ANALYSIS:RENEWED PRESSURE on the shares of Allied Irish Banks and Bank of Ireland has intensified debate on the routes open to the Government to strengthen their financial position and increase the flow of credit to business and consumers, writes Arthur Beesley

While the main mechanisms available to Minister for Finance Brian Lenihan are set out below, the final outcome may well involve a combination of these options. A further possibility is that the current volatility may serve to force consolidation among the banks, an option they resisted in their engagement with the Government late last year.

1. Proceed with recapitalisation:

Mr Lenihan insists the Government will proceed with the recapitalisation plan agreed last month, under which the State would provide €2 billion to each bank in preference shares. The Government avoids taking outright control of the banks in this plan, and receives an 8 per cent annual dividend from the banks on its shares.

However, the banks are obliged to raise an additional €1 billion each from private investors, bringing the scale of the recapitalisation in each to €3 billion.

The Government left open the option that it would provide additional public money for this purpose if private money cannot be found.

The banks hoped to raise the money from their existing shareholders and from international and Irish fund managers, some of them subsidiaries of the banks themselves. However, the nationalisation of Anglo Irish Bank makes that immensely more difficult.

If private investors fail to come forward with money, the Government must decide whether to invest an additional €1 billion in each of the banks by way of ordinary or preference shares. The drawback with preference shares is that a higher dividend burden lessens the availability of credit.

The drawback with ordinary shares is the dilutive impact on current shareholders. NCB Stockbrokers has calculated that a €1 billion equity injection into AIB would give the Government a 38 per cent stake in the bank. A similar injection into Bank of Ireland would give the Government a majority interest, with a stake of 53 per cent. This is an outcome that neither bank nor the Government wants.

The big question over the preference-share recapitalisation mechanism is whether the €3 billion scale of the recap in each bank will suffice to keep the core tier-one capital ratio in each institution at a sufficiently high level as their bad debts increase in the recession. As loan writedowns deplete bank capital, the danger for the Government is that further public money will be required if credit quality does not improve.

2. Seek outside capital:

The Mallabraca private equity consortium remains on the sidelines, having failed to secure an investment deal with Bank of Ireland before the Government made public its recapitalisation plan one month ago.

The question now is whether the consortium rejoins the fray following the weakening of Bank of Ireland’s share price.

Mallabraca is said to have some €5 billion at its disposal. However, in its previous engagement with Bank of Ireland, it sought a return greater than the 8 per cent dividend agreed on the Government preference share recapitalisation. It also sought a clear-out of the bank’s management. Bank of Ireland’s current weakness is such that the consortium might demand outright control of the institution in any further talks.

Looming large in any discussion about a private equity investment are fears of a repeat of the Eircom debacle, where the telco was run to maximise profit for financial investors at the expense of investment in its core business.

Private equity groups may make big promises to the Government to boost the bank’s provision of credit, but their prime responsibility is to meet the demands of their own investors. While any potential private equity investors deserve a hearing, the weakness in the banking system is such that that option might not find favour with the Government.

3. Protect banks from exposure to toxic assets:

The first option is develop a toxic insurance package along the lines of the British plan introduced this week.

This would insure against capital depletion arising from bad debts, by isolating their impact on bank balance sheets and reducing the capital required to be held against the existing loan book.

Another option, creating a “bad bank” to run off toxic loans, is discussed by Proinsias O’Mahony elsewhere on this page.

4. Nationalisation:

Although investors in AIB and Bank of Ireland fear nationalisation following the Government’s abrupt decision last week to take Anglo Irish Bank into public ownership, Mr Lenihan insists he will not go down that road. This is very much seen as the final resort.

However, sustained pressure on the shares of AIB and Bank of Ireland since the change of course with Anglo has led some analysts to claim that the Government now has little choice but to nationalise them too.

The argument here goes that Government is betting against the market in resisting nationalisation. In this scenario, questions about the extent of the decline in credit quality in both institutions dominate the market.

The counter-argument is that turbulent markets should not dictate Government policy to the extent that the overwhelming bulk of the banking system is nationalised, greatly increasing taxpayer exposure to growing risks in the financial sector.

With Ireland’s public finances already under great pressure, the Government sees no merits in taking control of AIB and Bank of Ireland. Like Anglo, each is exposed to the falling property market, but these businesses are greatly more diverse than Anglo, providing a bigger cushion against bad property loans.