Patrick Honohan: Some lessons from Irish experience on when and how to recapitalize banks

Irish central bank governor Patrick Honohan delivered an interesting speech at the 44th annual Trinity College Money, Macro and Finance conference on some lessons from the Irish experience on when and how to recapitalize banks.

He concludes

Prompt, transparent over-capitalisation in a systemic crisis should remain the preferred option for dealing with failing banks that it is deemed necessary to save.

Regular readers know that with the design of a modern banking system, it is not necessary to bailout and recapitalize any bank.  By design, banks can continue to operate for years and support the real economy while they have low or even negative book capital levels.

The reason they can do this is deposit insurance.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner during periods when they are rebuilding their book capital levels.  There is no need to bailout the bank and make the taxpayer the explicit owner of the bank.

Losses should be shared by both junior and senior creditors where necessary (unless the amounts involved are small) in cases where the banks are put into resolution. 

This is call for implementing the Swedish model and requiring banks to absorb the losses on the excess debt in the financial system and not have these losses socialized.

Experience shows, however, that this may be a counsel of perfection not always achievable.... 

Why would this always not be achievable?

it proved hard to generate reliable and precise information quickly. Clearly it would have been better if comprehensive accurate estimates of future loan-losses had been available from the outset.  However, despite best efforts, accurate information emerged only slowly. 

Please re-read the highlighted text again as Professor Honohan has made the case for requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This disclosure provides the precise, reliable information needed.

With this disclosure, market participants have the information they need to analyze each bank and create an up to date estimate of future loan-losses.

Given the early decision to socialise the losses by guaranteeing all senior debt and some subordinated debt for two years, the scope for over-capitalisation was very limited in Ireland because the Government’s finances quickly became over-stressed. 

By removing the possibility of more extensive burden-sharing with private creditors, the initial guarantee narrowed the options available to Irish policymakers and pushed public debt levels to the limits of sustainability.  

Not only was over-capitalisation no longer a serious option and the chance of deeper burden-sharing with bank creditors shut-off, but in addition some resolution actions had to be deferred lest they trigger an immediate cash call on the guarantee...

And who offered the advice to guarantee all senior debt and some subordinated debt before getting the precise, reliable information to determine exactly how much in the way of future loan losses might be on the banks' balance sheets?

Why the bankers!

Bankers with an extraordinary conflict of interest who stood to gain substantially if the advice they provided was acted on as it would be the Irish economy and taxpayer who absorbed the losses on the excess debt in the financial system and not the banks.

I bet the bankers did not explain to the Irish government how their advice was likely to bankrupt Ireland while at the same time letting the bankers escape any losses for having made bad lending or investment decisions.