Extending the Guarantees

In recent days the heads have AIB and Anglo have called for an extension of the bank guarantees.  (Colm Dohertys conference call transcript here; Mike Aynsleys interview with RTE here.) This has caused understandable dismay given the almost unimaginable costs the original blanket guarantee placed on Irish citizens.  But we should not allow the mistake of guaranteeing already lockedin funds for a period long enough to allow most of them to escape to colour the case against guarantees on new borrowing.   (It should be said that with the governments effective nocreditorleft-behind policy, it is not obvious that losses would have been imposed on long-term creditors with or without the original guarantee.) 

In looking at the case for continuing with prospective guarantees it is important to consider how the credit system would evolve without them.  Without guarantees the cost of new funds would increase, leading to increased pressure to raise rates on new business and household lending.  Moreover, without guarantees there would be greater market pressure to increase capital ratios, which in the current environment is likely to be met by greater deleveraging.    The credit squeeze would worsen. 

I have thought since the outset of the crisis that balance-sheet constraints on credit supply have received disproportionate blame for the credit collapse relative to credit demand and borrower creditworthiness considerations.  But one factor I didnt fully appreciate is how uncertainly about future credit supply can affect current demand.  Businesses will want to limit their debt exposure when there is a risk that their legs will be cut from under them when they try to refinance.   This may go some way to explaining Colm Doherty’s revelation that 40 percent of overdraft facilities are not being taken up.   (Simon Johnson makes a similar point in recent testimony before the U.S. Senate Budget Committee; this wide-ranging testimony is well worth a look more generally.)

The sustained deleveraging by banks, businesses and households risks a Japanesestyle lost decade for the Irish economy.   The recent soft numbers, which have come in despite the stronger performance of broader European economy, could be an early warning.  Restoring confidence in the stability of credit supply is an important part of the policy challenge.   Unfortunately, guarantees on new bank liabilities will probably have to remain a while longer.