ANALYSIS:While the State has yet to define a price for its €400 billion guarantee, clearly it must vary, writes Simon Carswell

INSURERS WOULD never agree to protect a car without setting a charge for the cover.

Yet the Government has not decided how it will charge six Irish-owned banks and building societies for taking on a potential exposure of €400 billion by covering their deposits and debts for two years.

There is no doubt that the Government's two-year guarantee - the most radical protection scheme since the Scandinavian bank rescues of the early 1990s - has been a shot in the arm for the banking system. With the backing of the State, the Irish banks can borrow more freely and cheaply.

Lenders such as Anglo Irish Bank, Irish Nationwide Building Society and EBS, which were previously regarded as weaker than the country's two biggest banks, AIB and Bank of Ireland, have had their credit ratings upgraded to match them. This gives them much-needed borrowing clout at a time when cash is scarce and depositors seek out the safest havens for their money.

The four Irish banks have also enjoyed substantial falls in the cost of insuring investors from the possible defaults on their debt - which is regarded as a proxy measure of how easy it is for banks to raise money from investors and other banks.

Yet, despite the initial positive effects of the guarantee, the benefits will not be immediately felt in the wholesale markets where the four public Irish banks raise one-third of their money - as these markets have been shut since the collapse of US investment bank Lehman Brothers last month.

"We are not getting access to funding yet," said one Irish banker who tracks the wholesale markets. "The money has not flowed in. The guarantee is a help but it's not like a switch being flicked."

Uncertainty still remains over what the guarantee entails and how it will work.

"Just what exactly is being guaranteed here?" asked one senior bank executive, "and how will the scheme work? Will it involve bilateral agreements with each bank or will it be a blanket guarantee?"

The charge appears to be the main point of confusion. The Government has said the guarantee was "being provided at a charge to the institutions concerned and will be subject to specific terms and conditions so that the taxpayers' interest can be protected".

This could help the Government argue the point in Europe that the measure is not anti-competitive or does not raise State aid issues because it is charging the banks for the guarantee.

The Government has said it would agree on the charge in consultation with the Central Bank.

"My understanding is that it is still fluid and open to influence," said one senior financial executive.

Government sources said the legislation grounding the guarantee enables the Minister for Finance to set a higher charge for institutions which have been engaged in higher-risk lending.

For example, banks and building societies which have a greater loan exposure to struggling builders and developers will have to pay a higher charge if they used these assets as collateral to borrow under the scheme. This will help deflect criticism of the "moral hazard" argument where the Government could be blamed for supporting banks that have taken higher lending risks.

One bank executive suggested that the guaranteed lenders could receive funding through the sale of Government bonds. Banks could pay the difference between the rate on the bond prior to the announcement of the guarantee and the rate to which State debt has risen since the scheme was revealed, covering the higher risk.

Banking sources speculated that the State could introduce another bank levy, with each guaranteed lender paying a proportionate share, depending on the risk weighting of their business.

One executive at a guaranteed institution said the scheme should not be "a crude one-size fits all" for the covered lenders, but should be "commensurate with their risk profile" and their current standing with the Irish Financial Services Regulatory Authority.

This could mean that lenders such as Anglo Irish Bank and Irish Nationwide Building Society, which have a higher exposure to the property development sector, will be charged more for using the guarantee to raise short-term funding in the money markets.

When those markets eventually reopen again, which is likely if the US passes the $700 billion (€485 billion) bank bailout plan, the lenders will be keen to flaunt their new guarantee of a top triple-A-rated Government to sell packages of loans to investors to raise much-needed funding.

Banks trying to sell loans with high loan-to-value (LTV) ratios could be charged more by the Government for using the State-covered insurance policy because the loans would be regarded as higher risk.

The Government is likely to be lobbied intensively by opposition parties to ensure that the State is well-insulated from a greater exposure to higher-risk lenders.

Institutions with lower-risk loans will press for the charge to be weighted at a higher level for perceived "problem cases" and at a lower level for lenders regarded as less risky.

Executives at two home loan providers, which are perceived as less risky than the heavy lenders to property developers, stressed that the Government needed to recognise the difference between the two. "Relating it crudely to total liabilities or assets would be unfair," said one executive.

He said that a €1 million home loan with an LTV of 75 per cent was very different from a €1 million loan on a development site with a LTV of 90 per cent, and both should priced appropriately.

The risks associated with the guaranteed lenders varies widely.

Some 11 per cent of EBS's loan book is commercial lending and the building society has a development finance book of about €500 million, representing less than 3 per cent of the total loan book.

Irish Life & Permanent does not lend to builders or developers.

Some 80 per cent of the loan books of Anglo Irish Bank and Irish Nationwide are secured primarily on commercial property assets in Ireland and the UK that are declining in value.

Analysts estimate that bad debts at the four guaranteed banks will top between €8 billion and €10 billion this year and over the next two years - with AIB, Bank of Ireland and Anglo Irish Bank accounting for most of the debt.

Loan losses will be driven higher by falling property values.

Bank of Ireland said last month that the bad debt charge in its fiscal year to March 2010 could be as high as €1.3 billion, five times the level recorded this year, with property investment and development accounting for almost half of this, as it expects property values to fall by up to 40 per cent.

The four banks have set aside about €28 billion in capital to cover losses. While the guarantee doesn't cover loans provided to customers or bank capital, the Government will be encouraged to ensure that the scheme does not allow financial institutions to include high-risk loans.

However, the guarantee ultimately covers these loans. By underpinning the Irish-owned banks and building societies, the Government has essentially indicated that it will not let any of these institutions fail. Therefore, it may be called upon to cover more than it had intended to, particularly if the recession is far more severe than anticipated.