ECB needs to realise Irish problem is its problem

 

The ECB is on the hook for the €177 billion it lent to the Irish banking system

THERE HAS been a lot said in the past few weeks about the feasibility of renegotiating the terms of the Irish bailout. There will doubtless be plenty more big talk before polling day.

So far, however, there has been very little said about the one thing – arguably the only thing – that will very quickly bring the EU and the IMF to the negotiating table: what if the current plan does not work?

And, if you subscribe to the view that one of the prime objectives of the Irish bailout is to get the European Central Bank out of the predicament in which it has found itself with regards to Ireland, then there is good reason to believe talks will be starting sooner rather later.

The ECB is on the hook for the €177 billion it has lent to the Irish banking system. It has lent €126 billion directly through various liquidity schemes and another €51 billion indirectly via the Central Bank of Ireland.

What started out as liquidity support for Irish and other European banks post the collapse of Lehmans in 2008 has become a life-saving transfusion for Ireland’s imploding banking system.

As confidence in the Irish banks and the Irish sovereign deteriorated, deposits left the system and have been replaced by short-term borrowing from the ECB. The deal agreed with the EU and the IMF is supposed to stop this spiral and in time reverse it as confidence in Ireland and the banking system is restored.

It is far too early to take a view as to whether or not the plan is working in this respect. The most recent figures for the amount of liquidity provided to the Irish banking system directly by the ECB actually show a slight decline from €132 billion to €126 billion. The liquidity provided via the Central Bank remains stuck at €51 billion.

However there is clearly a mountain to be climbed in terms of restoring confidence in the banks to the point that they can reduce their reliance on the ECB down to levels with which Frankfurt is happy – presumably single-digit billions. Deposits would have to flood back into the Irish system at something in excess of €1 billion a week over the next three years.

This looks pretty optimistic standing where we stand today, particularly as the first cracks are starting to appear in the plan.

Brian Lenihan’s decision to call Labour and Fine Gael’s bluff on recapitalising the banks last week may have been a political stroke but it served to highlight a very big flaw in the plan – namely, the requirement to recapitalise the the banks a month ahead of the stress tests that are supposed to establish their capital requirements once and for all.

It clearly makes no sense to do this and it raises questions about how well thought-out the rest of the plan is. It must be remembered it was hammered out in a couple of frenzied weeks.

It also has to be borne in mind that the IMF has never attempted anything on a par with the Irish bailout and Europe’s difficulties in framing a response to the crisis is there for all to see.

Things will become clearer as the various measures aimed at “cleansing” the banks are implemented over the coming months and they are slimmed down and over-capitalised. If the banks’ reliance on the ECB does not start to fall rapidly at that point it can really mean only one thing; investors’ concerns about the burden imposed on the State by the plan outweigh any comfort they may be taking from the sorting out of the banking system.

It is at that point that the ECB will have to decide whether it is going to fund the Irish banking system indefinitely or accept that something has to be done to reduce the burden on the State in order to return its debt dynamics to some sort of sustainable path.

In theory, the ECB can call in all the collateral pledged against the liquidity loans. That though would collapse the Irish banks and economy and, given that pretty much all the collateral amounts to Irish Government debt of one sort of another or is guaranteed by the Government, it is not really an option.

You would have to suspect that the ECB’s plan B in this scenario is to engineer the sale of the restructured Irish banks to other larger European banks. This solves the liquidity problem overnight as the Irish banks would presumably benefit from the credit rating and funding strength of their new parents, allowing them to repay the ECB. This in turn should improve credit flow because of the reduced cost of funds to the banks.

The flaw in this argument is that it will be hard to find buyers for the Irish banks – no matter how well restructured and over-capitalised – if the economy continues to stutter along under an unsustainable debt load.

Which brings us back to the need for the ECB to realise that there is no painless way for it to get its €176 billion back. Once the penny drops in Frankfurt, then the talking will start.