Tuesday, February 1, 2011

Is the Looting of the Irish Necessary? No!

Over the last week, there have been two interesting observations made about conditions in the Euro zone.

First, Bob Diamond, the chief executive of Barclays, observed that:
... the “acute” phase of Europe’s sovereign debt crisis now appeared at an end.
... Despite saying the currency was no longer under existential threat, Mr Diamond said bond markets would remain under pressure due to concerns about weak public finances and high indebtedness.
“I don’t think volatility in the markets has gone. But what was an acute issue a year ago is at worst a chronic issue today,” he said. “The question of whether the euro is going to stay together is last year’s issue.
“We’re still going to see some volatility, but the big question of whether the euro is going to survive is off the table.”
When approached by The Irish Times after the discussion, Mr Diamond declined to offer any view on the question of senior bondholders in Irish banks being compelled to take “haircuts” on investments.
Second, Adriaan van der Knaap, a managing director at UBS AG, observed that:
Ireland’s banks had more than 10 times the assets of Iceland’s lenders, making their collapse more dangerous for the European financial system. Ireland also couldn’t devalue its currency because it is part of the euro zone. Still, countries with larger banking systems can follow Iceland’s example.
“It wouldn’t upset the financial system,” says Van der Knaap, who has advised Iceland’s bank resolution committees. “Even Irish banks aren’t too big to fail.”
Together these observation show that the global Euro zone financial institutions expect to have haircuts applied to their investments in Irish banks, Spanish Cajas .... and they expect to handle these losses in the ordinary course of business without another government bailout.

Why might these haircuts not be problematic for the global Euro zone financial institutions?  Since the beginning of the credit crisis, governments and central bankers have adopted policies to make these financial institutions very profitable.  It is these profits that can now be used to absorb the haircuts.

Rather than proceed with a bailout that protects these financial institutions, Ireland and Spain should follow Iceland's lead and focus on applying the maximum haircut to financial institutions that are senior lenders to their banks.

The bottom line is that Euro zone taxpayers no longer need to bailout the global Euro zone financial institutions as they are fully able to absorb the losses on their investments.


Of course, all bets are off if the global Euro zone financial institutions are themselves insolvent despite three years of favorable policies.  What are the chances of this when according to the Wall Street Journal "Wall Street Pay Reaches Record"?  After-all, there is an implied assumption that regulators will not let record bonus payments if there is any doubt about a financial institution's capacity to absorb losses on known problems like Irish and Spanish banks.

Update II

Of course, in the case of the Irish banking system, it is possible that the large global Euro zone financial institutions no longer have any exposure to the Irish banking system.  The entity with significant exposure to the Irish banking system is the European Central Bank.

In theory, the ECB should only have extended funds to the Irish banking system to the extent that the Irish banking system put up good collateral.  The question is did it?

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