State will need all the help it can get in finding a way to repair banking system

BANKING:On some issues, the troika of the EU, the ECB and the IMF are unlikely to budge

THE NEW programme for government would appear to put the Fine Gael-Labour coalition on a collision course with the troika of the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF).

This is hardly a surprise given that the central plank of the election campaigns of both parties involved the renegotiation of the troika’s €85 billion bailout plan.

However, almost four months have passed since the deal was negotiated and the troika is understood to have softened its approach to some of the conditions and deadlines in the bailout plan to repair the banjaxed banks.

This will give the Fine Gael-Labour Coalition some flexibility with their programme. On others the troika is unlikely to budge.

The two main parts of the plan to repair the banks involves:

the immediate recapitalisation of the banks with a further €10 billion – some €8 billion will be used to bring their capital levels up to 10.5 per cent (of loans) initially and a further €2 billion to “over-capitalise” them to 12 per cent, which can be used for credit enhancements, or sweeteners, to help sell assets. The aim is to keep capital levels above 10.5 per cent.

shrinking the size of the banks to bring their loans closer in line with deposits so they can fund themselves on their own. This will involve off-loading about €65 billion to €70 billion in loans, in addition to the €88 billion in loans that had been earmarked for Nama.

The results of the Central Bank’s PCAR (capital) and PLAR (liquidity) stress tests will be known at the end of month.

The first test will assess the extent of further loan losses, including the likely holes left in the banks from rising bad mortgages.

The second will determine how much in loans each bank must offload to “right-size” the banks before a deadline under the bailout plan of the end of 2013.

The troika has earmarked €35 billion out of the €85 billion for the banks – €10 billion for the immediate recapitalisation and €25 billion in a contingency fund if bank losses rise further and to pay for the cost of selling off assets.

The troika has made it clear privately that the initial recapitaliation of €10 billion – which will come from State coffers, again tapping the National Pension Reserve Fund for the banks – was “a red-line issue” and non-negotiable.

The remaining capital needs – and how much of the other €25 billion will be required – is unknown.

There are three “dials” which have to be turned to understand how much more will be required:

• capital targets,
• loan losses,
• the cost of deleveraging.

The capital targets are set and the Central Bank – with consultants Blackrock, Barclays Capital and Boston Consulting – are poring over stress scenarios to decide on how much more capital the banks will require to cover further losses.

The new Government says it will end the previous government’s “blank cheques for banks” policy and has quite sensibly said there will be no further recapitalisation of the banks until losses are assessed in the stress tests.

The National Asset Management Agency (Nama) is in the crosshairs of the Government. The programme for government points to “the Nama asset purchases and the subsequent recapitalisation” as the root causes of the commitment of €100 billion in State funding to the banks.

“Much of this taxpayer commitment reflected the policy to crystallise – through asset transfers to Nama – massive losses in banks under taxpayer guarantee at a time of extraordinary financial distress,” the programme says.

It plans to stop any further transfers to Nama as they are “unlikely to improve market confidence in either the banks or the State”.

The Fine Gael-Labour coalition may be pushing an open door here as the troika appears to have softened its approach to Nama.

Sources with knowledge of the troika’s views say they no longer see Nama as a panacea now they understand the damage of valuing assets to market values when there is no market.

A further €12 billion in loans were due to be transferred under the “Nama 2” process involving individual loans of less than €20 million as part of the EU-IMF deal. But the Government wants this process stopped.

The loans, totalling about €8 billion at AIB and €4 billion at Bank of Ireland, are still likely to be removed from the banks as part of the deleveraging process as they were identified as excess assets at the two banks.

The timing of the removal of these loans and a further €65 billion to €70 billion is crucial. Force the banks to sell them quickly into a dead market and you will trigger further losses. Give them more time and you will lower the losses.

“Who is the damn counterparty [buyer] for all these trades?” asked one banker. “If you move these assets into a subsidiary, you have to apply a haircut.”

If the ECB funded these assets in a warehousing vehicle, this could require capital of €8 billion based on the haircuts that Frankfurt applies to collateral backing its loans, according to Dublin fixed-income firm Glas Securities.

While the new Government is committed to reducing the size of the banks and their reliance on central bank funding, this “must be paced to match the return of more normal market conditions and demand for bank assets”.

The new Government is playing up the “debt sustainability” argument – in other words, given the state of the public finances, further unnecessary bank losses could put a greater strain on the State’s ability to repay its debts, including the EU-IMF loans.

There is believed to be a growing understanding within the troika that forcing asset sales in a depressed market would be akin to giving away capital to foreign buyers of distressed assets.

While there is general acceptance that assets must be sold by the end of 2013 (coinciding with the new Basel III international banking rules on liquidity and stable funding anyway), the pace and conditions to be applied around the sale process must be decided in a measured approach.

Time will also help the banks as loans being repaid with economic recovery will help deleveraging.

The sensitive matter of sharing bank losses with unsecured, unguaranteed senior bondholders (who are owed €16 billion by the banks, including €3.1 billion by Anglo Irish Bank and €600 million by Irish Nationwide) will encounter the greatest opposition.

Burden-sharing with senior bondholders is one item listed on the Government programme that “may be necessary”.

The lack of a conclusion around the “burn the bondholders” debate is understood to be exacerbating the banks’ already highly stressed funding woes, which the EU-IMF bailout is designed to solve. Therefore, unless there is any change in this policy internationally affecting others countries, possibly at the EU summit in Brussels on March 24th-25th, the new Government is highly unlikely to secure an Ireland-only solution.

Restructuring senior bank debt would help but it is not regarded by the troika and the Government authorities as a cost-free option.

“The sooner there is some clarity around this issue the better,” said a well-placed source.

The proposal to establish “a strategic investment bank” could prove difficult at a time when Ireland is over-banked and a major objective of the EU-IMF bailout is to shrink the Irish banking sector.

The Government plan to replace directors who presided over the pre-crisis running of the banks will have the most impact on Bank of Ireland.

The biggest issue for the Government is to create a long-term funding platform that allows the banks to be restructured over time. That is not just an issue for Irish banks but European banks as the financial system recovers.

“We are quite cheap by comparison,” said one source familiar with the thinking of the troika.