Ireland: How much punishment for British and international banks?
Are haircuts in or out for Ireland? Will the putative experts at the IMF, European Commission and European Central Bank, who will spend the next few days examining Ireland’s intertwined banking and fiscal challenges, recommend that there should be losses imposed on the providers of tens of billions of euros of wholesale debt to banks.
It’s extremely difficult to be sure - which is going to unsettle markets.
This is what finance ministers from the eurozone said in a statement last night:
“We welcome the measures taken to date by Ireland to deal with issues in its banking sector, via guarantees, recapitalisation and asset segregation. These measures have helped to support the Irish banking sector at a time of great dislocation. However, market conditions have not normalised and pressures remain, giving rise to concerns that further reforms and stabilisation measures may be appropriate.”
Or to put it another way, the Irish strategy of using taxpayers money to strengthen the balance sheets of banks - by injecting new capital into them and dumping their worst loans into NAMA’s toxic bin - has only been partly successful. Other measures are needed.
What might those other measures be? Well goodness only knows. The European Commission’s Economic and Monetary Commissioner, Olli Rehn, said there would be an “intensification of a potential programme with an accent on the restructuring of the banking sector”.
It is that phrase “restructuring of the banking sector” which may alarm the banks and financial institutions which are wholesale creditors of Ireland’s banks, the providers of more senior debt which is supposed to be least at risk of non-repayment. The implication is that consideration is being given to forcing losses on them, such that they would share in the costs of rehabilitating Ireland’s banks.
If that were to happen, it would be counter to the passionately stated policies of Ireland’s Taoiseach or prime minister, Brian Cowen, and his finance minster, Brian Lenihan. They fear that reneging on these debts would see Ireland cast out into a financial leper colony, unable to tap new commercial sources of credit for years if not decades (see my post, Why Ireland can’t afford to punish reckless lenders to its banks).
However, and slightly to my surprise, I am told that the European Central Bank is also opposed to imposing losses or haircuts on senior debt holders. If true, this would matter, in that - as I made clear on Monday (see my post, Will the ECB pull the plug on Ireland?) - it is the ECB which is the prime mover in trying to force Ireland to take emergency finance from the EU or IMF, as part of a package to put its banks and public finances on a firmer footing.
That said, it would be a bit odd if the ECB, in the shape of all its senior movers and shakers, were opposed to such haircuts: there is a powerful moral argument, of the sort that normally appeals to central bankers, to the effect that overseas banks and institutions in the UK, Germany and so on should have known better than to encourage Ireland’s banks to lend recklessly and pump up a completely unsustainable property bubble - and that they therefore deserve a bit of a spanking.
What’s more, if Ireland is fundamentally incapable of paying off all it owes - which is equivalent to an oppressive 700% of GDP when banking, public sector and private sector debts are added together -some will say it is grotesquely unfair that the cost should fall entirely on taxpayers in Ireland, the European Union and (if IMF money is drawn) the rest of the world.
All that said, there might be sound practical reasons for protecting the senior debt providers.
Certainly it is very difficult to see - under the current law - how the senior debt holders could be punished in the absence of some dramatic events. First the two weakest of the big banks, Anglo Irish Bank and Allied Irish Banks, would probably have to be declared insolvent. And second, almost all the many billions of euros that Irish taxpayers have already pumped into these banks would have to be written off, which would be extremely painful.
What would then be triggered would be enormous payments by underwriters of credit default swaps (CDSs), the debt insurance contracts taken out by lenders and speculators. These payments would generate enormous losses for the financial institutions, including banks, which provided the CDS cover.
Sources close to the Irish government tell me that the US authorities are deeply concerned at the idea that CDS payments would be triggered in this way. The implication (yet again) is that insurance contracts designed to reduce risk are in fact a source of systemic instability. Which, of course, has been the hideous norm in the Frankenstein markets that have been engineered over the past decade or so.
Even without the CDS loss multiplier, the impact of debt haircuts would be painful for British and international banks. According to the Bank for International Settlements, total lending of non-Irish banks to Irish banks is around $170bn, of which British banks provided $42bn, German banks provided $46bn, US banks $25bn and French banks $21bn.
Which British banks are at risk? Well according to new research by Morgan Stanley, total lending to Ireland’s private and public sectors is equivalent to 92.3% of the net assets of Denmark’s Danske Bank, 89.5% of Royal Bank of Scotland’s net assets, 60.2% of Lloyds’ net assets and 15.9% of Barclays’ net assets. Those figures exclude bank-to-bank lending, but they indicate how exposed Britain’s banks are to Ireland’s woes (RBS is most exposed, as the owner of a substantial Irish bank, Ulster Bank).
What’s more, if there are haircuts imposed on Irish bank debt, it’s very difficult to see how haircuts could be avoided for Greek and Portuguese bank debt too, and also for plain vanilla Irish, Portuguese and Greek government borrowings.
If you add all that together, it comes to $435bn of exposure for international banks to the banking and public sectors of the eurozone’s three weakest economies. If, say, a third of that were written off (enough to make the residual debt almost bearable) that would trigger not far off $150bn of losses for banks alone.
By the way, bigger losses would fall on pension funds, insurers and other financial institutions.
Would that be an unthinkable, unbearable cost for banks, that would undermine the integrity of the financial system? Probably not. Is it understandable that the Irish government doesn’t want to be the first to test whether international banks can take the strain? Probably.