Stop bailing out bad banks and build a good one

OPINION: Why take the toxic debts away from the banks? Why not nationalise the good bits of the banks and leave the banks with…

OPINION:Why take the toxic debts away from the banks? Why not nationalise the good bits of the banks and leave the banks with the toxic mess they created in the first place? asks TERRENCE McDONOUGH.

GUESSING THE contents of Brian Lenihan’s forthcoming emergency budget has become one of the most popular pastimes in Ireland.

One of the most astonishing leaks was that the Minister intends to borrow money to continue contributions to the National Pension Reserve Fund. This is despite that the fund has lost 30 per cent of its value in the past few months and that the bond markets are charging the Government a premium over and above what they charge many other EU governments.

What can possibly be the purpose behind this? Saving money to pay for future pensions might be defended (though in the current crisis I doubt it). Borrowing money now and paying high interest rates for years is indefensible. As the recent €7 billion for the recapitalisation of AIB and Bank of Ireland was taken from the reserve fund, the purpose seems to be to reassure “the markets” by putting money aside for future bank bailouts.

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This is indecision masquerading as prudent planning. It is the worst of both worlds. It incurs costs now in a budget crisis, while doing nothing immediate about the problem of the banks. And something needs to be done now about the banks before it is too late.

Ireland’s financial institutions are essentially insolvent. If they are not right now, they will be in several months’ time. Nobody who counts believes otherwise.

This raises three important questions. When will they go down? Who will take the hit? And what will replace them? The answers to all of these questions are in the grasp of the Government. It must resolve to answer them and sooner rather than later.

When will the banks go down? They need to go down now. Lenihan must stop bailing and blow up the lifeboat.

Government policy to date has consisted of indecisiveness elevated to the level of strategy. The Minister is hoping to muddle through. He is planning to use the National Pension Reserve Fund to extend the banks just enough Government help to keep them going. Aside from nationalising Anglo Irish Bank in a panic, this is what has been happening. This strategy doesn’t help the taxpayer.

Over time the taxpayer buys an increasing share of a basically bankrupt set of enterprises. This strategy doesn’t help stockholders. Their assets have dropped to pennies per stock. This strategy doesn’t help borrowers. The banks remain lumbered with toxic assets and reluctant to lend.

The only group that benefits is the banks’ bondholders, the big lenders of cash to the banks. A “zombie” bank doesn’t have the lifeforce to lend, but has just enough energy to mail interest cheques to its bondholders and to roll over old debt by issuing new bonds. By guaranteeing bonds and keeping the banks barely alive the Government is flirting with a decade of depression.

Who will take the hit? Sadly, the options so far pursued by the Government put the taxpayer in the crosshairs. Other options discussed will only make the problem worse.

Providing the banks with public insurance against losses simply makes the public liable for the losses. It might be countered that the banks will have to pay a fee for this insurance, but it will have to be well below market rates.

These rates would be too low to protect the taxpayer against almost certain loss. So too does the much discussed creation of a “bad bank” which will buy the toxic assets of the rest of the banking system.

There was even talk by some commentators of using the now nationalised Anglo Irish for this purpose – as if it wasn’t bad enough already. Just as the public would receive under the odds for its insurance, the public would have to pay over the odds for the bad assets. This option basically visits the past sins of the bankers on the general public.

Recently some commentators have called for nationalising the banking system, but this would also nationalise their obligations.

All these proposals have one thing in common. They protect bondholders. This is precisely what Ireland cannot afford to do. The by now tiresome joke about Ireland and Iceland and the one letter difference is based on this problem. There are several differences between the Iceland situation and the Ireland situation including Ireland’s position within the euro zone. The one thing the two countries do have in common is that neither has a large enough economy to assume responsibility for the liabilities of its banking sector.

Who should assume responsibility? It should be those who contracted for returns in exchange for assuming risk, the stockholders and the bondholders, and this brings me to my last question.

What should replace the banks? Interestingly, the “bad bank” proposal is based on the principle that the only way to get things moving again is to purge the institutions of bad debt. This principle is correct and such a purge is one of the historic functions of economic downturns. Writing down debt allows individuals, businesses and the economy to start over again.

The “bad bank” proposal seeks to create a “good” private bank by segregating the bad debt in a public financial institution.

But wait a minute. Why not do it the other way around? We need urgently to create a publicly owned and operated "good bank" similar to that proposed by the Financial Timescolumnist and academic Willem Buiter. This institution (or institutions if some competition is deemed advisable) would assume the deposits of the existing banks. These are already guaranteed by the Government in any case.

The Government would then transfer to the new bank enough of the best assets of the banks to cover the deposits. Good assets are those which would have a price set in the markets. Assets whose ultimate worth is uncertain, and hence hard to price, would be left with what are now legacy bad banks.

The legacy bad banks would still be owned by their shareholders and would owe obligations to their bondholders. These groups would then assume the risk they contracted for in the first place. The legacy bad banks could be prohibited from accepting new deposits, but few would choose to deposit money with them in any case.

One really attractive aspect of this proposal is that the existing management could be left to manage the remaining assets. If these guys (and gals) are as clever as their bonuses indicate perhaps they can dig the legacy banks out. But if not, there’s always the bankruptcy court with the owners, lenders and managers squarely in the gun sights where they belong. If the legacy bad banks are bankrupted, the financial system will be in the hands of the Government’s good bank and the public will have dodged the bullet.

It will be argued that the negative fate of the bondholders under this proposal would prevent any Irish institution from obtaining funding in the future. What prevents future lending, however, is not things which happened in the past. Losses are water under the bridge and “the markets” are used to dealing with them.

What prevents future lending is uncertainty. Uncertainty is precisely the consequence of the Minister’s current dithering. After the creation of “good banks”, the new institutions will be purged of toxic assets. They will be backed by an Irish Government which has taken a big step toward solvency by avoiding responsibility for a mountain of bad debts in Irish banking.

The new institutions will be in a much better position to solicit new loans than the current institutions. They could, as well, accept further capitalisation by the Government and with the intent of actually lending the money in the Irish economy. Good public banks can bridge cash flow problems for solvent businesses by resuming lending, preventing unnecessary bankruptcies.

On the other hand, the legacy bad banks can stop pretending to be solvent by pretending their bad loans may still be collectable. Bankrupt business assets can be sold at attractive prices. Bankrupt entrepreneurs can start over cleansed of debt.

Family homes should be protected, but unpayable private debt should be written down in bankruptcy proceedings. Bankrupt individuals may be denied their credit cards, but they can stop paying interest and start buying products and services again. All of this must happen eventually anyway. The sooner, the better.

This is not necessarily a radical proposal. If you are conservative, the new banks can be privatised after a few years, perhaps at a profit for the State. If you’re a social democrat, the new banks can be kept in public hands and run like utilities providing the basic credit infrastructure of the private economy.

If you’re a little more radical, the new banks can become the centre of a popular development strategy to cope with extended bad times. This may well be needed as this downturn is one of the big ones like the Great Depression of the ’30s and the Great Stagflation of the ’70s and early ’80s. This is another reason why the Government’s Mr Micawber strategy, muddling through until something turns up, cannot work. The Government must do something, do something decisive, and do it now.


Terrence McDonough is professor of economics at the National University of Ireland, Galway