October 19, 2008
By inserting a clause which ties the fortunes of our biggest banks to those far more susceptible to financial ruin, the government has erred – with potentially catastrophic results.
There is a clause in the bank guarantee rescue plan that has the potential to complicate the scheme by placing the weaker banks in the state on a par with the stronger ones. In so doing, it threatens the integrity of the system. This column has maintained that the guarantee has to be the first phase of a three-phase programme, which would convert a banking threat into an economic opportunity.
Phase one was the guarantee, aimed at saving the system; phase two was a root-and-branch reform of the banks’ boards and senior management, which got us into this mess in the first place; and phase three was the orderly recapitalisation of the banks, to enable them to lend again and get the economy moving once more.
In arguing for the guarantee, this column understood that it would be part of a process which would lead to a better banking system in the years ahead. Underpinning such confidence was the expectation that the government would act in the national interest, rather than in the banks’ interest.
In addition, the working assumption was that ‘bad’ banks would not be rewarded for their ‘bad’ behaviour. However, now that the details of the guarantee have been published, we see a clause which has the potential to insulate those banks which behaved most recklessly and lumber those banks which are stronger with the sins of the others.
Clause 2.6 of the legislation covers the possibility of what might happen when a bank which has taken the state guarantee goes bust.
It says that, where the guarantee is called on and a payment is made, but the financial support cannot be recouped in full from the covered institution to which it was provided, it would be recouped in full from the covered institutions by the state over time, ‘‘in a manner consistent with their long-term viability and sustainability’’.
At first blush, it looks okay. It seems to protect us, the taxpayers, from the possibility of having to cough up for a bank which, despite the guarantee, might fail under the weight of the bad debts incurred during the boom.
Typically, in these desperate circumstances, such a bank would be unable to find a buyer at any price, the capital of the shareholders would be wiped out and the state would be compelled to nationalise the institution.
According to the legislation, any costs accruing to the state/taxpayer from such a bank failure would be recouped from the other banks. So far so good – we are insulated and at least the banks will pay for the sins of other bankers.
But let’s look at this another way. Let’s look at this from the perspective of cui bono. Who benefits from this clause? The people who stand to gain most are the management of the weakest banks because, by tying all the banks together, the government has linked the shareholders of the stronger banks to the balance sheets of the weakest.
This means that, if one bank goes, they all pay. The clause casts a huge cloud over the whole system because it implies that the ability of the strongest banks to lend over the coming years will be hamstrung by the bad debts of the weakest banks.
This is a living example of what is known in economics as Gresham’s Law. Sir Thomas Gresham was Elizabeth I’s chancellor, and came up with the expression that ‘‘bad money drives out good money’’, when trying to stamp out the use of debased coinage in England at the time.
He forecast that, if two currencies were in circulation and one was fully silver and the other debased silver, people would try to use, and thus get rid of, the debased silver coins, while hoarding the real silver ones. In such a case, the good coins would be hoarded out of circulation, leaving only the debased ones. This, he argued, would undermine the currency, leading to the progressive debasement of the currency and, eventually, to barter.
Fast-forward to today and we see the threat of Gresham’s Law in our banking system.
If the worst banks are tied to the better ones, the better ones will suffer. The ability of the better ones to lend will be compromised by the threat that their balance sheet will be penalised if one of the other banks goes under.
More egregiously, the management of the weaker banks – the most excessive cheerleaders and sponsors of the property mania – have managed to hitch their wagon to the stronger banks. Obviously, this is a brilliant deal for the management of our most reckless banks.
A conspiracy theorist might suggest that the weaker banks have pulled a stroke over the bigger ones – AIB and Bank of Ireland – using the Department of Finance in the process. Surely not? Could this happen in our clear-thinking country? Could our Department of Finance favour one bank over another? Never!
More likely, the scheme was drawn up with political considerations in mind – with the government under pressure from the opposition not to be seen to put taxpayers’ money at risk.
For the economy in general, the worst aspect of penalising all the banks for the sins of one is that it smells and looks like the discredited Japanese model. It means that we have tied the whole banking system up in knots. This can only slow down any recovery of the banks.
It would have been far better to have followed the Swedish or Swiss approach, by sticking to the three-phased programme, weeding out the guilty while recapitalising the system using government preference shares.
Now we potentially have the worst of all worlds. The moral of the story is that, when you try to satisfy the left- and the right-wing, you end up with a dog’s dinner. This is hardly the best platform for recovery.