Another Red Cent

Prior to the 2011 general election, opposition parties were falling over themselves telling us how they were going to play hardball with the banks. One senior opposition spokesperson, now a Minister, famously said a new government wouldn’t give the banks ‘another red cent’. Maybe, as another senior Minister in the FG-Labour government has said, that’s just the sort of think you say during an election campaign.

As a parting gift, the outgoing FF-led government decided to postpone publishing the results of the ‘Prudential Capital Assessment Review’ (PCAR). This was carried out by Blackrock Solutions, a credible player in the global financial world. The PCAR was supposed to put a number on the ‘red cents’ the banks would require to ensure they were bullet-proofed against what was supposed to be a worst-case economic scenario. To this end, Blackrock ran a slide rule across the banks’ accounts and loan portfolios and reported back to the authorities.

Fianna Fail clearly didn’t like what they saw. The election happened in February. The PCAR was published in March. The banks got another €24bn to tide them over until 2013. And bondholders continued to laugh all the way to the … well, not to the bank, I suppose.

The good news is that the economy hasn’t performed quite as badly as Blackrock’s adverse scenario. The bad news is that the PCAR only covered projections for losses up to end-2013. In their worst-case scenario, they projected €9.5bn in losses in the mortgage books alone of AIB, BOI, ILP and EBS. While we can be cheerful that losses have not materialized to anything like this extent, it is clear that the banks have stored up losses for the future with their self-serving extend-and-pretend strategy.

People who can’t pay, won’t pay. There is also increasing incidence of people who can pay but won’t pay, particularly among buy-to-let owners. The national psychology around debt may be changing, and to the best of my knowledge, Blackrock’s model didn’t allow for such a psychological shift.

If economic growth disappoints, and / or if people become less willing – as opposed to unable – to repay what they owe, then further loan losses are likely inevitable down the line, and not just on the banks’ mortgage portfolios. Under the terms of Ireland’s troika bailout, further stress tests are required to satisfy everyone that there are no further capital holes lurking in the banks’ balance sheets. There is some to-and-fro about whether this will take place later in 2013, as originally planned, before the country graduates from the bailout, or next year when the European Banking Authority is scheduled to carry out similar tests for banks across the EU. But happen, it will. Blackrock have been reappointed to carry out this thankless if lucrative task. Be afraid.

There is a further complication. Policy-makers were blindsided by the last financial crisis and are determined never to see it repeated. One of the changes to be phased in is an increase in the amount of capital that banks must hold to back the loans they make. This change, part of what is known as Basel III, should in theory make banks safer: if one did fail in future, there would be more of a buffer before bondholders, depositors or taxpayers would take a hit.

A bank can raise its capital ratio in two ways: 1) it can shrink its balance sheet by selling assets or rationing lending or 2) it can issue new shares. Left to their own devices, banks will prefer the former approach so that shareholders – not to mention bank executives with share options – will not be diluted. Unfortunately, this means that the credit crunch gets crunchier and the rest of the economy suffers. Of course, the Irish government owns most of the domestic banking system which puts it between a rock and a hard place: facing a choice between pumping more money into the banks or doing nothing and seeing credit tighten further.

Central Bank Governor Patrick Honohan may have let the cat out of the bag recently when he said that the Irish banks would need more capital before Basel III is fully implemented by 2019. It might not win him many friends, but Professor Honohan has made a habit of speaking truth to power in the national interest.

Luckily – if that is the right word to use – undercapitalization of banks is a Europe-wide problem. The authorities have already agreed in principle that the European Stability Mechanism can be used to recapitalize banks. It would not require rhetorical gymnastics to justify the use of this €500bn fund to force-feed European banks ‘foie gras’ style with new capital, ensuring the banks are made safer without exacerbating the credit crunch.

As the outgoing Icelandic government have learned the hard way, however, the maxim of Luxembourg’s Jean-Claude Juncker may hold true: governments know what to do, they just don’t know how to get re-elected afterwards.

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