The rules of the game have changed for Ireland. Should Ireland respond to this new risky-game environment by selling off some or all of its domestic banks to large foreign bank holding companies? I believe that it should. We can keep the names on the high street bank offices, but lose the liability guarantee.
Both bank runs and sudden stops (when all lenders suddenly cease lending to an entity such as a sovereign state) can be usefully modelled as coordination games. It is rational for depositors to withdraw their savings from a weakened bank if and only if most other depositors are doing the same. The particular “signal” which starts the co-ordinated run by depositors can be anything – new information about bank fragility, or something irrelevant such as a temporary blip in the length of queues inside a high-street bank office. Once a run starts, a bank can be crippled by the short-term illiquidity of its assets, so a run is often a self-fulfilling prophecy.
The same logic applies to sovereign-debt sudden stops – the inability of the state to borrow strangles domestic economic activity and thereby greatly weakens the state’s ability to pay back borrowing. So it is rational not to lend if others will not lend. There is also a dynamic co-ordination feature to a sudden stop, since medium and short-term lenders will not lend unless they have full confidence that the state will be able to roll over their repayments using future borrowing.
Lenihan’s bank guarantee changed Ireland’s co-ordination game. By insuring all the domestic banks’ liabilities, he substantially lowered the probability of a bank run against any or all of the domestic banks. On the other hand, the magnitude of this contingent liability makes its actual payment infeasible. The potential cash flow claim on the government is larger than twice the annual Irish GDP. If the continent liability is exercised by bank claimants, there is no feasible way for the government to pay it. The government, already over-extended in terms of tax revenues versus committed expenditures, could not extract even a small proportion of this claim from Irish taxpayers. With the liability guarantee in place, the real risk for Ireland is a sudden stop, not a bank run.
The Irish problem with Greece’s growing troubles is that financial crises tend to be contagious. One of the “signals” that could instigate a sudden stop in Ireland is a sudden stop somewhere else, particularly somewhere with regional or trade connections. This is why bad news for Greece is bad news for Ireland. If Greece hits a sudden stop, Ireland will wobble, and will be the next in line for a sudden stop in Europe.
There is another simultaneous game being played: the ECB and its bailout policies playing a reputation game against member sovereign governments and their fiscal discipline. Again, the Greek situation is bad for Ireland. Ireland and Greece are at the very top and very bottom of the ECB’s Christmas gift list. Ireland has done everything (so far) that the ECB could reasonably ask of her to impose fiscal discipline and restore competitiveness. If it were only Ireland at risk of a sudden stop, the ECB could be very accommodating about bailout assistance. The ECB would not let a well-behaved minnow like Ireland cause market turmoil. If a sudden stop was brewing and Irish bond yields rocketed up, the ECB could easily mop up any excess of Irish sovereign bonds, killing the run, and later tell some convenient story about why this did not violate EMU no-bailout guidelines. On the other hand, we now know that the Greek government has deliberately and substantially falsified its national accounts over recent years. Also, Greece shows no political will to impose any meaningful discipline on tax and spending. Her adherence to the Growth and Stability Pact is a charade. If the ECB bails out Greece, all semblance of future fiscal discipline throughout the Euro zone is lost. Again, bad news for Ireland. How can the ECB bail out Ireland if it refuses to bail out Greece? In this reputation game, we are greatly harmed by the company we find ourselves in.
Take My Banks …… Please!
Henny Youngman was the comedy-king of the one-liners, best known for his signature line “take my wife ….. please!” The irony is that he loved his wife and they stayed happily married for sixty years until her death. In my opinion anyone who truly cares about the Irish banking system and its role in the economy should be encouraging the government to sell off the Irish domestic banks, shorn of the liability guarantee, and with the worst of their excesses spun off into NAMA. If this were done, the risk of an Irish sudden stop would fall close to zero, and our sovereign borrowing rates would also fall sharply. A sudden stop is an ugly thing and we should do everything we can to prevent it. If the banks were safely inside large foreign holding companies then these insolvent Irish banks, and the risk they engender for the whole Irish economy, would cease to weigh down Irish economic recovery.