Author: John McHale

Jon Ihle on the Stress Tests

It was great to see Jon Ihle, one of Ireland’s best financial journalists, writing in the Sunday Business Post yesterday.    Missing Jon’s weekly insights was one reason to mourn the Tribune’s demise.  

Jon has an informative piece on the coming bank stress tests: see here. 

We are clearly being prepared for some additional bad news on the bank losses, and maybe for once we will be surprised on the downside.   In interpreting the additional capital needs, however, it will be important to distinguish between estimates of additional losses and the new capital required to meet higher capital ratio targets.   

The EU/IMF terms require A baseline capital level of 12 per cent for all banks – far above the normal 8 per cent regulatory level at which Anglo and INBS are being allowed to operate.

But if the stress level is as high as 10.5 per cent – meaning capital could not fall below that point even under dire conditions – bankers expect the baseline level could go as high as 16 per cent, imposing huge recapitalisation costs.

Colm McCarthy: Terms of the bailout deal are not unfair — they are impractical

I’ll take my turn linking to Colm McCarthy’s agenda-setting column in the Sunday Independent (available here).    

While I don’t find much to disagree with in Colm’s piece, I worry that some readers might come away with the sense that default provides a relatively painless solution to our problems, which I don’t at all think is Colm’s view.   

A few thoughts:  First, it would of course be wonderful if a Europe-wide solution to the banking problem is pursued, one involving other countries absorbing a large chunk of our banking losses.   It is unlikely to happen.  

Second, some hold the view that defaulting on State-guaranteed bank debt (ELG) would be less costly than defaulting on State bonds.   It would be good to see more discussion of why the reputational and balance sheet contagion costs would be less as a result of defaulting on State guarantees, especially given that available numbers indicate more than half of the bank bonds are held domestically.  

Third, we have to recognise that part of the reason that the perceived default risk is so high is the perception that an orderly default will in fact be organised as per Colm’s advice.   An orderly creditor “bail-in” – one supported by Europe and the IMF and probably involving additional funding – would indeed be less costly than the disorderly alternative.    But making defaults less costly raises the expectation that a default will actually occur and thus raises the risk premium.    We can see potentially self-fulfilling expectations of a default equilibrium emerging. 

Fourth, we have to recognise that a more organised system of creditor bail-ins that makes it easier to restructure debt will itself make market access harder in the future. 

Colm is right that the current bail-out mechanisms are deeply flawed and make exiting our creditworthiness crisis daunting to say the least.   It would be a mistake, however, to conclude that there is some painless alternative that is not being taken because of stupidity or even politics.   There are no easy solutions.   We may end up going the default route.   But given the costs of this route, the alternative of an assisted drive to shift expectations to the no-default equilibrium should not be too quickly set aside. 

Failure to Catalyse

While the change of government has brought a welcome fresh start, long-term bond yields – and the implied probability of an Irish default they signal – continue to rise.   The 10-year yield is now above levels that forced Ireland to seek the EU-IMF assistance programme in November.  It is of course early days.    But there is no getting away from the message the bond market is sending.  

The hope behind the programme is that it would catalyse private funding.    With this in mind, it is interesting to look at the literature on the catalytic effect of official funding, much of it originating from the IMF itself (see here for an example).   The basic idea is that official funding can be a complement to private funding.   

Continue reading “Failure to Catalyse”

Sutherland: EU Must Rethink Ireland’s Deal

Peter Sutherland makes the case for rethinking Ireland’s bailout deal here.

Renegotiation and the Bailout Black Hole

The most immediate task facing the new government will be to engage in the process of revising the euro-zone bailout mechanisms.   There has been much ink spilled on the strategy the government should adopt, with threats versus persuasion the early dividing line.

I think it is fair to say that persuasion has won out for the moment.   But the persuasion branch itself divides into those stressing a focus on European blame/Irish credit on one side, and those stressing shared interests in fixing broken mechanisms on the other.   I would expect our European partners will listen (mostly) politely to our assertions on blame and credit, but those assertions will be ultimately dismissed as self-serving yapping.

The case for shared interests stands a better chance.   It is becoming clear how flawed the bailout mechanisms are.  I have previously referred to a “bailout trap”, whereby it is difficult to regain market access once a country enters a bailout.   The 10-year bond yield shows the markets continue to place a high probability on a longer-term Irish default.   But I think a “black hole” is actually a better analogy: not only is exiting the bailout a problem, but any country that gets anywhere close is at considerable risk of being sucked in, with Portugal most clearly in the danger zone, followed by Spain, Belgium and Italy.

Perhaps the most revealing news of last week was the threat from S&P to downgrade Portugal if EU leaders follow through on plans to impose burden sharing as part of the proposed ESM, as well as insisting on official creditor seniority (FT article here). 

 “We believe that if the source of external financing for the Portuguese economy were to remain restricted, the government would have to approach the EFSF to avoid an even more severe economic contraction,” . . . [Eileen X Zhang, S&P credit analyst] said.

S&P warned it would downgrade Portugal’s sovereign debt rating by one or two notches if European leaders decided later this month to require borrowers from the European Stability Mechanism – due to replace the EFSF in 2013 – to restructure their government bonds and make the ESM a preferred creditor.

Potential new private creditors see considerable risk of taking disproportionate losses in any future burden sharing, and stay well clear if there is a chance a country will succumb.  But as these private creditors stay clear (and yields rise), the fear of entering the “bail-out” becomes self-fulfilling.  

It is in no one’s interests to have this black hole spreading from the periphery of the euro zone,  ultimately threatening its destruction.  That is the case the new government should be making, and it should have no shortage of allies.