Rushing to pay back the ECB loans may prove a costly mistake

Mon, Feb 21, 2011, 00:00

BUSINESS OPINION:The bailout agreement allows some wriggle room about how we restore banks’ liquidity

NOW THAT we have got our heads around capital and why the banks need so much of it to fix their balance sheets, it turns out that it’s no longer the real problem. Liquidity is the issue that now preoccupies the inhabitants of the top floor of the Central Bank and will soon start to impinge on the national consciousness.

Dame Street, along with the Government, is currently negotiating with the “external authorities” (aka the European Union, European Central Bank and International Monetary Fund) a plan to solve the liquidity crisis at the Irish banks.

The ECB has lent the Irish banks ever increasing amounts of cash as depositors withdraw their money due to fears about the banks and the economy generally. The banks have had to turn to the ECB because the assets they hold against the deposits could not be easily turned into cash in order to allow them repay the deposits. The main reason for this is that no one wanted to buy them because in large part they were loans and other assets which represent exposure to the Irish economy.

The ECB has lent the Irish banks some €150 billion via this process and holds all sorts of assets as collateral. It now wants out and letting it get out is one of the prime objectives of the bailout agreed last December. All else being equal it is of course very much in our interest that the ECB can exit because it would indicate that the banking system is finally fixed.

The details of the ECB’s exit are now being hammered out. There are two elements to the strategy. The first is that some of the Irish banks’ assets will be sold and the cash raised used to repay the ECB. The second – and concurrent – element is that as international confidence in the Irish economy is rebuilt, deposits will flow back and the balance of the ECB’s money would be repaid with them.

What is taxing minds at the moment is how to strike the balance between the two elements. The danger is that if the first part of the plan is conducted too aggressively it will undermine the recovery and be self-defeating from the overall objective of returning Ireland to a position where it can borrow normally from the bond markets.

Under the plan agreed with the EU-IMF the sale of the banks’ assets will be expedited. Some €25 billion of the €85 billion programme we have arranged (of which €67.5 billion is EU and IMF loans and €17.5 billion our own funds) is set aside to facilitate this. It will be done in two ways. First, the banks may sell the assets at a loss and use the EU-IMF funds to meet any resulting capital shortfall. The second is that some of the loan money will be used to guarantee that the purchasers of the banks’ assets don’t suffer a loss. These guarantees are called “credit enhancements” and again will be funded out of the EU-IMF facility if called upon.

The amount of the loan that actually has to be drawn down will depend on how hard and how fast the process proceeds. From the ECB point of view its a case of the faster the better. The Irish position is different.

Ireland’s credit rating is teetering on the edge of junk status. The rating agencies are all awaiting the outcome of the discussions currently under way and what they do next depends very much on how much of the €25 billion we end up having to draw down.

The more we use, the more likely it becomes that there will be another round of downgrades of the Irish sovereign, with all that means for the prospect of recovery and re-entering the bond market.

From Ireland’s perspective the longer the ECB can be made wait the better. The ECB no doubt feels it has waited long enough but at the same time it must see the danger of throwing the baby out with the bathwater should it force the pace to such an extent as to trigger further sovereign downgrades and bank recapitalisations.

It’s arguable that the outcome of these discussions could be as important as the parallel arguments about the interest rate being charged on the loan and burden sharing with the banks that were foolish enough to lend to the Irish banks.

It is also a far more productive area for the Government to concentrate its efforts on because, unlike the other two issues, it is very much up for negotiation under the terms of the agreement. The Memorandum of Understanding sets out the objective of slimming down the banks but does not go into the detail of the timing or the methodology. As a result there are no hardened public positions and thus there is space for pragmatism.

As things stand, we have not yet even got the other parties to the deal to accept that the interest rate and burden sharing are even up for negotiation. There is little to lose by hammering away on these fronts over the next few weeks as the negotiations on the new framework for rescuing member states are concluded. But in the end it may prove more fruitful to try to exploit the wriggle room in the existing agreement.