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We need to know the cost of sorting out the banks
13 December 2009 By Colm McCarthy
The bond markets have turned ugly in the last few weeks.
The Dubai default followed the revelation that Greece’s debt and deficit figures were unreliable, and the true situation faced by the incoming government considerably worse than had been assumed. Greece’s deficit is projected at 12.7 per cent of GDP next year and the debt ratio at 123 per cent.
The deficit for 2009 will be double what the previous administration had advised just two months ago, a remarkable state of affairs which has resulted in downgrades from rating agencies and an increase of over 1 per cent in the interest rate Greece pays on government debt.
In London, doubts about the credibility of the British government’s fiscal targets caused a severe sell-off in the gilt market on Thursday and Friday.
These events took place against a background of announcements from central banks that they plan to scale back their programmes of liquidity provision to commercial banks.
The European Central Bank will lend 12-month money for the last time this month, and 2010 will likely see a contraction of aggregate liquidity support as well as a shortening of the term. Banks have been using central bank money to buy government paper, and this temporary prop to bond prices will be removed in due course, since the process threatens to stoke inflation as economies recover.
For countries planning to borrow heavily over the next few years, these are unwelcome developments. The cost of funds has already risen, and the markets have been spooked by speculation that the next sovereign default could be a eurozone member, with Greece the current favourite.
Unfortunately Ireland is the second favourite, as measured by the risk premiums in the markets. Despite a generally positive reaction to the budget in the international financial media, Ireland’s interest rate penalty against Germany widened during the week (though it has fallen back from a high reached on Thursday), reflecting the general anxiety about heavy borrowers, rather than disapproval of Irish policy.
If this persists, new borrowing and any expiring debt that has to be re-financed will face the higher interest rate, adding to government spending.
The Department of Finance has already pencilled in an increase in debt service costs next year amounting to almost €1,000 for every employed person in the country.
The department has also assumed that the average interest rate paid in 2010 will be only marginally ahead of the 2009 figure,4.3 per cent versus 4.2 per cent. This could still happen, but there is an increased risk that higher borrowing costs for the government could add to our woes. The private sector of the economy is also heavily borrowed, via the banking system, and any uptrend in interest rates will hurt here too.
The European Central Bank has been providing huge amounts of liquidity to the Irish banks, at times up to €100 billion, almost equal to the total of residential mortgages held on their books. These banks have €376 billion lent to the Irish private sector, more than half of which represents mortgages and property-related lending, the legacy of the bubble.
In addition to ECB money, the banks are also heavily reliant on borrowings from the international money and bond markets, guaranteed by the government. At some stage, the amount of credit extended to the Irish public will have to be brought back in line with the deposit base of the banking system, which implies much smaller bank balance sheets and a smaller stock of credit.
This process of de-leveraging has already started. The stock of private sector credit peaked at €404 billion in November last year and has been declining steadily since then as loan repayments have exceeded new credit extended. There have also been write offs.
The most recent figure, for October, is €376 billion. The annual rate of decline seems to be about 7 or 8 per cent.
It is important to understand that this process is inevitable, and desirable. Ireland indulged in a credit fuelled property bubble larger, relative to the size of our economy, than occurred inmost other countries, and this has to be unwound. The banks will end up smaller, with less reliance on external borrowing or central bank money.
To some degree, this can be achieved through shifting performing loans off their books to non-Irish lenders, as well as through customers realising assets and otherwise paying down borrowings. If they eventually reached a position where credit bore a more normal relationship to GDP, and to their deposit base, the stock of domestic credit outstanding from Irish banks might be no more than half the level reached at the 2008 peak.
Provided access to external money and bond markets can be retained, by both government and their newly acquired dependants, the banks, this does not have to be done quickly. But the perceived solvency of the exchequer is the critical component that enables an orderly return to a sustainable financial system.
It is desirable that the reduction in credit outstanding is concentrated on the unwinding of those components of the credit stock which were excessively inflated, and not in areas such as working capital for viable businesses.
The de-leveraging should therefore be concentrated in that portion of the banks’ loan book which is property-related, which means that the substantial capital losses which have been incurred have to be crystallised.
The National Asset Management Agency (Nama) will do a part of this job for the qualifying loan assets, and is likely to crystallise substantial losses, exceeding provisions already made for bad debts and thus highlighting under-capitalisation.
But the non-Nama portion of the banks’ balance sheets must also contain substantial uncrystallised capital losses for bank customers.
The biggest item is residential mortgages. Most of the older, and presumably performing, residential mortgages seem to have been shifted off balance sheet through securitisation, and what remains consists mostly of mortgages advanced in the final years of the bubble.
Given the decline in household incomes, the sharp fall in house prices and the rise in unemployment, many borrowers are likely to be not just distressed, but also in negative equity, since much lending at the end of the bubble was at high loan-to-value ratios. It will be difficult to securitise here, and if default rates are as high as many fear, the banks are likely to end up in state ownership.
The exchequer costs of the bank rescue need to be minimised ruthlessly, and any opportunities to impose cost on bond-holders exploited in full when the guarantee runs out in September next year. Compensating providers of risk capital to failing businesses infuriates taxpayers, and gives capitalism a bad name. In approaching bank re-capitalisation next year, there should be no nervousness about revealing fully the capital losses which have occurred.
Crystallising losses does not cause them - they have already occurred, and everyone knows that, none better than the international capital markets.
The extent of the country’s budgetary problem is daunting, but the parameters are well established and a substantial start has been made in dealing with it.
If there is a further exchequer cost looming in sorting out the banks, better to know about it and get started on reconstructing the system. The capital markets will not be shocked: the pricing of government debt suggests that they already expect recapitalisation costs.
Also, the failures in bank regulation and supervision, and in the governance of the Irish banking system, have been colossal and home-grown.
The public are entitled to a thorough and public investigation into what went wrong.
Colm McCarthy lectures in economics at University College Dublin
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