Arthur Beesley provides a helpful report on the government’s emerging four-part support request for the banking system (see article here; related front-page article here). I think the plan is based on a broadly correct diagnosis of the challenge of restoring the creditworthiness of both the banks and the State; it is also realistic in not demanding policies that involve large expected net transfers.
1. A slower pace of deleveraging
First, Dublin wants the EU-IMF troika to agree a slower pace of bank deleveraging than could be read as a condition of EU-IMF deal in November. The objective is to avoid the immediate crystallisation of losses, which in turn would lead to a heavier upfront requirement for capital. There is some confidence that the troika accepts the argument that very rapid deleveraging at fire-sale prices would be a bad thing.
For a good analysis of the concept of fire sale losses, about which I know some readers have doubts, see this recent paper by Andrei Shleifer and Robert Vishny.
2. Provision of medium-term liquidity support from the ECB
But the full benefit from slower deleveraging would not be realised without some success on the second front of the Government’s campaign on the banks, the commitment it wants from the ECB to extend to the medium term the emergency short-term liquidity for Ireland’s banks. Shut out from private markets, the banks are now required to replenish their emergency liquidity very frequently. This is because the ECB has been trying to wean “addicted” banks off its emergency support by closing the tap of medium-term support.
This dims the benefit the banks derive from recapitalisation and higher solvency ratios because large corporate depositors are less inclined to trust banks that need emergency funding.
The ECB, however, remains wedded to a swift exit strategy from all forms of exceptional bank support. There is no evidence yet that the bank will reverse course to suit Ireland’s banks.
If it forces fire sales, a “swift exit strategy” could further undermine the creditworthiness of the State. It is hard to see the banks regaining creditworthiness without the State regaining creditworthiness, and forcing losses on the State could make it hard for the ECB to find the exit they are seeking. I would be surprised if the ECB doesn’t understand this.
3. Impose losses on unguaranteed bondholders
The third element of the campaign is to compel holders of unguaranteed senior bank bonds to bear investment losses. This is on top of compulsory losses on subordinated or second-class bonds worth €7 billion, which have yet to be touched in the bank rescue.
The senior bond question is highly sensitive, given fear of market contagion and the argument that large banks in countries such as Germany would have to take losses as a result of such a move.
However, public statements this week by Minister for Energy Pat Rabbitte in favour of senior bond burden-sharing suggest the Government remains determined to pursue this line. In part at least, this reflects the view in Dublin that some of the European opposition to senior bank bond default may be weakening.
The argument is made that recent moves to force losses on senior bonds in a Danish lender had no appreciable impact on funding conditions for other Danish banks. Still, the fact remains that Denmark is not a euro country. Unlike Irish institutions, its banks are not closely tied to the banks of 16 other countries.
Worth noting also is the argument that most senior unsecured Irish bank bonds have been sold by their original purchasers and are now held by “risk-based” hedge fund investors in New York, Britain and Luxembourg. This is at variance with the findings of European research only weeks ago which gave credence to the suggestion that the bonds were mostly held in Ireland.
Either way, the case is made that compulsory senior bond losses would not prompt a major requirement for fresh capital in other European banks. Yet whatever the merits of the theoretical argument, the ECB and other EU institutions have shown no willingness to test it in practice.
There is reasonably broad agreement that we should not jeopardise ECB support with a unilateral move to impose losses on unguaranteed senior bondholders. The interesting question is whether the ECB could be brought to accept such losses being imposed. Many commentators appear to assume that the ECB’s objection is primarily the fear of balance sheet contagion across the European banking system. I think the contagion concern is more to do with the undermining of implicit guarantees to senior bondholders, on which European banks depend to raise term funding. Unlike other policy makers, the ECB is acutely aware of the connection between bank resoltuion regimes and market access, and does not see now as the time to be ramping up market discipline.
Our focus should be on separating Anglo and INBS from the others on the basis that they are no longer “banks” and do not have depositors. It should be possible to impose losses without setting a broader precedent. The money involved is not enormous in the scheme of our debts – about €4.5 billion – but would have additional benefits in terms of shoring up political support for the adjustment effort.
4. EFSF participation in bank recapitalisations.
The fourth prong of the Government campaign is to persuade its euro zone partners to empower the temporary European Financial Stability Facility (EFSF) bailout fund to participate in bank recapitalisations as a provider of last-resort capital.
Although this would offer clear benefits to the Government, most of Kenny’s counterparts have adopted an ultra-cautious stance on EFSF reforms.
This will be a hard sell. However, EFSF capital injections need not involve an expected net transfer, but they would allow the sharing of the downside risk that is crippling the State’s broader creditworthiness. Any constructive approach to resolving the crisis must start with the creditworthiness challenge – though there does not seem too much evidence of this at the European level to date.
The government appear to be doing a good job pulling together a realistic package of measures that get at the root of the banking challenge. Now if only our European partners would listen.