The ECB, banks and Nama - everybody wins except the taxpayer
ECONOMICS:ECB is funding a bad bank for bad bankers and developers but will do little for real economy, writes TONY LEDDIN
DATA PUBLISHED by the Central Bank of Ireland reveals that in August 2009, Irish banks purchased €7.2 billion of government bonds, up from €641 million in July 2008. The banks now hold approximately 30 per cent of the total amount of bonds issued by the Government since January 2009.
According to Article 101 of the legislation underlying the establishment of the European System of Central Banks, the European Central Bank (ECB) cannot lend money directly to governments. This form of lending is known as government monetary financing (GMF) and it is outlawed under ECB regulations. The reason for this is that ECB lending to governments increases money supply. This, in turn, could increase inflation. To ensure the ECB achieves its inflation target, money supply must be kept under control and this is why GMF is prohibited.
The way the process works is that the Irish banks borrow from the ECB and then use the money to buy Irish government bonds. The bonds themselves are used as collateral for the loans from the ECB.
Everyone (bar the taxpayer) gains from this transaction. The ECB is creating money (that is, allowing the Irish banks to run up overdrafts) at zero cost and lending to the banks at 1 per cent. Not only is the ECB making a profit, it is also injecting a stimulus into a recessionary economy, a process called quantitative easing.
The banks are paying the ECB 1 per cent for money and then using it to buy Government bonds which currently offer a yield of 4.8 per cent. The banks are making almost 4 per cent profit on the transaction for doing, literally, nothing.
For its part, the Government here is happy to finance nearly 30 per cent of its budget deficit without having to go to the financial markets, where the cost of borrowing could be well in excess of 4.8 per cent.
This process raises a number of issues, such as why the banks should earn 4 per cent on the difference between its borrowing and its purchase of government bonds, especially as the gain to the bank is a direct cost to the taxpayer. This type of operation may be deemed consistent with the law governing the European System of Central Banks but it contravenes the spirit of the legislation, which seeks to prevent the ECB lending to government.
How does this process relate to the Nama proposal to purchase toxic loans from the banks? The answer is that the process is almost identical. The difference relates to the interest payments. The Government issues Nama bonds to the banks in return for €51 billion in toxic loans. The yield to the banks on these Nama bonds is currently 1.5 per cent, significantly less than the 4.8 per cent on “normal” government bonds.
The banks use the Nama bonds as collateral to obtain a loan from the ECB. The cost of this loan remains at 1 per cent. The banks are now only making a profit of 0.5 per cent on the transaction compared to almost 4 per cent in the normal run of things.
Currently, 40 per cent of the Nama toxic loans are operational and paying interest. If the proportion of operational loans falls to 33 per cent or less, the loans will not generate enough income to pay the interest on the Nama bonds. This, of course, does not take into account the potentially enormous capital losses that could be incurred on Nama’s toxic loan portfolio.
At the end of August 2009, the ECB issued an “opinion” on the proposed Nama legislation. The ECB stated: “It is understood that the draft law will comply fully with the prohibition of monetary financing.”
But will it? A is not allowed lend to C so, instead, A lends to B who then lends to C. Remove the veil and it could be said that the ECB is flouting its own rules to finance the Nama process. This, of course, puts the ECB in the driving seat in deciding which is the best option to deal with the Irish banking crisis. Without ECB funding and its blessing, the Nama proposal would be impossible.
The ECB has made it abundantly clear, for example, that nationalisation of the banks is an inferior option. It refers in its “opinion” to “the guiding principle that the preservation of private ownership is preferable to nationalisation” and mentions the “risk of banks’ objectives being diverted from profit maximisation to alternative goals”.
Equally, the option taken by the US and Britain to inject fresh capital into the banks, combined with deposit guarantees, is not possible as the Government here is running a sizable budget deficit and has no recourse to borrowing from the Central Bank of Ireland. Hence, the ECB-backed Nama plan is effectively the only feasible option.
In contrast to the recent dramatic rise in bank purchases of government bonds, bank lending to the private sector fell by 3 per cent in the year to August 2009. This reflects the lack of demand for credit for investment purposes. This, in turn, is due to the high real interest rates facing private sector borrowers from the banks and the impact of deflation on business confidence.
Real interest rates are high because the price level fell by 6 per cent in the year to August 2009. Given a nominal interest rate charged to small and medium enterprises of at least 4.5 per cent, few business plans can persuade the banks to lend.
Nama has been set up to get “cash-strapped banks lending again”, but excess cash deposits held by the domestic banks and the fall in lending indicate that this is not the only problem. There is a fundamental lack of demand for credit at prevailing lending rates and this is an issue Nama does nothing to resolve. The old dictum that, in a recession, monetary policy is as effective as “playing snooker with a rope”, remains pertinently true.
Overall, it could be said that ECB is circumnavigating its own rules to fund a bad bank that bails out recidivist and delinquent bankers and developers at potentially enormous expense to the taxpayer, but will do little to stimulate what is left of the real economy.
Dr Anthony Leddin is head of the department of economics at the University of Limerick.