In early 2009, the Irish domestic banks had three critical problems: insolvency, distress, and a liquidity crisis. Only one of these problems, the liquidity crisis, was solved successfully at an acceptable cost, via ECB liquidity provision. This massive liquidity provision was one key motivation for the Financial Measures Programme (FMP), which lays out a plan the banks must follow to become liquidity self-financing. Now, through no fault of the Irish banks but because of the continuing financial crisis, the liquidity target plan in the FMP is looking much too optimistic and needs some adjustment.
- 1. The loan-to-deposits target date should be changed from 2013 to (end-of) 2015.
- 2. The ECB should make clear that their liquidity assistance to Irish banks is for a longer period than originally envisioned.
Without these adjustments, the Irish domestic banks will be incentivised to continue to starve the domestic economy of credit over the next few years.
In 2009, the insolvency problem of the banks was that their assets (mostly loans) were worth much less than their liabilities so the implicit equity value of each and every individual bank, with the possible exception of Bank of Ireland, was negative. This problem was solved by massive equity injections financed by the Irish state. I do not want to argue or discuss why or how this policy choice was/(wasn’t?) a mistake, but that was the solution effected at the time.
The distress problem was that all the banks looked to become zombie banks, playing no useful role in economic recovery. An attempt at a solution to this problem was the setting up of Nama to remove a large bulk of problem loans from the banks. Evidence is mixed-to-negative on whether this policy is working – see namawinelake for a running commentary.
The 2009 Irish banks’ liquidity crisis was that the international lending markets which had financed the growth of the Irish banks’ assets were no longer willing to lend to the sector. The banks could no longer roll over their mostly foreign-owned institutional liabilities. They needed a new source of liquidity backed by their remaining good quality but illiquid assets (net of the government equity injection). This problem was solved by the ECB, which injected a truly massive amount of liquidity into the relatively small Irish domestic banking system.
The ECB/ICB should tweak the FMP slightly, lengthening the time that the Irish banks have to return to a more liquid asset/deposit ratio. The original plan to sell off foreign assets was always optimistic, and has become more so with the worsening European financial crisis. In current circumstance and under the current FMP plan, Irish banks have an incentive to substitute domestic asset shrinkage (or lack of growth) for unattainable foreign asset sales.