Stay away from bad banks and risk insurance

ECONOMICS:Nationalisation on a temporary basis would efficiently resolve our banking problems, writes KARL WHELAN

THE GOVERNMENT has put €7 billion of public money into AIB and Bank of Ireland, but it has also employed economist Peter Bacon “to assess the possibility of creating a bad bank or risk insurance scheme to take so-called toxic debts off the banks’ balance sheets in a bid to free up new lending”.

It is crucial that the Government deals with our banking problems quickly and efficiently. However, it is my opinion that the bad bank and risk insurance proposals would be inefficient and unfair.

In normal circumstances, when a firm can only survive with a significant equity investment from an outside investor, that investor gets a dominant ownership stake, reflecting the significant risk they are taking on. The Government, however, is very reluctant to take banks into public ownership.

Understanding this reluctance, bankers have been promoting the idea of a bad bank. The idea behind the current round of bad bank proposals is that governments buy “toxic assets”, thus removing them from banks’ balance sheets. However, removal of toxic assets is the not the key issue: banks could remove these assets themselves by simply writing these loans down to zero. The relevant question is: what price does the Government pay for these assets?

Governments are being asked to buy these assets because the prices banks would get for them in the marketplace would leave them undercapitalised and perhaps insolvent. So the plan relies crucially on governments paying more than the assets are worth. Every euro the Government overpays will be a euro of equity capital the bank will not have to raise elsewhere.

It is easy to see why bankers are enthusiastic about such a scheme. However, it should be equally obvious that this is unfair and a bad deal for the taxpayer. Once the crisis is over, shareholders of the institutions that created this crisis will have benefited from a large unconditional transfer of funds from the Government.

Advocates claim it has been successfully used in dealing with previous banking crises. In reality, the proposals are completely different. Previous bad banks were state asset management companies that worked to obtain the best sales price for assets that governments inherited from insolvent banks that had been nationalised. The current proposal, which involves paying over the odds for assets to keep insolvent banks in private hands, has not been tried before.

In addition to being unfair, it is questionable whether the bad bank proposal could achieve its goal of properly re-capitalising private sector banks. There may be limits on the price the Government can pay for impaired property loans under EU state aid rules. Banks may still have to write down their assets. It is easy to imagine a scenario where banks struggled with weak capital bases even after a bad bank scheme has been put in place.

This brings us to risk insurance, a proposal under which the Government agrees to assume responsibility for all losses incurred by banks over some fixed amount. By setting a ceiling on losses, it could encourage private investors to make equity investments in the banks.

One can see why this proposal might be attractive to banks and politicians. The banks would eventually get to transfer most of their loan losses to the Government. From the politician’s perspective, it may take some time before the banks call on the insurance programme, thus deferring the need for large payouts. They might even boost exchequer funds through some form of insurance payment from the banks. (In reality, the idea is akin to selling fire insurance to a man leaving a burning house.)

Like the bad bank proposal, risk insurance leaves the taxpayer on the hook for most of the loan losses, but does not give the State any further control of the banks.

It is also unlikely to produce a clean solution to the problem of undercapitalised banks. Bank chief executives would have no strong incentive to minimise losses on loans that ultimately would end up being owed to the taxpayer and may still choose to eschew outside equity investment. By the time the insurance kicks in, the scale of the bad loans could be far higher than it is today.

Irish banks need further equity capital. The Government is the only source of this capital. The bad bank and risk insurance proposals should be seen for what they are – indirect methods of recapitalising the banks without giving the Government any further control. If further major State recapitalisation is required, it is only fair that the Government take control and temporarily nationalise the banks. At that point, underperforming property loans could indeed be taken over by a State asset management company (a more accurate and useful terminology than bad bank) which could work to minimise the losses incurred by taxpayers.

The State can also decide on the appropriate level of equity capital for our banking system, a crucial decision in the control of existing management at our troubled banks. This approach is more likely to produce a fair and efficient resolution of our problems than schemes that keep management in place and reward shareholders. Temporary nationalisation would be a difficult political decision, but it is more likely to produce a lasting and fair resolution.

Karl Whelan is professor of economics at University College Dublin