Last night on The Week in Politics, Fine Gael’s Leo Varadkar criticised proposals for nationalisation of the banks on a couple of grounds, one of which was that it “wipes out 300,000 small shareholders.” Later, in describing FG’s plan he said that the new banks created as part of this plan “would buy the good loans off the banks, take the good loans off the banks and set up a clean bank and, by doing that, you then create capital for the old banks and give them some chance of survival.”
Those watching would probably interpret these comments to imply that Fine Gael’s plan does not involve nationalisation and that it would be better for bank shareholders than what has been proposed under nationalisation. In my opinion, neither of these positions are correct.
First, let’s look at what happens to the shareholdings in the current banks under the FG plan. Here’s the relevant section:
11. The “legacy banks” left behind would remain in private ownership. Their banking licences would be withdrawn and they would no longer engage in any new lending (beyond what is needed to facilitate work-outs of their loan-books). Their shares might continue to be quoted on the stock exchange.
12. The purpose of the legacy banks would solely be to work down the remainder of the loan book (mostly the distressed developer-related debts and associated collateral) and recoup maximum value from it over time. It would be managed in the interests of the existing capital owners and other creditors. If enough money is recovered over time from property developers, they would be fully repaid (any Government debt would be repaid first).
13. If the legacy banks prove to be insolvent, at some point they will be unable to service their obligations. At this point, normal bankruptcy proceedings would apply. This may involve significant haircuts for unsecured creditors, and / or debt-to-equity swaps.
Leo may think that this scheme is giving the legacy banks “a chance of survival” but with banking licences withdrawn and their only role being to manage bad debts, this looks more like a temporary period of living death. Clearly, the shares in these banks will be worthless. This is, of course, the essential idea of the FG plan: Providers of risk capital should take the hit and equity is the riskiest form of capital. Legally, you can’t clean out bond holders without wiping out equity first.
[Before my FG friends start complaining, I am aware of the offer of discounted shares in the new banks for existing shareholders. More on that below.]
But what about the new banks—who’s going to own them? The FG plan is not too clear about this but Willem Buiter (whose plan FG are essentially following) has described pretty clearly how this works with this kind of plan. He proposes that the new banks are capitalised by the state.
If the new bank takes on a higher level of assets than liabilities, then the government will pay the old banks the difference, so that it has provided the equity capital for the new banks (you can’t simply strip assets greater than liabilities out of a privately-owned listed company with debt obligations, though note that Leo is not correct that this process is “creating capital” for the old bank.) In the (unlikely) case that a new bank’s good assets are less than liabilities, the government can provide the difference required to recapitalise (FG optimistically propose that the old bank could owe the difference to the state-owned new bank with this obligation being senior to other debt.)
So, as proposed by Buiter, the new-bank-old-bank plan clearly involves nationalisation of the good parts of the banking system. FG are a bit coy about this. They discuss the idea of raising new capital from “private investors, including shareholders of the legacy banks at discounted prices” but this process would undoubtedly take time. Most likely, the good banks would need a period of stability in state ownership to appoint new management and set out a clear business strategy
As for the shareholders, whether the opportunity to buy new shares in a good bank at a discount at some point in the future proves to be any kind of compensation would depend on the size of the discount, which has not been specified. Certainly, there is no reason to assume the shareholders would do better under the FG plan than under some of the proposals associated with advocates of nationalisation (such as paying current market value). Indeed some advocates of nationalisation have proposed giving shareholders in the old banks an ownership share in the banks once they have been privatised again.
The real differences between the FG plan and the various nationalisation proposals are twofold:
- FG want to wait 16 months before nationalising most of the banking system, hoping that a National Recovery Bank will somehow keep credit flowing.
- FG want holders of longer-dated bank debt to absorb losses. The advocates of nationalisation have, by and large, kept the debate within the government’s terms of reference, which assume that guaranteed bondholders to not lose out. However, one could debate whether or not further nationalisation needs to follow the Anglo model and be accompanied by assurances that all debt will be paid back. Legally, I believe the banks will still be limited liability companies and one can debate whether or not financial markets would indeed see such a default as equivalent to a sovereign default.
My scepticism about the FG plan relates to the weakness of Point 1. I don’t think their proposed resolution would work and I don’t think we can afford to wait 16 months.
Point 2 is to my mind, the attractive part of the FG plan. If the loan losses turn out to be a lot larger than the current equity capital of the banks, then the loss of longer dated bond debt as a cushion could greatly increase the cost of the banking crisis for the taxpayer. That said, one can debate whether such defaults would have negative implications for the future funding of the Irish financial system. Opposing Varakar on the The Week in Politics, Michael Martin was fairly explicit that he saw this as a problem with the FG plan. In any case, FG are to be congratulated for getting a proper debate on this issue going.