How 'oxygen supply' of funding was cut off

The Government was forced to guarantee deposits and debts at the six Irish-owned banks and building societies on Tuesday, to help pump an emergency supply of money into the banking system which has grown starved of cash due to the worsening international credit crisis.

The collapse of US investment bank Lehman Brothers on September 14th proved that the authorities would allow a major bank to fail, contrary to the perception in the market.

This spooked those shareholders and investors who buy bank debt around the world.

It had been widely believed after the rescue last March of another Wall Street bank, Bear Stearns, that if a major international bank teetered on the brink of collapse, it would be protected.

This did not happen, however, and as a result, credit markets, where money is raised by banks around the world, froze.

The crisis spread to Europe on Monday, leading to State bailouts or rescue takeovers of four major European banks, including Germany's Hypo Real Estate, whose Dublin-based bank Depfa ran into trouble trying to raise short-term funding.

Irish bank shares suffered their biggest one-day falls in more than a quarter of a century, with Anglo Irish Bank losing almost half its value.

Irish-owned lenders are particularly exposed to the financial turmoil, as they have grown to rely more heavily on wholesale markets to raise money to feed the decade-long boom in property lending that peaked in 2006.

Construction and property accounted for 6 per cent of economic activity in 1998, but surged to 25 per cent in just eight years.

Residential mortgages have more than doubled to €145 billion in the last four years. Of all private Irish debt, more than €3 out of every €5 relates to property loans.

Builders, developers and property investors owe €110 billion of all private borrowing, which totals more than €400 billion.

In 1997, the ratio of loans to deposits was almost 1:1, meaning that Irish-owned banks and building societies were lending Irish borrowers roughly the equivalent of €1 for every €1 they held on deposit.

By 2002, this had grown to €1.30 in loans for every €1 on deposit. It now stands at €1.50 in loans for every €1 on deposit.

This compares with the European bank ratio of €1.30 to €1. In other words, these institutions source one third of their money in the wholesale markets.

The closure of these markets has dried up liquidity, which is essentially everyday cash flow for the banks, or short-term funding.

This, combined with collapsing confidence and bank stocks - and the threat of further share price falls and large out-flows of deposits - forced the Government to act and guarantee the Irish-owned financial institutions.

The Government has since agreed to consider extending the protection to foreign-owned Irish banks with significant retail operations in the Republic.

These include UK-owned Ulster Bank and Bank of Scotland (Ireland)/Halifax, both of which have applied to be included.

Danish-owned National Irish Bank has said it intends to apply.

- Simon Carswell