'Bad' bank is best bet as recapitalisation clearly not enough

 

ANALYSIS:Slicing off toxic debt from overburdened banks should fuel more widespread lending, writes SIMON CARSWELL.

MINISTER FOR Finance Brian Lenihan’s announcement that he is to consider setting up an Irish “bad bank” to take toxic assets out of the Irish financial institutions makes sense given that internationally, bank recapitalisations alone have not improved the flow of credit to struggling businesses.

To proceed with this week’s anticipated plan to recapitalise Allied Irish Banks (AIB) and Bank of Ireland with €3.5 billion each – without at least saying the Government will assess some method of removing bad loans from the banks’ balance sheets – would have been to ignore the biggest challenge facing the banks.

In the current dire economic climate, assets just aren’t selling, forcing banks internationally to write off massive losses.

Substantial state capital injections into banks have not helped as governments have thrown good money after bad trying to prop up banks that have shouldered heavy losses.

By taking control of these bad assets – through creation of a “bad” bank or an insurance scheme guaranteeing losses on impaired loans, or a mixture of both (as the Netherlands did with Dutch bank ING) – governments would act where the markets have not. They are trying to put a floor under falling prices and assign values to assets that markets are unwilling – and unable – to price.

As part of a $2 trillion US economic recovery plan announced yesterday, US treasury secretary Timothy Geithner said the Obama administration would create a fund of $500 billion using public and private money, starting with government finance, to buy toxic assets out of the system.

The hope is that this will lift the growing bad debt burden from the US banks, enabling them to resume lending into the economy.

Mr Lenihan has indicated that he will not move as decisively when he confirms the €7 billion recapitalisation of AIB and Bank of Ireland, expected to be announced today or tomorrow.

The Minister said in Brussels yesterday he would not be “jump-led by markets and market expectations into solutions”.

He warned that removing toxic debts through a bad bank or risky asset insurance schemes could leave the taxpayer exposed. Such proposals involved “payment of a definite premium to the taxpayer in return for assumption of an indefinite risk”, he said.

This is the difficulty. The Government has yet to conduct due diligence of AIB and Bank of Ireland. Such an examination will only begin once the banks accept the State’s recapitalisation plan.

PricewaterhouseCoopers has assessed the capital needs of the two banks for the Government. Due diligence will give Mr Lenihan a full picture of their toxic assets, which will include most – if not all – of the €36 billion in loans to developers and the risks associated with insuring losses against them. Stockbroker Davy expects AIB and Bank of Ireland to write off €5.8 billion and €5.2 billion respectively over the next three years and that the banks will make losses in two of those years.

Injecting €3.5 billion into each bank will clearly not be enough, though insuring losses on loan write-offs could help fill the gap.

The European Commission and European Central Bank are assessing a possible combined bad bank/toxic assets insurance scheme to solve the problem facing all banks. Mr Lenihan will be keen to wait for international consensus on a plan.Meanwhile, the recapitalisation plan is expected to include a Government statement saying it will consider proposals to remove toxic loans.