Banks and Financial Signals: Irish Perspective
European Banking Crisis and Financial Signals:
An Irish Perspective
Patrick A. McNutt FRSA
www.patrickmcnutt.com
Dublin based strategy consultant
Visiting Fellow, Manchester Business School, UK.
Presentation to ICAEW Valuations Group Conference, London, 14 July 2011.
Abstract
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The EU cannot fix the sovereign debt crisis in Greece, Ireland or Portugal unless it fixes the banks. Insolvent banks should be identified and de-listed and share trading suspended for a period of (say) two years. The new Irish Government, however, has embarked on a stealth process of nationalisation. Each of the Member States, Ireland, Greece and Portugal should collapse all insolvent banks into one new post-IPO Start-Up Bank per Member State. Traditional shareholders and institutional shareholders could be allocated restricted stock units (RSU) which convert to equity only after an IPO and cannot be resold on any exchange.
The Start-Up Bank plc’s financial innovation structure, for example, would be a combination of an IPO (new pledged asset) and a new bond - re-issued senior bonds from the individual banks and financial institutions. Sovereign debt exchange arrangements, reminiscent of the private sector, could then be put in place by the ECB. The ECB embeds the CDS market default probabilities into policy and plays the game with investors and strategists who are willing to place a bet on the probability of a default occurring. How? The ECB issues (i) new sovereign ‘default’ bonds to financial investors, such as hedge and pension funds and bondholders, and (ii) with China as an investor, offer a once-off Euchina bond to facilitate the internationalisation of RMB.
Banking crises are not an infrequent occurrence in economic history; the present Irish banking crisis, however, is profound. As a direct and immediate consequence of Irish bank failure, bank indebtedness is now embedded within an Irish sovereign debt for the foreseeable future. This poses an enormous challenge for government policy; the challenge is complicated by the fact that financial signalling has now become an integral part of the solution. In this presentation, using the language of game theory, the phenomenon of a signalling cycle is introduced.
Commentary on a Member State’s finances influences the probabilities of default. Rumours morph into news. The CDS market which insures investors against restructuring of bonds is a recognised barometer of default. Commentary on the Irish bail-out is now fully integrated into the cycle beginning Q3 2008 when commentators observed an event - a domestic banking crisis morphing into a crisis on sovereign debt. During a signalling cycle panic begins to set in when increasingly more evidence of financial illiteracy and incompetence is identified, coupled with the probability of contagion across EU Member States. Although a general election was called and a new Irish government elected on March 2011, the signalling cycle continues into 2011 as new events are observed and rumours continue to translate into news.
Introduction
The date is April 1st 2011 and the lead in The Irish Times reads as follows:
The Government has agreed to a €24b recapitalisation of the main Irish banks without to force senior bondholders to share the burden. It will be the fifth bailout of the banks since 2008 and brings the total State support to €70b. The Governor of the Central Bank, Patrick Honohan, described the Irish banking crisis as one of the most expensive in history.
November 30th 2010 Ireland agrees to a €85b bail-out from the EU and the IMF. How did we end up here? How indeed in an economy that expanded by 4% a year on average since 1960, bringing[1] ‘[sic] income per person from below two-thirds of our EU peers to 1.25 times today’? The question is relatively easy to answer; Irish banks and the profligacy of Irish bank management. Reckless lending and the capture of Government Ministers by savvy bankers transferred bank debt to the State’s balance sheet. The sad reality is that the Irish banks are now firmly entrenched in their positions, courtesy of an explicit government guarantee signed by the (previous) government on September 30th 2008. In a classic demonstration of capture theory, Irish bank management captured Irish policy makers at that critical meeting. They continue to capture policy makers as our banking crisis morphs into a sovereign debt crisis. The relative inexperience of the new government and the ‘[sic][2] black hole that is the Irish banking system’ presents a disturbing picture. Is there a workable solution?
At this juncture, it may be judicious to present a short synopsis of the great financial crisis (GFC, henceforth) as a backdrop to facilitate the conjunction of an EU-wide solution with an international solution. The approach is called critical time line analysis, allowing a researcher or commentator the ability to locate a crisis in context. In the broader church of events, GFC may have begun as early as March 12th 2007 when shares in a relatively unknown New Century Financial Bank were suspended[3], and the phenomenon of NINJA loans was identified and critically assessed by a financial media, baffled, as they learned that some of these mortgages required no documentation, for example, like proof of a job or salary slip. The complex and convoluted debt instruments were traded in a financial world of risky assets and cheap money.
Mortgages were assembled into large opaque bond packages, divided .up and resold as exotic derivatives, which were bet on by bond traders and investors. According to Michael Lewis, whose book The Big Short is a fascinating read of the GFC, even regulators were confused by the content of the convoluted debt instruments. Bad news about the US housing market in that hot summer of 2007 surprised investors in AAA-related mortgage-backed securities precipitating the collapse of the asset-backed commercial paper market. In September 2008, a run on money market funds, nationalisation of AIG, Fannie Mae and Freddie Mac, and particularly the collapse of Lehman Brothers, precipitated GFC. By October 2009, it takes a combination of government intervention in financial markets and the injection of equity in banks, to restore some measure of stability across the financial markets
Neglect of Small Risks
Why so many banking crises across the world? In a recent publication[4] Rochet (2008) argued that the ‘[sic] real problem lies with politicians who too often insist on rescuing insolvent banks for short term reasons of their own’. Ireland is an example and maybe the book should be mandatory reading for officials at the Department of Finance in Dublin.
Ireland joined the Euro-zone in 1999: a zone of low wholesale inter-bank rates, and cheap and easy money became readily available. Across the economy, house prices were increasing, house buyers neglected the risk that home prices could collapse. The euphoria of ever increasing houses prices, facilitated the neglect of small risks, and this neglect further facilitated the taking of greater risks by risk-averse house buyers, who now find themselves in negative equity. Likewise, with low wholesale inter-bank interest rates, cheap and easy money became readily available to Irish bank management. Irish governments pursued pro-cyclical policies[5].
At one level, Irish management of small indigenous Irish banks – Irish banks were small in capitalisation compared to EU banks – believed they were global managers of global banks, and acting accordingly, while at another, the cheap credit and Lehman liquidity (no risk management) allowed them to take risks in pet projects, as share prices increased. They entered a world[6] anathema to them: securities’ risks ‘held by people in one jurisdiction sold by companies operating in another jurisdiction that may have assets in yet another’ and come under multiple regulators but none at all.
Fly-fishing for tuna
More controversially[7], bank management may have been speculating: what we can only describe as fly-fishing for tuna, that is, speculating on the spreads between returns on mortgage-backed securities and the cost of funding these positions with commercial paper and repurchase agreements. In retrospect, it demonstrates classic Tullock rent-seeking behaviour; not an Irish phenomenon necessarily, but it had a poignant Irish dimension as assets (pet projects) were in construction, construction and more construction. That a sharp decline in asset values was inevitable as the housing bubble burst has been in the macroeconomics literature since[8] Fisher (1933). The deterioration of balance sheets of Irish banks has led to a broader economic crisis - the minimal cost amounts to a €85b rescue package at a 5.8% rate of interest.
A Template for Solutions
Beginning from the premise (as at July 2011) that the Irish banks are insolvent[9] (with lending books that outstrip their deposits) it is not too late to adopt a one-bank solution. Ironically, it is happening as we witness the nationalisation of the banking system in Ireland. The specific case of Ireland’s indebtedness is one that combines sovereign debt with bank undercapitalisation. However, it is precisely because the Irish banks are insolvent that a solution requires an innovative solution - an immediate shrinking and consolidation of Irish banks to one and only one bank, with an interim de-listing of all Irish banks and financial institutions until the one bank has been established. It will drive banking behaviour and possibly change it as well. Nothing less will suffice as ‘insolvency deniers’ prefer to debate liquidity.
In the grand debate in Ireland, solutions have been proposed from restructuring sovereign debt to ‘walking-away from the bail-out’ to renegotiation of the bail-out to balancing Irish budgets sooner rather than later. Calling time[10] on insolvent countries to restructure their debts should the bail-out fail resonates of a ‘lost decade’ wherein a generation are locked into fiscal adjustments. A solution must address the causes of the crisis and also recognise the relative economic significance of Ireland Inc in Europe. It must address the sustainability of growth in the real economy.
A political solution may be more complex because the ECB has a limited mandate in the absence of a United States of Europe. Although the Euro must survive as a global reserve currency there is a sovereign debt default hanging over EU policy makers like the proverbial sword of Damocles, and once embedded into FOREX there is a grave danger of the Euro debt crisis becoming a crisis of confidence in the Euro per se.
One Irish Bank: De-List and IPO
So there has to be room for an innovative solution that not only links into an international perspective but also provides both a sustainable and a pan-European solution – in the Irish case, simply begin a process at time period t of de-listing the (Irish) banks for a t+1 period. It is not too late.
Preamble: Note that in the case of performing loans some Irish banks[11] are booking costs in negative margin, as funding costs exceed the interest charged. If we have more than one bank, each bank’s profitability will be constrained by costs and interest margins and also by a ‘common pool problem’ – that is, too many banks, and thus a dissipation in individual bank profitability - as more banks make money both by lending to customers and from their depositors. More deposits will be required to meet the loan-to-deposit ratio and in a competing market (for deposits) the spread will be negligible.
Research at the Swedish banks[12] has suggested that a 1% increase in short-term interest rates could increase profits by 20%. Solving the bank crisis or ‘repairing’ the banks before attempting to solve sovereign debt crisis is the optimal solution since it has been pointed out that many European banks are large holders[13] of sovereign debt, so a fall in the value of their holdings (on the presumption that a restructuring takes place) would dilute their capital, reducing further their ability to lend, and thus exacerbate a debt-deflation cycle across Europe.
One Bank: Post-IPO Start-Up Bank plc
Preamble: The EU cannot fix the sovereign debt crisis unless it fixes the banks. EU banks, and Irish banks are no exception, are undercapitalised (Irish banks are absorbing €35b), supported by ECB funding. Ireland has a disastrous and possibly catastrophic banking crisis. The newly elected government has progressed, thus prolonging, a second-best solution of tinkering around the edges of the Latin square of bank finances. By de-listing the insolvent banks, a moratorium is placed on trading shares until an IPO is placed at an agreed 2 or 3 year date. It will deprive the speculators of the oxygen of uncertainty and facilitate a type of convoluted debt solution that may have contributed to GFC, and thus allow EU policymakers to fight fire with fire!
How would it work?
Preamble: The ECB embeds the CDS market[14] default probabilities into policy and plays the game with investors and strategists by issuing new sovereign ‘default’ bonds to financial investors, such as hedge and pension funds and bondholders that are willing to place a bet on the probability of a default occurring (say) in Greece or Ireland and at a particular time.
Traditional shareholders and institutional shareholders could be allocated restricted stock units (RSU) which convert to equity only after an IPO and cannot be resold on any exchange. During the moratorium period, the EU banking sector would be consolidated in an efficient and timely manner, balancing redundancies and redeployment with financial innovation measures to restore solvency and liquidity. Debt exchange arrangements, reminiscent of the private sector, would then be put in place.