OPINION:Ensuring there is enough risk-bearing investment in the banking sector is vital, writes Patrick Honohan
FOR MONTHS, many bankers and policymakers have been in denial over the severity of the financial crisis.
However, since the US authorities allowed the big investment bank Lehman Brothers to go into bankruptcy in mid-September, there has been a growing realisation that this is not a transient affair or limited in its scope.
Market reactions have been rapid and in some cases devastating. Banks that have excess liquidity are not interested in lending to other banks. Instead they are placing their surplus funds in low-interest deposits with central banks, forgoing sizeable profits.
If they have the necessary collateral to offer, they have in recent days even been borrowing from the central bank and redepositing the funds at a loss to be sure of being able to meet any depositor withdrawals. Banks that relied on ready access to wholesale funds and have exhausted their eligible collateral for central bank borrowing have been forced to seek emergency assistance from national governments.
The policy reactions have been different in different countries, but in every case governments have sought to keep their retail depositors from panicking and to assure the flow of bank lending. The first task is easier than the second.
To calm depositors, several European countries have announced increases in deposit insurance coverage, in some cases apparently covering all personal accounts, though several of the announcements have been rather vague.
The Irish Government's blanket guarantee is the most far-reaching, going well beyond what would be needed to make the personal depositor secure and even guaranteeing all existing and future subordinated debt.
Subordinated debt is issued by banks at high interest rates to comply with regulations designed to supplement shareholders' funds in ensuring an adequate cushion to absorb losses.
By including this debt, the guarantee enables an Irish bank - unless it is forbidden to do so by some new regulation - to boost capital at a low cost, given that the risk is being borne by the State.
The piecemeal expansion of deposit insurance has created problems, not least between UK and Irish banks, and there have been understandable complaints.
However, while it is a natural focus of politicians, reassuring the retail depositor is only a small part of the story.
Retaining their retail deposit base will not be a sufficient basis to get bank lending moving again or to reduce the exceptionally wide risk premiums that have opened up and add to the cost of borrowing.
It is increasingly evident that the only way to do this is to arrange for large-scale injections of risk capital into the banks. After all, part of the reluctance of liquid banks to lend to their peers is due to the continued uncertainty as to which banks are fundamentally sound and which are not.
There are huge embedded losses, likely well over €1 trillion, of which only a fraction has been acknowledged and reported by banks worldwide over the past year. Where the remaining losses lie, and what contagion their discovery might entail, remains very unclear to all.
Equity could be injected from private or official sources. Sovereign wealth funds in the Middle and Far East participated in recapitalisation of several large banks in the early stages of the crisis, but the losses they have taken so far on these investments have made them cautious.
The central banks are being careful to limit their exposure. It is really now down to the governments.
This is not just a question of stabilising the financial condition of individual banks, it is about ensuring that there is enough risk-bearing investment in the banking sector in the advanced economies to support the level of lending needed to avoid a protracted recession. This risk capital has been eroded by the losses, and needs to be built up again, preferably higher than before, given the heightened risk aversion that now prevails. It is to this aspect of the problem that the US $700 billion initiative is supposed be addressed. By buying that amount of the most opaque and potentially toxic assets from the leading US banks, the US treasury is hoping to dispel much of the uncertainty. These assets will presumably be bought at prices well above what could be realised in the current market.
The US taxpayer is thus likely (though not certain) to take a big loss on these transactions, but by the same token the banks will increase their capital and reduce the risk they face. (The loss to US taxpayers could be limited if, along with the toxic assets, the treasury is granted some entitlement to equity).
But the US scheme may not succeed. Its effectiveness in injecting capital depends on the price which the treasury is willing and authorised to pay for these assets. Furthermore, the sum of money allocated is arguably not large enough to deal with the whole problem in the US.
European authorities are also feeling their way towards a solution involving large-scale equity injections. I say "feeling their way" because we have already seen several false starts, for example with both the initial injection of government funds into Fortis Bank (Belgium and the Netherlands) and the initial specific borrowing guarantees for Hypo (Germany) proving insufficient. Iceland's nationalisation of its third largest bank was also clearly an inadequate response to the market's pessimistic views of the solvency of the two larger banks.
Ireland's action too, though admirably decisive and vigorous in implementation (albeit problematic in design), is likely to need supplementing with specific equity injections. The banks will be reluctant to sell equity to the Government even at a sizeable premium to current historically low market prices, and the liquidity pressure to do so has been removed by the guarantee. Yet in the long-run the prosperity of the banks and of us all depends on their having adequate capitalisation.
• Patrick Honohan is professor of international financial economics at the department of economics in Trinity College, Dublin