Private Debt Relief
This post was written by John McHale
The debate over the private debt relief has developed a lot of momentum, with the both the Central Bank and the Department of Finance now seemingly increasing the pressure on banks to provide debt relief. While there certainly is a case for targeted debt relief, it seems to me that there are a number of confusions in the debate. I think the following points are worthy of some discussion.
1. The distinction between accounting loss recognition and debt relief
This is a point that has previously been emphasised by Greg Connor (see quote here). The processes of loss recognition for accounting purposes and debt forgiveness are very different. In part motivated by the Japanese experience, it was recognised early in the crisis that it is critical for banks to recognise losses and then to be properly recapitalised. Failure to do so can lead to the “zombie banks” phenomenon, whereby effectively undercapitalised banks are unwilling to lend. This can further be associated with “zombie borrowers”, whereby banks engage in “evergreening of accounts – essentially lending more money to prevent default – so as to avoid having to recognise the losses.
Through the PCAR process, Irish banks have been forced to recognise losses and to be propertly recapitalised, although concerns about mortgage losses have left lingering doubts about whether the process has gone far enough. But this process is consistent with banks doing everything possible to maximum the recovery of loans – even loans that they have written down on their books. Minimising the need for yet further capital injections requires that banks only forgive debts if it actually increases the expected recovery.
2. The “debt Laffer curve”
I have mentioned the “debt Laffer curve” before, but I think my exposition just caused confusion. But I still think it is a very useful device for thinking about the case for debt forgiveness. The basic diagram is here. The horizontal axis measures the present value of payments to the bank assuming full repayment on a given debt obligation. The vertical axis measures the expected present value of the repayment. The “debt Laffer curve” shows the relationship between the present value of the debt obligation and the expected repayment. The basic case for (mutually advantageous) debt relief comes from the possibility of the curve beginning to slope down beyond a certain point. This means that debt forgiveness could actually raise the expected value of repayment. This could happen, for example, if lowering the debt burden means the borrower has stronger incentives to raise their income or to avoid default (where repossession would b e costly for the bank). Such cases are certainly conceivable, but it is a fairly demanding hurdle. (I would be very interested in commenters’ views on this.)
There is, of course, the extra complication of the much discussed moral hazard/strategic default. If the bank provides relief for people in certain conditions, then there is the potential for a bad “pooling equilibrium” where people have the incentive to be in those conditions. Colm McCarthy has famously put this in a pithy way:
Since you cannot get blood from a stone, it is desirable to streamline the personal insolvency arrangements so as to recognise this reality. But no incentives should be created which encourage those who can pay to disguise themselves as stones.
Now it may well be that the government wants the bank to provide debt relief even where the curve is upward sloping but relatively flat. The relief would have the added advantage that it could help stimulate household spending. But if this is the policy, then it is better to admit up front that the policy means bigger losses for the bank and, where the bank is State owned, ultimately for the State. There is a danger that State-owned banks will be forced to follow a range of political objectives, storing up longer term fiscal problems and making harder to gauge the ultimate performance of the banks. If the government wants broader debt relief, then it is better to provide appropriate subsidies and then let the bank get on with – and be accountable for – maximising value.
3. Insolvency rules
One way to make it more likely that the bank has an incentive to forgive debt to prevent outright default is to strengthen the “threat point” of the borrower through more debtor-friendly bankruptcy laws. Making bankruptcy or other insolvency rules more borrower friendly is likely to reduce the value of the banks. But I think the focus here should be on the overall design of the regime. The current regime is archaic and brutal and needs to be reformed. If moving to a modern regime results in losses, then additional losses for the banks is a bullet to be bitten.
However, much of the discussion in pitched in terms of a trade off between debt and creditor rights – and creditors understandably get little sympathy at the moment. But it is important not to forget the “instrumental role” of creditor rights in ensuring there is an incentive to provide credit in the first place. Everyone’s creditworthiness is tied to there being reasonable protection of creditor rights.