Muldoon alert on likely €25bn of impaired SME debt breaches recovery consensus

Fiona Muldoon has launched her campaign to succeed Matthew Elderfield in some style. Speaking last week at the Cantillon conference at the Institute of Technology, Tralee, the head of bank supervision at the Central Bank lifted the lid on the plight of small-business-related lending losses.

She summed it up in one paragraph. “In many cases, family businesses borrowed to expand the business, invest in their premises and maybe a buy-to-let property for their pension. Some cases include personal guarantees or drawdowns on the family home. That same SME is now the only source of cash flow in servicing both direct and indirect debt.”

She also made the connection between the SME debt problem and the hundreds of thousands of people who work for such firms and are dependent on them for their salaries to pay mortgages and other debts.

Impaired loans
The question nobody seems to have a convincing answer to is this: how do you deal with all this impaired debt – €25 billion according to Ms Muldoon – and save the viable businesses and the jobs they support?

One thing is clear. As was the case with mortgages, the cost will be spread across society, directly or indirectly. We will either have to put money into the banks so they can absorb their SME losses and move on, or we will deal with the consequences of sclerotic growth including higher unemployment and further cuts in spending while the SME sector struggles on with a zombie banking industry.

But, as with the mortgage crisis, there are different views as to which way it should be done. The banks prefer the indirect route because kicking the can down the road and hoping for the best makes them look solvent on paper.

Indeed, all the signs are that they will have to be made face up to the SME debt problem as they were forced to deal with mortgage losses. It is only now – five years into the crisis – that there is any real sense that the banks are moving to address the mortgage issue and taking the associated write-downs. That required an ultimatum from the regulator to the effect that they will be made take the write-downs anyway.

In a further echo of the mortgage crisis, the Government is conflicted because ultimately it will have to stand behind the banks should they need more money. Putting more money into the banks – assuming we can get it – may be the right thing in terms of economics but it does not fit well with the current iteration of the Irish recovery story.

The official narrative is that the banks are fixed and are no longer an impediment to exiting the bailout at the end of the year. The fact that half of lending to the all-important SME sector is impaired falls into the category of inconvenient truth. But the cat is out of the bag. And quite seriously so, thanks to Ms Muldoon and we should be grateful for that. What is needed is serious focus on the problem and whether or not fixing it will require an injection of more money into the banks. Where that might come from is another day’s work.

It is not a given that more money will be required. What is worrying about the figures given by Muldoon last week is that they do seem some way ahead of the assumptions made when the banks were recapitalised in 2011. The prudential capital adequacy review, or Pcar, assumed that some 30 per cent of SME debt was impaired: Muldoon quoted 50 per cent of the outstanding €50 billion.

Hysterical overreaction
When you consider that mortgage losses also seem to be running ahead of the base-line scenario used in the Pcar, it's not a hysterical overreaction to ask whether more capital might be needed.

The Pcar is due to be repeated later this year and should provide an answer of sorts, provided its terms of reference and underlying assumptions are realistic. These will be a matter for the Government, the regulator, the troika and, to a certain extent, the banks themselves.

Given the stakes involved and the conflicted position of the Government – and even the troika – this will be a very fraught process and will sorely test the new financial regulator.

Muldoon seems to have nailed her colours to the mast somewhat by telling the Cantillon conference that her background was in insurance rather than banking and in insurance companies – good ones at least – economic losses have to be dealt with upfront.