By spending wisely, the Government can punish bad management and fix the banking crisis, writes KARL WHELAN.

REPORTS INDICATE that the Government is hoping to implement an “integrated” approach to our economic problems in the coming weeks, dealing with both the budgetary and banking crises.

The various options open to the Government for dealing with its fiscal problems are being widely discussed and, at this stage, the public is reasonably well-informed about the issues.

The debate about our banking problems, however, has not been nearly as adequate. In particular, there has been very little critical discussion of the widely-leaked proposals for fixing our banking system that economist Peter Bacon has delivered in a report to the Government. This is unfortunate because these proposals appear to involve an unacceptably high cost to the Irish taxpayer and would reward the current shareholders and management of the banks for the poor jobs they have done in monitoring and managing our major banks.

Let’s start with some figures. The current balance sheets of AIB and Bank of Ireland show that they have equity capital of about €17 billion, meaning their assets are valued at that amount more than their liabilities. However, the two banks have combined property-sector loans of about €80 billion and will be forced to take considerable writedowns on these loans in the near future.

In a recent report, Goodbody Stockbrokers (a subsidiary of AIB) estimated that the two leading banks may have combined loan losses of almost €19 billion, which would leave them insolvent, meaning their assets would not cover their liabilities. Since their combined property and construction portfolios include about €42 billion in loans to developers and builders, which could prove to be almost worthless, these loss estimates could be conservative.

Now let’s suppose that these two banks will need to remain at their current book-value level of equity capital – €17 billion – to satisfy regulatory requirements and keep future bond purchasers willing to lend to them. How can that this goal achieved?

As reported, the approach recommended by Bacon is as follows. The Government agrees to pay more for the portfolio of troubled loans that it is currently worth.

If the Goodbody calculations are correct and the true net equity position of the two major banks is minus €2 billion, this plan could see the Government purchasing these loans for €12 billion more than they are worth, to bring the equity capital of the banks back up to €10 billion. It could then use its pre-announced €7 billion re-capitalisation to take a stake in the banks and get the equity capital back to the desired level of €17 billion. Here I’m assuming that the Bacon plan is a supplement to the existing re-capitalisation proposals, rather than a substitute for it.

Having purchased these bad property loans, the Government could then set up an asset-management company to sell off the property loan portfolio that it has over-paid for, in the hope that a well-managed sell-off would minimise losses. This is the “bad bank” or “toxic bank” regularly mentioned in the media.

However, at current prices, the Government would be making a loss of €12 billion if the Goodbody calculations are correct and potentially far more if, as is likely, those figures are underestimates.

As an alternative, I propose the following four-point plan.

1. Nationalise: Admit that the banks are insolvent and nationalise them. Currently, the total value of shares in the two banks is below €1 billion. To make the process work smoothly and ensure no further losses for the beleaguered shareholders, I would recommend that the Government purchase all private shares for their closing value on the stock market the day before the plan is announced.

2. Reorganise: Use taxpayer money to buy the bad assets from the nationalised banks at their fair value as estimated by a team of property experts. Then set up a State asset management company to sell these assets over time to attempt to recoup as much as possible. This step gets the bad assets off the bank balance sheets but would still leave the banks with negative equity capital.

3. Recapitalise: The Government then recapitalises the banks by using taxpayer funds to invest in the newly-cleansed banks, getting them back to an equity capital level of €17 billion. If the Goodbody figures are correct, this will require a total outlay of €19 billion, but most likely more will be required.

4. Privatise: The first three steps will have created two banks with €17 billion in equity capital, no toxic loans to property developers, strong retail bases and a Government guarantee on liabilities through September 2010. They will be an attractive potential investment for private investors and they could be sold off using a competitive tender process. This process would recoup the €17 billion in equity capital.

Despite widespread concerns about political involvement in nationalised banks, international experience shows that this kind of nationalisation, cleaning up and re-privatisation can be achieved quickly and efficiently.

Let’s compare the two plans.

The Bacon-style plan would have a net cost to the Government of €12 billion if the Goodbody estimates are correct, but most likely it would cost more. It would result in a large direct transfer from taxpayers to the current bank shareholders (the value of these shares would jump well above their current levels if the Government removed the toxic assets by overpaying for them). Most likely, it would involve current management staying in place. Finally, since this plan would be supplemented by the €7 billion preference share investment, it would keep the Government involved in the management of the banks for a number of years.

My four-point plan would cost the taxpayer far less than the Bacon plan. It would have a net cost to the government of €3 billion if the Goodbody estimates are correct (€2 billion to make up the negative equity and €1 billion to pay off the current shareholders). If the loan losses are larger, the cost would turn out to be higher but so would the final cost of the Bacon plan, so the difference relative to the Bacon approach would remain at €9 billion. Beyond the direct cost to the taxpayer, my plan would see the banks end up with new ownership and, almost certainly, with new management. And it would most likely see a faster end to State involvement with our leading banks.

Both plans involve a State asset-management company, so the relevant issue here is not whether a “bad bank” is introduced, but how.

Over and above the madness of massively overpaying for bad assets at a time of fiscal crisis, the Bacon plan is patently unfair in rewarding the bankers that helped to bring the country to the brink of economic disaster. There is a better way of solving our banking crisis and it is not too late to implement it.

Karl Whelan is professor of economics at University College Dublin. Previously, he worked as an economist at the Central Bank of Ireland and the Federal Reserve Board.