property assets over time in order to minimise the losses for the state (but which, on current valuations is worth €25 billion less than the government paid for it) and a couple of cleaned-up banks with no bad assets and equity capital of €15 billion. As soon as the operation is complete, the government can look to privatise the cleaned-up banks, thereby recouping its €15 billion it has provided in capital.
Scenario 2: The Irish government sets up an asset management company and it buys the bad loans from AIB and BOI for €5 billion less than their book value. It sets up an asset management company to get as much as possible for these assets over time but the current valuation of this company is minus €25 billion. Again, we now have two cleaned-up banks with no bad assets and equity capital of €15 billion.
As Patrick Honohan pointed out in comments yesterday, it is now widely accepted that the Irish banks need to be cleaned up, so the real issue is how to allocate the necessary losses between the existing shareholders and the taxpayer. Under Scenario 1, the €30 billion in necessary losses are shared so that shareholders lose their €20 billion in equity capital and the Irish taxpayers lose €10 billion (the €25 billion loss on the bad property assets minus the €15 billion gained from spinning off the new banks.) Under Scenario 2, the losses are split so that the current shareholders lose €5 billion and the Irish taxpayer loses €25 billion.
Under both scenarios, the outcome is a cleaned-up banking system ready to perform its crucial financial intermediation functions. Perhaps Keenan and McWilliams would be indifferent between these two scenarios. However, I prefer Scenario 1 because
- It costs the Irish taxpayer €15 billion less.
- By nationalising, cleaning-up, and re-privatising, it leaves the banks in new private ownership, so that the management and shareholders of the banks that caused this trouble are not rewarded with the gift of a valuable asset courtesy of the taxpayer.
As Patrick pointed out in his comment, there are still a lot of details to come out about Bacon’s bad bank proposals. However, they appear to look a lot more like Scenario 2 than Scenario 1, particularly when you factor in that the Independent article describing the leaked details of the report cited “staving off nationalisation” as a key achievement of Bacon’s proposal.
One final issue is worth flagging. Both of these scenarios have an asset management company, a “bad bank” if you must. So, to say that the issue is that “we need a bad bank” is simply beside the point. The real question is how the losses are allocated. And previous international examples of bad banks have operated along the lines of Scenario 1 above, not Scenario 2. On Prime Time, Keenan noted his reluctance to nationalise but came out in favour of the bad bank idea (so presumably endorsing something like Scenario 2) and said that the IMF had noted that such schemes had worked well in the past. Here is a link that brings you to yesterday’s IMF report and here’s what it says on page 11:
Insolvent institutions (with insufficient cash flows) should be closed, merged, or temporarily placed in public ownership until private sector solutions can be developed. While permanent public ownership of core banking institutions would be undesirable from a number of perspectives, there have been numerous instances (for example, Japan, Sweden and the United States), where a period of public ownership has been used to cleanse balance sheets and pave the way to sales back to the private sector.
PS. The most confusing aspect of last night’s program was McWilliams’s references to “Noddyland”. I’m pretty sure Noddy lived in Toyland.