Applying same analysis to all Ireland's debt makes no sense

 

OPINION:Morgan Kelly’s article made some valid points but offloading the banks is not realistic

IN IRELAND the government sector is merging with the banking sector as the Government is progressively taking ownership of the banks. The Irish banks have a balance sheet roughly three times the size of national income (€500 billion versus €150 billion) and more than 90 per cent of the assets of the banks are funded with debt. Irish banks have lent domestically roughly €300 billion while the domestic deposit base is only €150 billion. There is therefore a funding gap between the domestic assets and the domestic deposits of the banks that needs to be funded from off-shore.

Since 2008, but especially after the summer last year, off-shore investors have increasingly refused to roll over maturing deposits and bond issues and thus the banks are now very dependent on the lenders of last resort – the European Central Bank (ECB) and the Irish Central Bank – to fund this gap.

Although the dividing line between the Government and the banks is becoming more and more vague, it makes no sense to add the debt of the banks to the debt of the Government and apply macroeconomic Government debt analysis to the sum of the two. Funding the assets of the banks and funding the recapitalisation of the banks, on the one hand, are fundamentally different from funding a Government deficit and funding a loss once the capital buffer has been wiped out, on the other. Against the former there is income generated by assets. Against the latter there is no income and thus the cost of funding the debt is a burden on society that will need to be paid from taxes.

In order for Ireland’s funding environment to be restored, confidence in the Government finances and the banking sector needs to return. The latter is a much bigger problem than the former.

It is internationally recognised that the Irish Government is well on its way to putting their finances, excluding the banks, on a firm footing. The main issue here is to make the necessary adjustments without killing the economy. Time is therefore needed and I do not think that even the most hard-nosed IMF official would support the cold-turkey treatment Morgan Kelly is advocating.

Back to the main problem facing Ireland: the banks. The Government is holding the baby and wishful thinking in the category of could have, would have, should have, is not productive at this point.

It is always easier to judge with the benefit of hindsight. It is difficult, if not impossible, to see how the Government could get rid of the sticky plaster which is the banking sector. Who will take the banks off the hands of the Government? The ECB? I don’t think so.

Confidence in the banking sector can only return when the banks have cleaned up the asset side of their balance sheets, have access to long-term funding and are recapitalised. The latter has recently been addressed by the CBI and it is a great step forward.

However, this leaves the deleveraging and the funding to be sorted. These two issues are of course interdependent. The more assets that can be sold in an orderly fashion quickly, the less funding needed. The ECB and Central Bank can do their bit in providing short-term liquidity support, but these liquidity facilities were never meant to cover bank losses that should really be funded long term if there is insufficient capital or cash to cover them.

ECB and Central Bank facilities are also less suitable for funding the recapitalisation of the banks and the term funding needs that exist in order for the deleveraging to be executed over a number of years.

A complicating issue is the fact that the Government has used the banks to fund itself with the ECB and Central Bank. The Government has recapitalised some of the banks not by injecting cash, but by giving them a State-backed asset on the balance sheet of the bank. With this, the bank can go and raise cash.

A comparable process has taken place in the context of the Nama transfers. The consideration for the loans transferred has not been cash, but bonds issued by Nama with a Government guarantee. As market funding disappeared, the banks increasingly used repos with the ECB-Central Bank to meet payment obligations. As a result the balance sheets of the banks have not delevered, which would normally be the result of losses incurred or assets sold by the banks.

Last year the ECB supported Greece and other peripheral countries because there was no mechanism within the euro zone to support governments when access to capital markets dried up. In other words there was no lender of last resort for governments.

So, the European Financial Stability Facility (EFSF) was created which means that there is now a window for governments other than the route via the banks to the ECB (it is interesting to note that the ECB is forbidden according to its statutes to lend to governments directly). The EFSF is there for the coming three years but can provide long-term financing.

At the start of this article, the point was made that one needs to look at the debt that covers the deficit and the losses incurred by the banks differently from the debt that funds the balance sheet of the banks. In order for the former debt to be able to be serviced over time the coupons and maturities of the debt need to be comparable to the size of the debt.

If the burden turns out to be too much for Ireland to bear, then aid from Europe needs to be forthcoming. There is no need to be melodramatic about this. It will be part of the political process.

The Government is of course concerned about the debt it will need to assume in its own name to solve the banking crisis. If Ireland were to accept term financing from the EFSF to repurchase the promissory notes and the Nama bonds, this funding would not necessarily have to be significantly more expensive than the funding from the ECB and Central Bank. The advantage would be that the financial sector could be delevered and the ECB and CBI relieved from part of their burden. If the Government were to borrow €60 billion in term funding from the EFSF and collapse the promissory note and the Nama bonds, the balance sheet of the banks could be delevered by the same amount and the recourse to the ECB and the Central Bank reduced commensurately. That would be a real step forward.

The bad assets of the banks need to be moved to an asset-recovery vehicle and this vehicle needs to have its balance sheet funded appropriately. In order for lending to the private sector to resume, the good banks need to be delevered, recapitalised and their funding put on a firm footing.

The question is how much the running costs for Ireland would go up, from the short-term rate with the central banks to the cost of borrowing long term from the EFSF. As the EFSF borrows at approximately Euribor flat equivalent for term funding, with a modest mark-up, the cost need not be punitive.

The promissory notes are part of Government debt already and the market routinely adds the Nama bonds thereto. Therefore, to the extent the Government borrows to repurchase these liabilities, it does not materially leverage itself further. Borrowing from the EFSF to recapitalise the banks or fund the asset-recovery vehicle will increase the Government debt, but the cost of this borrowing will be offset by the income on the assets funded and the return on equity injected into the good banks. This portion of Government debt thus needs to be analysed differently. Against most of the term funding necessary for the banks there will be offsetting income. Only against the funding of losses at the banks and the funding of the Government deficit there is no off-setting income. This funding will therefore need to be for the longest possible term. The need for funding at the banks may be very large, but against most of the funding needed there is offsetting income.

The asset-recovery vehicle/s should focus on selling the overhang of assets in an orderly manner. One needs to look at the income the assets are producing, the funding cost that has to be borne and the market outlook to absorb the sale of assets. The higher the funding costs, the more the pressure to sell and the more losses that will be incurred in the disposal process.