September 21, 2008
Making people’s savings secure is the best way to return confidence to the market.
When ordinary people are flocking to the post office to deposit their savings, we know that we are running out of time. Some Irish banks are in clear and present danger and, as events in the US have shown, when things are moving so quickly, old assumptions no longer hold.
Last Friday’s rally, although welcome, does not change anything. We are still looking at a banking dilemma because the wholesale credit market is frozen. In its simplest terms, the people who lend money do not trust the people who would like to borrow it.
In the Irish case, we have already seen a run on the banks, in terms of investors in any case – foreign investors are trying to get their cash out, and last Friday’s rally will be taken as an opportunity to sell by many investors because the root causes of the malaise are still there.
The question for the state is whether we are looking at a situation of illiquidity or insolvency. Pessimists say the banks are insolvent; optimists argue they are simply illiquid.
If it is insolvency, which is still unlikely, then there are the normal longer-term measures to deal with bad debts. But if it is illiquidity – a short-term crisis of confidence that can be rectified – then the state can manage this with some obvious measures.
Let’s be clear: it would be unforgivable if a situation of illiquidity were to prompt insolvency due to lack of decisive action from the state.
There are two key issues: time and confidence. The banks need more time to work through their loan books to see what is viable and what is toxic. This will allow them to make an accurate assessment. The depositors need confidence to allow them to feel safe in keeping their money on deposit. What happens in banking crises is that time and confidence head towards each other on a collision course.
Ultimately, the banks can’t sort out their bad debts as quickly as depositors can withdraw their money, and thus the banks fail.
Ireland needs to avoid this eventuality at all costs. So what are we to do? We know how we got here – mad over-lending on Irish property. The questions now are how do we get out of this mess and, more importantly, how do we restore confidence.
Three models were tried last week alone in the US. These options are open to us. However, there is a fourth, which might be the most effective for Ireland. Before we explore the different options, there is one argument that we have to settle and this is the argument about morality.
There are many who believe that the banks have been reckless and should not be saved because saving them would reward the bad behaviour of the banks’ bosses. There is obvious political logic to such a view. How can a politician be seen to bail out a fat-cat banker at the cost of delaying building a hospital wing? (One part of me shares this attitude, by the way.)
However, today we have a national crisis and the better part of valour is to sort out the problem immediately and leave recrimination for tomorrow. Heads will roll in time; today is for action, not vindictiveness. After we stem the crisis, we can go back and punish those responsible.
So what are our options? The first approach to dealing with this is the Lehman model. This is where the state allows the bank to fail. This is not an option for Ireland, as only failed states have failed banks.
The collapse of Lehman has done untold damage to the US, but at least the US has the comfort of being the world’s biggest economy and deepest financial market, as well as being able to print its own currency. We are not in that position. If Ireland lets a bank go under – even a small one – panic will follow.
We will get a run on the banks internally, while externally we will scare foreign investors, who are crucial to our economy. It would take years to restore credibility. Countries like Argentina allow their banks to fail with detrimental consequences; Ireland can’t afford to let this happen.
Therefore, the Lehman model is not on, even though some institutions might deserve to go under.
The second option is the AIG option. Last week, the US government nationalised the giant corporation to prevent bankruptcy. This is precisely the opposite of the Lehman approach.
In Ireland, the state could take over a failing financial institution and use a ‘bank bond’ to raise the finance if it were needed. In the past, we have seen this approach in Scandinavia. The state would have to take a gamble on whether it could ring-fence the problem, that is by nationalising a ‘bad’ bank, it would be enough to restore confidence in ‘good’ banks.
The third option is the Merrill Lynch or HBOS model. This is where the authorities broker a deal between a large, more solvent bank and a large, less solvent one. This is the ‘shotgun wedding’ solution.
However, there appears little point in two smaller banks with significant property exposures like Anglo Irish and Irish Nationwide saying they will merge.
What might be interesting is a foreign outfit like Zurich Insurance, which already has an operation here, looking atone of the domestic players, such as Irish Life & Permanent (ILP).This would greatly enhance ILP’s position.
The shotgun wedding scenario will have to involve a foreign bank and one of the big Irish banks. This is because all the Irish banks were at the same game. If we start ‘hiding’ weak banks in not-so-weak banks – as the Japanese did in the 1990s – we will get nowhere, as the weak banks’ balance sheets will contaminate the not-so-weak ones. In the present climate, no bank will do a deal with an Irish bank without some state underwriting of the ailing Irish bank’s balance sheet; the shotgun wedding will cost us cash and, like all marriages, the permanence of any arrangement will depend on the compatibility of the couple.
The fourth option is the most attractive one, but it hasn’t been tried anywhere and would demand a leap of faith from the authorities. Remember what we said before: the two critical elements are time and confidence. The single most persuasive route to take would be for the Irish government to guarantee all deposits in Irish banks. Yesterday’s announcement of a â‚¬100,000 deposit guarantee only goes half the way.
In contrast, a full guarantee would have meant full protection for all creditors, all our own deposits and those of the foreign institutions who have lent to the Irish banks. The government could do this for a limited period – let’s say two years.
Straight away all uncertainty would disappear. The deposits, of which there are close to â‚¬300 billion, would become sovereign. Peoples’ fears would be assuaged and, if done properly, it would not cost a penny.
The Irish government would be using its well-earned reputation as a sovereign entity, not its hard-earned cash, to solve this crisis. People will not bet against it. This would guarantee the deposit side of the banks’ balance sheets, where there is no problem but uncertainty. Therefore, we would solve the confidence side of the dilemma.
Furthermore, with the return of confidence, the banks would have time to sort out their asset problems. These loans on property will never be paid back in full, and the banks will need to negotiate with debtors.
The banks will have to accept that they will have to take large losses on these debts (with many technically in default already) and, with the property market going nowhere at the moment, these will not recover for some time.
However, financial history is full of such episodes and there are many viable ways of dealing with bad debts. There will always be buyers looking for value, and there can be no doubt that, at deep discounts, Irish property will be a decent bet again.
Of all the options, the deposit guarantee is the most attractive. The guilty parties will be punished in time. This means the heads of the top brass at some of our biggest banks. Over time, consolidation can occur with a well-planned marriage rather than the hasty shotgun affair and, most importantly, the state will be seen as being in charge. The crisis will pass, and Ireland will become a model of financial innovation.
Most crucially, the government must act quickly because, with the property market in tatters, the main engine of growth for Irish banks will splutter for the next few years. This implies that the bailouts we have seen internationally will not offer a lasting liquidity solution.
If we act now, quickly and with confidence, a potential insolvency won’t escalate beyond a temporary problem of illiquidity and will be sorted without panic or long-term consequences.