Government cannot bank on venture capitalists


OPINION:The State should be extremely careful in allowing venture capitalists take a stake in Irish banks, writes Patrick Honohan

GOVERNMENTS IN a dozen countries on both sides of the Atlantic have by now injected new capital into their country's banks by purchasing shares. They have done so for one or more of three reasons.

First, necessity: because their banks were encountering severe difficulties in raising the necessary funds to stay in business. Second, fear: because a bank with little capital has little to lose by taking risks, such as continuing to finance the biggest of their troubled borrowers despite knowing that repayment of these loans is only a long shot. Third, hope: that with a larger cushion of capital, management will feel sufficiently confident of survival that they will resume lending to smaller borrowers.

Despite their apparent incompatibility, it's possible for the last two reasons (fear and hope) to be justified simultaneously. Top management and the board of directors of a bank may be deciding to go easy on their biggest borrowers even as middle-level officials, in fear of their jobs, become super-cautious in lending to smaller customers.

The Irish Government has so far followed a different route. By guaranteeing all of the banks' liabilities, it has bought some time, ensuring that they can source the necessary cash. But this measure is only a stopgap and does not deal with the perverse lending incentives of undercapitalised banks. This is why reliance on the blanket guarantee has been derided by every foreign banking expert that I have spoken to in the past two months.

The Government has been advised, not only by the Financial Regulator, but by auditors appointed by the regulator, that the Irish banks are compliant with minimum capital requirements both now and prospectively.

That may be technically true, but as such it merely reflects known weaknesses in the new international financial reporting standards.

These standards inhibit accountants from making adequate provision for future loan losses in circumstances of a slow-motion system-wide property-led recession such as Ireland is experiencing. (This peculiar state of affairs reflects the influence that tax authorities had in the formulation of the standards; they feared that companies would try to minimise their tax liabilities by exaggerating future losses.)

The banks themselves have made public forecasts of these likely future losses going well beyond what is provided for in their official accounts. These forecasts imply that they are undercapitalised on any commonsense interpretation of the facts. Thus it is no surprise that investors have been reluctant to buy Irish bank shares, even at prices that imply that their true capital is only about [a fifth] of what the accounts suggest.

So what of the prospective strategic investors? The important thing here is that the venture capitalists and others of which we have been informed are also reluctant to buy shares without further guarantees. Otherwise they would have done so in the open market.

Instead, their strategy involves exploiting the optimism of the Government with regard to the true position of the banks, as well as the fact that, as the Government has already guaranteed everything, it may feel it has nothing more to lose.

But what the investors want is to structure a deal which allows them to benefit most from the existence of the deposit guarantee: they want to appropriate as much of the upside risk as possible, while taking little or nothing of the downside. To be sure, these investors also think they can run the banks better than the current management, and if so, there could be gains for the taxpayer.

I hope that the Government's negotiating position with these groups is not weakened by taking the auditor's assessment of the bank's capital at face value.

The way in which the US authorities seem to have been outwitted when they tried to get Citibank to buy the failing Wachovia Bank in early October is instructive in this regard. At first, it was announced that Wachovias business would be sold to Citibank for just a couple of billion dollars, and with a government guarantee for more than a quarter of a trillion dollars in problem loans.

In fact, the agency concerned had negotiated very badly: within days, another large bank complained that they were prepared to pay seven times as much as Citibank to take over Wachovia and would not be looking for any guarantees.

If the US government can be so badly wrong-footed in secret negotiations on bank recapitalisations, what chance has the Irish Government negotiating behind closed doors with venture capitalists? (Some commentators have suggested that the Citibank deal had the covert intention of strengthening Citibank, whose own weaknesses were already surely known to the US authorities).

Would it not be better for the Government to indicate openly the terms on which it is prepared to offer purchasers guarantees, matching share purchases and other sweeteners? That is what European and US governments have done, even though they have also retained the discretion to make special deals on a case-by-case basis. The investor groups currently in negotiation with the Government would not be so pleased.

But a more transparent process might attract other purchasers and almost certainly lead to a better deal for the Government, and hence the taxpayer.

If the banks are as well-capitalised as we are told they are, it is less clear to me exactly why advocacy of mergers has arisen as a matter of public policy. Most of the mergers that have occurred in other countries during this crisis have, in effect, been a way of dealing with failure: a failing bank's surviving business is folded into a healthy one.

In any other context, increasing bank concentration is likely to be bad for the customer. In particular, there is no reason to believe that the Irish banks are inherently too small to deliver the services they currently offer in a cost-effective manner.

The persistent inability of the banks and the Government to convince the market that they are as healthy as they say does mean that the Government will sooner or later have to strengthen their balance sheet by injecting capital.

It would be well to realise, though, that such injections are a necessary but not sufficient condition for expanded bank lending. As is evident worldwide, one cannot rely on a mechanical multiplier in this regard.

• Patrick Honohan is professor of international financial economics and development in Trinity College, Dublin