I have spent a lot of time arguing that, among the set of options available to us to put the Irish banking system back on track, the current NAMA proposals represent an approach that is unacceptably costly to the taxpayer. The sense I get back from those who defend these proposals is that, yes this may be risky for the taxpayer but that the risk is worth it because NAMA is going to “get credit flowing in the economy again.”
Forgetting for a minute the questions of cost or fairness, I would argue that there is little reason to think that the current NAMA proposals will achieve this goal over the next few years.
Let’s take a step back and start with a potted history of the Irish banks.
In recent years, the Irish banks rapidly expanded their balance sheets, most notably to do a huge amount of property lending. This was funded, not out of deposits, but via borrowings from international money markets. Many of these property loans went bad with the losses threatening the solvency of the banks. With global financial markets in turmoil, wholesale markets have largely withdrawn their funds from the Irish banks despite the presence of a state guarantee, and the banks are now heavily reliant on collateralised borrowing from the ECB.
Implicit in the idea that NAMA is going to get credit flowing in the Irish economy are three assumptions, one that is probably correct but not explicitly stated by the government and two that are probably not correct.
The probably correct assumption is that the Irish banks are now constrained in their ability to extend new loans (should they want to) because they have reached the limits of their eligible collateral. I can’t recall any explicit statement by the government about this, perhaps on the grounds of “commercial sensitivities”, but it certainly seems to be an implicit assumption. According to this reasoning, the replacement of property loans (ineligible as collateral in ECB repo loans) with government bonds (which are eligible) frees up this constraint and allows the banks to make new loans again.
The next (probably incorrect) assumption is that this access to new liquidity will result in new lending to businesses and households. I think this is based on some dubious thinking. The money from NAMA plus whatever recapitalisation funds come from the state are replacing property loans, not loans for small businesses. To expect this money to then be channelled into small business lending is to expect a large increase in lending to these firms over the levels that prevailed prior to the crisis.
Now the fact that so many firms are in trouble might lead you to believe that this type of lending should go up in recessions. However, the opposite is generally the case. This is partly due to demand—firms shelve investment plans during recessions. But it is also due to tightening of credit conditions. See page 9 of this release of the Fed’s Senior Loan Officer Survey for evidence that banks have tightened credit in each of the three recessions since the survey was introduced.
Researchers will, of course, be familiar with this as an example of the so-called “financial accelerator” mechanism associated with the research of Fed Chairman Ben Bernanke—as the underlying financial conditions of businesses deteriorate, banks become reluctant to them supply funds out of fear they’ll go bankrupt.
The final probably incorrect assumption is that, after NAMA, banks will not be concerned about their capital levels. The government has promised to recapitalise the banks after the losses triggered by the NAMA loan purchases. However, they are also reluctant to stump up too much money, partly because they have a declared goal of keeping state ownership of the banks to a minimum. So, in line with the various stockbroker reports, I expect that after NAMA the main banks will have Tier 1 capital ratios of either the regulatory legal minimum of 4% or else slightly above it. This is likely to be below the level that international money markets will consider safe, so it seems likely that a guarantee will remain in place and also that the banks will want to get their capital levels back up.
What would this mean for lending? The concept of bank capital isn’t very well understood by most journalists, who regularly repeat a line about undercapitalised banks “hoarding capital” by not lending. But that’s not really the way it works. Bank capital standards are assessed according to capital ratios in which the denominator is a risk weighted measure of assets. When banks want to get their capital ratios up, they can do so by adding to their capital or by reducing their risk-weighted assets.
With further loan losses coming on mortgages and businesses, the banks are unlikely to make much in the way of profits over the next few years, so capital won’t be added via retained earnings. Rights issues are a possibility but they would probably be limited. So, it seems very possible that the banks will engage in a medium-term strategy of tight credit, thereby getting loans back down to pre-bubble levels and gradually selling off the NAMA bonds to pay off liabilities.
These arguments may worry those who express concerns that the NAMA legislation doesn’t directly relate to getting lending going. Many have expressed the view that there should be something in the legislation that compels the banks to meet some set of lending targets. I think this is a really bad idea. It would undermine the commercial nature of the banks and would impede them on their longer-run path to a viable loan-to-deposits ratio. Those who oppose nationalisation on the grounds of political interference in the banks should consider why clauses like this should be considered anything other than political interference of the crudest form.
I should emphasise here that much of this scenario could also come to pass after nationalisation and that this is not just me taking another swipe at the NAMA proposals. One difference may be that, if the objective of minimising state control is set aside, the nationalisation process may produce better capitalised banks than are likely to emerge from the current proposals.
One reason why it is important to discuss these issues is that most of the political appeals in favour of NAMA, such as Brian Cowen’s on Prime Time on Thursday, are now focusing somewhat emotionally on the idea of NAMA as a quick fix to get credit to troubled firms—This is about saving the Irish economy and so on. I would suggest that this simply isn’t the case and that a more sober discussion about how to get our banking system back to solvency and on the path to a sustainable funding situation would be more useful.