The guarantee to banks, which was not the only way to deal with the financial crisis, means the Financial Regulator's negotiating position with those banks is weaker, writes Patrick Honohan
OVER THE past 10 days an astonishing array of different solutions has been adopted by governments to fix problems at major banks in Europe and the US. In terms of the degree to which bank shareholders and other insiders were treated, they vary from the tough, through the measured, to the rather lenient. In terms of protection for the taxpayer, there is a similar variation.
Of the spectrum of policies adopted, the Government's blanket guarantee is exceptionally generous to the bankers and exposes the taxpayer to considerable potential costs.
At the tough end of the spectrum was the US action on Thursday of last week to close Washington Mutual, a sizable bank with branches in 15 states. The insured depositors (covered for up to about €70,000) were unaffected: their deposits and the branches were seamlessly transferred to the ownership of another bank. The cost to the public was nil. But shareholders were wiped out and other creditors are unlikely to recover much of what they loaned in the liquidation.
Then - on Bank Rescue Monday - the US government stepped in to force Wachovia to sell its main banking business to Citibank. Wachovia's shareholders were not helped here either, with the shares losing most of their value.
The US government (again through its deposit insurance corporation) did not have to inject any cash this time either, and does not expect to incur any net costs, though it has sold a backstop guarantee to Citibank to cover any losses that Citi might incur on the loans that they have acquired beyond a threshold of about €30 billion.
The same day, Fortis, a sizable Benelux institution, was rescued, but in a different way: the governments of its three home countries injected a total of €11 billion in equity, and took 49 per cent ownership of the firm. This strengthens the capacity of the bank to withstand further losses, thereby securing the position of depositors.
Shareholders came out broadly neutral: the risk of bankruptcy was removed, but they have to share any recovery with the governments. The chief executive and chairman have resigned.
Other banks were rescued last week using one or other of these three approaches. Each of them faces up to fact that the banks concerned had little or no real equity capital cushion against further losses, hence their difficulties in attracting loanable funds.
The controversial US asset purchase scheme, which was approved by Congress last night, is a bit more ambivalent. It will entail the US government paying a range of banks more than today's market price for a €500 billion block of mortgage-related assets.
By replacing a dubious and hard-to-value asset with cash or its equivalent, it will strengthen the capital base of the banks, and benefit the shareholders, who will, however, continue to operate subject to the discipline of the market, convincing their funders that they are being well run.
The eventual net cost to the US government will depend on what they pay up front, and on how easy it is to make recoveries: unfortunately for the taxpayer, the banks will surely present for sale the very worst qualifying assets in their portfolios, so the cost could be sizable.
Then we come to the Irish case. Here there has been no intervention in the affairs of any of the banks, no attempt to transfer control of under-performing banks or to strengthen their capital base.
Instead, a blanket guarantee - covering even subordinated debt-holders, who had already been earning a premium for the explicit risks they were taking - was introduced.
Though reassuring to depositors, this guarantee, likely to cover about the same total amount as the US purchase scheme, should worry taxpayers, given the evidence from other countries, where the introduction of blanket guarantees was followed by heavier ultimate costs to government.
Any of the Irish banks that are now undercapitalised will no longer struggle to raise funds from sceptical lenders, but will be able to relax, and even take chances with high-risk, high-yield ventures, given that all the downside risk lies with the Government.
The Irish scheme is not unique: around the world about one in three banking crises of the last 50 years have ended with a blanket deposit guarantee, typically when depositor panic had reached otherwise unstoppable levels. These guarantees lasted for an average of almost five years (compared with the two years announced for the Irish scheme).
Their cost to the governments concerned was particularly high when accompanied by regulatory tolerance of under-capitalisation.
The message for the Irish Financial Regulator is clear.
Since the guarantee removes market discipline, that discipline must be replaced by intensified official supervision and prompt corrective action for banks thought by the regulator to be undercapitalised.
Unfortunately, the regulator's negotiating position has been greatly weakened by the introduction of the guarantee, and we can be sure that shareholders and controlling management will strongly resist compulsory recapitalisation.
There is also the somewhat worrying fact that official statements continue to deny any possibility of under-capitalisation of any Irish bank, despite widespread market concern. True, the regulatory authorities do have access to somewhat more information than most of the market, but are they processing that information through rose-tinted spectacles of denial?
The Government has suggested that it will recover any costs of this guarantee from the banks. Since we currently know neither the cost of the scheme nor the charge to be imposed on the banks, the plausibility of this claim remains to be verified.
However, a uniform levy on deposits is just a tax, likely falling for the most part on the banks' customers. But the value of the guarantee to shareholders and controlling management, and its likely cost, differs from bank to bank, depending on the risks facing each of them and their true degree of current capitalisation.
It remains to be seen to what extent a serious effort will be made to align payments with risk. After all, the key question is: how much equity capital is truly left in a bank? If there is little or no equity left, a bank will effectively be paying the insurance premium out of the Government-guaranteed deposit funds. This will increase the temptation for those controlling such a bank to "gamble for resurrection".
Patrick Honohan is professor of international financial economics at the Institute for International Studies at Trinity College, Dublin. From 1987-90 and from 1998-2007 he was a senior adviser in financial sector policy and lead economist in the development research group at the World Bank in Washington DC