The agency provides a vehicle by which some €50 billion cash may be pumped into the Irish economy, write JOHN KELLYand EUNAN KING

UNDER THE Nama (National Asset Management Agency) arrangement most of the banks will remain as companies quoted on the stock market and therefore, at least ostensibly, run by the dictates of the private sector.

In September 2008, the Government guaranteed the liabilities of the Irish banks for a period of two years. That put a large question mark over the private sector as the model on which these banks operate. There are, however, benefits in these arrangements.

First, the Nama model will enable the ECB to provide a substantial boost to the liquidity of the Irish banking system, and thus the Irish economy.

Once the “bad” loans have been taken off their balance sheets in exchange for Government bonds, banks will have additional high-quality collateral which they can use to obtain funds from the ECB or from interbank repo markets.

A second advantage of the proposed Nama model is that keeping most of the banks as stock market entities enables the ECB to fund part of the Irish Government’s deficit, in a manner that provides the veneer that the central bank is not buying government bonds directly.

This is a practice prohibited under the rules governing the establishment of the ECB, because it amounts to the central bank simply printing money to finance Government spending.

ECB Liquidity Injection to the Irish Banking System

A key attribute of Nama is that it will provide the banks involved with some €50 billion in collateral which can be used to obtain funds from the ECB. This liquidity injection is not a “free lunch” from the ECB, however, since the Nama bonds will be a liability of the Irish Government. When Nama is set up, loans valued in the books of the banks at €77 billion will be bought from them at the discounted price of €54 billion. The advantage to the banks from this transaction is that they will be able to borrow cash from the ECB, using these bonds as collateral.

The Minister for Finance has stated that the Nama bonds will give a return of 0.5 per cent above the ECB rate (currently 1 per cent), so there will be a small profit pick-up for the banks as well as a boost to their liquidity.

The development loans held by the banks at present are not acceptable to the ECB as collateral, so the banks cannot access this liquidity in the absence of the Nama mechanism. The developers who borrowed the money would still owe Nama the full €77 billion, however.

Thus the Nama mechanism will provide a vehicle by which some €50 billion of cash may be pumped into the Irish economy via the increased ability of the banking system to extend credit. Whether this extra liquidity in the banks will have much impact of course depends on the appetite for borrowing by the public. While extra funding is necessary for banks to extend credit, this alone is not sufficient. There must also be demand from the private sector for finance for viable projects. At the end of August, Irish banks were holding surplus cash of €2.4 billion in the ECB’s Deposit Facility, which pays only 0.25 per cent per year. So something more than availability of liquidity may be needed to get the banks lending again.

ECB Funding of the Irish Government Deficit

The Government funds its deficit by issuing or selling bonds – essentially IOUs. Normal banking operations do not usually necessitate exposure to long-term investments such as government bonds and banks are not thus natural holders of bonds, other than those with a fairly short time span before they fall due for repayment.

However, the behaviour of Irish banks with respect to holding government bonds changed late last year. In the Table we can see that up to October 2008, the date of the introduction of the Government guarantee, the holdings of Irish Government bonds by Irish banks were fairly steady at around €500-€600 million.

But by July 2009, their holdings had risen to almost €7.5 billion. The Government in the same period sold more than €26 billion of new bonds, almost half which will not fall due for repayment until 2012-2014. So the Irish banks took up over one-quarter of the new bonds issued in the October to July period. Banks with predominantly foreign business did not participate in these bond purchases, so it is reasonable to assume that the “guaranteed institutions” were the main buyers. So where did the banks get the money to pay for this addition of almost €7 billion to their bond holdings? The answer is that the ECB provided it. Once the banks had purchased the bonds, they could then be used as collateral to acquire funds in regular ECB repurchase operations.

Both Government and banks benefited from this arrangement. For Government, funding costs were reduced. Having domestic buyers for over 25 per cent of total issuance limited the premium which Irish bonds had to yield over similar German bonds, at a time when this spread was rising. Banks, at the same time, obtained assets yielding around 5 per cent, which they funded by borrowing from the ECB at 1 per cent!

Banks’ Holdings of Irish Government Bonds and Bonds Issued

The optics of such operations would appear very different were all the main banks fully Government-owned. Were that the case the ECB would be seen to be overtly buying Government debt (printing money to finance a government deficit). So Nama, the means by which the Irish banks can remain as publicly quoted companies, provides a veneer for what is called “monetary financing of the government deficit”.

In summary, the setting up of Nama will enable the Irish banks to receive a large injection of liquidity which could provide the base for an increased supply of lending. Whether this will materialise depends on the appetite for borrowing by households and the corporate sector. Keeping the banks as quoted entities on the stock market also enables the ECB to fund the Government deficit in a way that keeps a veneer that it is not printing money directly for that purpose.

The Irish taxpayer benefits from the current arrangement because the Government has had effectively an ECB-funded buyer for more than 25 per cent of the bonds issued since October 2008.

Though the current cost of Government borrowing is high, think how much expensive it would have been in the absence of these ECB-funded domestic buyers.

For a fuller discussion see www.KingResearch.ie-Ireland/Financial