Financial Repression Update

Six months ago, I highlighted the increasing tendency of Irish banks, many of which are owned in whole or in part by the state, to hold on their books significant amounts of Irish government debt. Far from the ‘vicious circle’ between banks and sovereigns being broken, it is growing stronger than ever.

I noted then that in the 9 months to March 2012, Irish banks’ holdings of our national debt had increased by 40%, or more than  EUR 4bn, during which time the benchmark yield on Ireland’s sovereign debt fell from 14% to 6%.

In the intervening 6 months, the banks’ holdings have increased by a further  EUR 4.2bn (of which  EUR 3.1bn is accounted for by the financial chicanery that saw Bank of Ireland effectively lend money to the government so that they didn’t have to borrow it elsewhere) to  EUR 18.9bn, more than 10% of the total outstanding.

Irish Banks’ Holdings of Irish Sovereign Debt (EUR millions):

Source: Irish Central Bank Monthly Statistics, October 2012 and ntma.ie

It may sound like this makes perfect sense: after all, with soaring deficits, Ireland is issuing record amounts of government debt, so it would be natural for Irish banks to hold more of it. The sheer scale of these acquisitions, however, is out of proportion with pre-crisis trends. Partly, this is down to increased Balkanization of the European financial system. But, is there more to it?

In January 2004, the Irish banks held some  EUR 4.6bn in Irish government debt, 10.5% of the total outstanding. The advent of the single currency supposedly meant that default and exchange rate risk on the sovereign debt of other Eurozone members had been eliminated, so banks did not feel they had to hold the government debt of their host nation.

Consequently, the ratio of Irish banks’ holdings of non-Irish to Irish sovereign debt rose from 13.5 in January 2004 to 192 in October 2008 on the eve of the fateful bank guarantee. By this point, their holdings of Irish debt had fallen to only  EUR 530m (or 0.7% of the total outstanding), while holdings of non-Irish debt had peaked to EUR 101.7bn, of which some  EUR 57bn was Eurozone debt (up from  EUR 61.5bn and  EUR 46bn respectively in January 2004).

The onset of global financial crisis re-introduced investors, and European banks, to intra-Eurozone sovereign default and exchange rate risk. Once the chimera had been lifted, these trends went into reverse, giving rise to the Balkanization – or the increased domestication – of the European financial system which is now plain to see.

Irish Banks’ Holdings of Sovereign Debt (EUR billions):

Source: Irish Central Bank Monthly Statistics, October 2012

Twice, in December 2008 – just after the introduction of the bank guarantee – and then during the October-December 2010 period – coinciding with Ireland’s troika bailout, at the same time that they were ramping up purchases of Irish sovereign debt, the banks were offloading tens of billions of non-Irish sovereign debt, non-Eurozone debt being jettisoned first.

Since December 2010, holdings of non-Irish sovereign debt – and the balance between non-Irish Eurozone debt and non-Eurozone debt, at a ratio of 1.7 – have been essentially flat whereas holdings of Irish sovereign debt have surged 60%.

Given the state’s almost complete absence from the primary market, it is clear that the banks have been purchasing significant amounts of government debt on the secondary market since the introduction of the bank guarantee in October 2008. With benchmark yields having fallen to 4.5% – meaning that the price of those bonds has increased – the banks are sitting on a tidy profit on their investment.

And what could possibly be wrong with that?

Surely this is an example of the bailed out banks pulling on the green jersey, helping ease Ireland’s re-entry to the bond market, and beginning to repay the debt of gratitude they owe to a hard-pressed citizenry?

Everybody wins, right?

Carmen Reinhart – along with Kenneth Rogoff, one of the twin oracles of financial crises and author of This Time is Different – describes as ‘modern financial repression’ the purchase by central banks and captive commercial banks of huge amounts of the government debt of host sovereigns. She also notes the preferential treatment of government debt in balance sheets under the Basel III regime (Essentially, banks have to keep in reserve little or no capital to back their holdings of sovereign debt, whereas they have to conserve significant amounts of capital to back their commercial and consumer loan books).

So what?

This means that at the same time that the banks are shrinking their super-sized balance sheets (i.e. lending less overall), they are incentivized to lend scarce funds to the government rather than to firms and families. There is a further perverse incentive for banks in Ireland and other peripheral Eurozone members: while sovereign yields are near record lows in Germany, Japan and the US, for example, they are significantly higher in Ireland et al.

Even without the preferential treatment under Basel III, or the opportunity for moral suasion that accompanies state ownership, why would AIB for instance, on a purely commercial basis, lend to homebuyers – any one of which is more likely to default than the Irish government – at a variable rate of 3.5% when they could use those funds to buy Irish government debt yielding 4.5%?

These perverse incentives only exacerbate Ireland’s already severe credit crunch while perhaps putting a false floor under Irish bond yields on the open market.

Ireland has one of the largest private sector debt / GDP ratios on the planet, even when the IFSC sector is stripped out. De-leveraging is both inevitable and essential, regardless of its being mandated by troika conditionality.

Eventually, Ireland needs a fully-functioning, competitive, robustly regulated, (mostly) privately-owned, and smaller banking system. As we work towards this goal, painfully and slowly, we must avoid a banking system that rubs salt in the wound.