Ireland demonstrates why nations recapitalizing banks is a flawed idea

As Greece considers whether or not to use its scarce access to capital on recapitalizing its banks or on boosting economic growth, it might want to consider the Irish experience.

As described in his Irish Times column, Simon Carswell looks at the current status of the Irish banking system.

ANY BANKING SYSTEM that posts combined losses of €6 billion for a year is far from out of the woods, particularly when the road back to profitability is not straightforward, or even assured for some.  

The State-owned banks have all reported results for 2011, and it is clear the lenders, even plugged with €63.7 billion of State capital (including the €1.3 billion to go into Permanent TSB from the sale of Irish Life) still require further help to return to full health....

By comparison, the Greek banks lost 32 billion euros in the Greek sovereign debt restructuring.

But that is not the full extent of their losses.  These banks are also holding loans to Greek borrowers that are unlikely to be repaid given the on-going contraction in the Greek economy.  How much more will be lost on these loans is anyone's guess.

Given that it is a guess, the EU insisted that the Greek government pay BlackRock Solutions to provide an estimate.  Like Ireland, no one will believe this estimate as market participants know this estimate is constrained by the simple fact that Greece has only been given 50 billion euros to recapitalize its banks with to maintain the fiction of the banks having positive book capital levels.

As for the four State-supported banks, the big questions the 2011 results raise is whether last year’s bank stress tests by the Central Bank, verified by a group of costly outside consultants, stand up or whether the banks require further capital....

This is one of the problems with bailing out the banks.  Not only does bailing out the banks divert scarce funds from being used to boost the real economy, but it sets up the situation where there is a call on additional scarce resources when the initial guess on losses is shown to be wrong.

While the losses at the domestic banks have already hit the base case losses expected in the Central Bank stress tests in March 2011, the banks have enjoyed more success on the “deleveraging” of their businesses as they attempt to shrink in size and get off the drip of cheap funding....

On the issue of deleveraging, the lenders have so far picked the low-hanging fruit, selling assets overseas where there were buyers rather than dumping Irish loan assets for which there are few buyers and only at loss-making firesale prices at that.... 

Bank of Ireland offloaded 86 per cent of the €10 billion in assets that it must shed by the end of 2013 and managed to take a hit of just €600 million – a 7 per cent discount in the process. 

AIB’s €12.7 billion deleveraging in 2011 was €3.3 billion ahead of target at an average discount of 4 per cent, again within targets....

Is selling off the good loans on the balance sheet rather than writing down and working out the bad loans a good thing for a banking system?

AIB and IBRC both acknowledged during their respective results presentations that discussions were taking place on the future of residential mortgages across the banks. 

This was a reference to plans to shift the tracker mortgage books out of AIB (€18 billion) and Permanent TSB (€16 billion) to IBRC or another vehicle to run them down. 

Otherwise known as yet another bailout.

The removal of the tracker books forms part of the technical discussions around the next restructuring of the banks, tied in with a replacement of the promissory notes funding the bailout of Anglo and Irish Nationwide. 

Taking the tracker mortgages out of AIB and Permanent TSB not only purges them of loss-making loans that are a drag on a return to profitability, but may also encourage investors to take out some of the State’s shareholding in these financial institutions. 

“The removal of tracker mortgages from banks’ balance sheets would significantly improve net interest margin and enhance the prospect of attracting fresh equity investment to the pillar banks,” said IBRC in its results presentation. Reading between the lines, it would appear that IBRC would welcome the trackers with open arms.....  

Tracker mortgages reflect a more structural problem and the dysfunctional nature of Irish banking – banks are paying far more for funding than they are charging to lend it out. 

The debt markets remain closed to them, at least at any kind of meaningful rate at which they can repair their business models....

So, despite multiple rounds of bailouts from the government, market participants still do not have confidence in them.

The reason there is no confidence is related to the simple fact that market participants do not know how many more problems are hidden on and off the bank balance sheets or the capacity of Ireland to continue bailing out the banks.

In the meantime, the deteriorating situation regarding the mortgage crisis means arrears will continue to increase. 

While the high level of loan losses is a concern given that they have not reached the stress test base-case levels, the banks have not used up as much of the capital set aside to cover the deleveraging as was expected, said Stephen Lyons, analyst at stockbrokers Davy. 

This has created a contingency fund in addition to the €5.3 billion existing contingency buffer factored into last year’s additional €24 billion bank recapitalisations. 

But, as Michael Cummins says, the stress tests failed to resolve the issue of future operating profitability at the banks, despite the banks being recapitalised based on loan loss projections over three years and assuming a return to profitability after the three years. 

“At present, that assumption is beginning to look at risk,” he said.... 

The fact that the banks have not been aggressive in recognizing losses on their mortgage loans has had no impact on the ongoing collapse in the value of the collateral.  As a result of the delay in loss recognition, when the losses are finally recognized, they are likely to be far greater.

Until more light is shed on the next restructuring of the banks, their future is far from bright.

Once you start shedding light on the banks, there is no reason to stop at the form of the next bailout.  Better to go all the way and require the banks to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details.

This immediately weans the banks off of sovereign bailouts.

Instead, it sets up the condition under which the banks can recognize all of the losses hidden on and off their balance sheet today and through retention of earnings rebuild their book capital in the future.

At the same time, it frees up the funds that would be used for bailouts and allows them to be used to support the real economy.

So the question the Greek government faces is:  support endless rounds of bailouts to the detriment of the real economy or support the real economy and not invest a single euro or drachma in the banks.