March 21, 2011
A castle, like Ireland’s biggest Norman keep at Trim has many layers of defence. So too have the banks. But eventually those huddling inside the castle come under threat.
A few years back, while researching The Pope’s Children, I headed out To Kells in Co Meath. Kells had seen its population grow by 25 per cent between 1996 and 2002.This was an extraordinary expansion in population. Who were all these people?
Well, very early in the morning, I saw them at the hot food counter in Spar. The ‘Kells Angels’ were those thousands of early morning commuters from Kells and other towns in the area who left home in the dark and came home in the dark, commuting down the old congested N3 to Dublin every day. This surely was a group in Ireland worth writing about. How did they live, where did they come from and what did they do on a Saturday night?
Fast-forward six years and I am in Kells again. Two weeks ago, I was invited back by the Kells Chamber of Commerce to speak at its annual bash. The town, although suffering, has a resilient commercial core, and these traders and entrepreneurs are determined to survive the recession and thrive.
The Kells Angels are still here, and so are their counterparts in Navan, Trim and other towns in Meath. The talk that evening was about the lack of credit, the difficult trading position and the implosion of the local property market. But there was a strong sense of a refusal to give up.
Driving home, I took a detour via Trim to look at the amazing structure that is Trim Castle. It’s easy to see why the producers of Braveheart used Trim Castle in the film – its structure is enormous, elevated on the banks of the Boyne.
The castle’s defences, like the earlier Irish ring forts, are based on the idea of an outer wall and then concentric inner walls, all of which could be defended against the attacker. If the outer wall is breached, then the defenders would retreat to the next wall and so on, and each inner defence was less penetrable than the last, until you got to the citadel, the last line, which would be defended at all costs.
I couldn’t help thinking, with talk of default in the air, that Trim Castle’s defences are lined up to protect the occupiers in a way that is quite similar to the way a bank’s funding is set up to protect the depositors from losses.
These days, when we are supposed to be experts on bondholders, shareholders, subordinated debt holders and so on, it’s easy to get confused. It is difficult to get a handle on who is owed what by whom and who is protected to what extent.
It is also hard to understand why some forms of bank creditors have to be defended and others don’t. So why for example have all those who had shares in Bank of Ireland been almost wiped out, but those who lent to the same bank via the bond market are protected? After all, the shareholders and the bondholders were both lending to the bank weren’t they? So why is one sacrosanct and the other disposable?
Let’s think about the protection afforded to the various creditors of a bank in terms of the various levels of protection provided by a medieval castle, which is being attacked.
In the old days, the least protected were the surrounding peasants who ran to the castle at the first sign of trouble; the most protected were the nobleman and his family. In the modern case of defending the banks, the attackers are the markets and the defenders are the banks’ managements and, of course, the government.
In corporate finance, when a company is going bust, you have lines of capital, some of which are more exposed and others which are offered more protection. The more speculative the investment in the upswing, the more exposed this form of capital will be in the downturn.
The first line of defence for the castle is the moat. First line of defence for a bank is the most ‘liquid’ form of capital. It consists of shares. If you have shares in a bank, they are the first to go in a banking collapse.
So too are what are called ‘retained earnings’. These are the bank’s profits which have not yet been distributed to the shareholders in dividends. There are other forms of what is called Tier 1 capital like IOUs issued by the bank which are called ‘‘unsecured perpetual securities’’ and preference shares. These, like the moat, are breached first.
Next up is the curtain wall of the castle – the big solid wall that runs around its perimeter. For the banks, this line of defence is made of subordinated debt. This is called ‘‘buffer capital’’ and is the next to go in a bankruptcy. It is followed by what is called senior unsecured debt. These are bonds that are issued by the bank, but are not backed by any collateral. These are the mythical bondholders.
Of course, no castle is any good without an army to help defend it. In the case of Trim Castle, when it was built, the defenders were the Norman de Lacys. In the case of Irish banks, the army is the government guarantee. This army stands on the curtain wall of the castle defending it from the attackers; the government guarantee stands behind much of the unsecured debt, trying to defend it from the markets.
If the curtain wall of a castle is breached and those defenders slain, the last line in Trim is the castle keep itself. Trim Castle is an imposing structure that would be very hard to break into, with its elevated entrance an many points for the defenders to inflict casualties on the attackers below.
For a bank, the actual castle wall is the ‘secured debt’. This is debt that is fully underwritten by the assets of the bank. We are talking about stuff like secured creditors owning asset-backed securities which are in turn backed by the mortgages written by the bank.
Finally, inside the castle itself are the defenders and their families. These are the depositors in the banks. Without the depositors, there would be no bank. Without the occupiers, there would have been no Trim Castle. These are not so much a line of defence as a raison d’Ãªtre for the bank. But if the attack is successful, the occupiers of the castle will fall too.
If the bank fails to defend itself from the markets, then the depositors too will fall. There are two things that strike you when you look at Trim Castle – one is that it must have been a very impressive structure when it was at the height of its power. The second is that it is now a ruin, its time has passed and it was eventually allowed to fall to ruin. It was no longer worth defending. Trim Castle was never defeated in a military attack; it just outlived its usefulness.
The banks are under attack but, for the depositors, stuck in the castle, things are not as bad as they would be for the defenders of Trim Castle. Depositors are not stuck where they are – they can leave at any time. You can move your deposits in the morning, if you want.
The more resources we throw at defending the castle curtain wall, the less we will have to cover the deposits. The stakes couldn’t be higher.
Depositors in Irish banks have already been fleeing. With so much committed to defending the outer walls and so little sign of successfully repelling the attackers, is it any wonder the defenders deep on the inside are beginning to panic?